Tax Structure

1. Three things you want to do in all tax transactions: One plank of tax planning is to defer gains. A second theme is
to convert ordinary income into capital gains, because capital gains are taxed at lower rates than ordinary income.
The third theme is to accelerate losses. The sooner you can use your unrealized losses for tax purposes, the more
valuable they are to you
2. The benefit of deferral
a. the time value of deferring income is that the after-tax value of the deferred income earns interest at
the pre-tax rate for the life of the deferral.
b. The longer the period of deferral, the greater the interest return on the taxpayer’s investment. The
beneficiary of a deferred tax gains interest on the deferral until the receipt of the sum e.g. a roth ira. In
contrast, an individual who decides to save for retirement by earning interest on a savings account must pay
an annual tax on any interest earned.  
3. Things to Consider
a. Under what circumstances does the code section apply?
b. How does it operate if it applies?
c. Is the code section consistent with the Haig Saimons definition of income?
d. What policy goals are served or disserved by the provision?
4. COMPUTING TAX PAYERS LIABILITY
a. The starting point in computing a taxpayer’s liability for the year is the taxpayer’s GROSS INCOME.
i. Items expressly included in or excluded from gross income can be found in S61 and 71-140.
ii. With regard to gross income derived from business, GI really means the gross receipts from the
business less the cost of the items sold.
iii. Gross income also includes gains derived from dealings in property. The code calls the amount the tax
payer receives on the sale or exchange the “amount realized.” The code calls the taxpayer’s
unrecovered investment in the property (the cost of acquiring the property) “adjusted basis.” Thus, a
taxpayers realized gain equals the amount realized less the taxpayers adjusted basis-in other words, a
taxpayers gross income from dealings in property is net of the value of the property less taxpayer’s
unrecovered investment in the property.
1. Note: not all realized gains from dealings in property are included in gross income. A
realized gain is included in gross income only if the gain is also recognized. The general rule
is that a realized gain is recognized and included in income, but a realized gain is not
recognized if a specific nonrecognition rule in the code applies (S1001©). If one of the
specific nonrecognition rules applies to a transaction (e.g. “like-kind exchange”), the tax on
the gain realized in the transaction is deferred until the taxpayer sells the property received
in the nonrecognition transaction.
b. After computing gross income, the next step is to compute the taxpayers AGI.
i. Section 62 defines adjusted gross income as gross income less costs of earning income and other
above the line deductions i.e deductions listed in S62 are deducted when computing AGI.
c. The next step is to compute the taxpayer’s taxable income.
i. Section 63 defines taxable income as the taxpayer’s AGI less the sum of (i) the taxpayer’s personal
exemptions plus (ii) the greater of (a) the taxpayer’s standard deduction or (b) the taxpayer’s itemized
deductions.

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 1. A taxpayer is allowed one personal exemption deduction for each of the following: (i) the
taxpayer; (ii) the taxpayer’s spouse; and (iii) each of the taxpayer’s dependants. (s151). The
standard deduction amount is adjusted for inflation.
2. Itemized deductions include all deductions other than the personal exemption deduction
and the deductions allowable in computing AGI under s62 and s63(d) e.g. mortgage interest
and charitable contributions.
3. Note: Although many types of expenses incurred in business or in the production of income
are deducted in full in the year in which they are incurred, if an expense creates an asset
that will last beyond the year in which it was incurred, the expense must be capitalized.
d. After computing the taxpayer’s taxable income, the next step is to compute the amount of tax due on the
taxpayer’s taxable income.
i. Taxable income of individuals is taxed at rates specified in S1(a)-(d) of the Code.
ii. The rate applicable to the last dollar of income earned by the taxpayer is the taxpayer’s marginal rate.
The taxpayer’s effective rate is his tax liability for the year divided by his taxable income for the year-
same as the taxpayer’s avg. rate.
iii. A rate schedule exists for each of 4 possible filing statuses: (1) married filing jointly; (2) head of
household; (3) individual; (4) and married filing separately.
1. Note: There is also an implicit zero rate since a taxpayer does not owe tax if her taxable
income does not exceed the sum of her personal exemptions and standard or itemized
deductions. Also, while the top nominal rate in S1 is 39.6%, the top rate is really higher
because personal exemptions and certain itemized deductions are subject to a phase out as
taxpayer’s income increases beyond certain threshold amounts.
2. Capital gain is taxed differently than the remainder of income. Capital gain is the revenue
from the sale of a capital asset. Capital gain is short-term if the capital asset was held by the
taxpayer for a year or less before the sale. The precise rate that applies to capital gain other
than short-term capital gain depends on the type of asset sold. SS1(h) 1222-the maximum
capital gain rate is generally 15%. The preferential capital rates apply to individuals, trusts,
and estates, but not to corporations.
a. High tax bracket taxpayers pay less on capital gain than on ordinary gain, so they
prefer to characterize gain as capital.
3. Note Exam Point: The progressivity of the income tax encourages high bracket taxpayers to
attempt to shift income to family members in lower rate brackets. For this reason,
unearned income (that is, income not from personal services) of a child under age 19 (or a
child between the ages of 19 and 23 who is a full time student) is taxed at the parent’s
higher tax rate under S1(g), the so called kiddie tax.
e. After applying the appropriate tax rates to the taxpayer’s taxable income, the next step is to reduce the tax
due by the credits for which the taxpayer is eligible.
i. A credit is a direct reduction in tax. A deduction or exclusion, on the other hand, reduces the
taxpayer’s taxable income; it reduces the tax due from the taxpayer by an amount equal to the
product of multiplying the deduction or exclusion by the taxpayer’s rate.
1. If the taxpayer’s tax due exceeds the taxpayer’s credits, the taxpayer owes tax, but if the tax
credits exceed the taxpayer’s due, the taxpayer receives a refund (not all credits are
refundable).

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 ii. For purposes of computing tax liability, taxpayers use either the cash method of accounting or the
accrual method of accounting. A taxpayer must use the same method for both tax and financial
accounting. S446(a) (see section for accounting below)
5. CHARACTERISTICS OF GROSS INCOME
a. S61 provides that gross income includes “all income from whatever source derived.”
i. What if someone is compensated with services?
1. The fact that the compensation is in the form of services rather than cash is irrelevant. See
e.g. Rev. Rule. 79-24 (individuals taxed on services or property received under barter
arrangements).
b. The Haig Simons Definition of Income
i. Income equals the sum of (i) the taxpayer’s personal expenditures plus (or minus) (ii) the increase (or
decrease) in the taxpayer’s wealth. This is the ideal definition that many tax scholars advocate for, but
has yet to be implemented.
c. Noncash compensation: Fringe Benefits
i. S61(a)(1) provides that gross income includes “compensation for services,” including “fringe benefits.”
However, the code contains various provisions that exclude from gross income specific noncash fringe
benefits.
1. Individuals treated as employees for purposes of fringe benefits:
a. Retired and disabled employees and surviving spouse of employee
b. Spouses and dependents
i. Per S152, a dependent is a qualifying child or qualifying relative.
1. A qualifying child: is a person who: (i) is the taxpayer’s child or
sibling, or the descendant of the taxpayer’s child or sibling; is 18 or
younger (or 23 or younger if the person is a full-time student); (iii)
has the same principal place of abode as the taxpayer for more than
half the year; and (iv) has not provided more than half of his own
support for the year.
a. Note: the live at home requirement of S152 allows for a
temporary absence from the home to attend school.
2. A qualifying relative is a person: (i) who either (A) is the taxpayer’s
child or child’s descendant, parent or parent’s ancestor, sibling,
aunt, uncle, nephew, cousin, or in-law, or (B) has “the same
principal place of abode as the taxpayer and is a members of the
taxpayer’s household”; (ii) whose gross income for the year is less
than the S151 personal exemption amount (e.g. $3,400 in 2007); (iii)
who receives more than half of her support from the taxpayer; and
(iv) who is not a qualifying child of the taxpayer.
a. If a taxpayer’s child is not a qualifying child, they still may be
a qualifying relative.
2. Employer-Provided Meals and Lodging
a. S119 under certain circumstances allows employees to exclude from income the
value of employer-provided meals and lodging.
i. S119 excludes from income the value of meals if (i) the employer furnishes
meals to an employee, her spouse, or her dependants; and (ii) the meals are
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 provided for the convenience of the employer; and (iii) the meals are
provided on the business premises of the employer. The same section
excludes the value of lodging if (i) it is furnished on the business premises by
the employer to an employee, her spouse, or her dependents; (ii) it is
provided for the convenience of the employer; and (iii) the employee is
required to accept the lodging as a condition of her employment.
1. Focus on “furnished" by the employer
a. Commissioner v. Kowalski (1977)
i. A New Jersey State Trooper received meal
allowances because, while on call, he was required
to eat his meals at a public eating place within his
assigned patrol area. Held, S119 does not cover
amounts reimbursed for meals. S119 was intended
to cover situations in which the employee is
constrained in his or her choice of food, and
Kowalski was not so constrained.
2. Focus on “business premises”-
a. Lindman v. Comissioner (1973)
i. held that the employer’s business premises
included homes that are located near but not on
the property where the employer conducted most
of its business (home was across the street and
employee performed some of his duties at home).
b. Commissioner v. Anderson (1966)
i. Held that the business premises of a motel did not
include a home for the motel manager, which was
located two blocks from the motel, because the
employee did not perform a significant portion of
his duties there.
3. Focus on “convenience to the employer”
a. Generally a taxpayer can establish that the meals and
lodging were provided for the convenience of the employer
by showing that the employee is required to be on-call even
when the employee is not working.
b. Bengalia v. Commissioner
i. Held that meals and lodging for a manager of a
hotel were ok because they were provided so that
the manager could perform his duties not as
additional compensation.
4. Exception: if an employee is given money to purchase meals, then
one can deduct it as a de minimis fringe if it is occasional and such
that its purpose is to extend the employees work hours or for the
convenience of the employer.
b. Policy:
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 i. Does nontaxation of food and lodging lead to compensation arrangements
that otherwise would be inefficient?
1. Yes, suppose that meals and lodging cost a hotel 18k but are worth
15k to the taxpayer. In the absence of taxes, the hotel would simply
give the taxpayer 16k making both parties better off.
ii. Does Fairness and efficiency require a taxpayer to be taxed on these
benefits?
1. No, taxation of lodging and food at FMV would drastically increase
ones income. However, the taxpayer would probably not be as well
off as mot person earning that same sum because he is forced to
spend a substantial amount of it on particular food and lodging. One
way to determine if a tax is inefficient is to ask whether it prevents
(or induces) transactions that would be attractive (or unattractive)
in a no-tax world. It may also be economically inefficient to tax one
on the retail value of the meal and lodging because, in some cases,
it would discourage parties from sensible compensation
arrangements that included meals and lodging. For instance, the
meals and lodging might cost the employer a modest amount (e.g.
8k), but might be worth more to the taxpayer (15k). Second, the
hotel might benefit from having the taxpayer easily available during
nonworking hours. However, if the meals and lodging are taxed at
their retail value (e.g. 50k), it will no longer make sense for the
parties to reach agreements that include this benefit.
iii. If we could determine the amount that the taxpayer would have otherwise
spent on board and lodging, then would it be fair and efficient to tax him on
that sum since that is the amount he saves each year by virtue of his
compensation arrangement?
1. Probably not, the meals and lodging may be more or less valuable to
the taxpayer than the cost of the alternative arrangements. The
taxpayer may not be willing to pay the retail price, but may still
prefer the hotel food and lodging he would otherwise purchase. As
an alternative, an employee may also find the quarters much less
desirable than the food and lodging he would otherwise purchase.
iv. How should a taxpayer be taxed on this type of transaction?
1. The ideal solution would be to tax the meals at their value to the
taxpayer. Taxation at that value, often referred to as the good’s
shadow price, would be efficient because a benefit that is attractive
in a no-tax world would be equally attractive if taxed at each
individual’s shadow price. Taxing the taxpayer at this price also
seems fair since that’s the price the taxpayer would have paid for
the benefit anyway.
ii. Employer-Provided Insurance and Health, Accident, and Death Benefits (79, 101(a), 105, 106, 213,
223)

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 1. Section 105 excludes from gross income amounts employees receive from their employers
as reimbursement for medical expenses and the value of services employees receive under
an employer-provided health care plan.
a. Conditions: The benefits of S105 are conditioned upon the requirement that the
employer health care plan not discriminate in favor of highly compensated
employees (see S132(j(1) for definition of highly compensated employee)-generally a
health plan will meet this requirement if the benefits provided to highly
compensated employees are also provided to rank and file employees.
i. This exclusion has the same effect as requiring employees to include the
benefit as income and allowing them to take a corresponding deduction for
those expenses.
b. Unreimbursed medical expenses and contributions to a Health Savings Account
i. S213 allows a deduction for unreimbursed medical expenses, although the
S213 medical expense deduction is subject to significant limitations
including a floor of 7.5% of AGI.
1. E.g. if Leslie, who makes 4,500, had to pay 4k in medical expenses.
She could deduct the difference between the 7.5% floor, 2175, and
her 4k in expenses=1825.
ii. S223 provides that taxpayers can deduct their contributions to a Health
Savings Account and exclude employer contributions. Also, distributions
from HSAs are not taxed if the distributions are used to pay unreimbursed
medical expenses.
c. Life Insurance
i. If an employer buys life insurance for an individual employee and the
employee designates the policy beneficiary, the value of the life insurance is
income to the employee. Reg. S1.61-2(d)(2)(ii)(a). Under S79, however, if an
employer buys group term life insurance for its employees, the employees
can exclude the value of the insurance from gross income to the extent that
that the cost of the insurance does not exceed the sum of 50k (excludes
from income the premiums that finance the first 50k of group insurance).
ii. S101 holds that the proceeds of the life insurance contracts payable by
reason of death are also nontaxable on the beneficiary.
1. There are exceptions if there is a transfer for valuable consideration
or if the payment of the proceeds occurs at a date later than death.
See 101(a)(2) and 101 (d)
d. What is the likely impact of the differential tax treatment of employer paid and
employee paid medical expenses?
i. The fact that individuals who receive employer-provided medical benefits
pay less tax than individuals who pay for their own medical care encourages
employees to take a portion of their salary in the form of in-kind medical
benefits. Employees who must purchase medical insurance with after –tax
dollars will pay higher taxes than employees with identical economic
incomes who are able to secure tax-free employer provided medical care.
iii. The Section 132 Exclusion for Miscellaneous Fringe Benefits
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1. Section 132 covers miscellaneous fringe benefits that are not covered by other specific
exclusion sections. Section 132 excludes from income the following eight categories of
benefits (pursuant to S132(h) retied and disabled employees, the employee’s spouse, and
employee’s dependent children<or children whose parents are deceased and hasn’t turned
25> qualify for both no additional cost service and qualified employee discount):
a. No additional cost services
i. Requires two elements: (1) the benefit constitutes a service that imposes no
substantial additional cost to the employer; and (2) the service is offered for
sale in the ordinary course of the line of business of the employer in which
the employee is performing services (S132(b)(1) & (2)). the latter part of
this rule is designed to prevent employees of corporations that operate a
number of different types of business from receiving a wide variety of
services on a tax-free basis.
1. E.g. a hotel could offer employees free use of an unused hotel
room.
2. If an airline worker was permitted to reserve a seat, as opposed to
flying standby, he would be taxed on the seat because he may
displace a paying customer. Reg. S1.132-2(c)
3. Has a nondiscrimination provision.
ii. Note Exception:
1. Services provided pursuant to reciprocal written agreements among
employers operating similar business can qualify so long as no
employer incurs any substantial additional cost in providing the
service. (S132(i))
a. E.g. airline code share partners permitting one employee to
fly on a partner airline (on a standby basis) for free
b. Special rule for parents in the case of air transportation: any
use by a parent of an employee shall be treated as use by
the employee.
iii. Exception: Regulation S1.61-21(g)(12) provides a special valuation rule
where most of the passengers on a company airplane are traveling for
business and an employee “hitches a ride” on the plane (this generally
applies where a company has a plane for business use, but are not in the
aviation industry). The regulation provides that if at least half of the seats on
the employer’s airplane are occupied by the employees traveling primarily
for the employer’s business, the value of the flight to the employee
traveling for personal reasons will be deemed to be zero.
b. Qualified employee discounts
i. The 132(C) test for excluding employee discount varies depending on
whether the employee is purchasing goods or services at a discount. An
employee purchasing goods can exclude a discount up to the employer’s
gross profit percentage (132(c)(1)(A)) (See below for details). An employee
purchasing services may exclude a discount of up to 20% (132(c)(1)(B)). The

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 exclusion for qualified discounts is limited to goods or services sold in the
line of business in which the employee is providing services. (132(c)(4))
1. Has a nondiscrimination provision.
2. Gross profit percentage is equal to the gross profit on goods sold
(aggregate sale price-aggregate cost of goods sold) divided by the
aggregate sale price of the goods.
a. E.g. a store’s total sales for the prior year were 600k and its
costs of goods sold was 400k. The gross profit percentage is
(600-400)/600=33.3%. In this scenario the discount could
not exceed 33.3%.
3. Discounts on property held for investment (as well as discounts on
real property) are not excludable from income.
c. Working condition fringe benefits
i. An item that could be deducted as a business expense under S162 or 167 if
paid directly by the employee qualifies as a working condition fringe.
1. E.g. an employee who would be able to deduct the cost of a
subscription to a professional journal if he bore the cost is not taxed
if the company supplies it free of charge.
ii. S162 allows taxpayers to deduct all the “ordinary and necessary” expenses
paid or incurred during the taxable year in carrying on any trade or business.
S167 allows taxpayers to take depreciation deductions on property used in a
trade or business or held for the production of income.
1. Exam point: It must be noted that the working condition fringe
benefit is more valuable than the corresponding business expense
deduction for most taxpayers. First, certain employee business
expenses are deductible only if a taxpayer itemizes deductions. S63.
Second, employee business expenses generally are deductible only
to the extent they exceed 2% of the taxpayer’s AGI. S67
iii. Gifts: The deductable allowance for gifts to a single customer is maxed out
at $25 per taxable year. S274
d. De minimis fringe benefits
i. Any property or service the value of which is so small as to make accounting
for unreasonable or administratively impracticable (132(e)(1)). E.g.
occasional parties, occasional theater or sporting event tickets, coffee,
doughnuts, etc.
ii. Also, meal money qualifies if it is reasonable and satisfies three conditions:
(i) the meal money must be provided only on an occasional basis, (ii) it must
be provided because overtime work necessitates an extension of the
employee’s normal work schedule, and (iii) it must be provided to enable
the employee to work overtime. Reg. S1.132-6(d)(2)
1. 1.132-6(e)(2) states that membership in a private country club or
athletic facility will not qualify as a de minimis fringe.
2. See ? #22 on pg. 60 E&E for more info

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 iii. Note: S132 provides a special rule for eating facilities operated by
employers for their employees. The eating facility will be treated as a de
minimis fringe if (i) it is on or near the employer’s business premises and (ii)
the revenue from the facility generally equals or exceeds the employer’s
cost of operating the facility. A cash allowance for meals will also qualify as
de minimis if it is occasional and so that the employee can work
harder/extend its hours/etc.
e. Qualified transportation fringe benefits
i. Includes qualified parking (175 max a month-adjusted for inflation?), transit
passes (100 max a month-adjusted for inflation?), and transportation
provided in a commuter highway vehicle that is used principally to drive
employees to and from work (132(f)(1)).
1. Qualified parking is defined as parking provided to an employee on
or near the business premises of the employer.
2. Section 132(f)(3) provides that the free parking may be provided
directly or through cash reimbursement.
3. A commuter highway vehicle must seat at least 6 adult passengers
(not including the driver) and at least 80% of the expected mileage
of the vehicle must be incurred in transporting employees (at half
capacity or greater) to and from work.
a. E.G. if a cab that seats 5 was hired to pick up people it
wouldn’t qualify.
b. Note: even if it qualifies as a commuter highway vehicle,
only $100 (I think it may be adjusted for inflation-check this)
( may be excluded. S132(f)(2)(A) and Rev. Proc.2006-53
4. Does not have a nondiscrimination clause.
f. Qualified moving expense reimbursements
i. Amounts received by an individual from an employer as payment for
expenses that would be deductible by the employee as moving expenses
under S217 if paid by the employee. (S132(g))
g. Qualified retirement planning services
i. Includes retirement planning advice or information provided to an
employee and her spouse by an employer maintaining a retirement plan.
(S132(m)(1)).
1. The legislative history reveals that the exclusion applies to advice
about retirement planning, but does not apply to tax preparation,
accounting, legal or brokerage serves related to retirement.
2. A separate nondiscrimination rule applies (132(m)(2))
a. This discrimination policy applies in the case of highly
compensated employees only if such services are available
on substantially the terms to each member of the group of
employees normally provided education and information
regarding the employer’s qualified employee plan.
h. Qualified military base realignment and closure fringe benefits
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 i. Special Rule: On-Premises Athletic Facility
i. The facility must be located on the premises of the employer and operated
by the employer. Further, substantially all the use of the facility must be by
employees, their spouses, and their dependent children (132(j)(4)(B)(iii)).
iv. Imputed Income
1. Imputed income constitutes increases in wealth realized through non-market transactions
e.g. the individual who grows his own food and builds his own home. It also includes the
rental value of an owner-occupied home or a purchased car or suit.
2. Policy: the taxation of imputed income raises seemingly insurmountable problems of
valuation and liquidity and may be objectionable for other reasons. We really do not want a
system that monitors whether we do our own taxes, mow our own lawns, or clean our own
houses. Nonetheless, nontaxation of imputed income raises equity and efficiency problems.
3. May need further reading
v. Windfalls, Gifts, Scholarships, Prizes, and Transfer
1. Windfalls
a. In Commissioner v. Glenshaw Glass (punitive damages held to constitute gross
income), the S.C. expanded the definition of income to include any “undeniable
ascensions to wealth, clearly realized, and over which the taxpayers have complete
dominion.” This definition of income is consistent with the Haig-Simons definition.
Under this definition, it is irrelevant whether the taxpayer, through the provision of
his labor or capital, “earned” the income; instead, what matters is whether receipt
of the item increased the taxpayer’s wealth.
b. In Cesarini v. United States a taxpayer discovered 4,500 in a piano he bought for 15
dollars. The court held that the cash was income in the year in which it is found.
i. Note: the circumstances in Cesarini should be distinguished from situations
in which a taxpayer discovers that something he bought was worth more
than he originally paid for it. In that situation, the taxpayer would not have
income until the property was sold or exchanged-in other words until the
gain was “recognized.” The question hinges on whether the item was
“purchased.” For instance, if Matt Murphy had bought the baseball from a
kid who caught it, then he wouldn’t have to pay the taxes on it until after it
is sold.
2. Gifts, Devise, Bequests, Inheritance (SS102,1014,1015)
a. What is a gift?
i. Neither S102 or any other code define the term gift, but the S.C. has defined
a gift as a transfer that stems from “detached and disinterested”
(disinterested means free of bias and self-interest i.e. having no stake in the
outcome) generosity of the donor. Comissionr v. Duberstein. The Duberstein
test, which focuses on the donor’s state of mind, is subject to
exceptionssee S102.
1. E.g. S102(c) explicitly provides that a transfer from an employer to
employee cannot be a gift. Thus, unless some other Code exclusion
(e.g. S132(e) or S74(c)) applies, even the rare transfer to an

