FEDERAL INCOME TAX

Class NotesSeptember 2, 2003

Bring that Blue Book to Class!!!!

Immediately exercisable stock option Perpetual Easement Reversion in Fee

§1: Tax on Taxable Income (TI)§63: TI= Gross Income minus Deductions (GI)§61: Gross Income

Problem:Person on the beach finds a precious gold coin worth $10,000. Is that Gross Income?

§61 Except as otherwise provided in this subtitle, gross income means all income from whatever source derived, including (but not limited to) the following items. http://www.fourmilab.ch/ustax/www/t26-A-1-B-I-61.html

Go to the common law: The Supreme Court does not decide very many tax cases. Syllabus problem IIA1a:

o What is a stock option: The right to purchase stock for a specific price within a certain time period. It’s an option, not a duty. It can be a discounted price for something of a higher value.

LoBue see page 7 of the Syllabus.o Why would he want to get to year 3 before paying tax?

He may not have to pay tax at all at that point. Why? Because he can then control when he’ll pay tax, or whether he’ll pay tax (by dying. If he dies he doesn’t have to pay tax, and neither do his relatives §1014).

Year 1 Year 2 Year 30 0 150 10 5

The second line is the decision in LoBue. Despite the fact that he’d get hit for 15 in either scenario, why would he prefer to be hit in year 3? Because he could be in a lower bracket by year 3 (he could be retired, or he could have different deductions). All things being equal, why would he rather pay tax all at once in year 3? Because of the time-value of money. The longer you have money, the more it can work for you. (See the section on Deferrals). It’s the equivalent of an interest free loan by the government to you. The $2 in tax that he would pay in year 2 could earn interest for him ($.10) which he would still have to pay taxes on ($.2) but he would still have $0.08 more that the government does not get.

The Supreme Court said that he had to pay tax in Year 2. http://web2.westlaw.com/Find/default.wl?findcite=351+U.S+243&RS=WLW2.89&VR=2.0&SV=Split&FN=_top&MT=LawSchool&RP=%2FWelcome%2FLawSchool%2Fdefault.wl

1. C.I.R. v. Lo Bue,

1

351 U.S. 243, 76 S.Ct. 800, 100 L.Ed. 1142, 56-2 USTC P 9607, 49 A.F.T.R. 832 , U.S., May 28, 1956

What was the argument? The employer was giving him a stock option as a proprietary interest in order to give him an

incentive for future services, and not for compensation for past services.o The Supreme Court rejected that argument (page 8 of syllabus)

This is definitely not a gift…. This is gain.

**803 [2] We have repeatedly held that in defining 'gross income' as broadly as it did in s 22(a) Congress intended to 'tax all gains except those specifically exempted.' See, e.g., Commissioner of Internal Revenue v. Glenshaw Glass Co., 348 U.S. 426, 429--430, 75 S.Ct. 473, 476, 99 L.Ed. 483.

Read §1001; Definition of Gain.Computation of gain or loss The gain from the sale or other disposition of property shall be the excess of the amount realized therefrom over the adjusted basis provided in section 1011 for determining gain, and the loss shall be the excess of the adjusted basis provided in such section for determining loss over the amount realized.

(b) Amount realized The amount realized from the sale or other disposition of property shall be the sum of any money received plus the fair market value of the property (other than money) received. In determining the amount realized - (1) there shall not be taken into account any amount received as reimbursement for real property taxes which are treated under section 164(d) as imposed on the purchaser, and (2) there shall be taken into account amounts representing real property taxes which are treated under section 164(d) as imposed on the taxpayer if such taxes are to be paid by the purchaser

What if LoBue had asked “Where’s my gain”? This doesn’t work because the tax formula is not value received v. value given; the tax formula is value received v. what you paid for it.

(I missed Thursday’s class)

2

September 9, 2003

Income is All Gain except what is specifically excluded BUT 1. the cash bargain purchase 2. unascertainable valuation is also not included although not specifically excluded3. Imputed Income4. Intra family exchange of services

Fringe Benefits:See §119

Why don’t they take 119 off the books? Maybe because of the Valuation Problem.

(§ 119 excludes meals and lodging with employer but an exclusion spawns a myriad of questions, such as what are meals, what is lodging, etc)

If §119 doesn’t apply, what does…. §61§119 is considered as an excludable fringe benefit.

RECEIVED: Tax Guide 2002 (publication 17). When in favor of the taxpayer, Congress could say that the publication incorrectly construes the statute.

- It can be very useful- It includes a laundry list of fringe benefits

§132

§61(a) General definition: Except as otherwise provided in this subtitle, gross income means all income from whatever source derived, including (but not limited to) the following items:

(1) Compensation for services, including fees, commissions, fringe benefits, and similar items;

Page 68: Amount Realized (over) Basis. The Fair Market Value of the house-painting. Could the lawyer say this was like the meteorite? No. Let’s say that the lawyer has $900 of income. Basis is $0, so it’s $900 capital gain.This is the same as if the lawyer had worked for a 3d party, got paid in cash, and then paid the painter to paint the house. (I have no idea what’s going on, and it’s scary).

What if the Lawyer Paints his own house. Same service and everything. Does the house painter have income?

What does the painter get? A painted house. Right on the tax equation (LoBue) Wrong on the law. There is no specific section that deals with this, but everyone knows that it’s not income.The words IMPUTED Income really means no income. It is a But… and a very important one.

IMPUTED INCOME Why is it that if the lawyer paints his own house and the painter does his own legal work, there is no

income?o This rule ends up discriminating against people who can’t paint their own house or do their own

legal work. The valuation problem is the reason why this happens. Where would you draw the line… If you shaved

your legs, should you be taxed? (He also keeps throwing around the idea of Cash Bargain Purchase). Therefore no one gets taxed on their imputed income. (Another Big But [#3]).

The biggest effect of not paying imputed income is the money that is lost by not collecting tax on house-care. Cooking, cleaning, child care.

3

When a husband makes dinner, is that imputed income or 7924? With 7924 it’s difficult to determine the parameters.

Suppose that a going commission for a real estate broker is 6%. Seller has property which is sold for $100. Broker charges $6. Therefore, the seller only gets $94. The cases say that the real estate salesman has to include the commission.

Property rule of imputed income is also important. (see 68)o Situation2: An individual who owned an apartment building received a work of art created by a

professional artist in return for the rent-free use of an apartment for six months by the artist. The work of art ends up being payment as rent. That’s why it’s included as income.

Hypo: Receive $500 in work of art, transferred $500 stock (which I paid $250 for). Renting 6 months is conceptually indistinguishable from selling a part of the property Imputed income works the same for property

September 16, 2003

Make-up Class September 26th

§132 (a)3 Working condition fringe; defined under 4d. (page 127)The employee does not have income by the employer reimbursing for business travel. Allowable as a deduction under section 162 or 167. Example: Salary=100; Business Trip=$20; $80 Taxable income of $80. But if the employer reimburses, then the employee has a taxable income of $100, not of $120 (which is what would happen if he had to claim the $20 as a benefit).

Concept of a Wash. Our prof doesn’t claim the textbook, because if he had bought the book, he would have been able to claim it as a deduction. It avoids the problem of the double tax. (Infra. §108)

Commissioner v. Glenshaw Glass Co.348 U.S. 426 (1955) (Text 69)

Cited by LoBue Punitive Damages are taxable. “All gains except those specifically exempted.” Another frequently used quote: “[U]ndeniable accessions to wealth,

clearly realized, and over which the taxpayers have complete dominion.”

Hypothetical:X helps Y prepare a will. Y offers to take X to dinner. Would X have to include the value of the dinner, or is it a gift? See Duberstein. It must be detached and disinterested generosity.

“Cadillac Gift?”

Commissioner v. Duberstein363 U.S. 278 (1960), Text at 74

Dominant motive of detached and disinterested generosity. If it’s 51% detached, it’s 100% excludable. Facts: Cadillac was given by a business as a means of thanking a

colleague. Gift? No.

§102(b)(2) as a gift, bequest, devise, or inheritance.Don’t say in your will: “for my good and faithful servant”…. sounds like it would raise the flag for §102(b)(2). Doesn’t sound as though the dominant motive of detached and disinterested generosity.

4

Remember, if it falls under §102c, Duberstein doesn’t apply. If 102a doesn’t apply §61; gain is gain.

Suppose X gives $10,000 to his child, and the child takes the money and puts it in the bank and earns interest. Would the interest be excluded? Isn’t the interest also a gift? No. §102(b)1: Income from gift property is not excluded as taxable income.

A life tenant on a property gets hit with all the income, and the remainder-person is not taxed on that even though there is technically gain.

Stock Taft v. Bowers278 U.S. 470 (1929); Text at 95

A purchased 100 shares of stock for $1000 which became $2000 fair market value. B bought for $5000. How much should be considered as income for B?

§1015 had already been passed, and it basically said that you carry over whatever the seller’s basis was.

Constitutional question; Sixteenth Amendment. Argument is that this is a direct tax.

Supreme Court says no. Income can be taxed regardless of the provisions relating to the direct taxes. The Sixteenth Amendment was enacted to give the power to levy taxes.

We don’t tax income, we tax the gain of a particular taxpayer. The LoBue argument would be that B should be paying $5000!

But, the exclusion in Duberstein and in 102a. §1015 says you assume the basis of the donor; B steps into A’s

shoes. but §102 excludes the basis of the donor.

§102 recognizes intra family gifts and so if you give your kid $1,000 he does not have taxable income. You still pay taxes on your full salary.

Congress is saying you can shift gain to lower income brackets, but you can’t shift losses to higher income brackets. Wow, I don’t understand this.

Policies: Congress allows you to shift gain, but not loss. Is there any gain? No. He bought it for $2000 and it went down to $1900. So there’s no gain. To figure the loss you step into the shoes of A and because the price was $1900 there was no loss. Two basis. (See Supplement page 2)

Read up to D2

September 18, 2003

Review of §1014 and the problems in the syllabus.The justification for 1014 and the problem… this is to avoid double taxation. It’s a fairly weak justification though. The Canadian approach is to treat the property as if the donor had sold it at fair market value.1014(b)9

Page 2 in the syllabus

Page 1013.) During the next

a. Give it to Ana and let her sell it. 1015.

5

b. He should sell it himself and take the loss.c. Basis in cash is always its face value. (You’ll never have a gain because it has the highest

basis). Give her the money from the savings account, b/c then there’s no gain to declare. That way no one would have to pay the tax on the gain. If he really wants to get rid of the stock, advise him to give it to Ana and let her sell it.

d. Unless there are non-tax considerations, sell the $120k stock and take the loss.e. If she waits until he dies, she could take the 80k after a basis step-up; no tax on the appreciation.

But, it’s a gamble. The stock might be depreciated by the time of death.

§1012; the general rule. The basis shall be the cost except as otherwise provided (1014; 1015)

Basis must be the fair market value of the property received not given. Don’t ignore the gain on the exchange.

Philadelphia Park (Supplement page 27)Reason: “To maintain harmony with the fundamental purpose of these sections, it is necessary to consider the fair market value of the property received as the cost basis to the taxpayer. The failure to do so would result in allowing the taxpayer a stepped-up basis, without paying a tax therefore, if the fair market value of the property received is less than the fair market value of the property given, and the taxpayer would be subjected to a double tax if the FMV of the property received is more than the FMV of the property given.”

Rule: The basis of the property received will equal the adjusted basis of the property given plus any gain recognized, or that should have been recognized, or minus any loss recognized, or that should have been recognized.

Problems on page 2

A owns X=basis is 4, FMV =6B owns Y=basis is 4, FMV=5They swap: A now owns Y, and B now owns X. What is As gain? What is As basis in Y?A gets Y (FMV 5); had a basis of (4, what A paid for X and gave in exchange). Thus A has a gain of 1. A now has a basis of 5 in Y.B gets X (FMV 6); had a basis of 4 (what B paid for Y and gave in exchange) thus B has a gain of 2. B now has a basis of 6 in X.A sells Y for 6, his basis was 5, thus his income is 1.B sells X for 6, his basis was 6, thus his income is 0.

Basis + any gain that should have been recognized.

INAJA LAND CO. v. COMMISSIONERpage 106

Hypos:If you pay $10 for Whiteacre and you sell East Whiteacre for $10, what do you do with that?-What is the properly allocated basis? The total value of Whiteacre right now is $20. Let’s say that the total value of West Whiteacre is 12 and the total value of E Whiteacre is 8. (These numbers are not going to help you) The thing you want to know is what was it worth THEN. (When you bought it).You would need to get expert help in finding out how much it was worth when you bought it. Get it appraised.

Inaja LandWhat he was selling was a forever easement. It’s the same as selling part of it.

6

Lost profits, or loss of an easement?What was this $50,000 in lieu of?

The dichotomy between lost profits and loss of an easement is a false dichotomy. The ultimate question is a question of timing. If it’s forever, it should be a sale. See the difference between rent and sale. Sale gets a basis off-set.-Why does he get to use the 50,000 that he sold it for as basis and therefore declare no income?It is difficult to figure out the basis.

61-50=11 is how to figure out the basis. If he sold for 25; he would end up with gain of 14.

Remember the 2 nd rule of Philadelphia Park: If two parties are bartering you assume that each party is getting an equal value. Assume that what you received is the value of what you gave. (Which then becomes the basis of what you received.)

In a taxable exchange the FMV of what is received is the basis (The first Rule in Philadelphia Park).

Life Insurance1. The proceeds of life insurance benefits are excludable.

a. If you pay a premium for L.I.; the company is paying part of it into an investment pool, this becomes part of the proceeds when you die.

Read 79-99 in the booklet he gave us.

Annual Accounting

Lewis Amended returns are to be used to correct mistakes…things that you could and should have known at

that time. Therefore, it would not be proper to amend his first year taxes b/c he used that money as income. The government says that we will allow you to take the loss in year 2. but coming away from the case, we all think Lewis got screwed. And that’s what Congress thought too.

§1341 was passed to alleviate this problem.

What is the ‘claim of right’ notion? You have to claim it in the year that you receive it, even though the statute of limitations hasn’t run yet, and even if you don’t use it right away.

§1341 gives Lewis alternatives:1. The outcome in Lewis2. He can use the calculations from the Year 1 figure; and give himself a credit in Year 2.

This helps when you find yourself in different tax brackets in consecutive years.

September 25, 2003

$40,000 - $4,000 (State Income Tax) = $36,000 (The $4000 saved 1000 because she moved down to a lower income bracket of 25%.) This was year 1.

In year 3: $4000 refund; in a 33% bracket. But then she would have to pay tax (comes out to $1,333). She’s upset because she’ll be paying more due to the tax bracket for money that she sees as HER money.

7

This is due to the TAX-BENEFIT RULE. This is not written in the Code, it is a judge-made principal. It really comes under §61, but you have to read between the lines. See Text at 137. You would tell her that she had a tax benefit in the first year because she deducted it then and she saved $1000, therefore, when she gets it back, she has to pay tax on it. You tell her that you can’t have two tax benefits on the same money. This is also because if you don’t correct it, she would have had gain in year 1 that was never taxed. Now she turns to the fact that she see the IRS as taxing her for more gain than she had because of the increased bracket. This is constitutional b/c the money is the same, but the bracket is different. There is no equivalent to §1341 for the tax benefit rule. There is no choice or option of credit. Everything focuses on the picture in year 2.

(Hillsboro page 138) uses the term “fundamental inconsistency”.

Suppose in year 1 she didn’t have enough deductions to itemize. (This means that there are certain deductions that are itemized deductions, and they will not be able to take these deductions unless they meet the requirement for itemization by exceeding the standard deduction.) She takes the standard deduction. She gets back in year 3 the $4000. She wouldn’t have to pay tax on this. Why not? §111. Ask yourself: Did it help her? Did she have enough other deductions so that she didn’t need it? (Such as the standard deduction).

Keep in mind that the notion of the tax benefit rule is similar to that of the notion of basis. They have the same function… to keep the government and the taxpayer even.

Hypo:1st taxpayer gets hit by a truck. The jury awards the plaintiff 500,000 of pain and suffering; 600,000 in lost earnings; 400,000 in future medical expenses; and punitive damages of 1,000,000. Total judgment is 2.5 million.

If §104(a)2 didn’t exist, she would have to pay tax on pain and suffering. The basis of those things would have been zero, which means she would have received a gain.

She technically would have had to pay tax on all of those judgments. The concept of making a person whole is a tort notion, not a tax notion. Because of §104(a)2 she wouldn’t have to pay tax on pain and suffering. But why, isn’t that emotional

distress? No because the emotional distress was attached to the personal physical injury because it resulted from the physical injury. Therefore, everything but the punitive damages would be excludable from taxation. (The punitive damages case is Glenshaw Glass)

What if this was a settlement? The defendant (§162) could deduct all of this. You would try to negotiate for more pain and suffering and less punitive.

Hypo 2:Same scenario, except Π is hit with a lie (slander case). Same damages. §61 governs because 104(a)2 does not apply to non-physical injuries. Gain is gain. Taxed on everything.

Handout 5 (Private Letter Rule)

§104 (Touch)“The Pre-First Pain”

§104 (Assault & Pain)“The First Pain”

§104 (Cut and Bite)

§61 rules; gain is gain. Her award is most likely not excludable.

They don’t rule on the first pain b/c pain is subjective, and did not manifest itself as an observable harm. (No cut or bruise)

She can exclude everything b/c it was an observable physical harm. (Except for punitive damages)

As to the Touch period, §104 does not apply b/c it was not a physical injury (no cuts or bruises).o But, offensive touching is arguably a physical injury. If it was physical, she could exclude the

award. These letter rulings are not ‘published’ rulings and have no precedential authority. (Even though the

Supreme Court has occasionally cited them).

8

B could exclude his consortium damages if A can exclude hers due to physical injury. Damages that are ‘on account’ of a physical injury are excludable.

Suppose that the Δ says to the Π: “Instead of paying 2.5 million up front, I’ll pay 5 million dollars over ten years.”

The Π will want to know the PV of the 5 million dollars. What’s the economic equivalent? Is that more or less gain. What if it’s equal? Remember that you can’t exclude the interest that you earn on an award. But, if you work on a structured settlement, the interest that you earn IS excludable, b/c the court sees this as part of the award.

Suppose that Chris takes 2.5 million, and he’s going to put it into non taxable municipal bonds. The Δ says “Wait. Here’s 2.5 million in bonds.” What’s Chris’s basis? We will spend most of our time on that weird phantom sheet.

September 26, 2003

Suppose that Chris takes 2.5 million, and he’s going to put it into non taxable municipal bonds. The Δ says “Wait. Here’s 2.5 million in bonds.” What’s Chris’s basis?

Plaintiff would have to include the 2.5 million as income. The basis then would be $2.5 million. Philadelphia Park

If it had been the situation where the person got hit by the truck, all damages except for punitive damages would have been excluded. (§104a2) The only thing then that the person would have had to include would be the $1 million in punitive damages.

What would the basis be on this?o FMV or Philadelphia Park?o Or 104(a)2?

If you took a Philadelphia Park analysis, he would pay tax on $1.5 million. He would be paying tax then on the stuff he’s not supposed to be paying tax on. (The damage received on personal physical injury)

To prevent this, the basis is $2.5 million. The basis becomes irrelevant. If it’s not irrelevant it would be chipping away at the authority of 104. To preserve it, you must give the basis of FMV at the time it’s awarded.

The phantom sheetSimply because a person is liable (or obligated) to pay someone, it doesn’t mean that it will reduce his/her income for tax purposes. If we knew for sure that she was going to pay it back, then we would give her a deduction. The presumption though is that people will pay their money back. We treat them as though they paid it back in the year that they borrowed it. This basically puts everyone on an accrual basis.

How far do we carry it?o We don’t say that anytime you owe someone money you can deduct it.o Only if you borrow money.

Therefore if a lawyer can’t pay her secretary, she can’t deduct that amount from her taxes simply b/c she is going to pay it back.

How would the lawyer get the full $20k deduction? Borrow the money. Then she can deduct (is it really deducted, or just not included?) the full $20k. This is done all the time.

Kirby Lumber is an important case on this matter. See Text at 146-47. The value of the bonds went down, and the debtor was discharged from their debt The question was whether Kirby Lumber had income in the amount of the (forgiven) debt, and the court

said yes.

9

The $25 from the phantom sheet was previously encumbered by the liability, and now it’s freed assets. Therefore, it’s treated as income. If we knew in Year 1 that he’d only have to pay $75, we would have taxed him on the $25 in Year 1, but we didn’t know. That’s why we have to tax him in year 2.