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 employee that arises from an employer’s detached and
disinterested generosity is taxable compensation.
a. S132(e) may allow for an exclusion if the gift can qualify as a
de minimis fringe e.g. if an employee occasionally gave its
employees inexpensive gifts such as a new year turkey.
b. S74(c) is an exclusion for employee achievement awards
and allows for exclusion where the cost of the award
received by the taxpayer does not exceed the amount
allowable as a deduction to the employer for the cost of the
award.
2. What about in cases where an employee values the gift at
substantially less than what its worth?
a. Courts have taxed recipients of nontransferable property on
amounts substantially less than the retail value of the
property. See e.g. U.S. v. Drescher or Turner v.
Commissioner.
b. If the gift is transferable, the income recognized would be
equal to the retail price of the item or the amount it is sold
for. See McCoy v. Commissioner (where a game show
contestant won a car and immediately sold it to a dealer at
wholesale, the contestant was required to include in income
the wholesale and not retail price).
3. Note: gift given where two parties are involved in a joint venture:
In the case of two parties involved in a single joint venture (single
joint venture means companies working together in a single
transaction-whether one hires the other, or whether it is an actual
joint venture is irrelevant) , a transfer may or may not be a gift. The
court may argue that the transfer is intended as additional
compensation for past service or an inducement for future service,
and is therefore taxable. However, one could argue otherwise.
While not dispositive, an argument that it is a gift would be helped if
the other party (a) did not deduct it as a business expense and (b)
there is no prospect for ongoing work.
a. There is a counter argument that whether the person
deducts it is irrelevant is that the person would always
deduct it if they could because it saves them money.
b. Policy: Tax implication of a gift -If the Glenshaw Glass and Haig-Simons definition of
income was applied to gifts, the donee would have to include the gift in income
because it raises his wealth. Instead, however, S102 provides that a donee excludes
gifts from income because gifts, generally, are included in the donor’s tax base (i.e.
the donor cannot deduct the gift).
i. Best justified on the grounds that most gifts are made to family and it makes
sense to treat said family as one taxable unit and that it is easier to
administer taxes on the donor. Further, it would be difficult, albeit
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 impossible, to administer a system that taxed gifts between family members
e.g. would you tax a child on the value of food and lodging provided by his
parents? We could avoid this problem, at least, by requiring taxation only on
gifts above a certain threshold amount.
ii. Note: if the donor is in a higher tax bracket than the donee, however, more
tax is owed under the current approach than would be owed if the donee
were taxed on the gift. Indeed, the donors are usually in higher tax brackets,
so if the system was changed to tax a donee on gifts and give the donors a
corresponding deduction, the treasury might actually loose income.
c. What if a taxpayer receives tips from a customer-could they be characterized as gifts
under S102?
i. Regulation S1.61-2(a)(1) specifically provides that tips that constitute
compensation for services must be included in gross income.
1. In Olk v. U.S. the court applied the Duberstein test for tokes a dealer
got and concluded that tokes were not given as compensation for
services, but were instead given by the gamblers as a result of
“impulsive generosity” or “superstition.” The appellate court
reversed, however, concluding that the gamblers’ generosity was
not “detached and disinterested.”
d. What about in cases of appreciated or depreciated property?
i. Inter Vivos
1. Appreciated property: In cases of appreciated property, the donee
assumes the donors basis and is taxed on the increase in value at
the time the gain is realized/recognized. (S 1001(a) and S1015(a))
a. E.g. Mom owns a property currently worth $80, but that
only cost her $50. She then gifts the property to her
daughter with the $30 built in gain. The daughter is
assigned the $50 basis, and is taxed at the time of sale on
the appreciation, which would be $30 here.
2. Declined Property: In determining a loss on a subsequent
disposition of a property by a donee, the donee takes a basis equal
to the fair market value of the property at the time of transfer.
(S1015(a))
a. E.g. Mother gives daughter a property worth $10, with a
$20 basis. If daughter sells the property for $10, she realizes
no loss because, for the purposes of determining loss, the
property has a basis equal to its $10 fair market value at the
time of transfer. However, if she sold it for $15, she gets the
$20 basis and realizes no gain.
ii. Bequest at the time of death
1. If a beneficiary receives a gift as a bequest upon the death of the
donor, the beneficiary excludes the gift from income under S102.
2. However, under these circumstances the donees basis will not be
determined under S1015, but rather the special basis rule of S1014
12
 will instead apply property acquired by reason of death takes a
basis in the hands of the beneficiary equal to its FMV on the date of
the decedent’s death (if it is distributed w/in 6 months of the death
S2032(a)) or the value 6 months after the death if distributed 6
months after the death S2032(a)).
iii. Note: In the determination of what capital gains tax to appropriate to the
property, the donee steps into the shoes of the donor with regard to the
holding period. (S1232)
e. Can a person write off a gift to a customer as a business expense?
i. Up to $25 in a taxable year per customer. S274
vi. Scholarships, Prizes, and Awards (S74, 117)
1. S117 excludes “qualified” scholarships received by “degree candidates.”
a. A student is a degree candidate if he is a primary, secondary, undergraduate, or
graduate student.
b. A scholarship is qualified to the extent that it covers the student’s tuition and
required fees, books, and supplies.
i. Students must include in income scholarships that cover other incidental
expenses such as room and board. The term scholarship includes both cash
scholarships and tuition reductions.
c. The exclusion for qualified scholarships does not apply to the extent that the
scholarship is compensation for services, including teaching and research. (117(c))
i. Athletic Scholarships: if continued participation in the sport is required as a
condition of retaining the scholarship, S117(c) would apply, but to date, the
service has not taken the position that they apply.
2. S74(a) prizes and awards
a. Gross income includes amounts received as prizes or awards. The limited
exceptions, in S74(b) and (c), provide that there is an exception for certain prizes
and awards transferred to charities and certain employee achievement awards.

i. Exception: S74(c) provides an exclusion for employee achievement awards

and allows for exclusion where the cost of the award received by the
taxpayer does not exceed the amount allowable as a deduction to the
employer for the cost of the award.
d. Transfer Payments (S85, 86)
i. While federal tax payments reduce an individual’s wealth, such payments are not deductable.
1. Policy: On the flip side, government expenditures for items that benefit the public may
increase an individual’s wealth, but the increases in wealth in that regard are nontaxable.
a. However, if the government expenditures increase the value of a taxpayer’s assets
e.g. a home, the individual will then be taxed on the increase in assets when they
are sold.
ii. The tax treatment of direct transfers varies from program to program e.g. welfare payments are
nontaxable (S73-87), but unemployment compensation is fully taxable. (S85)
1. The legislative history of S85 and other Congressional and treasury reports draw a
distinction between (i) payments that provide subsistence benefits to families living and
13
 property and (ii) payments that are the equivalent of wages; the former are generally
excluded from income while the latter are generally included.
2. The tax treatment of Social Security programs is complex and varies. See pg. 76 E&E
a. Taxpayers with incomes of 25k or less (32k for joint returns) do not have to include
any of their SS benefits in gross income.
b. Taxpayers with incomes over 25k (32k for joint returns), but not over 34k (44k for
joint returns), include 50% of SS benefits as income.
c. Taxpayers with incomes of 35k or more (44k for joint returns) include 85% of SS
benefits in gross income.
e. Capital Issues: Partial Sales, Annuities, Insurance Policies (skip life insurance), Life Estates, and Remainder
Interests
i. Partial Sales (S61, 1001-Reg. S1.61-6)
1. The term partial sale is defined, as a sale of a portion of property currently held by a
taxpayer. Where there is a partial sale, a basis is allocated to the acre sold (based on the
relative value of the sold and unsold portions of the property at the time of purchase) and
that amount is deducted from the net proceeds of the sale to constitute income.
a. The rule can be expressed in the following formula:
i. The basis of the parcel sold=the total basis of all the parcels * [the value of
the parcel sold/the total value of all the parcels]
b. The allocation of the basis is determined by the value of the land at the time of
purchase e.g. if at the time of purchase the parcel represented 1/15 of the total
value of the property, 1/15th of the basis will be allocated towards it.
c. Note: in certain rare circumstances such as where there is an involuntary sale (e.g.
perhaps through govt. action) and the parcel sold is not susceptible to easy
valuation, taxpayers have been allowed to ignore the allocation rule stated above
and treat the entire proceeds of a partial sale as tax-free recovery of capital.
i. See Inaja Land Co. v. Comissioner: The taxpayer owned riverfront property
that was damaged by the actions of an upstream user. The taxpayer
ultimately settled with the tortfeasor and received 50k in exchange for
certain rights with respect to the land. The tax court allowed the taxpayer to
treat the proceeds from the sale as tax-free recovery of capital. In sum, in
this case, the court allowed the guy to allocate his entire basis to the portion
of the sold land because allocation of the basis according to the value of the
sold and unsold interest was problematic.
ii. Annuities(S72)
1. An annuity is a K that provides for a series of payments (based on a life expectancy) in return
for a fixed sum. There are several possible basis recovery methods:
a. Basis first method-treats each payment as a tax-free recovery of capital until the
fixed sum the taxpayer invested in the annuity is recovered. Thereafter, all the
remaining payments are taxed.
i. Rationale: The rationale for the basis first rule is that the annuitant may die
before their lump sum payment is recovered and may never receive a profit.
b. Income first method-treats all payments as income to the extent of any income set
aside for the policyholder in the insurance company’s policyholder reserves.
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 i. Rationale: This approach is based on the ideology that the annuity payments
are analogous to a home loan i.e. the interest starts out high, the decreases
over time, and the principal payment starts out low and increases over time-
withstanding the fact that the payment amount is fixed. On that basis, most
of the early payments to the annuitant would be income and most of the
later payments would be received tax-free as basis recovery.
c. Pro Rata method-allocates a pro-rata portion of the taxpayer’s investment to each
payment. Under this approach, the income and basis-recovery portions of each
payment would be constant.
i. adopted by code (S72(a))
1. Provides that gross income includes annuity payments, but that the
taxpayer may exclude from each annuity payment the product of
the payment multiplied by the exclusion ratio, which in turn, equals
the cost of the annuity K divided by the expected return on the
annuity K. (exclusion ratio=total cost of K/expected return)this is
the amount you can exclude, while the remainder would be deemed
income.
ii. Old Geezer/Early Demise: Under this approach, if the taxpayer outlives his
life expectancy, all of each subsequent annuity payment must be included in
income whereas if the taxpayer dies early, her estate will be able to deduct
the difference between the aggregate amount excluded from income under
S72(b) and the cost of the K i.e. the estate can deduct the unrecovered basis
on the deceased’s final tax return.
2. Deferred Annuity
a. An annuity that provides the beneficiary with no payments for a period of time
following purchase is called a deferred annuity. A deferred annuity is taxed in the
same manner as any other annuity; cost is recovered pro rata from each expected
payment; the portion of each payment that is not allocated to cost is income.
3. Premature Withdrawal
a. The tax treatment of premature withdrawals is very unfavorable. A premature
distribution is any non-period payment made to a recipient who is not at least 59 ½.
First, such loans are taxable to the extent of the increase in the value of the policy
e.g. if I invested 10k in the K and borrowed 5k against it, if the policy has increased
by more than 5k, the entire loan will be treated as taxable income. S72(e). In
addition there is a special 10% penalty on “premature distributions” from annuity K.
S72(q).
4. Benefits of an Annuity
a. If one invests in a savings account they are taxed on the growth in the account. On
the other hand, if one invests in a deferred annuity, one is not taxed on the increase
in the value of the investment until payment begins. Even after payments begin, the
annuity recovery of capital rules will defer recognition of income. Thus, the annuity
provides one with a substantial deferral of the tax liability on the investment,
making it very beneficial. Further, if an annuitant lives to life expectancy, the
annuity payments will exceed the annuity cost. If the taxpayer outlives their life
15
 expectance, then they are even better off. The difference represents interest. The
longer the period of deferral, the greater the interest return on the taxpayer’s
annuity investment. However, there may be nontax reasons as to why one would
not want to tie up their money in a deferred annuity.
iii. Gambling Winnings and Losses (s165(d))
1. A taxpayer must include gambling winnings (the gross amount of gambling winnings during
the year less the cost of the specific wagers that generated the winnings) in gross income,
but can deduct gambling losses from the same year, up to the amount of the taxpayer’s
gambling winnings-if the losses can be substantiated. (165(d))
a. Allows taxpayers to offset gambling losses against winnings, but not other types of
income. The reason for this is that gambling losses are conceptualized, at least in
part by tax code, as nondeductible costs of consumption.
2. Taxpayers who take a deduction for gambling losses must substantiate their claimed losses.
Gamblers who do not keep track of their losses, but later try to estimate them will be
allowed to take the deduction only to the extent they can prove their estimated losses.
3. The classification of a gambling loss deduction as an above-the-line or below-the-line
deduction turns on whether the taxpayer’s gambling activity is a trade or business. Unless
the taxpayer is a professional gambler, the deduction is a below-the-line itemized
deduction, although it is not subject to the 2 percent floor for itemized deductions, the
overall limitation on miscellaneous itemized deductions, or disallowance under the AMT.
(S67(b)(3), 68(c)(3), 56(b)(1)(A)). (Note that all three of these limitations apply to a
taxpayer’s miscellaneous itemized deductions for a recreational activity or hobby, other
than gambling, that is not a trade or business but is entered into for profit. In this respect,
the tax treatment of gambling losses is more favorable than other “recreational activities.”)
a. If a taxpayer’s gambling is a trade or business, the allowable gambling loss
deduction is an above-the-line trade or business deduction. (S62(a)(1)). In other
words, the AGI of a professional gambler includes only the net gambling wins.
i. Taxpayers prefer to keep AGI as low as possible because a lower AGI
increases the tax benefits of various other provisions in the Code, due to the
AGI floors and phase-outs.
b. How do you determine whether the gambling is part of a trade or business?
i. Per Commissioner v. Groetzinger, to be engaged in a trade or business, the
taxpayer must be involved in the activity with continuity and regularity and
the taxpayer’s primary purpose for engaging in the activity must be for
income or profit. A sporadic activity, a hobby, or an amusement diversion
does not qualify. In Groetzinger, the taxpayer’s gambling activities
consumed 60-80 hours a week for 48 weeks of the year. That was sufficient
to deem him a professional gambler.
1. Given the fact that regular and continues gambling may be a sign of
personal addiction to gambling, courts have analyzed the primary
profit purpose requirement by considering various factors, such as
the businesslike or nonbusiness like manner in which the taxpayer
conducted the activity, that are relevant under the hobby loss rule
of (S183).
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f. Personal Injury Recoveries (S104)
i. Section 104 excludes from gross income damages (other than punitive damages which only are not
taxed if, under state law, punitive damages is the only form of recovery for wrongful death) received
“on account of personal physical injuries or physical sickness.” (S104(a)(2)) This exclusion applies to
recoveries for medical expenses, lost wages and pain and suffering.
ii. What is a personal injury for purposes of S104?
1. S1.104-1(c) provides that a claim is a “personal” injury claim if it is a “tort-type” claim, not a
contract claim. The exclusion is limited specifically to recoveries for personal “physical”
injury or sickness.
a. Special Rules:
i. A taxpayer can exclude a recovery for emotional distress/P&S only if the
emotional distress is the byproduct of other physical injuries or a sickness. If
the emotional distress does not result from some other physical injury, the
emotional distress and any physical symptoms resulting from the emotional
distress (e.g. insomnia, headaches, and stomach disorders) are not
considered a physical injury, so damages received in such cases do not
qualify for the S104 exclusion. However, as an exception, a taxpayer can, in
such a case, exclude the portion of the recovery that is for the cost of
medical care attributable to the emotional distress. (S104(a))
ii. The personal injury exclusion does not apply to recoveries for medical
expenses already deducted under S213 (which permits a personal deduction
for medical expenses in excess of 7.5 percent of a taxpayer’s adjusted gross
income).
iii. Who can exclude the recovery?
1. The taxpayer excluding the recovery can be someone other than the person who suffered
the physical injury or sickness. For example, a taxpayer can exclude damages received on
account of physical personal injury to his or her spouse. Similarly, recoveries for wrongful
death are excludable under (S104). (Although punitive damages are not generally excludable
under S104, a taxpayer can exclude punitive damages if, under state law, punitive damages
are the only remedy for wrongful death S1104(c)).
iv. Is the interest earned on damages taxable?
1. Interest earned on damages received is taxable under S61(a)(4), but Section 104(a)(2)
allows the taxpayer to exclude amounts received “whether as a lump sums or as periodic
payments.” Thus, if payments are received over a period of years, the entire recovery is
excluded from income-even if the payments to be made in the future include implicit
interest as compensation for the delay in payment. (S104(a)(2))
a. Exception: if a person was to receive an annuity in year one in lieu of damages and
is granted full control over the annuity, he will be treated as if he had received a
lumps sum and purchased the annuity himself. On the other hand, if the person is
merely receiving the annuity payments in lieu of the damage award, but maintains
no control over the annuity then it won’t be taxable and fall under the “payments
over a period of years” exception noted above.
v. Workers Compensation