(I typed in the phantom sheet as we went along in case you can’t find the hard copy )

FREED ASSET THEORY VS. TAX BENEFIT RULE

1.Assets Liabilities Comments

Year 1 100 100Year 2 25 0 The creditor has taken the $75 and discharged the debt.

T is solvent before and after debt discharge. Thus 25 income under both theories (freed assets and tax benefit).

2.Assets Liabilities Comments

Year 1 100 0Year 2 200 100 T borrowed $100Year 3 75 100 T spent or lost $25. At this point T is INSOLVENT (he owes

more than he has.)Year 4 25 0 T got the bank to discharge the debt for $50. T is currently

solvent. Under freed assets, income is 25. Under tax benefit, income is 50. The state specifically designates 25 as the result (for a bankruptcy purpose as opposed to a tax purpose).

See §108; taxed to the extent that the person is Solvent.

3.Assets Liabilities Comments

Year 1 100 0Year 2 100 100 For example, if T receives no cash on the assumption of the

liability.Year 3 25 0 Under freed assets, there is income of 25. Under tax benefit,

income is 0. Case law supports tax benefit. Statute is silent.

In Kirby Lumber the Supreme Court sides for Freed Assets, but that wasn’t specifically on this point. §111 (deduction-exclusion concept).

4.Assets Liabilities Comments

Jan-Year 1

50 20 Assume that the 50 asset was a fee paid to T by a client and that the 20 is owed by T to his secretary.

June- Year 1

50 0 Assume T’s secretary S discharges the debt owed to S by T and that T could have deducted it if T paid it.

Under both freed assets and tax benefit, you might think there was income of 20, but §108(e)2 says no. Why? “No income shall be realized from the discharge of indebtedness to the extent that payment of the liability would have given rise to a

10

deduction.”

This is the equivalent of a “Wash”. If the taxpayer had paid the liability, T’s income would have been 30. But since he didn’t pay, his income was 50. T is made to account for the fact that he got something for nothing by an increase in income.

5.Assets Liabilities Comments

Year 1 100 100 Assume that the 100 asset is Blackacre and the 100 liability is the purchase price of Blackacre owed by T to S (seller)

Year 2 25 0 Under both freed assets and tax benefits there is income of 25. But under §108(e)5 income is 0. Why? What is T’s basis in Blackacre?

This is treated as an adjustment in purchase price. We really mean that they pretend in this situation that the 75 was the original purchase price. Why do we have this rule?

It’s not a liquid asset. See Zarin, Text at 149, for a discussion of disputed debt.

It is a capitulation by Congress to handle the administration of non-liquid assets. It’s an off-shoot of disputed debt. Instead of trying the case, Congress made this rule.

For Tuesday, study Zarin, Text at 149 go up to A1; go up to III B2 for the rest of next week.

September 30, 2003

No class on Tuesday or Thursday next week. He will reschedule Thursdays class for a day right before the exam as a review class.

Review of Last Class-p91 of publication 17; good explanation and example of the tax benefit rule.

ILLEGAL INCOME “Consensual Recognition” is the standard, combined with the “Intention to Repay” In a typical embezzlement, the embezzler intends at the outset to abscond with the funds. If he repays

the money during the same taxable year, he will not be taxed. James v. Commissioner; Text at 181. Consensual Recognition is an agreement between at least two parties. If you don’t have two sides, then

you won’t have the benefit of the presumption of repayment even though you may have the intent to repay.

See pages 34-35 of the syllabus (Handout 6). This money is not a loan, and it will be taxed as gain. But, the people that converted this money in November to a loan (35) will be able to deduct this money

if it is paid back within the same year. See Gilbert (Text at 181): “As we held in Buff v. Commissioner, if he spends the loot instead of

repaying, he cannot avoid tax on his embezzlement income simply by signing promissory notes later in the same year.”

But why did Gilbert get away with it?

11

o Joyce suggests that the signing of the note was viewed as payment as well as when he made an assignment to the court for his assets. The court basically said that this was close enough.

So then the ATM people who signed the note are thinking that if they put collateral up, they might have a chance at Gilbert.

Zarin v. CommissionerPage 149

Joyce says that this case should have just said ‘no debt, therefore no debt discharge income’. But instead, the court talks about disputed debt. The court also ends up ‘basket-ing’ his earning from wagering.

THE BIGGEST BUT FOR §61:There is gain with no specific exclusion in the statute, and yet there is no income. Here is an example:

Joyce buys stock in GM for $100. During the course of the year, and on December 31 it’s worth $120. Does he have income in that situation?

No, you won’t have any gain until you sell the stock. Although, it is sort of gain b/c you could borrow money against it at the bank. But, you wouldn’t be

taxed on the loan money anyway.Technically the amount realized is $0.

What if you worked for GM and they give you stock for $100 as compensation, that’s gain.

Read up to B1.

October 2, 2003

Macomber: A constitutional case regarding the definition of ‘income’ under the 16th Amendment. This has to do with the apportionment of taxation. The court says that it (dividends of stock) is not income as understood in the 16th amendment.

Page 195; must be derived from capital (is fruit from the tree) before it can be considered income. There was no real change in value; the company wasn’t any poorer and Mrs. Macomber wasn’t any richer.

Increase in the value of capital interest is not income. This is the basic holding of the case, and it is not really explained. Why is this case seen as requiring “realization”? (see 197-198)

Cottage Savings: Talks about the statutory problem of income. Sets out that Macomber was a case regarding realization. The paradigm of realization is a sale for cash. That becomes a taxable event. The practicality of realization (the achiles heel of income tax) is to avoid having every tax payer having to appraise every thing that they own.

Joyce keeps using the phrase “out of the old, and into the new”

Why are bonds different? The entitlement is different between a bond and a stock. In a bond, it is a more secured debt instrument.

Therefore, an exchange of bonds is a change of position.

BruunThis case ends up reinforcing Macomber b/c it looks at the economic reality situation in something.

12

Then the word recognize comes into play.

October 14, 2003

109 deals with the Bruun problem, and says that if the same situation comes up, the landlord doesn’t have to pay any tax.This is a deferral statute, not a forever statute.

Philadelphia Park

Received Handwritten Sheet:Bruun: amt re

Suppose that the landlord in Bruun after 1019 and 109 is in effect (after the landlord pays no tax) and after the landlord continues to have a basis of 100 in land worth 150, and the landlord swaps that property for Whiteacre. Whiteacre is worth 150.The landlord would have realized gain of 50 (under Cottage Savings)Under 1001c any time you have a realized gain it is also recognized unless statutorily prohibited

If it were a realized loss, and it were recognized (under 1001c), it’s not necessarily deductible. There would have to be a deduction section in the code that allowed for the loss to be deducted.

All recognized gains are included in gross income, unless 1031 or another provision says they’re not.

Is the property business or rental? That’s the question under 1031…. Like for like.

What’s the reason for 1031? It gets rid of the question of whether something is realized. It’s difficult to value everything every year. Also, if they are really like for like, if it was taxable you would be putting a damper on that kind of

transfer.

Is cottage savings overruled by 1031? No. Why wasn’t 1031 used? Because 1031 has exceptions (a2) for stocks, bonds, and notes. This is because you can easily convert stock, and bonds to cash. It’s about liquidity and the ease for

which you can determine the worth of stock.

What should the taxpayer’s basis in Whiteacre?

Boot: something extra to make a swap more even.

1031 says that if you get a transaction with a boot, you must recognize the lesser of the gain or the boot. For example, You swap property of 120 with 30 of boot. 150-100=50 gain; 30 boot. 30 recognized.

Start with the old 100 + 30 – cash (30) = 100 this is the basis of Whiteacre. Look at 1031d

See page 36 in the syllabus

Jordan Marsh (225)This is a taxpayer who wanted it all. Wanted to stay in the farm business. Wanted to stay on the corner of Washington and Summer and wanted to take the loss. Couldn’t sell out for cash and move to another place.

This is one of the best examples of how lawyers can structure the transaction to get the taxpayer what they want.

13

Structure was a sale on lease back. The taxpayer sold the property for cash, and then entered into a long-term lease of the property

promising to pay fair rental value for the property. And then went to the court and said, my sale for cash gave me my loss, and now I’m just renting my property. This allowed him to stay where he was and get his loss.

o Eisner v. Macomber works both ways.o There is no boot loss provision in 1031.

The treasury said that there was something smelly about this. You have done a like for like exchange, with boot, and therefore you should be held under 1031 and no loss should be recognized.

The 2nd Cir. Said no. Not a like for like exchange. This is a sale for cash, and then a lease back. The Court talks about the difference between a sale for cash and an exchange for like for like. The court

is kind of convoluted. This included an agreement as part of the deal. The agreement to lease it back. A transfer with an agreed upon transfer back is no transfer at all.

L transfers a term + remainder in fee + promise to pay rent to XX transfers a term + 23 + 100

Since the transfer was agreed upon, it was never done. The only real part was the transaction considering the remainder and the promise. Part of the 123 was for the remainder, and part was for the promise. This becomes essentially a simple loan.

Neither what the taxpayer said, nor what the Commissioner said ends up being the truth. This wasn’t a like for like exchange plus boot, but it wasn’t a sale.

The government wanted no loss, the taxpayer wanted all the loss. Remember that this is only a circuit opinion, and therefore if the same circumstance happens somewhere else, you never really know what the court would decide.

October 16, 2003

In an exchange for Whiteacre, where Blackacre’s fair market value is 350, and her basis is 100, she would have unrecognized gain of 250. §1031. The basis for Whiteacre is then 100.

This is to deal with problems of valuation. 1031 is also allows business people to stay in their business and just change location without severe tax

consequences. o This leads to third-party transactions (using an intermediary to buy Whiteacre, and then

trading Blackacre for Whiteacre).

Suppose that Blackacre is the productive business property which is exchanged for a personal residence. Does 1031 apply?

No. It is not ‘like for like’ property.

What if there was a personal property traded for personal property? No. It must be business property. You can then look to §121.

o Which says that you can sell your home for cash (gain up to $250k) and that gain won’t be recognized. (If married it is $500k). This gain would be protected forever. (§121 is like §104, and §119. It’s not like §102, §109.)

o In the unlikely case that you would try to do an exchange, you could still get §121, there would be no recognized gain or realized gain on the old. The basis would be for the fair market value of what they received (even though the gain is not recognized). That’s because this is not deferral, this is escape.

14

o It’s a win-win situation. It doesn’t really cost that much b/c without 121 there would be a roll-over (and the angel of death would apply).