17
 1. Compensatory recoveries received under workers’ compensation acts or under a statute, for
both physical and nonphysical personal injuries or sickness, are excludable under S104(a)(1).
However, if a person suffered an injury outside of work, and later received sick time
compensation as opposed to worker’s compensation since the injury was sustained outside
of work, then they will be taxed.
vi. Business injuries v. Personal injuries
1. Compensation received for a business injury is taxed according to the nature of the loss. If
the compensation is received for lost profits, for example, the recovery will be taxed as
ordinary income. If the compensation is received for the destruction of a capital asset,
capital gain treatment will apply. Damages received on account of personal physical injury,
on the other hand, may be excluded from income even if they are based on lost wages,
which normally would be taxed.
vii. Are attorney’s fees deductable from the gross recovery amount?
1. Withstanding attorney’s fees, the gross recovery amount of a recovery must be included in
gross income (despite the fact that the tax result is, in the words of Justice Ginsburg, “an
appalling situation”). Commissioner v. Banks. However, the attorney’s fees may qualify as
itemized deductions subject to the S67 and S68 limitations on itemized deductions and the
alternative minimum tax. Section 67 provides that certain itemized deductions, including the
deduction for attorney’s fees, are allowed only to the extent they exceed 2 percent of the
taxpayer’s AGI. S68 reduces the itemized deductions of some taxpayers by the lesser of (i) 3
percent of the excess of the taxpayer’s AGI less a specified amount or (ii) 80 percent of the
taxpayer’s itemized deductions. Under alternative minimum tax, taxpayers are not allowed
to deduct miscellaneous itemized deductions. S55 and 56(b)(1).
2. Contingent fee amount: The service has held that the Code requires inclusion of the gross
recovery amount, regardless of a contingent fee agreement and the nondeductibility of the
attorney’s fees. In 2004, however, Congress added a s62 above-the-line deduction for
atorney’s fees in cases involving a claim of “unlawful discrimination.” S62(a)(20). Section
62(e) defines the term unlawful discrimination as an act that is unlawful under the statutes
listed in 62(e).
viii. Policy:
1. Medical Expense Recovery: Presents the strongest case for tax-free treatment. The medical
expense recovery places the injured person in the same financial position that he would
have occupied had he not been injured. It seems fair, then that she should pay the same
amount of tax. This can be achieved by excluding the medical expense recovery from the tax
base.
2. Recoveries For Lost Wages: Because they replace funds that would have been taxed if the
person had earned them by working, taxing lost wages would place the taxpayer in the same
financial position that he would have occupied had he been able to work.
3. Pain & Suffering:
a. Against Tax: Supporters of tax-free treatment argue that P&S compensates the
injured party for the loss of imputed income from good health. Since the imputed
income from good health would not have been taxed, damages received for the loss
of good health also should not be taxed. This position is similar to that taken in
Solicitor’s Opinion 132, 1-1 C.B. 92 (1922), which held that compensatory damages
18
 for certain personal injuries were not income because they did not represent gain or
profit. Under general tax principles, however, gain is equal to the amount received
less the taxpayer’s basis. Calculating a sensible basis for human capital is extremely
difficult and thus it is simply not possible to determine with a taxpayer has received
an amount in excess of his basis. Perhaps we could arbitrarily give human capital a
basis equal to its FMV. Recovery of damages to human capital would therefore
never exceed basis and never be taxed. Such a rule would be consistent with the
view that someone who has suffered personal injury and who has (at best) simply
been “made whole” by a damage award should not be taxed. Moreover, most
property transactions are voluntary, but in personal injury cases the taxpayer has
involuntarily entered into the transaction giving rise to the damage award.
b. For Tax: Advocates of taxing P&S recoveries argue that an individual’s tax burden
should depend on his financial position, not on his psychic well-being. P&S damages
compensate an injured person for a nonmonetary loss and place the recipient in a
better financial position that he would have occupied had he not been injured. An
individual receives P&S damages has a greater financial ability to pay and thus
should bear a higher tax burden.
4. Punitive damages: Punitive damages represent a windfall gain to the recipient and thus
present a strong case for taxation. The best argument for tax-free treatment is that
excluding punitive damages from taxation will encourage taxpayers to file suit.
g. Transactions Involving Loans and Income From Discharge of Indebtedness (61(a)(12), 108, 1001,
1011,1012, 1016; Reg. S1.001-2(a)(3))
i. An individual is not taxed on amounts that he borrows on the theory that the obligation to repay the
loan offsets the amount received. In other words, the loan does not increase the taxpayer’s net worth.
Similarly, an individual does not receive a deduction for amounts used to repay a loan. However, the
loan is included in the taxpayer’s basis. A foreclosure is treated as a disposition of the property . Rev.
Rul. 90-16. However, a debt workout is not. Rev. Rul. 91-31. Also, the taxpayer reduces the basis of
the residence by the amount of debt discharge income excluded. (s108(h)(1)).
ii. What if the loan is discharged for less than the amount owed?( S108)
1. Although the repayment of a loan generally has no tax consequences, if a loan is discharged
for less than the amount owed, the borrower must include in income the amount of the
discount (the amount owed less the amount paid to discharge the debt). (S61(a)(12)).
a. Exception: A financially troubled taxpayer can exclude discharge of indebtedness
income if the taxpayer has filed a bankruptcy petition. S108(a)(1)(A) and (d)(2). If
the taxpayer has not filed a bankruptcy petition, the taxpayer can exclude the
discharge of indebtedness income only to the extent of the taxpayer’s insolvency
(the taxpayer’s liabilities less the value of the taxpayer’s assets) at the time of the
discharge. S108(a)(1)(B), (a)(3) and (d)(3). The insolvency test is defined as balance
sheet insolvency (liabilities exceed assts, and not equity insolvency (unable to pay
debts as they come due because of illiquid assets e.g. IRA).
i. E.g. Assume a taxpayer got a 10k discharge. If the taxpayer’s liabilities
exceed the value of his assets by 6k at the time of discharge, he could
exclude 6k of the 10k discharge income, leaving his 4k to include.
b. Interest: The discharge of interest payments do not constit
19
2. Section 108 and other exceptions permitting the exclusion of discharge of indebtedness
income
a. Purchase money debt-108(e)(5) provides that if the seller of property takes back
debt on the property sold (so-called purchase money debt) and later reduces the
purchaser’s debt, the reduction in the debt is treated as a purchase price
adjustment; it does not create a discharge of indebtedness income that has to be
included under S61(a)(12)
b. Already deductable-Section 108(e)(2) provides that the discharge of liability does
not result in discharge of indebtedness income to the extent that the liability would
have been deductible had it been paid.
i. E.g. the discharge at a discount of a liability to pay compensation to an
employee would not constitute income.
c. Student loans-108(f) provides that the discharge of certain student loans qualifies
for an exclusion.
i. E.g. if a law school agrees to discharge a law student’s loan and the
discharge is contingent upon the student working in public interest, the
student may be able to exclude the discharged debt from income.
d. Amount paid to lender-If a lender and borrower disagree about the original amount
owed and the borrower ultimately pays the lender less than the amount the lender
said was owed, the difference in the amount the borrower pays does not have to be
included in income. See N. Sobel, Inc. v. Comissioner, 40 B.T.A. 1263. In addition if
the lender cancels the debt at a discount as a gift to the borrower, the borrower
does not have to include the discount in income. S102(a).
i. Note: this can also apply to a situation where there is a dispute about the
value of something after the fact. For instance lets say X bought a car and
discovered after a month that it was a lemon. If he went back to the
dealership and negotiated a price reduction in the loan as a result of the
lemon status, that would not be income. Instead, it would be treated as a
nontaxable reduction in the purchase. 108(e)(5)
e. Debt Exchanged for Appreciated Property: where a taxpayer pays debt with
appreciated property, the taxpayer must realize and recognize the gain on the
transfer.
f. Debt Workout: if a lender reduces the loan amount w/o foreclosing, then there is
not a disposition of property. Instead, the taxpayer would simply reduce his basis in
the property unless one of the exclusions noted above apply. S108(h)(1).
g. Qualified Principal Residence Indebtedness (s108 (a)(1)(E)).
i. Mortgage Forgiveness Debt Relief Act added a new exclusion for income
from the discharge of debt for a qualified principal residence indebtedness
which is discharged before 1/2013. 108(a)(1)(E). The term also includes
indebtedness, secured by the taxpayer’s principal residence, from
refinancing qualified acquisition indebtedness, but only up to the amount
that was refinanced. (ss108(h)(2)and (163(h)(3)(B)(i)). The taxpayer reduces
the basis of the residence by the amount of debt discharge income
excluded. (s108(h)(1)).
20
 1. Qualified Principal Residence: The term qualified principal residence
indebtedness is defined as indebtedness that is secured by the
taxpayer’s principal residence and was incurred in acquiring,
constructing, or substantially improving that residence (not for
consumption purposes).
2. Limitation: For purposes of the exclusion, the qualified principal
residence indebtedness cannot exceed 2 million. (108(h)(2))
h. Nonrecourse (can only foreclose) liability in connection with disposition of property -
i. (the loan is added to the taxpayers basis) if a taxpayer is relieved of a
nonrecourse liability in connection with the disposition of encumbered
property, the consequences are not determined under S61(a)(12) and 108;
instead the debt relief is included in the taxpayer’s amount realized for the
purpose of computing gain or loss realized in the property transaction. Per
S1001 a realized gain equals the amount realized less the adjusted basis and
loss equals the adjusted basis less the amount realized. (see E&E pg. 118
#86. (s165c). FMV is irrelevant in recourse loans.
ii. the debt relief is included in the taxpayer’s amount realized because the
debt will have been included in the taxpayer’s basis for the property when
the taxpayer acquired the property. Crane v. Commissioner and Reg.
S1.1001-2(a).The amount realized includes the debt relief even if the
encumbered property is worth less than the amount of debt at the time the
taxpayer disposes of the property. Commissioner v. Tufts
1. Reasoning: the debt relief is included in amount realized because
the taxpayer would have included the loan amount in his basis,
thereby allowing him to take depreciation deductions in excess of
his cash investment.
iii. Step by Step Instructions:
1. Add loan to taxpayer’s basis
2. Deduct depreciation deductions from taxpayer’s basis (if applicable)
3. Subtract Adjusted Basis from the Disposition amount (which may
include assumption of the loan).
4. If the amount realized is positive, then the taxpayer is taxed on that
amount, if it is negative, then he suffers a loss
a. If it is a personal residence, then the losses would be capital
in nature and not deductible against ordinary income,
whereas if the property was used in a trade or business
then they would be ordinary in nature, and conversely the
same rules would apply for gains.
5. E.g. Year 1 x purchases depreciable real estate worth 200k with 50k
of his own funds and 150k of proceeds from debt secured by the
property-basis thus equals 200k. Under S1012 and Crane, the
taxpayer’s basis in the property is 200k. Assume the taxpayer takes
70k of depreciation deductions in years 1-10 (lowering the
taxpayer’s basis to 130k) and sells it in year 10 for 10k and the
21
 assumption of the 150k debt. Under S1001 and Crane, the
taxpayer’s amount realized equals 160k (10k of cash+150k of debt
relief) and the taxpayer’s gain thus equals 30k (160k realized -130k
basis).
i. Recourse (can come after you directly) debt in connection with disposition -The tax
consequences of a disposition of the property are determined using a bifurcated
approach: (i) the debt discharge is included in amount realized, up to the fair market
value of the property; and (ii) any additional debt discharge is treated as S61(a)(12)
debt discharge income. Reg. SS1.1001-2(a), 1.1001-2(c) example 8.
i. Step By Step Instructions:
1. Add loan to taxpayer’s basis.
2. At the time of disposition, the amount realized equates to the sale
amount up to the FMV.
3. (a) The difference between the amount realized and the loan
amount is debt discharge income; and (b) the difference between
the amount realized and the taxpayer’s basis is income/loss.
a. E.g. Year 1 x purchases depreciable real estate worth 200k
with 50k of his own funds and 150k of proceeds from debt
secured by the property-basis thus equals 200k. Under
S1012 and Crane, the taxpayer’s basis in the property is
200k. The buyer purchases the home for assumption of the
150k of debt. At the time of disposition, the property is
worth 140k. The amount realized is 140k (the debt
discharge up to the value of the residence at the time of the
disposition), and the taxpayer realizes a nondeductible
personal loss of 60k-140k amount realized less 200k basis.
The taxpayer also has S61(a)(12) debt discharge income of
10k-150k of debt discharge less the 140k value at time of
disposition S108.
j. Note: when computing the basis, the depreciation deductions a taxpayer takes on
the property is to be deducted from the basis. Further, taxpayers are not allowed to
depreciate their principal residence.
i. Make sure to account for the type of property for purposes of deductibility.
3. There are two reasons why lenders might discharge a debt for less than the amount owed:
a. If the taxpayer is financially troubled and cannot repay the debt, the lender may
discharge the debt for the amount that the borrower can pay-something is better
than nothing.
b. If the market interest rate is higher than the loan amount, the lender may make
money by letting the borrower pay back less than the full amount and then
relending the loan at higher interest rates.
6. Annual Accounting (SS 61, 111, 172, 441, 1341)
a. The convention of annual accounting is necessary for practical and administrative reasons. However, there
are net operating loss provisions available under S172 which both individuals and corporations can take

22
advantage of (although salaried employees cannot have an operating loss and the interaction of the net
operating loss rules with the regime of personal deductions can be quite complex).
i. Net operating loss: Under S172(a) and (b)(1), a net operating loss suffered in any year can be carried
back to the previous two taxable years. The taxpayer files an amended return for the prior year,
reducing its income for that year by the loss carryback. As another option, the taxpayer could also
carry the loss forward and apply it against income from the next 20 years.
ii. Another exception is the so-called claim of right doctrine-the taxpayer who has possession of the
income is taxed on the income despite the dispute. If the taxpayer later is forced to give up this
income, an adjustment in the income is made in the year it is repaid (not the return for the year in
which the amount was included). The person receiving the income, would then include the income in
the year in which he or she received the funds under a “claim of right,” despite the fact that (assuming
the money was transferred by virtue of a verdict) the case could be overturned on appeal. North
American Oil Consolidated v. Burnet.
1. What happens if the taxpayer’s tax bracket year in which the amount is repaid is different
than it was in the year in which the taxpayer included the amount?
a. Section 1341 addresses this problem. If the requirements of that section are met
(e.g., if the amount of the deduction exceeds 3,000), the taxpayer will reduce his tax
liability (not income) in the year of repayment by the reduction in tax that would
have occurred in the year in which the income was included had the taxpayer not
included that amount. If, on the other hand, the taxpayer’s tax bracket is lower in
the year of inclusion than in the year of repayment, S1341 allows the taxpayer to
deduct the amount repaid, in the year of repayment, despite the fact that the
deduction saves the taxpayer more than she paid in tax when the item was included
in the earlier year.
2. Exam point-while an amendment and a later deduction under 1341 may seem intuitively
the same, they are not exactly the same because the government has to pay interest on
refunds owed to taxpayers under an amendment since it addresses an event that occurs in
the past, but does not have to pay interest on a tax reduction since it is applied to the
taxpayers current tax return.
iii. Another exception is the so-called tax benefit rule. The term tax benefit rule is used for two separate
rules: one that requires the taxpayer to include an item in income (the inclusionary tax benefit rule),
and the other that permits a taxpayer to exclude an item that would otherwise be included in income
under the inclusionary tax benefit rule (the exclusionary tax benefit rule). Both have their origins in
case law, but the exclusionary rule has been codified in S111.
1. Inclusionary tax benefit rule/Exclusionary tax benefit rule
a. Triggers an inclusion whenever an event occurs that is fundamentally inconsistent
with a tax benefit recognized in an earlier year. Hillsboro National Bank v.
Commissioner. However, the exclusionary tax benefit rule of S111(a) permits a
taxpayer to exclude the recovered item in the later year to the extent that it did not
reduce the taxpayer’s tax liability in the earlier year. Unlike 1341 above, the tax
benefit rule does not take into account any changes in the taxpayer’s bracket
between the year in which the item was deducted and included.
i. e.g. a taxpayer donates 10k to a college in year one. If the college was
forced to give up operations in year 2 and returns the money to the
23
 taxpayer at that time, the taxpayer must include that income in year 2.
However, if the taxpayer had no taxable income in year one, he need not
include the 10k in year 2.
ii. E.g. taxpayer’s item is stolen in year one so he deducts the loss, but
recovers the item in year 2. He must include the deduction taken in year 1
as income in year 2.
iv. Amended returns
1. Both the S1341 and tax benefit rule apply where a return was correct at the time it was
filed, but a subsequent event renders it incorrect. However, where a taxpayer discovers that
a tax return they previously filed was incorrect at the time of filing, the taxpayer would file
an amended return. A taxpayer generally may file a claim for refund anytime w/in 3 years of
the time of filing or from 2 years from the time he tax was paid, whichever of usch periods
expires the later. S6511(a). Most taxpayers supplement this claim for refund with a brief
explanation of the grounds on which the refund is sought.
2. If the service denies the taxpayer’s claim for a refund, the taxpayer may file a suit for refund
in either the district court or the u.s. court of federal claims. (usually a 3 year SOL starting
from the date the return was filed (S6511(a)).
b. Cash Method of Accounting v. Accrual method of Accounting
i. Under the cash method of accounting, a taxpayer includes an item of income in the year in which the
item is actually or constructively received. Inclusion is required whether the item of income is received
in the form of cash, property, or services. Reg. S1.446-1(c)(1)(i).
a. Constructive Receipt: Income is constructively received if made available to the tax
payer, but the taxpayer decides to defer actual receipt of it. 1.451-2
i. For example a client gives an attorney a check on December 31, 2009 for
services rendered on December 31, 2009, but the attorney refuses to accept
the check and says he wants to be paid on January 1, 2010. The attorney will
be said to have constructively received the check in 2009. Further, an
employee whose salary is made available to her on December 1, year one,
must recognize taxable income in year one, even if she does not pick up her
paycheck until year two. On the other hand, lets say that x decides to sell his
property to y on December 1, of year 1. However, after considering the
topic, x tells y that they should wait until year 2 so that x can get a tax break.
The constructive receipt doctrine would not apply because the sale
proceeds were not made available to x in year one. Reg. S1.451-2.
Moreover, for purposes of determining when a “sale” has taken place, we
look to whether the seller irrevocably transferred the item for sale to the
buyer and not when receipt of the payment occurs.
ii. Irrevocably set aside: The doctrine of constructive receipt is closely related
to the economic benefit doctrine, which is the product of case law. Under
the economic benefit doctrine, a cash method taxpayer recognizes income
as soon as a payor irrevocably sets aside funds for the taxpayer in a manner
that prevents the payor’s creditors from being able to reach the amount set
aside. See e.g. Pulsifer v. Comissioner. However, if the funds set aside can be

24
 reached by the payor’s creditors, the taxpayer does not have to include the
funds set aside.
1. Prewrite: The purchase of _____ (e.g. annuity) would guarantee
that the company would have funds to pay the ____. However,
there is no guarantee that the company will use the funds to pay
____. Moreover, because the company is the beneficiary of _____,
the contract is an asset of the company and is subject to the claims
of its creditors. As a result, the doctrine of economic benefit does
not require ____ to include the deferred payment in year _____.
b. A Promise to pay
i. Although an unfunded, unsecured promise to pay money in the future is not
treated as property generally, a promise to pay is treated as the “equivalent
of cash” and immediately included if the promise to pay is unconditional,
not subject to set-offs, and readily transferable. Cowden v. Commissioner.
ii. The aforementioned paragraph distinguishes between a mere promise to
pay, which is not treated as income for cash method taxpayers, and a
promise that takes the form of a negotiable promissory note, such notes are
generally considered “property,” the value of which must be included in
income.
2. What if the payment of an expense creates an asset with a useful life of way over a year?
a. Where the payment of an expense creates an asset with a useful life that extends
substantially beyond the close of the year in which the expense is incurred, the cash
method taxpayer cannot simply deduct the entire expense; instead, the expense
must be capitalized.
i. Exception: This rule applies to any asset that has a useful life of over a year
with the exception of advertising.
3. Valid forms of Income Deferral
a. Income can be deferred if the deferral agreement is entered into before the income
is earned. See Rev. Rul. 60-31 (which describes several deferred compensation
arrangements and explains why each of them would or would not result in income
deferral). For instance, an employee who contracts ahead of time to be paid on
January 1, year two, will not include the income until year two.
i. Note: in deferred compensation arrangements, such as the one noted
above, the employer will not be able to deduct the compensation until the
employee includes it. S404(A)(5).
1. Exam Point: Because the employer cannot deduct the expenses
associated with the contributions until the employee does, there is
no overall tax benefit to the parties from the deferral unless the
employee’s marginal tax rate exceeds that of the employer.
ii. See Deferred compensation for details on qualified employee plans and
deferred stock options below
4. What about virtual dollars and gambling credits?
a. If a cash method taxpayer plays an online game and wins game credits or prizes,
does the taxpayer have to include the game winnings when they are credited to the
25
 taxpayer’s game account, under the cash equivalence doctrine or constructive
receipt doctrine, or can the taxpayer defer inclusion until the credits or prizes are
actually redeemed for cash?
i. The IRS has not answered this question, but if credits can be redeemed for
cash, the credits may constitute a cash equivalent or constructive receipt of
cash value of the credits when credited to the taxpayer’s account. On the
other hand, if the winnings cannot be redeemed for cash and are not readily
convertible into cash, the winnings probably do not trigger an inclusion
under the cash method of accounting.
ii. Under the accrual method of accounting a tax payer generally includes an item of income in the year
in which (i) all of the events have occurred that fix the right to receive the income and (ii) the amount
of the income can be determined with reasonable accuracy. Reg. S1.451-1(a) An accrual method
taxpayer deducts an expense when (i) all the events have occurred that establish the fact of the
liability (called the all events test), (ii) the amount of the liability can be determined with reasonable
accuracy, and (iii) the “economic performance” requirement of S461(h) (which often requires
payment before a deduction is allowed) is met. The accrual method usually focuses on when the bill is
sent v. when the work is performed. Remember that this method does not employ a matching
ideology-meaning, one may include the item in income one year, but the other party to the
transaction may have to exclude it from income in the same year. Thus, make sure to apply the
elements to each party individually.
1. The accrual method does not follow the cash, but considers when your rights and
obligations crystallize. Some types of business are required to utilize the accrual method e.g.
businesses with inventories. Also, it should be noted that a year does not have to be a
calendar year. A business can elect fiscal years that vary.
a. For Example a computer guy fixes a laptop on December 31, 2009. The cost of
repair is 1k. The owner pays for it on January 2, 2010. The 1k is taken into income by
the accrual method in 2009-the time at which the right to receive the income is
fixed and the amount of income can be determined with reasonable accuracy.
Under the cash method, however, it would be deducted in 2010.
b. The accrual method is generally thought to be a more accurate measure of income
and expense than the cash method of accounting, and most companies use the
accrual method to keep their books (if you use accrual for the books you have to use
it for taxes S446(a)). Reg. S1.446-1(c)(2)(i)
i. Economic Performance Requirement
1. The accrual method of accounting, with its all events test, had a
loop hole which would allow a business that for instance was paying
off an obligation over time to deduct it in the year the payments
started. The loophole could have been closed by limiting the
amount deductible to the present value of the future obligation, but
instead, congress chose to adopt S461(h), which provides that an
accrual method taxpayer cannot deduct a future expense unless the
all events test has been met and economic performance has
occurred (meaning the payments have occurred). In the case of a
deferred payment in settlement of a tort liability, S461(h)(2)(C)
26
 provides that economic payment does not occur until the liability is
paid.
a. Services provided by the taxpayer: If the liability of the
taxpayer requires the taxpayer to provide property or
services, economic performance occurs as the taxpayer
provides such property or services. S461(h)
i. E.g. a company promises to service a machine for 2
years, they cannot deduct the expenses associated
with the servicing until the machine is actually
serviced.
b. Services provided to the taxpayer: If the liability of the
taxpayer arises out of (S461(h)):
i. the providing of services to the taxpayer by another
person, economic performance occurs as such
person provides services
ii. the providing of property to the taxpayer by
another person, economic performance occurs as
the person provides such property, or
iii. the use of the property by the taxpayer, economic
performance occurs as the taxpayer uses such
property
2. Reoccurring Item Exception: Section 461(h)(3) and Regulation
S1.461-5(b)(1) provide an exception to the S461(h) economic
performance requirement. Under this exception (generally referred
to as the recurring item exception), an item may be deducted
notwithstanding the absence of economic performance, provided
that the following conditions are satisfied:
a. The all events test is otherwise met;
b. Economic performance with respect to the item occurs by
the earlier of (a) the date that the taxpayer files a timely
return for that year (taking into account any extensions of
the time to file) or (b) eight and a half months following the
close of the tax year in which the deduction is taken
c. The item is recurring in nature and the taxpayer consistently
reports the item in accordance with the all events test; and
d. The item is either (a) not material or (b) accruing the item
under the all events test provides better matching of
income and expense than the economic performance
standard would provide.
e. Note: on the exam, always note the reoccurring item
exception and whether it may or may not apply.
2. What about prepaid income?-->applies only to the taxpayer receiving the income
a. While GAAP would not require inclusion of prepaid income in year one for services
to be rendered in year two, the decision in the American Automobile Association
27
 effectively requires an accrual method taxpayer to deem prepaid income as taxable
in the year received-thus, the decision effectively requires the cash method of
accounting to be used with regard to prepaid income. However, various types of
prepaid income can qualify for deferrals (max deferral (except for S456) is year 2,
even if the prepayment is for year 2, 3, 4, etc., but for exam purposes I may want
to point out that for accounting purposes the payment would be included in each
corresponding year, but that for tax purposes it would be years 1 and 2):
i. Regulation S1.451-5 permits deferral of prepaid income for certain types of
goods e.g. inventory.
ii. Section 456 permits “membership organizations” to include prepaid dues
ratably as services are performed.
1. Membership organization: a membership organization means a
corporation, association, federation, or other organization that
a. is organized w/o capital stock of any kind, and
b. no part of the net earnings of which is distributable to any
member
iii. Rev. Proc. 2004-34 significantly expanded the availability of deferral. It
allows taxpayers a limited deferral beyond the taxable year of receipt if
some or all of the prepayment will be included in a later year for financial
accounting purposes. The following advance payments qualify:
1. Services
2. Goods (other than those covered by S1.451-5)
3. The use of intellectual property
4. The occupancy or use of property that is ancillary to the provision of
services (e.g. advance payments for the use of rooms or other
quarters in a hotel, booth space at a trade show, campsite)
5. The sale, lease, or license of computer software
6. Certain guaranty or warranty contracts
7. Subscriptions (other than subscriptions for which an election under
S455 is in effect), whether provided in tangible or intangible format
8. Membership in an organization (other than memberships for which
an election under S456 is in effect)
iv. Rev. Proc. 2004-34 excludes from advance payment:
1. Rent (except for 3, 4, or 5 described above)
2. Insurance premiums to the extent the recognition of those
premiums is governed by Subchapter L
3. Payments with respect to financial instruments (e.g. options,
forward K, letters of credit, debt instruments)
4. Payments with respect to warranty and guaranty contracts under
which a third party is the primary obligor
b. A taxpayer qualifies for deferral of these types of prepaid income if some or all of
the prepayment will be included in a later year for financial accounting purposes.
iii. Note: the cash method permits some manipulation of the timing of inclusions and deductions, but not
all taxpayers may use it. Businesses that keep inventories must use the accrual method. In addition,
28
 s448 places limitations on taxpayers using the cash method. S446(b) also provides that if, in the
Commissioner’s view, the method of accounting used by the taxpayer does not reflect income, the
taxpayer’s taxable income is computed using the method the commissioner thinks better reflects it.
7. Gains and Losses From Investment In Property
a. Realization of Gains and Losses (S1001; Reg. S1.001-1(a))
i. Although the code does not define the term realization, Regulation S1.1001-1(a) provides that gain or
loss is realized when property is exchanged for cash or other property “differing materially either in
kind or in extent.” In Cottage Savings Association v. Commissioner, the S.C. held that “exchanged
properties are materially different if they embody legally distinct entitlements.”
b. Recognition of Gains and Losses
i. Realized gains and losses are taken into account, for purposes of computing the taxpayer’s gross
income, only to the extent that they are also “recognized.” Section 1001(c) provides that realized
gains and losses are recognized unless otherwise provided in the code. If a nonrecognition rule
applies to the transaction, the taxpayer’s realized gain or loss from the transaction will be deferred in
whole or in part.
ii. Like-Kind Exchanges (SS1001, 1031; Reg. SS1.1031(a)-1, 1.1031(a)-2, 1.1031(d)-2)
1. Sections 1031 through 1045 provide a series of nonrecognition rules that apply in certain
property transactions. Section 1031(a)(1) provides for nonrecognition of gain or loss
realized on the exchange of property for productive use (as opposed to property held
primarily for sale) in a trade or business or for investment property if such property is
exchanged for like-kind property that will also be used in the taxpayer’s trade or business or
held for investment.
2. Types of property that do not qualify:
a. S1031 does not apply to (a) stock in trade or other property held primarily for sale,
(b) stocks, bonds or notes, (c) other securities or evidence of indebtedness or
interest, (d) interests in a partnership, (e) certificates of trust or beneficial interests,
or (f) choses in action. S1031(a)(2)
3. Section 1031 is not elective; if the requirements of the section are met, it applies.
4. What counts as like kind?
a. Regulations 1.1031(a)-1(b) notes that “the words ‘like-kind’ have reference to the
nature or character of the property and not to its grade or quality.”
b. Administrative rulings and regulations treat all real property, developed or
undeveloped and commercial or residential, as like kind, making it relatively easy to
qualify real property exchanges for S1031.
i. See, e.g. Reg. S1.1031(a)-1(b) which provides that the term like-kind refers
to “the nature or character of the property and not to its grade or quality.”
c. If properties are in the same asset class for purposes of determining depreciation
deductions then they are of like-kind. Reg. S1.1031(a)-2(b).
5. Basis
a. Section 1031(d) provides that a taxpayer’s basis in the property received in the
S1031 exchange equals the taxpayer’s basis in the property given up in the
exchange.
6. What about nonsimultaneous exchanges?

29
 a. They qualify for S1031, provided that the requirements of S1031(a)(3) (the property
to be exchanged must be identified within 45 days after the original transfer and
the transfer be completed within 180 days) and Reg S1.1031(k)-1 are met.
7. What about exchanges that include both like kind and other property or money?
a. The nonrecognition rule of S1031(a)(1) provides that no gain is recognized on
qualifying like-kind exchanges provided the property is exchanged solely for other
like-kind property. However, solely really doesn’t mean solely. Section 1031 applies
even if the taxpayer receives both like-kind property (called permitted property) and
other property or money (called boot or nonpermitted property).
i. Receiving Boot: If a taxpayer receives boot in a S1031 exchange, any gain
realized is recognized up to the value of boot received in the S1031
exchange. S1031(b). Said another way, gain recognized equals the lesser of
(i) the gain realized in the exchange or (ii) the fair market value of the boot
received.
1. On the other hand, if a taxpayer realizes a loss in the exchange, the
loss is not recognized even if the taxpayer receives boot in the
exchange. S1031(d).
ii. Calculating the basis: If gain is recognized in a like-kind exchange, the basis
of the like-kind property received in the exchange is equal to (i) the basis of
the like-kind property given up, (ii) less the fair market value of the cash or
other boot received, (iii) plus the gain recognized .
1. The second and third terms in the basis formula at times cancel
each other out, but do not if either (i) the realized gain is less than
the amount of boot received or (ii) the taxpayer realizes a loss in the
S1031 exchange; in these circumstances, the gain recognized will
not equal the amount of boot received.
iii. Paying Boot: The party paying boot adds the boot to the basis of the like-
kind property given up in the exchange, for purposes of computing (i) the
gain realized in the exchange, and (ii) the basis of the like-kind property
received in the exchange.
iv. A taxpayer’s basis in noncash boot received is its fair market value. S1031(d)
8. What about exchanges of property with encumbrances?
a. Relief of indebtedness
i. If in a S1031 exchange, a taxpayer is relieved of indebtedness on the
transfer of encumbered like-kind property, the debt relief is (i) added to the
amount realized (under Crane and Tufts), for purposes of computing the
gain realized in the exchange, and (ii) subtracted (as a form of boot
received) from the basis of the like-kind property given up in the exchange
for purposes of computing the taxpayer’s basis in the like kind property
received in the exchange. Net relief from indebtedness is treated as boot for
purposes of S1031. Reg. S1.1031(d)-2
1. Relized gain= (property received + cash<boot> + debt relief<boot>)-
basis in property given up.

30
 2. Recognized gain=lesser of amount realized or boot received (debt
relief<boot>+cash<boot>).
3. Basis In New Property=basis in property given up + gain recognized
- boot received (debt relief + cash received).
b. Incurring debt
i. On the other hand, if a taxpayer incurs debt on the receipt of encumbered
like-kind property, the debt incurred is added to the taxpayer’s basis in the
property given up in the exchange, for purposes of computing (i) the gain
realized in the exchange, and (ii) the taxpayer’s basis in the like-kind
property received in the exchange.
1. Realized Gain= amount realized – basis (basis in property given up +
debt assumed + cash paid) . No recognized gain.
c. What about if both like-kind properties are encumbered?
i. If both like-kind properties are encumbered, one party to the exchange will
have a net increase in indebtedness and the other party will have a net
decrease. The party whose net indebtedness increases does not treat the
relief of indebtedness on the property as boot. The party whose net
indebtedness decreases treats the net debt relief as boot.
ii. If one of the parties pay cash to the other party, the cash payment is added
to the debt that party incurs in the exchange, for purposes of determining
that party’s boot from net debt relief. In other words, a taxpayers boot from
net debt relief equals (i) the liability that the taxpayer gave up in the
exchange less (ii) the sum of (a) the liability that the taxpayer assumed in
the exchange plus (b) the cash that the taxpayer paid in the exchange.
iii. Involuntary Conversions
1. Section 1033 provides that a taxpayer may elect to not recognize gain realized on the
involuntary conversion of property into cash due to the complete or partial destruction of
property (e.g. due to fire), theft, or condemnation, provided that the taxpayer reinvests cash
in property that is similar or related in use to the lost property. If some of the proceeds are
not reinvested in similar use property, realized gain is recognized to the extent that
proceeds are not reinvested in similar property (like the boot rule).
a. Basis Formula: (Basis of the lost property + plus any additional cash or debt
invested in the new property + plus any gain recognized on the involuntary
conversion transaction) – any proceeds not reinvested in the similar use property.
Reg. S1.1033(b)-1
iv. Special rule for Primary Residence
1. Section 121 permits taxpayers to permanently exclude up to 250k (500k for a joint return)
of gain realized on the sale of apersonal residence.
v. Tax free reorganizations and corporate transactions (need to check if I need to know this pg. 246-260)
c. Installment Sale and Open Transaction Reporting (SS453, 453A, 453B; Reg. S15a.453-1)
i. Section 446(c) provides a special accounting method for reporting gain from the sale of property in
exchange for deferred payments. Section 453 applies automatically to a sale of a property if a seller
realizes a gain and at least one payment will be after the close of the taxable year. S453(a) and (b). A
taxpayer can elect out of S453 and recognize the entire gain in the year of the sale if they want.
31
 S453(d) (Presumably, taxpayers will only do this if they face a really low tax bracket in the year of the
sale). consider TVM
ii. The most important thing to determine is when the sale occurs, if there isn’t a present sale then the
installment provision does not apply. A sale occurs where there is a transfer of property from the
seller to the buyer.
1. For instance, if X enters into an agreement with Y in Dec. of 2009 indicating that he will sell
her a stock in January of 2010 for a series of payments that will occur in 2011, 2012, and
2013, the agreement is simply an executory contract and not a sale since the seller has not
transferred property to the buyer. Once the property is transferred in 2010, then there is an
installment agreement that will be attributed to 2010.
iii. Calculating annual inclusions
1. Under S453(c), a seller first determines the overall ratio of the gain to the sale price-gross
profit/contract price.
a. The gross profit is (i) the selling price (ii) less the seller’s adjusted basis in the
property sold. Reg. S15a.453-1(b)(2). The selling price is the amount to be paid by
the buyer (other than interest).
b. The contract price is the selling price less the debt to be assumed by the buyer. If
there is no debt, then just the selling price. (see below for discussion of debt to be
assumed by buyer).
2. Next, the seller determines the annual inclusions of gain from the sale by multiplying any
installment payment (other than interest) received during the year by the ratio determined
under S453(c).
a. Note: if the mortgage assumed by the buyer exceeds the seller’s basis in the
property sold, then the debt relief is treated like a cash payment in year one. Reg.
S15a.453-1(b)(3)(i)
iv. What if the payments are set to start in a later year e.g. year 2 or 3?
1. The seller is not taxed on years in which she receives no payments. The seller simply
multiplies the gross profit percentage in the year in which payments are received.
v. What types of property qualify for Section453 deferred tax and are there other limitations?
1. Sales In The Regular Course of Business : S453 doesn’t apply to sales of personal property by
taxpayers who regularly sell personal property on the installment plan, such as department
stores, and sales of real property by taxpayers who hold real property for sale to customers
in the ordinary course of business, such as real estate developers. S453(b)(2), (l)(1).
2. Securities: S453 does not apply to the sale of publicly traded stocks or securities. S453(k)
3. Loss: It obviously does not apply if a seller realizes a loss on a sale as well.
4. Limitations on Amount of Deferral : If the installment payments exceed 5 million, the
taxpayer will have to pay the govt. interest on the tax liability deferred.
5. If an installment obligation is pledged as security for a loan, the proceeds of the loan will, in
some circumstances, may be treated as a payment on the installment obligation, triggering
an inclusion under S453.
6. Payment With A Debt Security: if a taxpayer receives a bond or other evidence of
indebtedness from the purchaser, the taxpayer’s receipt of the debt is also treated as a
payment if the debt received from the purchaser is payable on demand or is readily
tradable.
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 7. Relatives: Where there is a second disposition by a related person the amount realized with
respect to such second disposition shall be treated as received at the time of the second
disposition by the person making the first disposition. Section 453(e)
a. Reasoning: This section came about to close a loophole where one family member
disposes of property on a payment plan and they sell the same property to someone
else at basis so they have no tax liability. This allows the first disposer to defer his
tax liability for several years and considering TVM make a lot of money.
vi. What if the total amount of the deferred payment on the sale is uncertain at the time of the sale?
1. While Burnet v. Logan allowed the taxpayer to utilize a basis first (known also as open
transaction) approach where the total amount of deferred payments were uncertain,
S453(j)(2) promulgated after the Logan decision requires sellers receiving contingent
payments to apply S453 in the year of the sale and preclude open transaction reporting
except in extraordinary cases. See e.g. Reg. SS15a.453-1(c) and 1.1001-1(a).
2. Regulation 15a.453-1(c) provides three special rules for determining the timing of basis
recovery and gain inclusion where the amount paid for property is contingent:
i. First, if a maximum payment for the property can be determined, that
amount is treated as the selling price for the purpose of computing the S453
inclusion ratio.
ii. Second, if a maximum payment cannot be determined, but the number of
years over which payments will be made can be determined, the taxpayer’s
basis is allocated equally over that period.
iii. Third, if neither a maximum payment nor time period for payment can be
determined, the taxpayer recovers basis equally over 15 years.
b. Note: A fairer method might be to attempt to estimate the most likely total
payments rather than the maximum. Note that if the Treasury’s allocation method is
adopted and the taxpayer receives less than the maximum expected amount, the
taxpayer will have a basis remaining after all payments received. At that point he
will take a loss deduction for his unrecovered basis.
8. ORIGINAL ISSUE DISCOUNT
a. Interest can be either (i) stated explicitly or (ii) unstated and implicit. Original issue discount is the term for
unstated interest on debt, determined at the time the debt is issued. If the interest is actually stated, then
we simply tax for the stated interest.
b. The total unstated interest, or OID, on a debt instrument equals (i) the stated redemption price at maturity
of the debt instrument (the amount payable under the debt instrument less any stated interest that is paid
at least annually) less (ii) the issue price of the debt instrument, which is generally the amount of cash the
bondholder paid for the debt. SS1273(a) and (b).
i. Reasoning: The purpose of being taxed on the interest now as opposed to later computing the gain at
the time of redemption is because of the difference between the normal tax rate and the capital gains
tax rate.
ii. Computing Inclusions
1. The inclusion can be computed by multiplying (i) the yield-to-maturity (the implicit
interest) by (ii) the adjusted issue price of the bond. S1272(a)(1), (3), and (5). The
inclusions are computed on a six month basisimportant to remember this step because of
the interest earned on interest.
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 a. The adjusted issue price is (i) the issue price of the bond (the actual price for which
it is sold or if bond is transferred for property, the PV of the bond) plus (ii) any
unstated interest that has already accrued on the bond but not been paid to the
bondholder. S1272(a)(4).
i. E.g. a 1k coupon bond sold for 377 with 10 years until maturity would have
a yield to maturity of 10%. The adjusted issue price would be 377. The OID
for the first six-month period in year one equals $18.85 (5% semiannual
interest on $377). The OID for the second six month period in year one is
19.80 which is 5% semiannual interest on $395.85 adjusted issue price
($377 issue price plus the 18.85 of accrued, but unpaid interest).
2. The OID included each year in income is added to the taxpayer’s basis so that they are not
taxed on receipt of the lump sum upon maturation.
iii. What if the company does not pay the full redemption amount upon maturation?
1. Then the taxpayer will recognize a capital loss equal to the difference between her basis at
that time and the amount received. SS1271(a)(2) and 1221.
iv. Policy: Why do the OID rules require inclusion of interest before its receipt?
1. There are 2 ways to tax people on these types of securities: (1) to allocate the yield (E.g. a 1k
coupon bond purchased for 300 would have a yield of 700) equally over the term (this
would overtax the bondholder in earlier years and allow a greater write off for the bond
seller in earlier years) or (2) to tax the yield the same way a person would be taxed on a
savings account i.e. require them to include amounts of interest that increase each year-
because the interest inclusion is calculated by applying a constant rate of interest to a
balance that keeps increasing to reflect prior accrued but unpaid interest (this method is
called either the constant-yield-to-maturity method or the economic accrual method).Given
that the issuer of the bond, generally a company of some sorts, is likely an accrual method
taxpayer, there would be asymmetry between the issuer, who applies the accrual method,
and a taxpayer, who applies the cash method. As a result, the OID rules put both issuers and
bondholders on the same accounting method, the accrual method, for the purpose of
determining OID interest deductions and inclusions. SS1272(a)(1) and 163(e)(1), (2) (of
course we could also avoid the asymmetry by allowing cash method bond purchasers to
defer recognition of interest income until payment, and putting the accrual method issuers
on the cash method so that interest could not be deducted until payment).
v. What other areas do the rules of original discount apply to?
1. The rules also apply to certain property sales-where there is a sale of property for a debt
security. In these cases, the transaction is split into two: (1) the property transaction (which
may qualify for installment sale method) and (2) the debt transaction, the interest of which
must be included in income while the bond is outstanding.
a. Computing Sale Price: The sale price of the home for computing the realization of
gain on the property sale is the present value of the entire payment to be made at
maturity. The difference between the Present value of said payment and the actual
payment at maturity is the interest.
vi. What areas does it not apply to?
1. Section 1274 does not apply to (i) sales of principal residences, (ii) sales in which payments
are not deferred for more than six months, and (iii) certain sales of farmland. S1274(c).
34
 2. It also does not apply if the total payments to be made on a debt instrument exchanged for
property are not at least 250k. 1274(c)(3)(C). However, S483 may still apply to such debt
instrument.
vii. Determining the interest if transferred for property
1. If no interest is stated on the debt instrument issued in exchange for property, the
payments to be made on the debt instrument are discounted to present value using the
applicable federal rate (AFR). S1274(b). The AFR is set monthly by the treasury, pursuant to
the prevailing yields on government bonds (If the stated principal on debt issued in
exchange for property does not exceed the amount specified in S1274A(b), adjusted for
inflation-for example $4,800,800 in 2007-the rate used in the OID calculations cannot
exceed 8 percent. S1274A(a), (b), and (d); Rev. Rul. 2007-4.)
a. The unstated interest on the debt instrument equals the gross amount of payments
to be made on the debt instrument less the present value of those payments.
SS1273(a)(1) and (b)(4), and 1274(a) and (b)(1).
2. If debt issued is publicly traded, or the property for which the debt is exchanged is publicly
traded (For example, traded stock), we do not use S1274 to impute an issue price for the
debt. Instead, the issue price of the debt is the value of the property in exchange for which
the debt is issued, so the OID on the debt equals the stated redemption price at maturity for
the debt less the value for the property exchanged for the debt. S1273 (a) and (b)(3).
9. DEFRRED COMPENSATION
a. Qualified Employee Plans
i. A way to avoid the two drawbacks of an employee deferral plan, 1) running the risk that payor will be
unable to make the deferred payment when due and 2) that the employer cannot deduct deferred
compensation until the employee includes it, is by including the compensation in a qualified pension
or profit-share plan. Under such a plan, funds are set aside for the irrevocable benefit of the
employees, allowing the employer to deduct it, but the employee is not taxed on the contributions or
interest until the funds are received. need to add to this. What are they taxed on when the funds
are received…just the interest or the principal to?
1. note that certain deferred compensation arrangements can trigger S409A, which
accelerates inclusion of deferred compensation and imposes interest and penalties if
nonqualified deferred compensation plans do not meet certain requirements.
2. Limitations
a. There are antidiscrimination rules that require, in general, the ratio of pension
benefits to salary for highly paid employees is no greater than the ratio of such
benefits to wages of rank-and-file employees.
b. S457 places dollar limitations on such plans when used by state agencies.
c. S501(c)(3) places limitations on charitable organizations (schools and churches) and
public educational institutions . See 403(b)
d. S409A provides that amounts payable in the future are taxable when bargained for
if the plan allows employees to accelerate benefits or provides that upon
deterioration of the employer’s financial health, assets are shielded from outside
creditors.
e. Compliance with ERISA rules are also required-it imposes obligations on the safety
of investments by the plan and vesting requirements. The vesting rules ensure that
35
 after specified periods of service, an employee’s retirement benefit becomes
nonforfeitable.
ii. IRAS/ROTH IRAS
1. Self-employed individuals are permitted to set up qualified plans called H.R. 10 or IRAs. No
tax is levied on the contributions, or the interest earned, until withdrawal.
2. Roth Ira: Instead of contributing to a normal IRA, individuals filing a joint return whose
adjusted gross income is below 150k (95k for singlet taxpayer) can elect to contribute to a
Roth IRA. S408(A). Contributions to a Roth IRA are nondeductible, but there is no annual tax
on the income earned by the funds in the Roth IRA and qualified distributions are tax free.
a. A qualified distribution is one that takes place 5 years after contribution, after age
59.5, made after the contributor becomes disabled or dies, or is made for certain
higher education or first-time home buyer expenses of up to 10k.
3. Limitations:
a. An individual may set aside in an IRA and claim as a deduction up to 5k (6k if over
50) with inflation adjustments after 2008, but not more than his or her income.
However, individuals that turn 50 before the end of the end of the taxable year can
also deduct annual “catch-up contributions” of 1k. S219(b)(5)(B)
b. The amounts put into the account are deductable if the taxpayer is not covered by
an employer plan or, if covered, has adjusted gross income below certain limits,
with a phase-out as income rises above those levels. S219(g)
i. Individuals who are unable to deduct their IRA contributions may still wish
to establish an IRA because the interest earned is not taxed until
withdrawal.
iii. Penalty for early withdrawal
1. Amounts withdrawn from a qualified plan before reaching age 59.5, in addition to being
includable in gross income, are subject to a penalty of 10%. S72(t).
a. The penalty does not apply if the employee has retired after age 55, has died, or has
become disabled; or if the distribution is one of a series of periodic payments for the
life the employee or the joint lives of the employee and a designated beneficiary; or
if the distribution does not exceed deductible medical expenses; or to distributions
used; or, in the case of an IRA (normal or Roth), if the distribution is used for higher
education or a limited amount of first time purchase costs.
iv. Mandatory distributions
1. Qualified plans are subject to rules specifying minimum distributions, which generally must
begin in the calendar year following the year in which the employee reaches age 70.5.
v. Limitations on contributions and benefits
1. The code imposes limitations on contributions to and benefits from qualified plans,
including a rule under which the maximum benefit under any plan may not exceed 160k
adjusted for inflation after 2001. See 415.
b. Section 83 And Compensatory Transfers Property
i. Section 83 applies to compensatory transfers of property (some of the case law that established the
economic benefit doctrine has been supplanted by S83) in connection with the performance of
services (applies to service providers, which would include employees and independent contractors).
ii. What is property under S83?-->includes Trusts, Escrow Accounts, etc.
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 1. The term property does not include money or an unfunded, unsecured promise to pay
money in the future, but does include real and personal property or a beneficial interest in
assets transferred to a trust or escrow account if the assets are beyond the reach of the
transferor’s creditors.
a. This is what the professor would call funding i.e. an arrangement where an
employer puts funds beyond its reach (and beyond the reach of its creditors) for the
benefit of the employee. Thus, where s83 would deem the item at issue “property”
then it has been funded, because for it to be “property” under S83, it must first be
funded.
b. Note: some type of 3rd party enforceable guarantee will usually imply that the
property is funded.
iii. When must the income be included i.e. when does it vest?
1. Under S83(a), the employee must include income from the transfer in the first year in which
the transferred property vests, which means that it is either transferable or no longer
subject to a substantial risk of forfeiture. Note that the inclusion upon vesting is applicable
to property as defined by S83, meaning, it must be funded as property under S83 which only
deems property as that which has already funded. In sum, if it is property under S83 it is
funded, if it is not funded, it is not property and therefore even if it vests there would be no
income until it is funded.
a. Rights in the transferred property are subject to a substantial risk of forfeiture if the
person’s rights in the property are conditioned on the future performance of
substantial services by the employee. S83(c)(1).
b. Rights in the property are transferable only if the employee can transfer the
property to someone else who would not be subject to a substantial risk of
forfeiture (which does not generally happen if the employee is subject to a
substantial risk of forfeiture). S83(c)(2).
2. Deductibility For Employer: The treatment of employer and employee is symmetrical so an
employer gets a corresponding deduction when the employee includes it in income.
iv. How much must be included and what is the tax rate? Also, what is the employees basis thereafter?
1. Amount Included: The amount included under S83(a) is (i) the value of the transferred
property at the time that it vests less (ii) the amount (if any) that the employee paid for the
property. When sold (not when exercised), the taxpayer is taxed on the difference between
the exercise price and the sale price.
2. Tax Rate: Since the amount included is compensation for services, it is taxed at ordinary
income rates, not the special capital gain rates. However, the appreciation in the property
following the S83 inclusion does qualify for special capital gain rates (assuming the property
transferred, which is often stock, is a capital asset).
3. Basis: The employee’s basis in the property is the value of the property at the time of
inclusion under S83 since that’s what they are taxed on. Reg. S1.61-2(d)(2). The employer
deducts the compensation only when the employee includes it. S83(h)
v. What if the person wants to include the entire amount withstanding the right to defer (and why would
someone want to do this)?
1. An employee can choose to make a S83(b) election and include the amount in the year in
which it is transferred, but before it vests. If so, the valuation is as follows: (i) the value of
37
 the property at the time of the transfer less (ii) the amount (if any) that the employee paid
for the property.
2. Amounts included under 83(a) or (b) constitute ordinary income, but appreciation in the
property following the S83 inclusion does qualify for special capital gain rates (assuming the
property transferred, which is often stock, is a capital asset). Thus, an 83(b) inclusion would
allow the employee to be taxed at ordinary income rates in the year of inclusion, but capital
gain rates on the appreciation in the property after the transfer to the employee.
a. Exam Point: In effect, a taxpayer making a S83(b) election is betting that the cost of
accelerating the S83 ordinary income inclusion will be more than made up by the
tax savings from converting ordinary income on the appreciation in the property
into capital gain. When doing such calculations, one must consider the time value of
money as well. Thus, if the present value of the tax savings from converting ordinary
income in year ____ into capital gain is more than the tax paid in year ____, the
taxpayer should consider making an election.
vi. What if the transfer is an option to purchase something as opposed to property (E.g. Stock Options)?
1. The parties to employee stock option arrangements sometimes prefer to avoid S422 (ISO’s
explained below) for reasons that range from preserving corporate-level deductions to
discomfort with some of its requirements, such as the need to submit for shareholder
approval the details of option arrangements with senior management. The process for
valuation is as follows:
a. Mandatory includability
i. When a stock option is issued to an employee, if it has a “readily
ascertainable fair market value”, its value must be included in the income
for the employee (and may be deducted by the employer) the first year in
which it vests, which means that it is either transferable or no longer
subject to a substantial risk of forfeiture. S83(a).
1. Valuation: The option value to be included in income is the value of
the option at the time of vesting and not issuance (thus, if it is
thought to increase in value, an 83(b) election may be better).
2. Basis Upon Exercise Of Option: The employee’s basis in the stock
received on exercise is the sum of (i) the amount he included in
income under S83(a) on receipt of the option plus (ii) the price he
pays for the stock when exercising the option. Reg. S1.61-2(d)(2).
3. Tax Rate: The tax rate on value of the stock option is ordinary, but
the difference between the sale price and exercise price (if
exercised) is granted capital gains treatment.
ii. Substantial risk of forfeiture and transferability
1. Same definition for substantial risk of forfeiture and transferability
used above. SS83(c)(1) and (2).
iii. What if the option does not have a fair market value at the time of
issuance?
1. Then there are no tax consequences at the time of issuance. See
Regs. S1.83-3. Rather, when the option is exercised, the employee is
taxed on the spread between the exercise price and the value of the
38
 stock (assuming the stock is transferable or is not subject to
substantial risk or forfeiture) and the corporation is entitled to a
corresponding deduction. 1.83-7(a) ( refers to the taxation and
not to the matching principle). Indeed, an option w/o a FMV cannot
be included in income (an 83(b)) election cannot be made). If an
option is sold instead of being exercised, S83 applies to the money
or property received for the option. Reg. S1.83-7(a).
a. Regulation S1.83-7 provides that the value of an option is
generally not ascertainable unless the option is actively
traded on an established securities market.
2. Rationale: If an employee was permitted to make an 83(b) election
on the grant of an option w/o a FMV, then he could understate its
value to reduce or eliminate the tax consequences of making an
83(B) election.
iv. What if it lacked a readily ascertainable FMV when granted, but then
becomes ascertainable before exercise?
1. An option that lacked a readily ascertainable fair market value
when granted is not taxed until it is exercised, even if the value
becomes ascertainable after it is granted but before it is exercised.--
>tax rate?
v. What if the option is never exercised because it’s out of the money or it
depreciates in value after exercise of the option?
1. Out of the money: If the employee does not exercise the option
because it’s out of the money, he can, subject to certain limitations,
deduct the amount previously taken into income. SS1234, 1211.
The deduction may be limited by the capital loss exception.
2. Depreciates: If a stock depreciates in value after exercise of an
option, the employee cannot deduct the loss on the stock against
ordinary income (the value of the option received) since stock is a
capital asset, and capital assets are fully deductible only against
capital gains.
a. Exception: 3k of the excess of capital losses over capital
gains may be deductible in any given year against ordinary
income.
vi. What if the stock option is in the money when granted?
1. Section 409A would apply. 409A accelerates deferred compensation
and imposes interest and penalties in certain circumstances. Reg.
S1.409A-2
b. Elective includability
i. An 83(b) election can be made on stock options if they have a readily
ascertainable value. Under such an election, the FMV of the property is
determined w/o regard to any restrictions other than those that will never
lapse. The amount included in income is the employee’s basis in the stock,