If the basis of property X is 50, and the fmv is 350, only 250 is unrecognized gain. $50 is recognized and realized gain.

The gist of §121:You have to have used the home as principal home for an aggregate of two years out of the last five.

If B/A fmv=350; basis 50; 300Swapped with W/A 350;

Typed the sheet that was handed out:

Jordan MarshThe key is that a remainder is less value than a fee, and the longer time the remainder has to be realized, the more disparate the values.

Assume 5% interest/discount rate FMV = 2.3 million Basis = 4.8 million Unrealized loss = 2.5 million What’s the value of a 30 yr term of Blackacre?

o 1.8 million What’s the fair market value of the remainder?

o $500,000 How much of the basis is allocable to the term?

o 1.8 million divided by 2.3 million x 4.8 million = 3.8 million How much of the basis is allocable to the remainder?

o 500,000 divided by 2.3 million x 4.8 million = 1 million

HypoB/A fmv 350; basis 50; wants to get the gain of 300 but doesn’t want to lose the property. You could take out a loan for 350, but this doesn’t cut it. You need to cut yourself off from the risk of gain and the risk of loss. You need to be indifferent to the property.

Realization is not just ending the risk of losing your gain.

B/A Lender

L Fee (Term + Remainder) + Promise X

Term + 500,000 + 1.8 million X

So basically there was the sale of the remainder and a loan of 1.8 million.

Sale of remainder =1,000,000 basis - $500,00 amount realized = $500,00 realized and recognized loss.

15

This is a legal title passing, you’ve ended your opportunity for gain. Now the question is how do you figure the gain in that situation? The amount realized is the $350, which is the amt of money which you were lent.

§1259 Constructive Sales provision:In the situation where stock is borrowed and sold, you will be considered to be buying your own stock, and will be taxed on it. As opposed to deferring it until the time that you pay back the broker. Congress also said that the Treasury has the right to issue regulations that will take care of other types of arrangements that deal with stock. They haven’t been written yet.

Suppose you have a share of stock. You say to your tax person that you would like to be protected from downward movement and not be taxed on the gain. Tax person says, you will buy an option called a put. This put will give you the option of making a person buy your stock if it goes below a certain amt (like 350). Will this be considered selling short against the box? No. B/c even though you protected yourself against stock going down, you still have opportunity to gain if the stock goes up.

Collars: You buy the right to make somebody buy the stock if it goes below 350 (a put), and make somebody buy the stock if it goes above the 350 (a call). This is a constructive sale because you have ended the risk of gain and loss.

When we start on deductions, please bring to class that taxpayer’s guide that he gave us awhile ago.

Read page 185-186 in TP Guide.

Borrows 350 from X (no income) X forgives the debt (kirby lumber, 102); If instead of that, the TP transfers B/A to pay the debt (fmv 350; basis 50). If you transfer the property to X, you get the same treatment as if you sold it for cash and paid the debt with cash.

Suppose that the debt that you owe is something that you could have deducted. You would have gain on the sale, and a deduction on the cash. If you do it all in one, you get the same treatment.

Davis Case (page 298); Supreme Court interpreting the law in DE:She was entitled to a share of the property that was in her former husband’s name. The central issue of this case is:Is this the same as if Mr. Davis had paid off a debt with appreciated property? (Sold for cash, paid cash to his wife). He took the position that he was just giving her what she already owned. In DE marriage is treated as economic partnerships. Therefore it wouldn’t be a realization.The Supreme Court said that it was merely a question of when. But it is also a question of who. If the property was always hers, Mr. Davis wouldn’t have had to pay tax ever on it. The SC decided that Mr. Davis was paying off debt.

Congress passed §1041 to solve this problem. Basically says that transfers between spouses, or former spouses in the context of divorce, will not be considered taxable events. No gain. No loss.1041b says that the transferee takes the transferors basis.

You represent Husband (Chris) Margo (Wife); house is worth 350, basis of 200; stock is worth 350, purchased for 100. Chris says you keep the stock, I’ll keep the house. Negotiate in light of 1041.

October 21, 2003

16

Margo says no. The dramatic difference in basis. The gain on the stock would be 250, whereas the gain on the house would be 150. §1041 says that any swap between the spouses would not recognize any gain or loss. §121 says that if he sold the house, he wouldn’t be taxed (and §121 doesn’t apply to stock).

If they don’t agree, it will be imposed upon them by the court. The court will take tax consequences into consideration, but the parties must do some work and bring the tax consequences to the attention of the court, or they may have waived their right.

Husband says, there’s a big if there. She doesn’t have to sell the stock, and he doesn’t have to sell the house. The angel of death could come, and it would be an even exchange. It’s also not certain that he would have all of the qualifications necessary to use §121…. He could move out before the two year requirement.

Problem on 3031. Henry and Wilma were married, jointly owned a house with a fmv of $400k and a basis of 100k.

Pursuant to their recent divorce, Henry took title to the house and executed a promissory not for 200k payable to Wilma and secured by the house.

a. No gain. §1041. Wilma gets his basis in the notes ($200k).b. His basis is $100kc. Wilma would be selling her half of the house for Henry for 200k, and she would have to

recognize the 150 gain realized. (Her basis would be half of the total, which is 50). She might qualify for 121.

2. Herb and Wanda were divorced six years ago. Herb was awarded custody of their two children. The decree of divorce provided that Herb was to remain in the family home until the younger child reached age 18 and that the house would then be sold, with the proceeds equally divided between Herb and Wanda. Last month….

a. 121 (d) (3) (B) If pursuant to a divorce decree, his use becomes her use, and she qualifies.

Negotiations and Transactions that Take Place Before Marriage

Farid-Es-Sultaneh v. Commissioner (page 303) She sold some of the stock that she got for $19 a share. The only question was what was her basis. The commissioner said that §1015 applied because it was a gift. The Supreme Court held, in Merrill v. Fahs, that transfers made for a promise to marry are transfers

without consideration. He keeps bringing up Duberstein, which I don’t know where that is, but he says it’s the case that

follows Farid. §1015 is not applicable. Look first to §1012. Basis is cost unless it’s a gift. Since this isn’t a gift, her basis is cost. If her basis is cost, then what is her cost? The court ends up giving her Fair Market Value.

o She promised to marry and gave up her marital rights.o You would then think Philadelphia Park: Start with the basis that you had add any gain,

subtract the money.o The problem with this is if you do the normal drill, she didn’t have any basis in her marital

rights. She would have had to recognize some gain.o You have to give her a fair market value basis in what she get, because otherwise she would be

taxed on her marital rights. The previous cost was $0.15.

You say to defer until 1041 is applicable. The transfer will take place as soon as the marriage takes place. (If and when).

Adjusted gross income = Gross Income – business deductions§63a =Gross Income – Business Deductions – Itemized Deductions - 151

17

§63b = Gross Income – Business Deductions – Standard Deductions – 151 (if the taxpayer chooses not to itemize, this one applies)

We are used to thinking in terms of the meteorite (if you have gain LoBue says it’s all taxable unless you can find an exception)

In a way, the opposite is true for deductions: nothing is deductible unless you can find a specific section that says it’s deductible.

Even though you have to find the sections, you will find them, and they will say that the taxpayer will be able to deduct business expenses, but not personal living types of expenses.

Suppose that a taxpayer is asked to go paint a mural on a restaurant wall. He spends 100 on supplies and pays his employee 200.Gross Income of 500, Deduction for 100, and deduction for 200 salary. His taxable income will be 200.

If he painted a picture at home (100 for supplies, paid his employee salary of 200) and sold it for 500. His basis then was 300. His gain was 200. Taxable income is the same as gain.

Three Sections: §162 / §212 (212 should have just been a subjection of 162) Expenses

o Is this really a business expense as opposed to a personal expense? §165 Losses

o Allows loss deductions for business or profit seeking. Doesn’t allow for personal losses. §167 / §168 Depreciation

o For business depreciation only. Not for your personal property.

§162Two distinctions:

Is this personal, or is this business? Is this a capital outlay, or is it an expense?

PERSONAL BUSINESSCAPITAL Wing on a Personal Residence Wing on a FactoryEXPENSES Haircut, Movies Paying a Salary

(This is the only one that’s deductible).

All of the distinctions represented in this diagram are attempting to make the distinction between personal and business. (I think this is on 185).

Going from home to your regular job is never deductible.o Why not? Flowers. (The guy who went from Jackson to Mobile) It is a personal choice to live

where you want, and you should choose to live where you work. Why is this relevant? He says that it’s really not any different from the secretary deduction. It costs you something to go to work.

o The fact is that it is too difficult to determine how much is due to the business and how much is due to personal choice. Therefore, no commuting is deductible. And they will also say, btw you can get a standard deduction.

The diagram says that if you’re at work, and you have to go to a meeting regarding business, that is always deductible. (Job to Job; Business to Business)

This is a maddening section of the Code because it is constantly changing. Much of it is based on the Revenue Rulings.

Read up the end of IVb

18

capital expenditure

Money spent to acquire or upgrade physical assets such as buildings and machinery. also called capital spending or capital expense.

October 23, 2003

Discussing the boundaries of 162See Rev. Rul. Supplement page 40

If X has a regular working situation here, but travels to NYC for business, stays in a hotel, eats meals, etc…What’s deductible?Pretty much everything under §162.

U.S. v. Correll: In order to get your meals you need to have an overnight stay. 162 (a) (2) combines them together…. Statutory interpretation…. No meals without lodging.

X goes to Rochester to meet a lawyer, eats lunch and comes home to OP. Can he get meals? No Can he get travel? Yes

There is a provision under 162 (a) (2) which says that you can’t get anything that is lavish or extravagant (six martinis).

Remember that you can only deduct it if you’ve paid for it in the first place, so it’s obviously better if the employer pays for it for you.

If a lawyer goes to Brooklyn to argue a case, he gets everything that X gets, but he gets that as a deduction that goes from gross income to adjusted gross income. He gets that whether he itemizes or not. Meaning he could take the standard and also deduct this. This has to do with the difference between an employee and a non-employee. (The lawyer is the non-employee).

X would first have to get over the 2% floor before he could take this as a deduction. It doesn’t matter too much for X because if he’s reimbursed, he doesn’t bother to report them. It’s a wash.

Suppose that: B stays in NY to go to a meeting (overnight) and stays for the weekend. B goes to see a show, and comes back on Sunday night.

What happens if B finds a way to get reimbursed for this trip?o Would some of that be income?