39
 but an employee who ultimately forfeits the property cannot claim a
subsequent deduction by reason of the forfeiture. S83(b).
c. Deductibility For Employer: The treatment of employer and employee is
symmetrical so an employer gets a corresponding deduction when the employee
includes it in income.
d. Exam Point: One common, but questionable tax technique is to elect immediate
inclusion of a stock option when granted, but claim it has a 0 value. E.g. an
employee of a speculative start up may claim that the company is such a long-shot
no one would pay anything for the option even if it were unrestricted. If the
treatment is allowable, its consequence is that, in the guise of immediate inclusion,
the taxpayer has actually received treatment equivalent to that afforded ISOs under
S422. The govt. has attempted to combat this technique through Regs. S1.83-7,
which provides that in many situations an options FMV will be treated as
nonascertainable.
vii. Incentive Stock Options
1. Section 422 covers what are called “incentive stock options” (ISOs) applies a capital gain
upon sale of stock approach to taxpayers who meet the specified statutory requirements.
Under this approach, a person is treated as having received no income in the year of the
option’s issuance and exercise, and the employee’s basis is equal to the amount paid for the
stock on exercise.
2. Tax Rate: The person is then taxed on upon the sale of the stock by the difference between
the exercise price (i.e. how much he paid for the stock) and the sale price as capital gains.
3. Requirements:
a. Employment Requirement: An ISO only refers to an option granted to an individual
for any reason connected with his employment by a corporation, if granted by the
employer corporation or its parent or subsidiary corporation, to purchase stock of
any such corporation.
b. Retention Period: Employee must retain the stock for at least two years after the
grant of the option and one year after receiving the stock under the option. S422(a)
(1)
c. Pricing: Option price must be no less than the fair market value of the stock at the
time the option is granted. 422(b)(4). Also, there is a 100k ceiling on the value of the
stock that has yet unexercised options constituting ISOs can cover per single
employee. 422(d) The value of the stock is determined as of the time the option is
granted.
d. % Limitations On Ownership: The grantee must not own more than 10 percent of
the total stock of the company at the time the option is granted
e. Shareholder approval: The option must be grated pursuant to a plan that
stockholders of the granting corporation approve after receiving information about
how many shares and which employees the plan covers. S422(b)(1)
f. Nontransferability: The option must be nontransferable other than by the laws of
descent and distribution, and is exercisable only be the grantee during his lifetime
g. The option must be granted within 10 years from the date such plan is adopted, or
the date such plan is approved by stockholders; whichever is earlier and such option
40
 by its terms is not exercisable after the expiration of 10 years from the date such
option is granted
4. When does an employer get their qualifying deduction?
a. An employer gets no deduction at any time. S421(a)(2). Under many plausible
assumptions, the disadvantageous treatment of ISOs to the employer outweighs the
advantageous treatment of ISOs to the employee because an employer is usually in
a higher tax bracket than an employee thereby increasing the parties combined tax
burden (in comparison to a Section 83 issuance of a stock option that is-since that
would allow the employer to get a deduction).
10. INCOME SHIFTING
a. The basic rule governing attempts to shift personal service income is that the person who performs the
services is taxed and he or she cannot shift it to a lower-bracket taxpayer regardless of whether the service
is attributable to past or future services. Lucas v. Earl (assignment to taxpayer’s wife of half of the
taxpayer’s income from personal service did not shift that income to his wife); Helvering v. Eubank
(assignment to a family trust of commissions to be received in the future for service rendered in the past by
the taxpayer did not shift the commission income to assignees).
i. Helvering-the difference between this and a bond would be that you buy the bond with after tax
money. The purchase results in a basis. On the other hand, in Eubank, he is simply streaming the
income to someone else professors argument
b. In practice, the loss of tax revenue due to income shifting is limited by a number of statutory provisions:
i. First, virtually all married couples will find their tax liability minimized through filing a joint return on
which all income is combined. The attribution of income between married persons is therefore
irrelevant. Compare SS1(a), 1(d)
ii. Second, under the “kiddie tax,” net unearned income of a child under 19 years old (or a full time
student over 18 and under 24 whose earned income for the year does not exceed one-half of the
amount of the individuals support i.e. the parents don’t provide the kid with more than half of his or
her support) is taxed at the greater of the child’s marginal rate or her parents’ marginal rate. SS1(g),
152(c)(3)(A). Note: a child above 19 who is a full time student claiming that he receives no support
from his parents and refusing to provide support to his parents cannot get off the hook, rather, the
rule still applies.
1. Unearned income is that portion of income is defined in S1(g)(4) as income that is not
earned income under S911(d)(2). That latter section states that “the term earned income
means wages, salaries, or professional fees, and other amounts received as compensation
for personal services actually rendered…” Net unearned income is unearned income in
excess of twice the S63(c)(5) limited standard deduction available to an individual who is
claimed as a dependent on another taxpayer’s return (in 2009 $500 or the sum of $250 and
such individual’s earned income).
a. To illustrate the operation of S1(g), suppose that in 2009 a married couple gave
their infant daughter a bond that pays 10k a year, and the daughter had no other
source of income and no itemized deductions. The daughter would have net
unearned income of 9k , which is 10k less twice the minimum standard deduction of
500 (=1k). That 9k would be taxed at the parent’s rate. The remaining 1k of the
daughter’s gross income would be reduced by the S63(c)(5) 500 standard deduction.
The remaining $500 of income would be taxed at the daughter’s individual rate.
41
 i. Note: the daughter is not allowed to take a personal exemption because her
parents are allowed to take a dependent exemption for her on their return.
S151(d)(2)
iii. Third, the tax law is less progressive than it once was.
c. What are some legitimate ways of shifting income?
i. The prohibition against shifting income does not apply to the value of services provided free of charge
to a third party. (imputed income)
1. E.g. consider a carpenter in the 30% bracket who gives his cousin 1k of his earnings ot pay
for household improvements. The carpenter is taxed on the 1k. By contrast, the carpenter
would not be taxed on the value of his services, if instead, he builds cabinets for his cousin
worth 1k withstanding the fact that the performance of free services has the same effect as
shifting 1k of income from the 30% to 0% tax bracket. (see imputed income)
ii. Similar advantages are reaped by contributing money to a S501(c)(3) charity. A lawyer is taxed on that
portion of her salary she gives to such organizations, but may deduct her donation; subject to the
annual deduction limitations of S170 (the aggregate of such contributions cannot exceed 50% of the
taxpayer’s contribution base for the taxable year). The lawyer could also work for no pay for the
nonprofit which would have the effect of shifting income to a taxpayer in the 0 percent bracket
(imputed income).
d. What if the donee sells the services to unrelated parties?
i. Donated services to charitable and political organizations are treated as untaxed imputed income
even if the organization sells the services to the public and the value of the service is easy to ascertain.
ii. On the other hand, if the services are donated to an individual and then sold to an unrelated party, the
tax treatment is much less clear. For example, a parent who provides legal services to her daughter’s
law firm, which in turn charges out his services to its clients, may well be thought to be in a
partnership with his daughter and taxed on the income attributable to his services.
e. Variations in the form of transactions and resulting tax implications (services offered for free)
i. For taxpayers who wish to offer free services w/o recognition of income, form is all important. For
instance, an entertainer avoids taxation on the proceeds from a charity or political benefit only if the
benefit is arranged by the organization or its agent. If instead, the benefit is arranged by a for-profit
promoter not acting as a charitable organization’s agent and the entertainer directs the value of the
services to charity, then he will be taxed on the net proceeds of the event and be left to then seek a
S170 charitable deduction if the event qualifies. However, if the performers services are “sold” by the
person arranging the event, but the performer neither receives the profits directly nor organizes the
event and rather only performs free of cost, then he or she will likely escape taxation (one might argue
that the performer performed for usual compensation and then gave the sum to the organizer
though-this would likely fail if the performer neither received any profits directly or organized the
event).
ii. A similar emphasis on form is present in gifts of services to family members or friends. While a real
estate broker can sell her daughter’s home free of commission w/o paying tax on the commission
forgone, one who sells her daughter’s home, collects the commission, and then returns it to the
daughter will be taxed on that commission.
iii. What if someone is compensated for services with services?

42
 1. The fact that the compensation is in the form of services rather than cash is irrelevant. See
e.g. Rev. Rule. 79-24 (individuals taxed on services or property received under barter
arrangements).
f. What about the shifting of property income as opposed to service income?
i. As opposed to personal service income, which (with the exception of imputed income from services)
cannot be shifted, income from property can be shifted by transferring the income-producing
property. Thus, a parent with a rental property can shift the rental income to his 26 year old son by
giving the son the property. A parent with appreciated property can have the appreciation taxed at
his 26 year old son’s rate by giving him the property prior to sale. (see discussion of gifts infra).
1. There is a notion that a trust is separate from the income beneficiary. Ownership in tax does
not mean title, it means beneficiary owner i.e. beneficiary of interest. It is the person who
controls the acquisition and disposition of the property. It doesn’t matter whose name it is
registered in e.g. stocks are usually registered to the clearing house (record ownership), but
the beneficiary interest belongs to the person who bought it on the secondary market.
2. Note: Here too, form is important.
a. A transaction which a donor negotiates a sale of appreciated property and then, a
moment before the sale is consummated, transfers the property to a donee who
completes the sale, may be re-characterized as a sale of property by the donor,
followed b a gift of the sale proceeds to the donee requiring the donor to pay tax for
the gain. The determination usually hinges on whether the terms of the sale
agreement have already been agreed upon. (although a good exam counter
argument is that under state law a sale is not final until title passes even though it
may not work).
ii. What about partial interests in property?
1. An interest in property that is coterminous in time with the donor’s interest is often referred
to as a horizontal interest. A gift of horizontal interest in property shifts the income to the
donee. Blair v. Commissioner
a. E.g. a 10% undivided interest in property is a horizontal interest, as it extends as far
in time as the donor’s remaining interest in the property.
2. An interest that is not coterminous in time with the interest retained by the donor, but that
reverts back to the donor, is often referred to as a vertical interest, or a carved out interest.
A vertical or carved out interest in the property cannot be shifted as the owner maintains
entire control of the underlying property. Helvering v. Horst
a. E.g. a donor gives her son the rental income on an apartment building for the next 5
years, but retains the rental income after the next five years or other incidents of
ownership thereafter.
3. If the gift is both horizontal and vertical, then the donor is taxed on the entire income.
a. E.g. a parent that gives her son a one-half interest in property for five years with the
parent regaining sole control of the property thereafter.
4. Note:
a. E.g. lets say a parent has a bond that pays 1k in month in interest. If a parent gives a
child a 10% interest in the revenue derived from the bond, then the parent would
be taxed on that interest and not the child. On the other hand, if the parent gives