The trips to and from the airport and everything up to the last meeting. Actually there’s a question about airfare. When you go on a trip that is a

combined business/personal, you then have to make a decision as to whether this is primarily business or primarily personal. Duberstein.

If primarily business, you get all of the airfare.

Suppose that on the way to the airport X takes his dog and drops him off at the kennel, and he (the dog) stays overnight and gets meals and lodging.

Can X deduct this expense? See Smith v. Commissioner, (2nd Cir. 1940). Held: Babysitting not deductible. Why? The courts said

that she said “but for” paying the babysitter she couldn’t work. The courts said that that was a stupid argument basically because “but for” eating, you couldn’t work. Therefore everything would be

19

deductible. But she didn’t really say that. She said but for the job, she wouldn’t have to pay the babysitter.

o So what’s the element of personal choice in Smith? She chose to have children.

Suppose that X works construction and he has to wear a surgical mask because there is a lot of dust and the dust makes him violently ill. Can X deduct the cost of the surgical mask?

Probably.Would you continue to give it to X if the reason he has the condition is because he did drugs?

The argument is we take taxpayers as we find them. If X needs a,b,c to do the same job as B, but B doesn’t need a,b,c to do the same job, who should be penalized? There’s a lot of gray areas here.

Smith ends up being a lot like Flowers.

§162 is a broad provision that doesn’t say that you can’t deduct babysitting. It says you can only allow business expenses. This is a statutory interpretation thing. What is a business expense. It’s not an end all be all thing.

Congress has added §24 and §129 to deal with this, but it’s subject to lots of limitations.

CAPITAL EXPENDITURES V. EXPENSESPersonal v. Business side of §162 and §212

1. You have to establish that the outlay will be considered business2. You have to establish that it will be considered an expense

We will now be learning about what is considered an expense.

Look at §262. It doesn’t really say anything, because you don’t need to be told that you can’t deduct a personal expense. Remember you can only deduct something if you can find a section that entitles you to (and you won’t find one that will let you deduct a personal expense). This section is mostly just a reminder.

§263 says you can’t deduct capital expenditures. Again, this isn’t really telling us anything because we know that we can only deduct expenses.

Things that can be depreciated are capital expenditures.

So, why can’t we deduct capital expenditures?Let’s say you start out with 40k. You buy a truck. In year 1 you make 100k off of the truck. In year 2 you make 100k out of the truck. Then the truck is done.The taxpayer would like to take the 40 and deduct it so that his income is 60. In year 2 his income would be 100.

Year 1 Year 2100 10040 060 100

100 1000 020 2080 80

20

This is all about the time value of money again. The question is who’s right? Which reflects more accurately the taxpayers gain. At the end of the first year, the government says you started with 40 and ended up with 120 and that’s 80. (Where’s the other 20? You still have the truck. The truck is a two year truck.)

Midland Empire (page 483)The taxpayer wins in this case. The taxpayer’s outlay on the basement was considered a business expense and fully deductible in the year that it was made. The rationale really comes from the Regulation’s two-pronged test:

1.) Did the outlay increase the value of the property2.) Did the outlay substantially prolong the expected life of the property

In what sense is the court wrong? Without the lining, the life of the property would be over. The value without the lining was zero. Now it’s infinitely more.But, if you look at the useful life before the oil spill, it really didn’t prolong its useful life. Hmmm. You will often have to interpret these regulations because they bind the government. What if we analyze this in terms of the truck? Where is the cement lining at the end of the year? It’s still there. If it’s considered to be a repair instead of a replacement it will be considered an expense rather than a capital expenditure. That’s the law.

Suppose X (on December 3rd) replaces the bulb in a factory. Is she going to deduct it? Sure. Even if it’s a two year bulb? Yes. The alternative is to figure out how to depreciate the bulb, and the alternative is simply unacceptable. The administrative cost is too great. Therefore the question is whether it’s a repair or a replacement. This also depends on where you are. There are also cases that go the other way (like everything). See Hotel Sulgrave: without a sprinkler system they would go out of business. Tax court said no deduction, capital expenditure.

Revenue Ruling 94-38 (page 486)Facts: groundwater problem. Excavated to prevent contamination and built a facility. Held that they could deduct the excavation as an expense, but not the facility.

If you run into this situation in real life you should try to find a case or revenue ruling that is directly on point to help your client.

Suppose that after X passes the bar, he finds a place to rent and buys himself a set of McKinneys and some office furniture. Can you deduct those as expenses? See 1.162-6 of the Regs. (on page 986 of the big statute book). What happens if there’s a fire? Can you take a loss? The answer will be: In that given year you cannot take both an expense and a loss because to get a loss you have to have basis. You won’t have basis if you deduct something as an expense because you’ve used it up already.

Suppose you buy yourself another set of books to replace the set you lost. Can you get a deduction for that year as well? If the answer is yes (and it should be) then the question is why didn’t the taxpayer in Midland go for two deductions? Wasn’t Midland’s attorney wrong for not going for both?

For next week: C, D, E, F

21

October 28, 2003

TAXANALYSTS.COM

MACOMBERRECOGNIZE

Work Related Education and ExpensesSee chart on page 197Regs: 1.162-6You can’t take the loss in the second year because that would essentially give you the same loss twice.(We’re talking about the truck)

Suppose that in the beginning of that year a relative bought you some furniture and books for your office. They write a check for 5k and next day you have the stuff delivered to your office. What if it burns down the next day? Can you take a deduction under §1.165? Where is the basis? You need to have basis to have loss. What’s the basis for the books and furniture. You take the basis of the gift giver when you take the gift.51% detachable and disinterested generosity. Duberstein. It would be included in the income (no exclusion –Lobue). Cost 1012. So you buy yourself another set of books. Can you deduct those books? Yes. Replacements. 1.162 expense. Is this a double deduction? It’s not the same 5,000. One was the gift, one was from you. Therefore, there should be two deductions.

Page 485 problem b.Measure the loss by the amt it took to replace.What about Cottage Savings? Was there a realization? The farmer still owns the barn. It can’t be deductible without being realized. Why can the farmer get this deduction? Although he still owns the barn, the roof is on the ground. In effect the regs (and the treasury) allow you to treat the roof as though you sold the roof to someone. Realization becomes physical destruction.

Isn’t this page wrong? Shouldn’t there be two deductions? Remember we came from Midland. The taxpayer’s lawyer didn’t

“go for two”. Realistically the farmer should not have a shot at two. Roofs are capital expenditures. In Hotel Sullgrave there was no realization, and the taxpayer got nothing.

What happens to the basis of the new books? The basis ends up being zero because it was deducted as an expense. Therefore, if it’s sold, the amt they sold for would all be gain.

Let’s back up to the Hypo with books which are given to me. What if your mom gave you five thousand to buy the books. Can you deduct the books? You’d be able to not include the money as gain because it was a gift.

By not allowing a scholarship recipient to deduct the amt of the scholarship, if effect you are making that person include the scholarship. The courts are still debating this.

Suppose you got the 5k for the book in a settlement for personal injury.

Encyclopaedia Britannica “If one really takes seriously the concept of a capital expenditure as anything that yields income, actual

or imputed, beyond the period in which the expenditure is made, the result will be to force the capitalization of virtually every business expense.” (475)

The administrative costs of keeping track of all of that are too high. Why the separate case on intangibles? The reasoning used is that they were focusing on one book.

22

Idaho Power involved the taxpayer who wanted to depreciate the value of the truck. The two year truck worth forty. The Treasury said no. You built a building with the truck. You can’t take a deduction for depreciation under 167 either.

100 100 100 100 40 0 20 20 60 100 80 80

This is the truck that built the building that built the truck. So follow the money. Take the 40 for the truck, put it into the building, and take it out of the truck that it built. Eventually the truck will be sold.

If you can see that there is a focus on the creation of a specific asset, you can say that it has to be capitalized. Encyclopedia Brittanica. But if you’re in a situation exemplified by the in-house costs where people are doing a multitude of things, then they can deduct the costs of those expenses.

But then

§263A was passed. It requires you to capitalize in house costs even though otherwise you would think that administrative costs would be too great. There are some exceptions however. This is really an accounting problem.

Then came INDOPCO (481)INDOPCO is really being adopted by the regulations. What about the decision for the supreme court. Who is going to get involved…. It’s really a standing issue. Who would bring that claim? It’s possible that these proposed regs won’t be passed.1.263(a)-4. page 1052.

Legal Expenses

The next big case is Gillmore. There’s something in there about origin of the claim. The question is why since a good deal of what was in issue in Indopco were legal expenses, why wasn’t this decided under Gillmore.

October 30, 2003

INDOPCO paid legal and investment banking fees incident to a merger. The Court held that the merger produced long term benefits to the taxpayer. The fees incurred to achieve that merger were capitalized rather than deducted.

Why didn’t Gilmore control?o Gilmore revolves around personal expenses. Indopco is business.

Remember:PERSONAL BUSINESS

CAPITAL Wing on a Personal Residence Wing on a FactoryEXPENSES Haircut, Movies Paying a Salary

(This is the only one that’s deductible).

In Gilmore the taxpayer has to get by both, but in Gilmore there is the question of whether it is business or personal. In Gilmore it was decided that his situation was personal.

“Cruel Hoax”page 459

UNITED STATES v. GILMORE372 U.S. 39 (1963)

23

Facts Gilmore hires a lawyer in connection with a divorce. He hired the attorney to protect

himself from losing his stock in a divorce action. The wife said that it was divisible property. The lawyer did her job, and the stock was protected.

Is that capital, or an expense? Joyce says that’s the easy question. Stocks will produce dividends over a long period of time, therefore it is capital.

The Supreme Court ducked this issue though, and decided to analyze whether this was business or personal.

Since the claim originated in a divorce action and a divorce action is personal, this claim is personal, and therefore he couldn’t deduct it.

This case was really a capital case. That’s why he shouldn’t have been able to deduct it. What they did end up saying is indefensible.

Hypo:X bought a lottery ticket and won the lottery. $5M on his own ticket. In a divorce action his wife comes after the money. The lawyer wins, and he pays the lawyer $100k.

What if he loaned money to someone, and the person doesn’t pay interest. He sues for the interest and pays legal fees. The legal fees would be deductible.

Suppose that Mrs. Gilmore pays the lawyer to negotiate an alimony agreement. We’ll see under §71 that alimony will be includable by the recipient and deductible to the transferor. Can she deduct the lawyer’s fee?

You would have to say that although Gilmore says that it’s not deductible, the regs say that it is. That little brochure 203. Despite Gilmore.

Gilmore IILet’s say his basis of his stock was 50 and the value of the stock was 50. He hires the lawyer and the lawyer gets 10. He decides to capitalize, so his basis now is sixty. He sells it for 50. Now he has a loss under 165 (c) (2). It is now a loss incurred in a transaction entered into for profit. Commissioner went ballistic. This was held to be deductible because stock is business (profit seeking property) not personal property.

A taxpayer wants to capitalize; a business person wants to expense.

Hypo: Suppose that Mr. G was in a stock owning business. He was the sole proprietor. He ran a pizza business, he hired a person to deliver the pizzas. That person negligently injured someone. That person sued under the doctrine of Respondeat superior. G hires a lawyer. The lawyer wins. G pays the lawyer.

It’s clearly business. What about capital v. expense?

o The question is how long is the benefit (future benefits)? The long term benefit is ? You could say that this is a process of ejectment…

Focus it into the land. Encyclopedia But, this is going to be deductible. Why? Because think about Capitalizing.

24

First because the government doesn’t push the limits of INDOPCO. Second because where will you capitalize it? The plaintiff is fighting for

anything they can get. This is an impossible allocation.o There will come a time probably when the court will say that this

needs to stop and that all these things should be capitalized. o Some lawyers say that INDOPCO was just a decision saying:

Doesn’t matter to us where you capitalize it, but it cannot be expensed.

What are the regs going back to? If you can see an asset, then you can capitalize it.

Received 2 photocopies from Tax Guide page 3 and 55

Work Related Educational Expenses

So what are you going to do with your tuition? Can you deduct under §162 or §212?

o No. The education is part of a program of study that will qualify you for a new trade or business.

o This is basically saying that the education is capital, because there is long term benefit.o Use the arguments on Figure A to argue.

INDOPCO If X buys the truck, or puts in the drainage ditch, then X will be able to get it back (not all at once, but he can capitalize and get it back over time through depreciation). But what do we do with our tuition? We can’t expense it. Where could we capitalize it? What basis would we add it to? The answer is you can’t capitalize it because what you got for your tuition doesn’t wear out. It is non-depreciable. But your career is running out. Doesn’t matter. It is just as good at the end of your career as it was when you got it. So you really get an outlay that you may never get back. That might be what really happens in INDOPCO. Maybe if they go out of business they could take a loss, but there’s no certainty, and if you’re going out of business there’s probably not much you can attribute the loss to. INDOPCO’s kind of a no-man’s land. It’s kind of a breakdown of the system.

Federal Tax Guide: Read the chart on page 75. Modified Accelerated Cost Recovery.

In order to have depreciation you have to have two things:1. Something that has physical wear and tear. Depreciation deals with physical assets. Land is

non-depreciable because it is an intangible (as is stock).2. You secondly need basis, because you’re depreciating your basis.

Part of that notion is that, for depreciation, it is irrelevant what the value is worth at any given time.

November 4, 2003

Received Depreciation hand-out.The economic value of anything is the sum of the present values of the item for it’s useful life.

Depreciation: The method of getting back the cost of something over its useful life. It’s how you get the cost back. Tax-wise, depreciation helps the taxpayer a lot.

25

You can’t add the four though because it’s not realized.

Real property = building. Not land. Land doesn’t depreciate.Double declining balance which switches to flat-line when it helps the taxpayer.

The truck is a truck that delivers pizzas. It’s earning income that you have to include in income that year. You buy the pizza delivery business. The business only consists of two things. The truck and the goodwill of the business. You pay 50K for the business. How much is for the truck and how much is for goodwill? 35K for the truck and 15K for goodwill….and he says no how about 40K for the truck and 20K for the goodwill.

Welch v. Helvering: Focuses on the word “ordinary”. No one knows what this word means because of this case. This should have been decided not on the fact that it’s ordinary, but on the fact that this would have been a capital expenditure and not an expense.

Goodwill is non deductible capital expenditure. (Because it will create income for more than just this year). The Welch case was about the cost of building one’s own goodwill. This is really Encyclopedia.

So they decide 35K and 15K; he would have to capitalize the 15. Until 1997, the IRS said that you had to capitalize it and that you couldn’t depreciate it.

Then Congress comes along with §197. Amortization of intangibles for things like goodwill (but only for purchased goodwill). MACRS doesn’t deal with amortization, it only deals with tangibles. Amortization is straight-line.

§162/212; 165 loss deduction; 167 and 168 depreciation. These are the deduction heavy hitter sections.§166-bad debt deduction. Allows bad debts to be deducted even if they’re personal.

Profit seeking non business bad debt

SPLITTING INCOMEIn our hypothetical system the first 100 is taxed at 10% and anything above is taxed at 20%.So the first taxpayer has 1000:Pays 10 on the first hundred, and 180 on the 900 = 190. This taxpayer is paying two different percents. We say that this taxpayers marginal rate is 20% because that’s where the last dollar gets taxed. How much does he owe the government? 190. The taxpayers real bracket is 19% (190÷ 1000).

The name of the game in income splitting is to get more than one ride up the bracket. The value of the bracket in this system is 10. (20-10).

If T=500; t=500T= 10 + 80 = 90; t=10+80= 90. Their total tax then would be 190. They’ve been able to get two rides up the bracket. Two people got the benefit of the first 10.

Congress won’t let this happen:Keeps the individual as a human being and not as a family unit. §61. Who’s income is it?

26

Lucas v. Earl (this is now taken care of by the statute’s joint return schedules) Mr. and Mrs. Earl didn’t have taxes in mind when they made their arrangement. This was just

them doing marriage as an economic partnership. But it ended up affecting the tax people. It gave rise to the principles which have been applied (and misapplied) in the area of income-splitting.

“fruit and tree” (he who earns must pay the tax). Where did the court get that? “attenuated subtleties” They read into the statute “he who earns must pay the tax”. They did it because they thought if

they didn’t do it, that would be the end of the progressive system. Instead of letting Congress fix it.

Big T says have of his income will go to t. Lucas v. Earl says that the T has to report 1000, even though t is entitled to the 500, and even though the contract is enforceable under state law. What happened to LoBue? How much gain does T have?

Suppose T has a friend that paints a mural for 20 an hour. They contract. He starts doing these murals, and people start noticing…. T sells the murals for $1000. Who pays the tax on the 1000? T. Who earned it? t. He earned the money that T keeps. This is the confusion that’s been bred from Earl. It all comes down to what does earn mean? It can’t mean economically generated.

November 6, 2003

Income Splitting:Lucas v. Earl with respect to personal service income is the most important rule. Which basically is just, you can’t do it. He who earns must pay the tax. The person who gets the income has gain, but can most often look to 102 for a gift. Therefore the amount is still only taxed once. Contracts, even if they are enforceable, cannot allow you to split income. On the fringes we start talking about what earn means. We looked at Teschner. That’s the case about the father who writes the essay for the daughter. Earn means not only generated but could have gotten. Even though a person generates the income, the painter who contracts for 20 but people are paying his contractor 1000. The painter only pays tax on what he gets. Even though technically he could have gotten the 1000. But so could Mrs. Earl. It really depends on the arms-length transaction. “Anticipatory Arrangement”. (One of the ways around the Earl rule is to work for nothing. Although, if the IRS wanted to they could probably find some economic benefit to some third party and still tax you. If you still decide to work for nothing, you better do it all the way and from the very beginning.)

Lucas v. Earl has had such an effect on the way judges think about income shifting, even if it’s not between relatives.

Poe v. Seaborn (577): Community property state. The earnings were generated by the husband, but by law, the earnings are never the property of the husband, but that of the community.

After this case, you had the ability to split income in community property states, but not in other common property states. This is what led to the Married Filing Jointly provision. See Handout 9.

The value of joint filing is the extra ride up the bracket. Poe v. Seaborn gave the two rides up the bracket. This meant that the person that wasn’t married was being penalized, and could get a bonus

27

by getting married. It also meant that everyone in common-law property states were being penalized. When Congress passed the Joint Return, they put every single person in a penalty situation.

In 1979 Congress decided to give some relief. Congress Desires:

1. Married people, no matter who makes what, get taxed the same. 2. To keep the progressive rate structure.

When they tried to alleviate the singles penalty, they made the marriage penalty.

When people are divorced, the statute allows them to determine what is and what is not alimony. And, the tax function of alimony is to split income. (Even though it’s in the deduction section, it isn’t really. It’s just allowing people to do what Lucas v. Earl does not permit people to do.)

Armantrout (583): Not a husband and wife situation, but a parent-child situation. (He gives the food hypo: It’s gain because it discharges his legal obligation to support/feed his kids. This is LoBue income, not Earl income.) In Armantrout the employer has a plan to send the employee’s kids to college. It was clear that the money used to send the kids to college was not coming from the money that the employer had saved up before they went into business. That money was generated from the employees. The employer kept some of the money generated by the employees and put it into the plan. The IRS said to the employee that that’s your income. If this had been grammar school, this would have been a LoBue issue because it would have discharged his legal obligation to support. But, this is college. Parent’s are not obligated to pay for college. That’s why they talk about Lucas v. Earl. Earns means generated and could have gotten for himself. In effect, Mr. Armantrout is saying, I shouldn’t be taxed on this b/c I couldn’t have gotten it. Basically the court is saying that this is a tax subterfuge. Look on page 587. “There is no evidence to indicate that petitioners were unable to bargain with Hamlin about the terms of their employment and the available avenues of compensation.” This reinforces how strong Lucas v. Earl is.

X has Blackacre and Whiteacre, they’re both worth 100 and rent for 10 a year. X wants to shift the income from one of those properties to his child and get an additional bracket ride. So X gives that child Blackacre. The child has gain of 100 but it’s excluded under §102. When the rent is paid, who pays the tax?

Margo says the kid pays the tax. Blair. (592) The taxpayer in Blair was an income beneficiary of a trust. Decided to transfer to one of the children part of the income interest. Basically said he would give the kid half of his income strain. The court said it’s the kid that pays the tax, not the transferor. The government said what about Earl? The court said no. This is not personal service, nor is it discharge of a legal obligation. The court says: This is not a case of evasion. Joyce says: That’s not true. This is meant to evade the progressive rate structure.

o Blair and Earl are dynamically opposed. With respect to earnings the answer is no. With respect to property, the answer is yes. You can do it, but you’ve got to know the rules.