43
 the child a 10% interest in the bond which gives the child a 10% interest derived
from the bond, then the child would be taxed on that
b. Also, if the parent gives a child one of 10 coupons for a bond, which, lets say
accounts for 5% of the value of the bond, then one might argue that was a transfer
of property. However, the government looks at the coupon as fruit (the income)
and the bond as the tree (the actually property), and the transfer of fruit would not
suffice. There has to be a transfer of the underlying property interest, and not just
the revenue. Thus, if the parent said I give you a 5% interest in the bond i.e. the
property, which accounts for 5% and equals one coupon, then that would shift the
income.
i. Assignment of matured coupons does not shift property.
ii. Assignment of an undivided interest in the bond is a valid income shift.
iii. Assignment of an unmatured coupon
5. I need to go over basis allocation with regard to bonds.
a. Interest stripping if you sold coupons. Not triggered by gift.
g. What all qualifies as property?
i. Homes, stocks, etc. qualify as property. Also, in both a colloquial and legal sense, a composition,
patent, or book is seen as property, albeit property of a more intangible nature. The transfer of rights
to intangibles such as copyrights or patents does have a form consideration though.
1. E.g. an author can shift income from a work by transferring her copyrighted manuscript to a
donee and having the donee negotiate a K with the publisher, but cannot sign a publishing K
and then assign the royalties under the K to the donee. While this assignment may be legally
binding for state law purposes, it is ineffective for tax law purposes. Compare Wodehouse v.
Commissioner (novelist P.G. Wodehouse taxed on royalty income notwithstanding
assignment of K rights) with Cory v. Commissioner (assignment of manuscript by
philosopher George Santayana effective to shift income to assignee).
ii. On the other hand, a transfer of the right to payment for personal services by the service provider is
not property for allowable purposes of shifting income.
h. Basic Summary:
i. Personal service income cannot be shifted except by the performance of gratuitous services.
ii. Income from property can be shifted provided there is a complete transfer of the income producing
property, and the donee does not receive a carved out or vertical interest.
i. Shifting income Through and To Corporations
i. The intellectual tradition of treating corporations as separate entities has exerted a strong influence
on tax law. For instance, if a parent entirely owns a corporation and give his son a 40% stake by issuing
him stock, the income he ultimately realizes may take the form of dividends and appreciation in stock,
and at a highly conceptual level one might argue that this income is from property (the shares of
common stock they own) rather than from services even if the corporation generates revenue from
only from the father’s services. This ignores underlying economic reality, but in the case of ordinary
corporations the reality is likely to be ignored; the income is not likely to be attributed to the parent.
ii. Given the double taxation of corporations i.e. tax at the corporate level and then tax on the
distribution of dividends, this may not always be advantageous (unless subchapter S). In the past,
corporate rates were sometime significantly below individual rates, so that an advantage to income
shifting remained even after the payment of the corporate income tax. This is still true for
44
 corporations with modest amounts of income. See S11(b)(1)(A)corporate income up to 50k is taxed
at 15%.
1. The corporate level tax could be reduced by paying salary to the parent, but to that extent
the object of shifting income may be defeated.
iii. Two organizations, trades, or business controlled by the same interests
1. S482 holds that in any case of two or more organizations, trades, or business (whether or
not incorporated, organized in the U.S., or affiliated) owned or controlled directly or
indirectly by the same interests, the Secretary may distribute, apportion, or allocate gross
income, deductions, credits, or allowances between or among such organizations, trades, or
businesses, if he determines that such distributions, apportionment, or allocations is
necessary in order to prevent evasion of taxes or clearly to reflect the income of any of such
organizations, trades, or business
a. Generally if you are an employee, you are not in a trade or business.
b. In Fogulson the tax lawyers tried to argue that the sole employee of a corporation
(that he created) should be taxed as opposed to the corporation being taxed since
he was the one who controlled it. As evidence they tried to point to the fact that he
did not have a covenant not to compete with the corporation. The court held that
since he could have just ripped up the covenant since it was between him and the
corporation (that he solely ran) it was not dispositive. S482 didn’t apply because it
was one employee and a company as opposed to 2 organizations, trades, or
businesses.
2. Virtually all of the cases upholding the application of 482 have do so either in situations
involving attempt to offset the profits of one business with losses of another or in situations
in which the individual performed work other than that he did on behalf of the corporation.
a. See. Borge v. Comissioner where a successful entertainer who also ran a poultry
farm that suffered losses organized a corporation and transferred all of the assets of
the poultry business to it. He then entered an agreement to work for the
corporation as an entertainer and thereby offset the poultry losses with the
entertainment profits. Because he only put on a % of his entertainment profits into
the business, the court ruled that he was not devoting his time and energies to the
corporation, but instead was carrying on his career as an entertainer, and merely
channeling a part of his entertainment income through the corporation. An indicium
that that the man, not the corporation was running the entertainment business was
that the parties seeking his services as an entertainer required that he, not the
corporation, guarantee K.
j. Examples:
i. Mother makes a patent, and assigns it to her son who sells it for profit. Who has income?
1. The son would have income because its property that was transferred.
2. Simply put, if you can come up with property (property can be made from personal
services), and give away a vertical slice, then it is properly shifted.
ii. An investor buys a patent and gives it to her son.and he licenses it. Who has income?
1. The son would have income for the same reasons noted above.
iii. You help the mom get her patent, and she assigns you an interest in the patent to compensate you for
the services. You then take that and give it to your son. Who has income?
45
 1. You have income because you were given the patent. Once given to you, you immediately
have income. You can then assign it to your son, since its property, and he’d have income
from any future royalties etc., but you have to pay income for the initial transfer to you.
11. DEDUCTIONS FOR COST OF EARNING INCOME
a. Statutory Framework SS62,63,67; Reg. SS1.62-1T(d), 1.670IT(a), 1.162-17(b)
i. Individuals are only taxed on net income and business and investment expenses are subtracted from
gross income in order to determine net income. Section 162(a) provides that a taxpayer is allowed to
deduct “all the ordinary and necessary expenses paid or incurred during the taxable year in carrying
on any trade or business (you have to be IN the business when deducting it).” (Reg. S1.162-2(a) says
“reasonable and necessary”). Section 212 also allows for the deduction of expenses for production of
income through other means such as investment activities, management, conservation, or
maintenance of property, and in the connection with the determination, collection, or refund of any
tax. (Unlike S162, S212 deductions are itemized deductions below the line)
1. Note:
a. The expense will not be deductible if it is deemed personal in nature. For e.g. in
Gilliam v. Commissioner, the taxpayer was denied a deduction for expenses
incurred to settle lawsuits arising out of a business trip. The court held that,
although the incident wouldn’t have occurred but for the business trip, the costs
that were incurred in connection with the altercation were not ordinary expenses of
the taxpayer’s trade or business. Courts use an objective approach to distinguish
between ordinary business expenses and personal expenses.
i. The professor says that there is no nexus between him taking the
medication and hitting someone and being on the business trip. Rather, it is
just a coincidence. It could have just as easily happened at any other point.
On the other hand, there is a case
ii. Technically: Ordinary is the key word for saying capitlizable and necessary
means that it is actually reasonable.
ii. Limitations: Why does it matter whether you are above the line or below the line?-because of
Limitations on earning income for below the line expenses:
1. Expenses that are treated as full expenses on earning income are expenses on schedule C-
they are used in computing your gross income (above the line). There are a special category
of expenses (consumption items that are deductible or items that go toward some sort of
social agenda) or disfavored expenses that are associated with earning but are included
below the line on schedule A.
2. All expenses of earning income, unless otherwise noted in S67, are subject to S67, which
generally limits a taxpayer’s itemized deductions to his aggregate deductible expenses in
excess of 2% of his AGI. The 2% floor eliminates the business expense deduction for most
employee taxpayers. The taxpayer is allowed to take a deduction for excess over the floor
only if the taxpayer itemizes deductions (i.e. they do not take the standard deduction).
S63(b)
a. The following are not subject to the 2% floor, but instead are reviewed under
separate subsections:
i. Deduction under S163 (relating to interest)
ii. Deduction under S165 (a)
46
 iii. Deduction under S170 relating to charitable contributions and gifts and
section 642(c) relating to amounts paid or permanently set aside for
charitable purpose.
iv. Deduction under S213 (relating to medical, dental, etc. expenses)
v. any deduction allowable for impairment-related work expenses
vi. Deduction under S691(c) (relating to deduction for estate tax in case of
income in respect of the decedent)
vii. Any deduction allowable in connection with personal property used in a
short sale
viii. The deduction under S1341 (relating to computation of tax where taxpayer
restores substantial amount held under claim of right
ix. Deduction under S72(b)(3) (Relating to deduction where annuity payments
cease before investment recovered)
x. The deduction under S171 (relating to deduction for amortizable bond
premium)
xi. The deduction under S216 (relating to deductions in connection with
cooperative housing corporations)
3. S68 also sets an overall limit on itemized deductions (for all deductions other than medical
expenses, investment interest, and casualty, theft, or wagering losses). This effectively
increases the effective marginal tax rate for affected taxpayers (e.g. if a taxpayer who is
above the threshold earns an additional 1k, the taxable income increases by 1030 because
the taxpayer’s income goes up by 1k and the itemized deductions must be reduced by 30).
In the case of a taxpayer whose AGI exceeds 100k, adjusted for inflation (presently at
around 168k), the total amount of otherwise allowable deductions is reduced by the lesser
of:
a. 3% of the excess of AGI over the applicable amount; or
b. 80% of the amount of the itemized deductions otherwise allowable for such taxable
year.
4. Note: this rule has been reduced for 2006-2007 to 2/3 the applicable fraction and 2008-
2009 to 1/3, and is set to be phased out entirely for any taxable year beginning after
December 31, 2009.
iii. Do you have to already be in the business for it to constitute a business expense?
1. For it to be capitilizable, you have to already be in the trade or business. For instance, law
school is not deductible as a business expense because we aren’t’ lawyers yet. However, if
you are working in a field and seek higher education that supports your existing trade or
business, then you can deduct it as a business expense. For instance, someone that works in
business and is getting their MBA can deduct the cost of their MBA as a business expense.
iv. The computational effect of a business expense depends on whether the one incurring the expense is
an employee or one who is not an employee as an employee is not considered to be engaged in a
trade or business for purposes of computing AGI under S62. Reg. S1.62-1T(d).
1. Non Employee
a. If business expenses are incurred by a taxpayer who is not an employee (that is he is
engaged in a trade or business as the rule requires e.g. a law firm partner who is
considered to be self-employed), the business expenses are subtracted from gross
47
 income to determine AGI under S62(a)(1). This is because the person in the business
is the one who is taking the risk of the losses that could come about.
i. Deductions taken into account in computing AGI are called above-the-line
deductions.
2. Employee
a. If business expenses are incurred by an employee (e.g. an associate at a law firm)
and are not reimbursed by the employer, the expenses are subtracted from AGI to
determine taxable income. SS62(a)(1) and 63(a).
i. Deductions taken into account in computing taxable income are called
below-the-line deductions.
b. Limitations:
i. Subject to the S67, 68 limitations noted above.
c. Reimbursed employee business expenses
i. Reimbursed employee business expenses are treated like nonemployee
business expenses i.e. they are above the line deductions and not subject to
S67. S62(a)(2), Reg. S1.6701T(a)(1). If the amount reimbursed by the
employer is equal to the employee business expense, regulation S1.162-
17(b) allows the employee, for reporting purposes, to disregard both the
reimbursement (which would otherwise be included in income) and the
business expense (which would otherwise be an above-the-line deduction).
d. How do you differentiate between an employee or independent contractor (who
would qualify as a non employee)?
i. Sets his or her own hours, is responsible for his or her own supplies or
equipment, and determines how to go about conducting the job (e.g. a
painter makes his own determination of how to paint i.e. he isn’t told to
paint right to left, and if he wants to paint left to right he can).
3. Expenses in earning income from sources other than a trade or business
a. Expenses incurred in earning income from sources other than a trade or business
are deductible under S212. Section 212 expenses are generally below-the-line and
thus subject to S67 limitations.
b. Exception: one exception is the deduction for S212 expenses attributable to
property held for the production for rents or royalties, which is an above the line
deduction. S62(a)(4)
4. Deductibility of (reasonable) compensation
a. Section 162(a)(1) allows a taxpayer to deduct a “reasonable allowance for salaries
or other compensation.” On the other hand, “unreasonable” compensation paid to
an employee is not deductible. Reg. S1.162-7(b)(3). The service has generally taken
the position that compensation is unreasonable only if the arrangement between
employee and employer involves tax avoidance.
i. The test is a facts-and circumstances test that takes into account a number
of factors including: (i) the employee’s qualifications; (ii) the nature of the
employee’s work; (iii) the employer’s history of paying or not paying
dividends; (iv) the compensation paid to comparable employees by
comparable employers; (v) the amount the employer has paid the employee
48
 in previous years; (vi) the results of the employee’s efforts; (viii) general and
local economic conditions; and (viii) the profitability of the employer after
the compensation has been paid. See Mason Manufacturing Co. v.
Commissioner.
b. In addition a publicly held corporation is allowed to deduct compensation paid to its
most highly compensated employees only to the extent that the compensation does
not exceed 1 million. S162(m). The 1 million cap does not apply to any portion of
the compensation that is based on commissions or the financial performance of the
employer. S162(m)(1), (4), Reg. S1.162.27
5. Deductibility of costs associated with illegal or unethical activities
a. Income obtained illegally is taxable (even if the taxpayer-criminal is required to
return the funds to the victim). James v. U.S. Similarly, expenses of illegal activities
are deductible unless S162 explicitly provides that the expenses are nondeductible.
i. S162 provides the following expenses are not deductible: most bribes and
kickbacks, fines and penalties; and the punitive damages portion of criminal
antitrust violations. S162(c), (f), (g). Also, S280E specifically provides that
expenses incurred in drug trafficking are nondeductible.
1. Prior to the adoption of S162, courts used to utilize a frustration of
public policy test.
ii. Note: the cost defending oneself against criminal charges are deductible
regardless of whether the person is convicted or not. Commissioner v.
Tellier
b. Current Expenses V. Capital Expenditures
i. Current business expenses are deductible in the year in which they are incurred, but the cost of a
business asset with a useful life that extends beyond the year in which the expense is incurred must
be capitalized. S263. It should be noted that depreciable assets are “S1231 assets” and not capital
assets (just because an asset is capitalized/depreciated does not mean it is a capital asset).
1. The object of the capitalization requirement is to accurately reflect the taxpayer’s true
income for each year by matching an expense with the income to which it relates. See e.g.
Encyclopedia Britannica v. Commissioner
ii. Capital Expenditures
1. The cost of an asset with a useful life that extends beyond the year in which the expense is
incurred is deducted as depreciation over the useful life of the asset, provided the asset has
a determinable useful life. S167. Annual deductions for the cost of business assets are
determined by reference to bright-line statutory rules rather than by reference to the actual
decline in the value of the asset. SS167, 168
a. S167 allows for a deduction for “exhaustion, wear and tear” of property used in a
trade or business or for the production of income.
2. The application of the capitalization rules apply to tangible and intangible property.
a. Both tangible property, such as a machine or building, and intangible property, such
as a patent are susceptible to the capitalization requirement. Reg. S1.167(a)-2, -3.
i. Note:
1. The term amortization, rather than depreciation, typically is used to
describe deductions for the cost of intangible property.
49
 2. Under S168, most tangible property with a limited useful life is
depreciated under the accelerated cost recovery system (ACRS)
which gives the taxpayer the ability to deduct the cost of an asset
over a period of time that is shorter than the actual useful life of the
asset.
ii. Rule for intangible property: Pursuant to S1.263(a)-4 Taxpayers must
capitalize amounts paid to: (i) acquire intangibles described in -4(c); (ii)
create intangibles described in -4(d); (iii) create or enhance a separate and
distinct intangible asset (INDOPCOsee below for exceptions) ; (iv) create
or enhance a future benefit; and (v) facilitate the acquisition or creation of
intangibles.
1. A separate and distinct asset is a property interest protected under
state law that can be transferred separately from a trade or
business. Reg. 1.263(a)-4(b)(3)
2. Acquired tangibles are defined in S1.263(a)-4(c) and created
intangibles are defined in 1.263(a)-4(d).
a. Both (c)(1) and (d)(2) define “intangibles” to include the
following financial interests: (i) owner-ship interest in
corporations, partnerships, limited liability companies or
other entities; (iv) annuity and insurance contracts; and (v)
nonfunctional currency.
b. For purposes of (c)(1) (acquired intangibles), the term
intangibles also includes: (i) leases; (ii) patents and
copyrights; (iii) franchises, trademarks, and trade names;
(iv) an assembled workforce; (v) goodwill; (vi) customer
lists; (viii) servicing rights; (viii) customer-based intangibles;
and (ix) certain computer software.
c. Created intangibles include: (i) prepaid expenses, such as
prepaid insurance; (ii) fees for memberships and privileges,
such as hospital privileges; (iii) certain rights granted by a
government agency, such as a business license; (iv) costs of
creating or renewing contracts; (v) certain contract
termination costs; (vi) certain costs of real property
transferred to another or produced for another; and (vii)
costs of defending or perfecting title to intangible property.
S1.263(a)-4(d)(3)-(9).
3. Exceptions to the INDOPCO future benefits test
a. In applying the transaction cost rule, the taxpayer may
disregard de minimis costs (costs aggregating 5k or less),
compensation paid to the taxpayer’s employees, and
overhead expenses. Reg. S1.263(a)-4(e)(4).
b. Taxpayers may deduct costs of acquiring or creating
intangibles if the rights acquired or created do not extend

50
 beyond 12 months after the taxpayer realizes the right. Reg.
S1.263(a)-4(f)(1).
c. Taxpayers may also disregard de minimis costs (costs
aggregating 5k or less), compensation paid to the taxpayer’s
employees, and overhead expenses. Reg. S1.263(a)-5(d).
d. Note: In INDOPCO, the taxpayer took a deduction for
investment banking and legal fees incurred during the year
in connection with a friendly takeover. Because the
takeover produced significant long term benefits for the
taxpayer’s shareholders, the court held that the fees had to
be capitalized.
b. Prepayment of an expense that is attributable to later years
i. If a taxpayer prepays an expense that is attributable to later years, the
expense must be capitalized. Commissioner v. Boylston Market Association
(where a cash method taxpayer that prepaid three years of insurance
premiums had to allocate that expense over the three years and deduct a
portion each year.
c. Amounts paid to acquire or improve the property
i. Section 263 generally requires capitalization of amounts paid to acquire
produce or improve property: (i) real or personal property, including land,
buildings, machinery, and equipment; or (ii) intangibles. S263(a) and Prop.
Reg. S1.263(a)-1,-2,-3.
d. Otherwise deductible business expenses
i. Pursuant to Commissioner v. Idaho Power Co., an otherwise deductible
business expense (wages paid to employees) used in constructing a building
or machinery must be capitalized.
3. Exceptions to the capitalization requirement:
a. Costs of acquiring property- S179 allows taxpayers to immediately deduct certain
costs of acquiring property.
b. De minimis exception-Regulation S1.263(a)-2(d)(4) provides a de minimis exception
to the capitalization requirement if the taxpayer’s deduction of certain relatively
minor expenses is consistent with the taxpayer’s treatment of the expenses for
financial accounting purposes.
c. Materials and supplies-While taxpayers must generally capitalize amounts paid to
acquire or produce property, under S263(a), there is an exception for “materials and
supplies.” Prop. Reg. SS1.162-3(a), 1.263(a)-2(d)(1)(i).
i. The regulation define the term “materials and supplies” to include tangible
property that is used or consumed in the taxpayer’s business and (i) costs
$100 or less, or (ii) has a useful life of 12 months or less. Prop. Reg. SS162-
3(d)(1), 1.263(a)-2(c)(2), (d)(1)(i).
1. Incidental materials and supplies (goods carried on hand for which
no record of consumption is kept, such as a firms legal pads and
pens) are deducted in the year in which the supplies are used or

51
 consumed, and nonincidental materials and supplies in the year in
which the supplies are used or consumed. Prop. Reg. S162-3(a)
ii. In cases of a rotable part (i.e. a part that a taxpayer can remove for repair
and reinstall after repair) or a temporary spare part, the taxpayer deducts
the cost in the year in which the taxpayer disposes of the part. Prop. Reg.
S162-3(b).
d. Property with an unlimited useful life- Property with an unlimited useful life, such as
land, cannot be depreciated or amortized. Reg. S1.167(a)-2. Instead, with a few
statutory exceptions (See S197, which for instance, includes good will), the costs of
such property may be recovered only when the property is sold (by subtracting the
taxpayer’s adjusted basis from the amount realized on the sale).
e. Incidental repairs-see section below on incidental repairs
iii. UNICAP-Special rules for manufacturers, wholesalers, retailers, etc.
1. The UNICAP rules apply to manufacturers, wholesalers, retailers, and any other taxpayers
who produce real or tangible property for sale or acquire real or tangible property for sale
to customers in the ordinary course of their business. S263A(b). However, S263A does not
apply to wholesalers or retailers with average annual gross receipts from sales, over a three
year period, that are below 10 million, but always applies to manufacturers. S263A(b)(2)(B).
a. Tangible property is defined to include books , films, and sound recordings. S263(b).
However, it does not apply to freelance authors, photographers, and artists.
263A(h).
2. If S263A applies, when does a taxpayer recover the expenses?
a. If 263A applies, it requires the taxpayer to recover the expenses of producing or
selling goods when the goods are sold, by including those expenses in the taxpayer’s
“cost of goods sold” (taxpayer’s inventory cost for the year). S263(a)(11).
3. Does UNICAP/S263 apply to direct or indirect costs?
a. The UNICAP rules apply to the direct costs of producing and selling goods and the
portion of the indirect costs allocable to the goods sold. S263A(a)(2).
i. Direct costs include: the cost of materials and wages of employees who
produce or sell goods. Reg. S1.263A-1(e)(2)(ii), (g)(1), (2).
ii. Indirect costs include: the costs of repair and maintenance of equipment or
facilities; utility costs; rent on equipment, facilities, or land; indirect labor
costs; indirect material costs; the costs of tools and equipment, if such costs
are not otherwise capitalized; certain taxes; depreciation on equipment or
facilities; depletion the cost of certain administrative or support
departments or functions compensation paid to officers; insurance
premiums contributions to deferred compensation ; bidding expenses; and
certain interest costs. Reg. S1.263A-1(e)(3)(ii).
b. Exceptions:
i. Taxpayer’s expenses for marketing, advertising, and general business and
financial planning do not have to be capitalized. Reg. S1.263A-1(e)(3)(iii), (4)
(iv)(B), (C). (Even if the purpose of the advertising is to create goodwill).
ii. Most research and experimental expenses do not have to be capitalized
even though they provide a benefit extending beyond the taxable year.
52
 SS174, 263A(c)(2). However, the costs of researching a book (along with
preproduction costs such as editing and illustrating) have to be capitalized.
Reg. S1.263A-2(a)(2)(ii)(A)(1).
iii. Soil and conservation expenditures incurred by farmers also generally do
not have to be capitalized. S175.
iv. Business costs that are not incurred in connection with the resale of an item
e.g. general business planning can be deducted immediately. Reg. S1.263A-
1(e)(4)(iv)(B).
iv. Repair and Maintenance Expenses
1. Incidental Repairs v. Capital improvements- The “cost of incidental repairs which neither
materially add to the value for the property nor appreciably prolong its life” are generally
allowed as current deductions. This is because taxpayers must capitalize the costs of
improving property, but can deduct the cost of incidental repairs. S162(a), 263(a); Prop.
Reg. SS1.162-4, 1.263(a)-3.
a. Compare Midland Empire Packing Co. v. Commissioner (Oil from a newly
constructed refinery began to seep through the walls of the taxpayers meat curing
plant basement. The Federal meat inspectors threatened to shut down the plant
unless the taxpayer paid 5k to line the wall of his basement with concrete. Court
ruled that it was a repair and not a capital improvement because adding the wall
merely permitted the taxpayer to keep doing what it had been doing) with Mt.
Morris Drive-In Theater Co. v. Commissioner (taxpayer was denied a current
deduction for the cost a drainage system installed to stop runoff to nearby land
caused by clearing land during construction for the taxpayer’s drive in theater. Court
ruled that the need for the drainage system was foreseeable at the time the
taxpayer constructed the drive-in theater, so its cost had to be capitalized.)
b. Factors courts consider are whether it adds to the value, prolongs the expected life,
or changes the use.
c. Read 526-531
c. Depreciation and the Accelerated Cost Recovery System
i. Given that a business asset with a useful life greater than a year has to be capitalized, we must
determine the taxpayer’s depreciation deductions for the asset. In so doing, we must determine (i) the
useful life of the asset, (ii) the salvage value of the asset, and (iii) the method for allocating the cost of
the asset (less the salvage value of the asset) over its useful life.
ii. Tangible asset
1. Depreciation on tangible business or investment property generally is determined under
S168. SS167(b) and 168(a). The S168 system of depreciation is referred to as the accelerated
cost recovery system (ACRS).
a. The ACRS accelerates the depreciation deductions in 3 ways: (i) it uses recovery
periods that are substantially shorter than actual useful lives of the property; (ii) it
allows the use of accelerated depreciation methods; and (iii) it assumes that the
salvage value of the property is 0, permitting deduction of the entire cost of the
property. S168(b), (c), and (e).
2. Under S168, a taxpayer’s annual depreciation deductions are determined using (i) the
applicable depreciation method, (ii) the applicable recovery period, and (iii) the applicable
53
convention. S168(a)(1), (2), and (3). Note: salvage value is always treated as 0 regardless of
the method used. S168(b)(4).
a. The applicable depreciation method is determined under S168(b) which is generally
more than the actual decline in the value of the item as the recovery period is
usually less than the useful life, acceleration if applicable, and the salvage value is
always 0.
1. Exception: Property specified in S168(g)(1) is depreciated using the
depreciation method specified in S168(g)(1). Property subject to his
alternate system has a longer recovery period and is depreciated
using the straight line method. S168(g)(2). Said property includes:
a. Any tax-exempt use property
b. Any tax-exempt bond financed property
c. Any imported property covered by an executive order under
paragraph (6), and
d. Any property to which an election under paragraph (7)
applies.
ii. Straight line-a taxpayer must use straight line to depreciate real property
and may elect to use straight line to depreciate other types of property.
S168(b)(3)(5). (level over time)
iii. Declining/Double declining method-If the property is not real property and
the taxpayer does not elect to use the straight line method one of two
methods will apply: if the property is 15 year property or 20 year property,
the 150 percent declining balance method will apply; if the property is any
other type of property, the 200 percent declining balance method generally
will apply (unless the taxpayer elects to apply the 150% method under
S168(b)(2)(C)). S168(b)(1), (2) (usually front loaded)
1. Under the declining balance depreciation method, the percentage
deduction that would be allowed under str8 line is calculated and
multiplied by 1.5 or 2 . This amount is then subtracted from the
basis and repeated for the remaining years-the pattern is done over
and over until the first year in which the str8 line is more than the
deduction computed using the declining balance method.
iv. Bonus depreciation-If the property has a recovery period of 20 years or less
and was acquired in 2008 and placed in service by the end of 2008 (or by
the end of 2009 if the property has a long production period), then a bonus
depreciation deduction applies. The bonus equals 50% of the taxpayer’s
basis in the property and reduces the basis. The taxpayer also deducts
regular depreciation on the property, in addition to the bonus depreciation,
but the taxpayer’s regular depreciation deduction reflects the taxpayer’s
reduced basis.
v. Exam point- interestingly, none of the above are the most accurate
measures of income. Rather, the most accurate method is the economic
depreciation method which allots for an annual depreciation deduction
equal to the decline, during that year, of the value of the property. The
54
 decline could be determined from market transactions, or books or indexes
that reflect such transactions, or discounting expected income streams.
(usually back loaded).
1. One of the reasons this method is not used is because it is
sometimes difficult to estimate income streams. We may also want
to encourage investments in business assets as a matter of fiscal
policy.
b. The applicable recovery period for tangible property is determined under 168(c) and
(e). (Recovery period is often shorter than the class life of the asset).
i. Property with a 9 year class life has a 5 year recovery period. S168(e)(3)
ii. Car or light general purpose truck is 5 year property. S168(e)(3)(B)(i)
iii. Recovery period for 5 year property is 5 years. S168(c).
iv. Recovery period for residential property is 27.5 years and the recovery
period of nonresidential property is 39 years. S168(c)
v. A business asset that is not real property and is not one of the types of the
assets listed in S168(e)(3), the recovery period is determined under S168(e)
(1).
c. The applicable convention is determined under S168(d). This section determines the
date on which the depreciable property is deemed to have been placed in service by
the taxpayer as it, and not the date the item was purchased, determines when
depreciation deductions begin.
i. Not Real Property
1. If the asset is not real property, a “half year convention” generally
applies so the asset is deemed to have been placed in service on the
date that is halfway through the year. S168(d)(1) and (4)(A).
a. Note: If a disproportionate amount of depreciable property
is placed in service in the last 3 months of the year, a mid
quarter convention instead of the half year convention
applies. In that case, the property is deemed to have been
placed in service on the date that is halfway through the
quarter in which the property .
ii. Real Property
1. A mid month convention applies to depreciable real property, so
real property is deemed to have been placed in service on the date
that is halfway through the month in which the property is actually
placed in service. S168(d)(2) and (4)(B).
iii. Special Mid-Quarter Rule
1. If during a taxable year, the aggregate bases of the property placed
in service in the last 3 months of the taxable year exceed $0% of the
aggregate bases of property placed in service during the year shall
utilize the mid-quarter convention. S168(d)(3)
iii. Intangible asset
1. Depreciation on intangible assets is determined under S167 (or, in some circumstances,
under S197 e.g. good will).  If S167 apples, usually straight line over the useful life.
55
 iv. Property’s basis as it is depreciated or amortized
1. The taxpayers basis is the amount paid for the property + the amount to improve it.
S1016(a)(2) and (a)(1). As property is depreciated or amortized, its basis is reduced by the
amount of the deductions taken. S1016(a)(2). The depreciation deductions are ordinary
deductions so the portion of any gain on the sale of depreciable property that is attributable
to having taken depreciation deductions is recharacterized as ordinary gain under the
depreciation rules of S1245. If sold for more than the original basis, any amount over the
original basis is characterized as capital gains.
a. E.g. property acquired for 1k is fully depreciated and sold for 1,200. The taxpayer
would realize a 1,200 gain on the sale, 1k of which would be ordinary and 200 of
which would be capital gains. S1245(a)(1)-(3)
2. Real Property
a. Depreciation is recaptured only to the extent that the depreciation taken is greater
than straight line, but since straight line is required for almost all real property, this
seldom occurs. S1250
v. S179 Election to expense certain depreciable business assets
1. A taxpayer can elect to depreciate certain types of property in the year in which it is placed
in service. S179
2. Limitations: S179(b)(1) caps the aggregate annual cost that is currently deductible at
$25,000 (100k in the case of taxable years beginning after 2002 and before 2010). Also, this
limitation shall be reduced (but not below 0) by the amount by which the cost of S179
property placed in service during such taxable year exceeds 200k (400k in the case of a
taxable year beginning after 2002, but before 2010). The S179 deduction also cannot exceed
the taxable income from the taxpayer’s business in the year in which the property is placed
in service (any excess deduction is carried over to the next year). S179(b)(3)(B).
a. Increases in limitations for 2008, 2009
i. The deductible amount is 250k and the dollar limitation is 800k. S179(b)(7).
3. Types of S179 property: S179 property is defined generally as depreciable tangible personal
property, but more specifically(1) tangible property (to which S168 applies), or computer
software (as defined in S197(e)(3)(B)) which is described in S197(e)(3)(A)(i), to which S167
applies, and which is placed in service in a taxable year beginning after 2002 and before
2010; (2) which is section 1245 property (as defined in S1245(a)(3)), and (3) which is
acquired by purchase for use in the active conduct of a trade or business.
a. This property does not include any property described in S50(b) and shall not
include air conditioning or heating units.
4. What if the taxpayer fails to take his allowable depreciation deductions?
a. The taxpayer’s basis is reduced even if the taxpayer does not take the depreciation
deductions permitted under S167 and S168.
d. Depletion Deductions
i. Deductions may be taken for the depletion of certain natural resources, including mineral deposits, oil,
gas, and timber. SS611-613A. There are two methods of depletion:
1. Cost depletion: allocates the cost of the property among the estimated number of untis of
raw materials that will be recovered from the property.

56
 2. Percentage depletion: simply permits a taxpayer to deduct a stated percentage of its gross
income as a depletion allowance. There is no need to estimate the recoverable units, and
percentage depletion in fact continues after the taxpayer’s entire cost has been recovered.
a. The permitted depletion percentage ranges from 5-22 percent, depending on the
type of natural resource. However, generally it may not exceed 50% of the taxable
income from the property, computed w/o allowance for depletion.
i. E.g. X owns a sulphur mine and uses the % depletion method
(sulphur=22%). In year one x has 1 million of gross income and 800k in
expenses. X’s depletion deduction is 220k, but since the taxable income is
only 200k, the depletion deduction cannot exceed 50% of the taxable
income (here 200k). Thus, x is only allowed to deduct that allowance to the
extent of ½ of his income, or 100k.
12. PERSONAL DEDUCTIONS, EXEMPTIONS, CREDITS, AND THE ALTERNATIVE MINIMUM TAX
a. Itemized personal deductions/Standard deduction
i. In order to determine taxable income, an individual reduces AGI by any personal exemptions
(explained below) and either the applicable standard deduction or itemized deductions. A taxpayer
may elect to take either (i) itemized personal deductions or a (ii) standard deduction S63(b).
1. Limitations: An otherwise qualifying itemized deduction may be lost entirely or partially due
to S67(a) or S68.
a. Section 67(a) provides that itemized deductions, other than the ones listed in
S67(b), are allowed only to the extent that they exceed the 2% floor.
b. Section 68 sets an overall limit on itemized deductions (for all deductions other than
medical expenses, investment interest, and casualty, theft, or wagering losses). This
effectively increases the effective marginal tax rate for affected taxpayers (e.g. if a
taxpayer who is above the threshold earns an additional 1k, the taxable income
increases by 1030 because the taxpayer’s income goes up by 1k and the itemized
deductions must be reduced by 30). In the case of a taxpayer whose AGI exceeds
100k, adjusted for inflation (presently at around 168k), the total amount of
otherwise allowable deductions is reduced by the lesser of:
i. 3% of the excess of AGI over the applicable amount; or
ii. 80% of the amount of the itemized deductions otherwise allowable for such
taxable year.
c. Note: Provisions in the EGTRRA are gradually limiting the S68 limitation: it has been
reduced for 2006-2007 to 2/3 the applicable fraction and 2008-2009 to 1/3, and is
set to be phased out entirely for any taxable year beginning after December 31,
2009.
ii. Standard deduction
1. Per Section 63(c)(2), the standard deduction, which is adjusted for inflation, was 5,350 for
an unmarried taxpayer and 10,700 for a joint return in 2007. Rev. Proc. 2006-53 (in
addition, 63(f) provides small additional inflation adjusted standard deductions for the
elderly and the blind). For most taxpayers that are not paying interest on a home, the
standard deduction will often times generate a larger deduction than would an itemized
deduction.
iii. Which taxpayers benefit the most from itemized deductions?
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 1. Itemized deductions, such as charitable contributions, are more valuable to a high-income
taxpayer because they are subject to a higher marginal tax rates. E.g. a wealthy taxpayer in
the 35% bracket who donates $100 to charity will reduce the amount of tax owed by $35 so
the after tax cost of the contribution was only 65, as opposed to a person who is in the 15%
bracket donating the same amount would reduce the tax owed by $15, making the after tax
cost of the donation $85. Also, itemized deductions are only available to those who do not
opt to take the standard deduction, and many low income taxpayers take the standard
deduction.
b. Personal Exemption
i. Like Personal deductions, personal exemptions are also subtracted from a taxpayer’s AGI and may be
taken in addition to the standard deduction or itemized deductions. Each taxpayer receives a personal
exemption and an additional dependent exemption for each dependent. S151(b), (c). Although S151
provides that the exemption amount for both personal and dependent exemptions is 2k, that amount
is adjusted for inflation under S151(d)(4)(A) (in 07 it was 3,400).
1. Who is a dependent?
a. Per S152, a dependent is a qualifying child or qualifying relative.
i. A qualifying child: is a person who: (i) is the taxpayer’s child or sibling, or the
descendant of the taxpayer’s child or sibling; is 18 or younger (or 23 or
younger if the person is a full-time student); (iii) has the same principal
place of abode as the taxpayer for more than half the year; and (iv) has not
provided more than half of his own support for the year.
1. Note: the live at home requirement of S152 allows for a temporary
absence from the home to attend school.
ii. A qualifying relative is a person: (i) who either (A) is the taxpayer’s child or
child’s descendant, parent or parent’s ancestor, sibling, aunt, uncle,
nephew, cousin, or in-law, or (B) has “the same principal place of abode as
the taxpayer and is a members of the taxpayer’s household”; (ii) whose
gross income for the year is less than the S151 personal exemption amount
(e.g. $3,400 in 2007); (iii) who receives more than half of her support from
the taxpayer; and (iv) who is not a qualifying child of the taxpayer.
2. Personal exemption phaseout (“PEP”)
a. The deduction for personal exemptions is phased ratably for taxpayers with AGI
over certain thresholds. If the taxpayers AGI income exceeds the “threshold
phaseout amount,” the taxpayer’s personal exemptions are reduced 2% for each
2,500 increment (or faction thereof of adjusted gross income in excess of the
threshold phaseout amount) S151(d)(3). The threshold phaseout amounts provided
S151(d)(3) are adjusted for inflation under S151(d)(4)(B). In 07, it was $234, 600 for
married taxpayers filing jointly and 156, 400 for unmarried taxpayers.
b. Note:
i. The income-based limitations on personal deductions and exemptions
increase the progressivity of the tax system. Congress enacted EGTRRA in
2001 and amended S151 to gradually eliminate the personal exemption
phaseout. In 2007, EGTRRA reduces the phaseout by two thirds in 2008 and
2009, and eliminates it completely in 2010. S151(d)(3)(E)(F).
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c. Tax Credits
i. Unlike deductions and exclusions, which reduce a taxpayer’s taxable income, tax credits reduce a
taxpayer’s tax liability dollar for dollar. E.g. lets assume a taxpayer is in the 35% marg. bracket. If he is
given a $100 deduction, it would reduce his taxable income by 100 and recue his tax liability by 35, but
if he is given a 100 credit, it would reduce tax liability by 100. A credit is not refundable unless a there
is a rule that specifies that to be the case e.g. child credit.
ii. Credit for employee taxes withheld by an employer
1. The most generally applicable credit is the S31 credit for income taxes withheld by an
employer. This credit is refundable, meaning that a taxpayer is entitled to a refund to the
extent that this credit exceeds the taxpayer’s income tax owed for the year.
iii. Earned Income Credit
1. The most significant credit premised on ability to pay is the earned income credit, designed
to reduce the tax burden on low-income workers. If the credit amount exceeds the
taxpayer’s tax liability, the excess amount is refundable. As the taxpayer’s income increases,
the credit is phased out. S32(b) Earned income includes wages, salaries, tips, and any other
employment compensation and income from self-employment, but does not include
pensions or annuities. S32(c)(2). The term qualifying child is defined as in S152(c), w/o the
support requirement of S152(c)(1)(D).
2. For 2007, the credit percentage was (i) 34% if the taxpayer had one qualifying child, (ii) 40%
if the taxpayer had two or more qualifying children, and (iii) 7.65% if the taxpayer had no
qualifying children. S32(b)(1)(B). The earned income amount was: (i) 8,390 if the taxpayer
had one qualifying child; (ii) 11,790 if the taxpayer had more than one qualifying child; and
(iii) 5,590 if the taxpayer had no qualifying children. S32(b)(2)(A) and Rev. Proc. 2006-53.
a. E.g. Thus, the maximum earned income tax credit for 2007 was (i)2,853,(the 34%
credit multiplied by the 8,390 earned income amount) and 4,716 (the 40% credit
percentage multiplied by the $11,790 earned income amount) for a taxpayer with
more than 1 qualifying child.
iv. S22 credit for the elderly
1. It provides a credit for taxpayers who either are at least 65 years old or are retired because
of permanent and total disability. The maximum credit is $750 (15% of 5k) for unmarried
taxpayers or where only one spouse qualifies. S22(c)(2)(A)(i). If married taxpayers filing
jointly both qualify, then the max credit is 1,125 (15% of $7,500). S22(c)(2)(A)(ii). The credit
is reduced if the taxpayer receives certain types of government pension, annuity, or
disability payments. S22(c)(1) and (3). The credit is also subject to a phaseout based on AGI.
S22(d).
v. Child Credits
1. S24 provides a 1k child tax credit for each “qualifying child.” S24(a). The term qualifying
child is defined as a S152(c) qualifying child who is 16 years or younger. S24(c)(1). The credit
is reduced by $50 for each 1k by which the taxpayer’s AGI exceeds the threshold amount in
S24(b)(1) and (2) which is 110k for married taxpayers filing a joint return and 75k for single
taxpayers. The child tax credit is generally refundable up to a maximum of 15% of the
taxpayer’s earned income above 11,500 (indexed for inflation) in 2007 and later years.
S24(d)(1) and Rev. Proc. 2006-53.