Horst (593). If the hypo was that he would give the income from Blackacre to the kid for six years. Who would pay the tax? The father. Horst. There was an interest coupon. Basically: If you keep the tree and give away the fruit, you get taxed on the fruit.

What if the father gave the kid half the rent forever? He would be giving half the fee simple. The kid would have to pay the tax. Blair. The duration is the key. “Chronologically co-terminus with the

28

interest that he has”. Half the income for the same duration that he owns. He recalls Inaja Land. (The question was who gets basis off-set. Where does this come from? Basic feudal property notions.) Basically it’s a dance. The name of the game is if you slice it the right way you stay away from reversions. Anything that results in a reversion is not successful.

Suppose that the dad waits until the day before rent is paid to give Blackacre to the kid in fee simple. The father will pay the tax anyway because it’s too late. There is a notion that if the income has already been earned, it’s too late to shift. There is another aspect of this notion of being too late: signed contracts and accepted offers will also be seen as too late.

You also have the so-called Kiddie Tax; even if you do the right dance at the right time sometimes it still doesn’t work. If it is unearned income, and the kid is under 14, it will be taxed at the parent’s rate. Not to the parents, but at the parent’s rate.

Now we come back to Joyce’s neighbor and splitting of income. He builds his own home, and he’s got 40,000 worth of costs of materials. The house is worth 300,000. Suppose he gives the house to his kid and the kid sells the house. What’s the basis of the kid. Carry-over basis §1015. Basis of 40,000. The kid sells the house and has 260,000 of gain. Who pays the tax on that? Why is this a hard question? What case governs? Blair or Lucas? He didn’t retain a reversion, and it wasn’t too late. The question is did it come from personal services, or non-personal services? The dad technically made the house, so that’s personal service…. But, it’s governed by Blair. How do we know that? Heim (600).

Heim. Property created by personal services is governed by Blair. But it must be a certain kind of property, see Eubank (599).

Eubank was about life insurance. The parent had to pay the tax. The court said that personal service income was governed by Lucas. You cannot assign personal service income before or after it’s earned. But if you can get the court to see something that’s tangible property that is distinct from your personal services, like a patent, then it will be governed by Blair. The endgame on this is Heim gets you out of Lucas and into Blair, but it doesn’t get you around Horst. You still have to do the right dance.

If X builds a house and then rents the house out and gives the kid the rent, X is taxed on it because of Horst.

For next week read Alimony and all of VI.

November 11, 2003

Personal Services You can’t shift the income.Property You can shift the income by transferring property if:

1. You don’t keep a reversion2. You do it early (not too late)3. Don’t do it to a kiddie (1014)

The question then becomes what’s services and what’s property? Patent? Copyright? (Both are property says the court)

29

Heim The taxpayer had a patent and proceeded to enter a contract whereupon he sells the patent to a corporation, and then assigns all of his rights to a relative. Tax wise he would have been much better off to shift the interest to the relative and then have her sell it.

Eubank: Was considered to be personal services. (Life insurance renewal commissions).

If the trust keeps the income, the trust pays the tax (and it’s big usually)A lot of income shifting is done in trust. Because the rules are laid out in the statute, and you would end up getting Blair treatment.

We started this course with LoBue who was granted the option to buy stock. The stock that he could buy was worth 10. The next year he exercised the option, and it was worth 15. The Supreme Court held that because it was not transferable, there was no tax during the exercise of the grant, but there was in the year that he exercised his option.

What if the LoBue’s kid gets it through a transfer in year 1? The kid exercises it in year 2. What result?

o It’s property. But what about Eubank? He worked through personal services to get it, just like this…. So even though it is property, it’s the wrong kind of property. You created it through personal services…. Renewal commissions weren’t property, so stock options are not property. The court can’t see it as something you can touch….

o This means the father will pay the tax because of Lucas v. Earl. He who earns must pay the tax.

What if instead of transferring the stock option to his kid, he transfers it to his wife in the context of a divorce proceeding.

Before the revenue ruling that was handed out today in class, the husband would have had to pay the tax.

This is despite 1041. The revenue ruling states that now we will contend that 1041 wins over Lucas v. Earl. So when the wife exercises her option, it’s her income. There’s no gain or loss recognized. The revenue ruling restricts this to transfers in the context of a divorce, and the options or rights

must be vested.

What type of situation will be deemed to be covered under Lucas v. Earl.

X builds a house, gives to kid, kid sells it. Who pays the tax? Heim If you create something that is a real thing, it will be treated the same as if you got it from your

employer and paid tax on it.

So a transfer of a vested stock option in the context of a divorce is governed by 1041 (Lucas v. Earl is overridden in this context).Why is that not alimony? It’s not cash.Checks are cash. Promissory notes are not cash. Demand promissory notes might be cash.

You want 215 and 71 treatment you deal in cash.

30

Many people talk about alimony as a deduction. But §71 is not a deduction section, it’s an inclusion section. §215 is the deduction section. But it’s not saying much except that if it was included under 71 it’s deductible under 215. It is an income splitting device given to people who were married and are now divorced, basically to continue the joint return break they were given when they were married.

Questions on page 3101.) Alimony agreements must be in writing.2.) Recapture. Why do they care whether things are front-loaded? Congress says that if you front

load alimony, it’s not in the nature of support, it ends up being a property settlement. 71f says that you can deduct the whole alimony payment in the beginning, but in the year when it drops significantly, you need to include the difference in your income. 3 years seems to be the magical number. Back-loaded payments are fine.

3.) Not alimony 71(b)1(d). Payments that do not end with the death of the payee. Therefore it was never alimony. The insurance policy taken on its own is tricky. It could be argued to be cash because premiums are paid in cash, and she doesn’t have to pay it. If she had the right to choose the beneficiary, it would be considered to be hers. Payments of cash to a third party can be considered alimony if she reaps the benefits. 71 Maybe. ;)

4.) Not alimony. Reductions (here it’s total) based on the death or some contingency with the child are considered child support. Alimony is in the nature of spousal support.

31

November 13, 2003

(page 309) Negotiate about the savings that takes place. Who will get what part of that 6,000? The parties can’t make something deductible that’s not. But, they can order something not to be deductible if it could be. A court can though.

Handout 11:Loy’s going to have to deduct it, and his ex-wife will have to include it. The way taxable income is determined for a person like this, different schedules have to be filled out. You won’t find $206,860 anywhere.

Interest is deductible under §163 of the code. A – all interest is deductible.H (1) – Except for personal interestH (2) – Personal interest is all interest except the following:H (2) (A) – Interest paid on indebtedness properly allocated to a business. (Even without this provision we probably could have deducted it under § 162.

1. Capital Point2. Tracing Point3. Gross to Adjusted Gross §62 deductions.

Acquisition loan: money must be to buy or improve, can’t go over a million, and it must be secured.Home equity: has to be secured, 100,000 limit.

Handout 11 discussionA) Deductions only for property, not services. The treasury has said that giving blood is a service.B) Not a charitable organization.C) The Stock: Because this is property which if it were sold would give rise to long term capital gain, the property is considered to be the same as cash. The only limitation is on how much you can give of this type (50% of adjusted gross income) to publicly supported charities. You would have to pay income on any excess donated.

If he would have sold the stock he would have had 2500 of gainRemember stock is intangible property

Discussion of Handout 12Tangible physical property will only be treated as cash only if the charitable donation will be used in its capacity for a public purpose. Which would be how this flag would be used if these people were able to donate the flag to the government. Tangible is decided by what gives rise to its value.

Eventually the city determined to give the flag back to them. However, the flag that they got back was not theirs. They think it might have been lost or stolen.

Back to the blood thing. Even it was determined to be property, it still wouldn’t be fully deductible because the Supreme Court says that you can’t show long term gain. (and you haven’t owned it for more than a year).

32

November 18, 2003

Open book exam.

Hypo: You give 100 to charity but you get a meal. You should deduct the check you wrote minus the cost of the dinner. §6115. If the check is over $75, the charity is obligated to give you a written statement of the worth of your contribution. (The excess of what you give over what you get back)

Hypo: What if what you give is appreciated property? Lawyer gave stock to UB which was worth 3000, he paid 500 for it. As we analyzed it, the deduction is for 3000 but he will also get the goody of not having to realize the gain. (Saving the tax you would have paid by selling the property and donating the proceeds. It’s a double benefit.)

Hypo: Suppose Lawyer sold the stock to UB for 500. (Sale at basis… bargain sale to charity). Would have taken a 2500 deduction. And he also didn’t have to report any gain. For a while the Treasury was allowing him to get away with it. Now he can’t. What he really was doing is selling 1/6 of the property and he was giving the other 5/6 away. Therefore you could only use 1/6 of the basis. On that transaction today he would still get the 2500 deduction, but he would be treated as selling 1/6 of his stock, basis of about 83, and he would have to report that gain.

Regulations:1.1001-1e; (3) 1015-4(b) (1)

Suppose Lawyer sold it to his kid for 500. No charitable deduction (kid not a charity), but these regs allow him not to report the gain. Kid gets carry over basis of 500. He’s shifted the tax to his kid under Blair.

The Mechanics of Capital Gain:See page 49 of our materials. For Line 24 and 25, §61 applies. Payment for the preparation of the tax return ($150) but 2% of AGI more than this so he’s not able to deduct any of the preparation fee. Kenseth involves the stuff on line 20.

Remember §162?

Kenseth: Age discrimination suit against employer. Court said it rose in connection with your employment and you business as an employee. When he recovers 230,000 and pays his lawyer 90,000; he didn’t want to include the 230,000 and exclude the 90,000. He wanted to include the 140,000 only.

§63(a): Gross income minus deductions§63(b): If don’t itemize, Adjusted Gross Income minus standard & 151 personal exp.

Kenseth is on page 57 of our supplement. According to Posner: Taxable income is gross income minus allowable deductions. If a taxpayer obtains income of 100 at a cost in generating

…. Can he deduct the amount he pays the author? No. It’s a capital expense. He must add it to his basis in the book. What does he do with the 100 that he pays for the guy to edit the book? Britannica §263 (a). It should go into the cost. (If you pay a carpenter to build a tree house that you are going to

33

rent, it is added to your basis.) What’s the result when he sells the whole thing? He has 400 gross income. Taxable income? Yes.

Posner is basically saying that this case is governed by Lucas v. Earl. Aside from whether you can assign a contingent fee… what is LvE about? What is the government worried about? Two rides up the bracket. They’re worried about shifting income by gratuitous transfers. Did this taxpayer give away anything.

Look at the last question on the handout:Suppose T transfers his/her claim against the employer to L in return for L’s promise to pay T

60% of the settlement/verdict? In effect that would exclude the 98,000 that was such a problem. What’s the basis in the claim? What if state law said there was nothing wrong with that? So how much would you pay Kenseth for his claim, assuming that you knew what would happen. Remember Jordan Marsh. Structuring transactions.

Joyce says Kenseth shouldn’t have come out the way it did.

Problem: The education law clinic brings a claim under a federal statute to state that the child’s placement isn’t appropriate. Hires a lawyer. The federal statute provides that the university will provide for the lawyer’s fees. Is that income to the parent’s?In Kenseth the ultimate payment to him was cash, which represented payment for a tort claim which was not excluded under 104a2 because it was a nonphysical injury. Kenseth wanted to know if he had to report the entire amount. Suppose that the lawyer worked for nothing. Would anybody have to include the value of what was received from the school board. (The value being proper placement of the student). No. It would be under the General Welfare Doctrine. Not included in §61.

Capital GainPreference for long-term capital gain which takes the form of rate differentials. Handout says 20%; now it’s 15%. There is a great differential. Lawyer’s marginal rate was 30-something percent; but his long term capital gain would be at 15. Calculate taxable income on its own without the capital gain, and then add it together later.

Capital losses get disadvantageous treatment. They are only allowed to be deducted in a capital year, minus capital gain plus 3,000. If they are ordinary losses, there’s no limit (up to the amount of income you’ve made). So there is a push to make losses not capital, but ordinary. (Reminds us of Cottage Savings and Realization).

Handout 14§1222(3) Gain from sale or exchange.

34

November 20, 2003Kenseth: When the plaintiff receives 230,000 and pays the lawyer 92,000; it’s clear that under all versions that the attorney ends up paying tax on the 92K. The only question is whether the plaintiff includes it and then deducts it.

Suppose a faculty member had to include it in their income, but then has to give it to the school. What kind of deduction could he make. Work related expense. It’s part of earning a salary. Charitable Deduction (as long as the school is a charity).

The worst kind of income is ordinary income, the best kind is long term capital income Short term gain is better than long term gain Sometimes it’s good to have short term gain rather than ordinary income because it can

sometimes raise the umbrella for reducing capital losses. Losses: It’s always bad to have a loss. If you’re going to have a loss, the best kind to have is an

ordinary loss b/c there is no limit to its deductibility. It’s only limited by your income. The worst kind to have is a long term loss b/c a long term loss directly cancels out long term gain which gives rise to preferential treatment.

Hypo:Sale of business truck. Truck was purchased…

§1221-Capital Asset Exceptions(a)(1) Inventory Exception

Why does this happen? Eisner v. MacComber. Tax Free Gain. Unrealized gain. That’s the reply. I didn’t catch the question. It has to do with complaining and selling Blackacre.

The IRS worries about the “lock in effect” where people make bad economic decisions to avoid paying large taxes. In effect, the preferential treatment removes disincentives. This explains the inventory exception. Macy’s wants to sell. That’s what Macy’s is about… they’re not going to hold until the angel of death comes.

§1221 (a)(3) a copyright, a literary, musical, or artistic composition, a letter or memorandum, or similar property, held by--(they’re also trying to sell)

1-4 are most important

§1221 (a) (2) property, used in his trade or business, of a character which is subject to the allowance for depreciation provided in section 167, or real property used in his trade or business;

Why doesn’t this get capital gain treatment?o We do, but not under this section §1231 (covers sales of long term business property)

Says that in a given year, if you see how many trucks you’ve sold, put it in a large pot and see if you’ve had a net gain, or a net loss. If you have a total net gain. All the transactions in the pot are considered capital assets. The converse is true. If net loss, everything in the pot is ordinary.

35

§ 1245. Gain from dispositions of certain depreciable propertyLower of gain or depreciation will be ordinary income. (The gain was six and the depreciation was six). Therefore the 6 is ordinary income. See the supplement page 60.

What if the truck was sold for 31. Basis of 24 (6 depreciation). Gain of 7; 6 of depreciation. The 6 would be ordinary income. The 1 would be §1231 capital asset.

Why did they do this? Policy wise? When you took the depreciation you offset ordinary income. When you sell property your gain to the extent of the depreciation should be ordinary because you used it to offset ordinary income.

Congress won’t give you capital gains on the sale of this type of property to the extent of depreciation. So if the depreciation is more, there won’t be anything left over to go into the pot.

31-24 = 7; 6 depreciation. Six is ordinary gain. 1 goes into the §1231 pot. 27 – 24 = 3; 6 depreciation. 3 is ordinary gain. There’s nothing left for the pot. They’re saying to the extent of the 1, that they’re worried about him holding on to the truck for

too long when they should get rid of it economically.

So if it was a truck dealer, §1221 (a) would apply. Same with a Real Estate Seller. It really depends on how busy they are. The other troublesome area is Traders in Stock. They aren’t considered to be in business because they’re “speculating”, unlike a dealer in securities….

Start with 1221 1245 1250 1231.

We’ll start with Corn Products next time.Really study the explanation on page 658-59 and the table on 660 (8.1). If you understand that, you’ll understand Corn Products.Read to the end.

November 25, 2003

Charitable contribution deduction makes distinctions turning on whether the property that you gave would give rise to capital gain if sold.

Corn Products/Arkansas Best

Hypo: To protect against a drop in cattle prices, a cattle farmer buys a cattle/put future, ie. the right to sell cattle to X for $Y.

Is the put a capital asset? If the purchaser was in the business of dealing with speculating cows, then yes. Today a corporation wouldn’t have this issue b/c the break is only for individuals.

Corporations don’t even get that extra 3000. Arkansas Best wanted to have ordinary losses. Even though Corn Products is a gain case, and Arkansas Best is a loss case, the Supreme Court

is in the same position. They want the truth to be told. Analysis: Is it property 1221. Yes. It’s a contract. Arkansas Best: Everything is a capital asset unless you can fit yourself into an exclusion.

That’s how the statute is written. But the question became: even if it’s property, and if we can’t ask the question of whether it’s

the kind that Congress meant to give capital treatment, is it’s purpose so close to the business that we should treat it as ordinary business losses and give it ordinary treatment.

36

The Court was not clear when they decided Corn Products. On 662: the capital asset provision must not be so broadly applied as to defeat rather than further the purpose of Congress.

Thirty years later, the court said, hmmm maybe we shouldn’t have said that. They really were within 1221(1)

Arkansas Best says… well the corn probably could have fit under the inventory exception. Arkansas Best: The purpose in acquiring and holding the stock was irrelevant to the

determination whether the stock was a capital asset. § 1221. Capital asset defined (a) In general.--For purposes of this subtitle, the term "capital

asset" means property held by the taxpayer (whether or not connected with his trade or business), but does not include-- (that phrase was meant to say even if instead of whether or not).

It needs to be found in one of the exclusions. This caused a lot of problems for the business industry. For example, cattle farmers.

Congress says no to hedging in: 1221 (7) any hedging transaction which is clearly identified as such before the close of the day on which it was acquired, originated, or entered into (or such other time as the Secretary may by regulations prescribe); or

Commissioner v. PG Lake Inc. Page 680: “We do no see here any conversion of a capital investment.” So in our hypo C on page 3; it could be seen as ordinary income.

Where certain lump-sum amounts were received as consideration for transfer of oil payment rights and a sulphur payment right, but such consideration essentially was a substitute for what would otherwise have been received at a future time as ordinary income, there were no conversions of a capital investment, but a mere conversion of future income into present income, and therefore consideration received for such payment rights was taxable to seller, under Internal Revenue Code, as ordinary income subject to depletion, rather than being taxable as long-term capital gain. 26 U.S.C.A. (I.R.C.1939) § 117.

This has to be irrelevant. We said that hypo A was capital gain. The 200,000 was a substitute for what would otherwise be received at a future time. Value of the fee. But that’s not enough to make it ordinary income. Because if it is, then everything is ordinary income. And if it isn’t then everything is capital gain.

Look at Hypo B. So we have a dilemma as to what is and what is not a capital gain. So we reach for the same thing we

reached for in assignment of income. It all comes down to a reversion. You have to dance the right way to get capital gains.

BUT look at the footnote on page 680. If you retain the reversion you will get ordinary income.

McAllister (page 675) Trust case; Life Estate. Relied on Blair. The dissent says; what the hell does Blair have to do with this? Blair was an income shifting case. But we know better. They use the same rule. So that in our Hypo C(i): Capital Gain. McAllister. Gave

up entire interest. So what about C(ii)? The answer is Hort. Ordinary income. Substitute for future ordinary income.

(But we know that the real reason is reversion) What if instead, he sold the entire property. (Selling the reversion too). Then he would get capital gain.

No reversion. There is no rationale for why they did that, but at least you can know the rule and predict what will

happen.

December 2, 2003

37

Arkansas Best: No questions regarding business motive. No Congressional Intent Corn Products squeeze into 1211

Pittston: (Note 4 on page 708) Landlord paid the tenant to get out. No reversion was retained by the tenant. Sells the whole 25 years. Consistent with McAllister, tenant gets capital gains. If it was the other way around and the tenant paid the landlord, it would be the Hort case

substitute for rent = ordinary income. 3 reasons capital gain was denied:

o Substitute for ordinary income. This is the strongest argument. Even if you can get over the next two arguments, you will always have to deal with this problem. It is based in Hort and Lake. Joyce says although it is strong, it is the worst. Because it means that if you sell B/A for 100,000 it is then a substitute for rent. It is an argument that proves too much. But, it continues to carry the day in these cases. Point out the reversion. You can also analogize other kinds of cases as falling under cases like Hort.

If you face this argument, you can’t say that Hort is baloney. The only thing left is Arkansas Best. The problem becomes: where do we draw the line? One year? What’s the

difference between twenty or thirty years? But there is no wiggle room. The fact is that personal service contracts will most likely get ordinary income

treatment.o No sale or exchange, the contract rights were merely released. (‘Disappeared’ or

‘Vanished’… Nothing has been transferred.) Not really a good argument says Joyce.o This is a bare naked contract. Not a good argument says Joyce, or else bonds and all

that would also be denied.

Skip the hypos on 672 and 673.Skip section 1001 (e) in McAllister. The life estate holder gets capital gains treatment. (But no basis offset).

Payments: Two questions:1. Business or personal; 2. Capital or expense

38