59
 a. Note: Taxpayers with 3 or more children may be able to qualify for a larger amount
of refundable credit. S24(d)(1)(B)(ii).
2. S23 also provides a credit for qualified adoption expenses, which include reasonable and
necessary adoption fees, court costs, attorney fees, and other costs directly related to
adopting an “eligible child.” S23(a)(1), (d)(1). A child is an eligible child if he is under a18 or
is incapable of taking care of himself. The max credit was 11,390 in 2007 and is adjusted
annually for inflation. This credit is phased out if the taxpayer has AGI of more than 170, 820
(adjusted for inflation). S23(b) and Rev. Proc. 2006-53. If in a given tax year, a taxpayer
qualifies for a S23 credit in excess of the taxpayer’s tax liability for that year, the excess
amount is not refunded, but can be carried forward (up to 5 years) to offset the taxpayers
liability in following years. S23(c).
a. The same applies for an adoption assistance program provided by an
employersee pg. 194 E&E if necessary.
d. Alternative Minimum Tax
i. AMT is a separate system for computing tax liability-taxpayers must compute their tax liability under
the regular income tax and AMT and pay the higher amount. S55(a)applies to both individuals and
corporations. The AMT imposes tax on the taxpayer’s taxable excess, which is the taxpayers AMT
income (AMTI) less the AMT exemption amount.
1. Computing AMT: To compute AMTI, taxpayers start with their taxable income, as computed
under the regular income tax, and add amounts to reflect various adjustment required by
SS56-58 e.g. personal and dependent exemptions, state and local taxes, and itemized
deductions are included in the broader AMTI base. S56(b)(1)(A). The taxpayer then
subtracts form AMTI the relevant AMT exemption provided in S55(d)(1) and multiplies the
excess by the appropriate taxable rate.
a. AMT Exemption: The AMT exemption (the exemption amounts are not adjusted
annually for inflation, but congress, in recent years has increased them annually by
statute) is 45k for a joint return or surviving spouse (69,950 in the case of taxable
years beginning in 2008) and 33,750 (46,200 in the case of taxable years beginning
in 2008) for single taxpayers. Married taxpayers filing separately divide the joint
amount by 2.
i. Phase out: A phase out rule in S55(d)(3) reduces a taxpayer’s exemption
amount by 25% of the amount by which the taxpayer’s AMTI exceeds: (i)
150k for married taxpayers filing a joint return, and (ii) 112,500 for
individual taxpayers. Under this phaseout, the AMTI exemption is reduced
to 0 if the (i) married taxpayers filing a joint return have $415k or more of
AMTI and (ii) individual taxpayers have 289,900 or more of AMTI.
b. Taxable rate: the taxpayer’s taxable excess, up to 175k, is taxed at a 26% rate. The
taxable excess above 175k is taxed at a 28% rate. 55(b)(1).
13. SOME COMMON PERSONAL DEDUCTIONS
a. Casualty Losses
i. A taxpayer can deduct net personal casualty losses (personal casualty losses less personal casualty
gain) to the extent that the aggregate losses during the taxable year exceed 10% of the taxpayer’s AGI,
after reducing each loss by $500. S165(h). Personal casualty losses are losses of property not
connected with a trade or business or a transaction entered into for profit, if such losses arise from
60
fire, storm, shipwreck, or other casualty, or from theft. S165(c)(3). Losses of property used in
business or profit-seeking activity are deductible whether or not they are due to casualty or theft.
S165(c)(1), (2).
1. To what extent is a casualty loss permitted?
a. A casualty loss deduction is permitted only to the extent the loss is not reimbursed
by insurance or otherwise. S165(a). The deduction is permitted in the taxable year in
which the loss occurs or, in the case of theft, in the taxable year in which the
taxpayer discovers the loss. S165(e), Reg. SS1.165-1(d)(1) and 1.165-8(a)(1), (2). If
the taxpayer has a claim for reimbursement of casualty loss, the loss may not be
deducted until the taxable year in which the amount that will be reimbursed can be
ascertained. Reg. S1.165-1(d)(2).
2. What if a taxpayer has a gain from the personal casualty?
a. If a taxpayer’s casualty gains exceed the taxpayer’s personal casualty losses, the
personal casualty gains and losses are treated as capital gains and losses. S165(h)(2)
(B). In that case, the loss would not be an itemized deduction, but instead would
offset the gain. On the other hand, if the casualty losses exceed the taxpayer’s
personal casualty gains, the net personal casualty loss is an itemized deduction.
3. How do you compute the amount of the casualty loss and are there limitations?
a. The amount of the loss is determined by comparing the FMV of the damaged
property before and after the casualty. Reg. S1.165-7(a)(2)(i) and (b)(1). However,
the loss cannot exceed the taxpayer’s adjusted basis in the property. The amount of
the loss claimed as a deduction reduces the taxpayer’s basis in the property. Reg.
S1.165-1(c)(1). In addition, the loss from each casualty is allowed only to the extent
that it exceeds $500. S165(h)(1). The casualty loss itemized deductions are not
subject to the limitations of S67 and 68, but are not allowed to the extent that they
do not exceed 10% of the taxpayer’s AGI. S165(h)(2)((A).
4. What qualifies as a casualty?
a. If a taxpayer’s loss is caused by an event other than fire, storm, shipwreck, or theft,
the taxpayer may deduct the loss only if it was caused by a casualty. S165(c)(3). The
service’s position is that only an event that is “sudden, unexpected, and unusual”
qualifies as a casualty. Rev. Rul. 72-592. A taxpayer may take a casualty loss
deduction for property destroyed due to his negligence, but not for gross negligence
or a willful act. Blackman v. Commissioner (where he was denied a deduction for his
destroyed home because of his gross neg. in failing to put out the fire he started).
i. Sudden
1. E.g. termite damage does not qualify because it’s not sudden. Rev.
Rul. 63-232
ii. Unexpected
1. Breakage of household goods by a family pet is not unexpected.
Dyer v. Commissioner.
iii. Differences of opinion on sudden, unexpected, and unusual
1. Courts do not always apply the “sudden, unexpected, and unusual”
standard consistently e.g. compare Keenan v. Bowers (where the
taxpayer was denied a casualty loss deduction for two diamond
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 rings that were wrapped in a tissue and mistakenly flushed down
the toilet) with Carpenter v. Commissioner (where the taxpayer was
allowed a casualty loss deduction for a diamond ring that had been
left in a glass of ammonia and water for cleaning and later poured
into the kitchen sink and destroyed by the garbage disposal).
5. Federal Disaster- special rule in 165h3 that doesn’t make TP offset loss with casualty gains in
that year.
6. Net Operating Loss – 172(b)(1)(F) Special rule for individual’s casualty loss can be carried
back for 3 years.
b. Extraordinary Medical Expenses
i. Under 213(a), a taxpayer can deduct amounts spent on medical care for the taxpayer, taxpayer’s
spouse, or taxpayer’s dependants to the extent that the medical expenses exceed 7.5% of the
taxpayer’s AGI. On the other hand, medical benefits provided by the employer are fully excluded from
income. S105(b) and 106.
ii. What constitutes a medical expense?- Medical care is generally defined as amounts paid for the
diagnosis, cure, mitigation, treatment, or prevention of disease, or for the purpose of affecting a
structure or function of the body. S213(d)(1)(A). If an expense improves the health of the taxpayer,
but is not directed at diagnosing, curing, mitigating, or preventing a disease, it is nondeductible. Reg.
S1.213-1(e)(1)(ii). On the other hand, the service has ruled that an obese patient may deduct the cost
of a weight loss program because obesity is recognized clinically as a disease. Rev. Rul. 2002-19. Note:
a doctor’s recommendation is not needed for an expense to be deductible.
1. Costs of medical items: If a taxpayer incurs costs for a medical item (other than OTC drugs)
not specifically recommended by her doctor, she may be able to deduct the cost of the item,
but will have to establish that she bought it primarily for medical reasons. See e.g Rev. Rul.
76-80.
2. Dental expenses
a. Dental work is considered a medical expense under S213. Reg. 1.213-1(e)(1)(ii).
3. Property improvements
a. Amounts spent on property improvements for medical purposes are deductible only
to the extent that the cost of the improvement exceeds the increase in the value of
the property. Reg. S1.213-1(e)(1)(iii). E.g. if a taxpayer adds a swimming pool, based
on the advice of his doctor, which adds 40k in value to his home, but costs 50k, then
10k would be deductible.
i. However, even that deduction will not be allowed if the taxpayer has access
to a nearby pool. Evanoff v. Commissioner (where a medical expense
deduction for a home pool was not allowed because, but for a personal
religious objection to boys swimming in the same pool with girls, the
taxpayer’s daughter could have used a nearby swimming pool).
ii. Also, if the pool is extravagantly built, the taxpayer will be allowed to deduct
only the average cost of a home pool less the value added to a home by
such pool and not the price of the extravagantly built pool. Ferris v.
Commissioner.
b. Improvements that do not add value : Certain improvements do not add value to the
residence. For example, ramps, railings, lifts, and hardware, and modifying
62
 doorways, hallways, stairs, electrical outlets, and kitchen cabinets are generally
improve the value of a personal residence. Rev. Rul. 87-106
4. Medical expenses to maintain or improve healt h
a. Medical expenses that help a person who is not ill to maintain or improve health are
not deductible. Reg. S1.213-1(e)(1)(ii). As such, ordinary personal activities, like
tennis, golf, etc., that provide general health benefits are not deductible. Even if a
dr. recommends that a person participate in said activities to relieve stress, the
taxpayer probably will not be able to establish that the activity was necessary as
there are cheaper ways to relieve stress e.g. running. See Altman v. Commissioner
(where taxpayer was denied a deduction for his costs of playing golf, despite the
fact that the taxpayer’s doctor had recommended that he play golf for his
emphysema).
i. Exceptions:
1. The costs of an annual diagnostic checkup are medical expenses
even though they are not designed to treat a specific illness. Reg.
S1.213-1(e)(1)(ii).
2. Smoking cessation costs are medical expenses because nicotine
causes disease and is addictive. Rev. Rul. 99-28
5. Cosmetic Surgery
a. S213 allows a deduction for the expense of cosmetic surgery if it is necessary to
correct a congenital deformity or an abnormality arising from injury or disease.
S213(d)(9).
6. Drugs
a. The cost of insulin and prescription drugs is deductible, but not OTC drugs. S213(b)
i. Note: for purposes of the S105(b) exclusion, the term medical care includes
OTC drugs.
7. Lodging, transportation expenses, and medical insurance
a. Deductible medical expenses also include the costs of medical insurance, hospital
lodging, and transportation incurred “primarily for and essential to medical care.”
S213(d)(1).
b. Lodging/Transportation: The cost of conventional medical care at hospitals,
including food and lodging costs, is fully deductible even if the taxpayer pays more
than is necessary for adequate care. Reg. S1.213-1(e)(1)(v)
i. The cost of lodging, outside the actual hospital, while away from home for
the primary purpose of obtaining medical care by a physician or licensed
hospital or equivalent medical care facility is only deductible up to $50 per
night (but food is not deductible). S213(d)(2). However, the lodging cannot
be lavish and have no significant element of personal pleasure, recreation,
or vacation. Id. Additionally, if a taxpayer travels on a doctor’s orders to a
more hospitable climate, the costs of travel may be deductible, but the cost
of meals and lodging are not, even if the taxpayer sees a doctor from time
to time in the area visited. Polyak v. Commissioner.
ii. If medical treatment is available where the taxpayer lives, the costs of
traveling to receive care are not deductible.
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 iii. What about a family member traveling with the taxpayer?
1. The service noted that the “transportation costs of a family member
traveling with the taxpayer have been allowed as a medical expense
deduction where the presence of the family member was necessary
to enable the taxpayer to obtain medical care.” Priv. Ltr. Rul.
8516025.--> subject to the $50 per day limitation.
c. Long term care and long term care insurance: . Amounts paid for “qualified long-
term care” services and certain premiums for “qualified long-term care insurance”
are treated as medical expenses for purposes of S213. S213(d)(1)(C), (10) The costs
of a nursing home may qualify for the S213 deduction
i. Qualified long-term care services are defined in S7702B© to include
various medical, rehabilitative, maintenance, and personal care services
that are performed for a chronically ill person and that have been provided
pursuant to a plan of care prescribed by a licensed medical personnel.
1. A person is considered “chronically ill” if he (i) cannot perform at
least two activities of daily living, such as eating and dressing, for a
period of at least 90 days; (ii) is disabled; or (iii) must be supervised
in order to avoid harm resulting from his severe cognitive
impairment. S7702B(c)(2).
ii. Qualified long-term care insurance
1. See S7702B(b) which sets forth a multi-part test for qualifying long
term care insurance.
8. Special rehabilitation schooling
a. The cost of special schooling designed to rehabilitate an ill or disabled individual is
deductible as a medical expense. Reg. S1.213-1(e)(1)(v)(a). e.g. a school for the deaf
or blind. The extra cost of braile books (i.e. the cost it exceeds the price of a normal
book) and the cost of a seeing eye dog or human guide are also deductible. Reg.
S1.213-1(e)(1)(iii), Rev. Rul. 75-318, and Rev. Rul. 64-173. On the other hand, if the
school serves some other purpose, e.g. to discipline a bad kid, then it likely is
nondeductible.
b. If a sick spouse stays at home and sends her children away to boarding school to
facilitate recovery, the costs of schooling are not deductible. Ochs v. Commissioner
9. Special Transportation Vehicles
a. Can deduct the cost of a special vehicle purchased to help an individual navigate
some type of impairment to the extent that it exceeds the cost of a comparable
ordinary automobile e.g. a custom made van to allow a paralyzed person to drive.
Reg. S1.213-1(e)(1)(iii). See also Rev. Rul. 70-606
10. Vasectomy or abortion
a. The costs of a vasectomy or legal abortion, even if undertaken solely for
contraceptive purposes, are deductible. Rev. Rul. 73-201
11. Child care to enable medical treatment
a. The costs of child care are considered personal expenses, even if incurred to enable
an individual to receive medical treatment. Ochs v. Commissioner
iii. Health Savings Account
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 1. To qualify for an HAS, the taxpayer must not be covered by medicare and must have a High
Deductible Health Plan (HDHP) and no other health insurance (other than ancillary coverage,
such as accident, disability, dental care, vision care, or long-term care). S223(c)(1). A
taxpayer can take an above the line deduction for contributions to an HSA and can exclude
employer contributions to an HAS. S223(a).
a. HSA Qualifications: A health insurance plan is a HDHP if: (i) the annual deductible is
not less than 1,100, for individual coverage, or 2,200, for family coverage; and (ii)
the annual combined deductible and out of pocket expenses are not more than
$5,500 for indv. cov. Or 11,000 for family cov. S223(c)(2); Rev. Proc. 2006-53
b. Caps on contributions: Section 223(b) caps the contributions that may be made to
an HAS. For 2007, the annual contribution was capped at $2,850, for individual
coverage, or 5650 for family coverage. S223(b)(2), (g) Rev. Proc. 2006-53. If the
taxpayer is 55 or older, the latter dollar caps are increased to $3,650, for individual
coverage, and $6,450, for family coverage. S223(b)(3)
c. Income earned on the HSA: Income earned on an HAS is not included in the
taxpayer’s income and distributions from the account are not included as well if the
they are used to pay unreimbursed medical expenses. S223(f)(1). The definition of
medical expenses under S223 tracks the S213(d)(1)(A) definition.
c. Charitable Contributions
i. An itemized deduction for charitable contributions is permitted under S170(a)(1). Charitable
contributions are defined in S170(c) as contributions to or for the use of certain listed nonprofit
enterprises:
1. The United States government, a state government or any other political subdivision of the
United States, including local governments and United States territories if the contribution is
made for exclusively public purposes. S170(c)(1).
2. A charitable corporation, trust, community chest, fund, or foundation if the organization is
operated exclusively for religious, charitable, scientific, literary, or educational purposes, to
foster national or international amateur sports competition, or for the prevention of cruelty
to children or animals. S170(c)(2).
3. A fraternal order or lodge, but only if the gift is to be used exclusively for charitable,
religious, scientific, literary, or educational purposes. S170(c)(4). Thus, general contributions
to such organizations may not be deductible, unless, the fraternal societies establish
separate funds devoted exclusively to charitable purposes.
4. An organization of war veterans or a nonprofit cemetery company or corporation. SS170(c)
(3), (5)
5. Note: Tax exempt status as opposed to qualifying contributions
a. The aforementioned list defines charitable contributions, but even within charitable
contributions there is a division of A charities and B charities discussed below.
b. Section 170 determines the extent to which donors may deduct contributions to
charitable organizations. Sections 501-528 determine the tax treatment of charities
receiving contributions. Section 501 generally exempts from tax the organizations
listed in 501(c). These organizations are not taxed on income from contributions,
fees for services related to their charitable service, and income from passive
investments. The S501(c) list of organizations is substantially broader than the list of
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 organizations in S170(c). On the other hand, if a donor’s contribution qualifies for a
S170 deduction, then organization receiving the contribution will almost always
qualify for tax exempt status under S501.
i. E.g. political parties, pension plans business leagues, labor unions, and
nonprofit recreational clubs can qualify for tax-exempt status under S501(c),
but donors contribution to those organizations generally cannot qualify for
the deduction under S170(c).
ii. A charity v. B Charity and overall contribution limitations
1. Contributions to an A charity (charities listed in S170(b)(1)(A)) are limited to 50% of the
taxpayer’s AGI in that year. Any contribution in excess of that limitation is carried forward
five years and may be taken in those years as a charitable contribution. S170(d). A charities
include (if asked a question on the exam view statute for details):
a. A church or a convention or association of churches
b. An educational organization
c. An organization the principle purpose or functions of which are the providing of
medical or hospital care or medical education or medical research
d. An organization that receives a substantial part of its support from any type of
government entity
e. A government unit referred to in subsection ©(1)
f. A private foundation described in subparagraph (E), or
g. An organization described in section 509(a)(2) or (3),
2. For contributions to a B charity (the less common types of charities not listed in the A list
S170(b)(1)(B)), a less favorable limitation rule applies. It holds that any charitable
contribution shall be allowed up to the lesser of 30% of the taxpayer’s contribution base for
the taxable year, or the excess of 50% of the taxpayer’s contribution base for the taxable
year over the amount of charitable contributions allowable to the A charities.
3. The S170 deduction for corporate taxpayers is limited to 10% of the corporation’s taxable
income, determined w/o regard to its charitable contributions and certain other items (such
as net operating loss carrybacks and the S243 deduction for dividends). S170(b)(2).
a. Other special rules for corporate deductions can be found in S170(a)(2), (c)(2), (d)
(2), and (e)(3).
iii. General Limitations
1. Politics and Shareholders: Contributions are not deductible if any part of the net earnings of
the donee organization benefits any private shareholder or individual or if the done
organization participates or intervenes in the influence of legislation or political campaigns.
S170(c)(2)(C) and (D).
2. Earning Income: If an exempt organization earns income from a business that is unrelated to
the organization’s charitable purpose, the exempt organization is taxed on the income from
that business. SS501(b) and 511-514. These organizations are not taxed on income from
contributions, fees for services related to their charitable service, and income from passive
investments such as stocks, bonds, and annuities. S512
3. Discrimination: An organization that engages in racial discrimination or terrorist activity or
supports terrorist activity will be denied tax exempt status. Bob Jones University v. United
States (holding that the test for exempt status includes a requirement that the organization
66
 serve a public purpose and not operate in a manner that is contrary to public policy).
S501(p).
iv. What if the donor receives a benefit from the contribution?
1. A s170 deduction for the full amount is allowed only if the donor receives no benefit from
the contribution (other than intangible religious benefit). Ottawa Silica Co. v. United States.
If a donor receives a substantial benefit, for purposes of S170 the donors contribution is
reduced by the benefit received. This is the case even if the donor receives a benefit which
he decides not to use e.g. a taxpayer purchases tickets to a fundraising dinner for $300 that
has a value of $50, then he will be allowed to claim $250 as a charitable contribution. Rev.
Rul. 67-246. However, if the taxpayer refused to the tickets or returned them to the
organization, then a full deduction will be allowed. S6115 requires done charities to provide
donors with an estimate of the value of property received by the donors in exchange, if the
contribution exceeds $75.
a. A benefit is substantial if the benefits received by the donor are greater than those
that inure the general public from transfers for charitable purposes. Ottawa Silica
2. Special Rules:
a. Right to purchase tickets to athletic events : If a donor contributes to a college or
university and the contribution gives the donor the right to buy preferred seating
tickets for athletic events at the school. In these circumstances, the donor’s
deduction is limited to 80% of the contribution. S170(l)(1).
b. Fixed Payments: Fixed payments to charges or synagogues for pew, rents, dues, or
to attend specific services are deductible under S170 despite the fact that the
contribution would appear to confer a specific benefit on the donor. Rev. Rul. 70-
47.
v. Contributions of services, property, or cash
1. Cash/Credit Card
a. The S170 deduction for cash is subject only to the general deduction limitations in
S170(b)(1)(A), (B), and (2), which limit a taxpayer’s charitable contribution
deduction to a percentage of the taxpayer’s “contribution base” (generally AGI).
b. If the taxpayer makes a donation to charity using a credit card, for tax purposes the
contribution occurs at the time the charge is incurred, not when the charge is later
paid by the taxpayer. Rev. Rul. 78-38.
2. Services
a. If a donor contributes services, he will not be allowed a S170 deduction for the
services. Reg. S1.170A-1(g). However, his unreimbursed expenses incurred in
rendering those services (other than child care expenses-deemed nondeductible
personal expenses) are deductible. Id.
i. For the justification in the treatment of deductibility with regard to services
and cash/credit see question 50 on pg. 230 in E&E.
3. Property
a. Donors of appreciated property deduct the value of property they contribute.
Limitations:
i. First, if the property contributed would have produced ordinary income or
short-term capital gain had it been sold (because the property is not a
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 capital asset or has not been held by the donor for at least a year), the
donor may deduct only his adjusted basis in the contributed property.
170(e)(1)(A).
1. E.g. I own a painting worth 10k with a basis of 1k. If I donate it to a
museum, my deduction is 1k because the painting would have
produced ordinary income if I sold it.
ii. Second, even if the sale of the property would have produced long-term
capital gain, the donor’s S170 deduction is limited to the donor’s adjusted
basis in the property if:
1. The contributed property is tangible personal property and the
done charity’s use of the property is unrelated to the organization’s
charitable purpose. (e.g. a painting donated to a church as opposed
to an art museum);or
2. the property is donated to certain private foundations listed in
S170(e)(1)(B)(ii); or
3. the contributed property is a patent or certain intellectual property,
including specific types of copyrights and software, trademarks,
trade names, trade secrets, know –how, or similar property. S170(e)
(1)(B).
a. Note: if the done subsequently earns income from
contributed IP that is subject to the S170(e)(1)(B) limitation,
the donor in some circumstances will be entitled to take
additional charitable contribution deductions. S170(m).
iii. Third, S170(b)(1)(C) generally applies to contributions that would have
produced long-term capital gain had the donor sold it, and the S170(e)(1)(B)
limitation noted above does not apply to. In that case, the donor’s
contribution to an A charity is limited to 30% of his AGI. S170(b)(1)(C)(i).
Any excess is carried forward 5 years. Id. @ (ii). Alternatively, the donor can
also apply the S170(e) election which allows a deduction equal to the
donor’s basis. Again, a less favorable contrition limitation applies to B
charities. S170(b)(1)(D).
b. Valuing Property
i. Substantiation requirements:
1. If the contribution is $250 or more, the donor must substantiate the
contribution with a contemporaneous written acknowledgement
from the donee charity. S170(f)(8).
2. If the contribution is more than $500, but not more than 5k, the
taxpayer must attach to the tax return: (i) a description of the
contributed property; and (ii) other information required by the IRS.
S170(f)(11)(B).
3. If the contribution is more than 5k, but less than 500k, the taxpayer
must (i) get a qualified appraisal of the property; and (ii) attach to
the tax return additional info required by the IRS. S170(f)(11)(D).

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 a. Note: if a donor contributes property (other than publicly
traded securities) valued at more than 5k and the donee
charity sells it w/in 2 years of the date of contribution, the
donee must file a special return with the service giving them
information about the donor, the contribution, and the
subsequent disposition of the property. S6050L.
4. If the contribution is more than 500k, the taxpayer must get a
qualified appraisal and attach the appraisal to the return. S170(f)
(11)(D).
a. Note: the same rule under (b)(i)(3)(a) immediately
preceding this section applies here as well.
ii. Special rules for contributions of cars, boats, and airplanes:
1. Vehicle: If the claimed value of the contributed vehicle is more than
$500, the donor must attach to the tax return a contemporaneous
written acknowledgement of the contribution, prepared by the
donee charity. Further, if the charity sells the vehicle w/o significant
intervening use or material improvement of it, the donor’s
charitable contribution deduction is limited to the gross proceeds
from the sale. S170(f)(12)(A)(ii). If the charity makes significant use
of the car or materially improves it, the gross proceed limitation
does not apply, but the donor is still subject to the substantiation
rules in S170(f)(11).
iii. Penalties for overvaluation: Section 6662 imposes an accuracy-related
penalty for valuation over statement. If a taxpayer claims that the value of
property contributed to a charity is two or more times the actual value of
the property, then the penalty is 20% of the tax deficiency that results from
the valuation overstatement (provided that the deficiency is at least 5k for
an individual), and if he claims a value that is 4 or more times the actual
value, then the penalty is 40% of the deficiency. S6662(a), (e), and (h).
d. Personal Interest Deductions
i. The 1986 act eliminated the deduction for personal interest except for qualified residence interest.
163(h). Qualified residence interest is defined as interest paid on either “acquisition indebtedness” or
“home equity indebtedness” with respect to a “qualified residence” of the taxpayer. S163(h)(3).
1. Qualified Residence: a qualified residence is the taxpayer’s principal residence and one
other residence of the taxpayer. S163(h)(4)(A). A dwelling that the taxpayer rents to others
is a qualified residence only if, during the year, the taxpayer uses the dwelling for personal
reasons for longer than the greater of (i) 14 days or (ii) 10 percent of the number of days
that is rented. S163(h)(4)(A)(i)(II) and 280(d)(1).
2. Acquisition Indebtedness: any indebtedness that is secured by the residence and was
incurred in acquiring, constructing, or substantially improving the residence. S163(h)(3)(B)
(i). Acquisition indebtedness also includes any indebtedness, secured by the residence,
from refinancing qualified acquisition indebtedness, but only up to the amount that was
refinanced. Id. The aggregate amount (for both qualified residences if there are two) for any

69
 taxpayer cannot exceed $1 million. 163(h)(3)(B)(ii). If the aggregate amount exceeds 1
million, then see if the home equity indebtedness could qualify in conjunction.
a. Note: debt secured by a qualified residence and incurred before October 13, 1987,
is treated as acquisition indebtedness and is not subject to the 1 million limitation.
However, such debt will reduce the 1 million limitation (but not below 0) for any
additional loans (other than qualified refinancing). S163(h)(3)(D)(ii).
3. Home equity indebtedness: any indebtedness, other than acquisition indebtedness, secured
by a qualified residence. S163(h)(3)(C)(i). It is subject to two limitations. First, the total of (i)
home equity indebtedness plus (ii) acquisition indebtedness cannot exceed the FMV of the
qualified residence. Second, home equity indebtedness cannot exceed 100k.
4. Points: Per 461(g)(1) Points paid in connection with a loan must be capitalized over the term
of the loan unless S461(g)(2) is met. S461(g)(2) provides that points are deducted in the year
incurred if (i) the payment of points is an established business practice in the area in which
the indebtedness is incurred and (ii) the points do not exceed the amount generally charged
in the area. Points paid to finance an existing home mortgage are not within the S461(g)(2)
rule are capitalized over the term of the loan.
5. Policy: The home mortgage deduction is a method of encouraging home ownership, or more
persuasively, as necessary to prevent individuals who have purchased homes in reliance on
the deduction from suffering large losses. One important argument against the home
mortgage deduction is that it seriously undermines the repeal of the deduction for other
personal reasons. Homeowners can deduct interest on loans secured by their residence (up
to 100k) even if the amounts are borrowed for purposes unrelated to home ownership, such
as for the purchase of a new car.
ii. Note: Trade, Business, or Investments
1. Interest on amounts borrowed in connection with a trade or business (business interest)
and on amounts borrowed for investment purposes (investment interest) generally are
deductible in calculating net income, subject to certain limitations to prevent tax avoidance.
S163. See business expenses above for further discussion

e. Taxes
i. A personal itemized deduction is permitted under S164 for state and local income taxes and taxes on
real and personal property. (Section 164 also permits a deduction for certain foreign taxes, but
individuals subject to foreign taxation generally take the S901 foreign tax credit instead). Taxpayers
may also elect to take a sales tax deduction in lieu of the income tax deduction (generally opted for by
states w sales tax, but no state income tax e.g. Florida, Nevada, Alaska). Taxpayers opting to take the
sales tax deduction can deduct either (i) the amount indicated in state sales tax tables prepared by the
IRS; or (ii) the sales they actually paid (provided they kept receipts). S164(b)(5)(H). The S164 personal
deduction for tax is an itemized deduction, but taxes incurred in a business or in connection with the
production of income are deductible under S162 or S212; this includes state and local excise, sales,
and other taxes, as well as income and property taxes. Federal taxes, however, remain nondeductible.
1. Qualifying personal property taxes: means an ad valorem tax imposed on an annual basis in
respect of personal property. To qualify, the tax must meet the following 3 criteria:

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 a. Must be ad valorem i.e. substantially in proportion to the value of the personal
property-tax based on something other than value does not qualify as ad valorem
e.g. a motor vehicle tax based on weight or year.
b. Must be imposed on an annual basis, even if collected more or less frequently
c. Must be imposed in respect of personal property. A tax may be considered to be
imposed in respect of personal property even if in form it is imposed on the exercise
of a privilege e.g. vehicle registration.
ii. Other types of payments made to the govt.
1. Amounts charged for government services are consider “fees” rather than “taxes” and do
not qualify for the S164 personal deduction for state and local taxes. They may be
deductible, however, as ordinary and necessary business expenses or as expenses incurred
in the production of income. Rev. Rul. 72-608
2. Excise taxes are not deductible under S164.
3. Assessments on real property owners for local benefits, such as sidewalks, are not treated
as real property for taxes for purposes of S164 and are not deductible. Reg. S1.164-4. This
ideology is further reinforced if the property value appreciates as a result.
iii. Special Rules For Taxes Paid In Acquisition/Disposition of Property:
1. If taxes are paid by the buyer, such transfer taxes must be treated as part of the buyer’s cost
of the property, whether or not incurred in a business context. Similarly, taxes incurred by a
seller in connection with the sale of property are not deductible, but instead reduce the
amount realized on the sale. S164(a).
2. When real property is sold, the property taxes for the year of the sale must be allocated
between the buyer and the seller. S164(d)(1). Under 164(d), the taxes are allocated based
on the part of the year the property was owned by each party (buyer is treated as owner on
the day of the sale). S164(d)(1). If the buyer pays property tax allocable to the seller, the
seller’s property taxes paid by the buyer increase the seller’s amount realized and the
buyer’s basis in the property acquired. On the other hand, if the seller pays property taxes
allocable to the buyer and is reimbursed by the buyer, the amount allocable to the buyer
reduce the seller’s amount realized and the buyer’s basis. Reg. S1.1001-1(b).
14. MIXED BUSINESS AND PERSONAL OUTLAYS
a. Child Care Expenses
i. Smith v. Commissioner: Cost of hiring nursemaids to care for the infant child of a couple, both of
whom are employed, not deductible as an ordinary and necessary business expense of the wife
1. Ct denied the but-for reasoning that without the expense, there wouldn’t be an income
2. She didn’t have to have a baby to hold this job, so expenses of the baby are not a direct
accompaniment to the business pursuit
ii. Rule: Per S21, a taxpayer is allowed a credit (recall that a credit is a direct reduction in tax) for certain
household and dependent care services incurred to enable the taxpayer to work. Section 21(a)
provides that, if the taxpayer’s household includes one or more “qualifying individuals,” the taxpayer
is allowed to credit in an amount equal to the “applicable percentage” of the “employment-related
expenses” the taxpayer paid during the taxable year.
iii. Who is a qualifying individual?

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 1. A qualifying individual is: (i) a dependent who is under the age of 13, or (ii) a dependent or
spouse who is physically or mentally incapable of caring for himself. The term dependent is
defined in S152(a)(1). S21(b)(1).
a. Special Rule for spouse who is a full time student
i. Per S21(d)(2), there is a rule which permits a credit where the taxpayer’s
spouse is a full time student. S21(d)(2). In such a case, the spouse is
deemed to be gainfully employed and to have earned income of:
1. $250 for each month if he or she is the only qualifying individual,
2. $500 if there are other qualifying individuals as well.
iv. What are employment related expenses?
1. Employment-related expenses are expenses incurred for the care of a qualifying individual
or expenses for household services, but only if such expenses are incurred to enable the
taxpayer to work. S21(b)(2).
a. Exception: “such term shall not include any amount paid for services outside the
taxpayer’s household at a camp where the qualifying individual stays overnight.”
v. Limitations
1. The amount of employment-related expenses that may be taken into account in computing
the credit is limited to: (i) 3k if there is only one qualifying individual in the taxpayer’s
household, or (ii) 6k if there are two or more qualifying individuals. S21(c) (these caps reflect
amendments made by EGTRRA n 2001. When the EGTRRA amendments sunset at the end of
2010, the caps will drop to the pre-EGTRRA amounts of $2,400 and $4,800).
2. Per S21(d), the eligible employment-related expenses cannot exceed the earned income (for
example wages) of the taxpayer, or in the case of a married taxpayer, the lesser of the
earned income of the taxpayer or his spouse. S21(d)(1).
vi. What is the applicable percentage?
1. The applicable percentage is 35%, but is reduced by one percentage point for each 2k by
which the taxpayer’s adjusted gross income for the year exceeds 15k (that’s 15k combined
not 15k each). S21(a)(2) (when the EGTRRA amendments sunset at the end of 2010, the
applicable percentage will drop to 30% and the dollar threshold for the percentage will drop
to 10k). The percentage cannot be reduced below 20%, however. S21(a)(2)
a. E.g. suppose a taxpayer’s AGI is 29,500. The taxpayer’s AGI income exceeds 15k by
14,500. There are eight full or partial 2k increments in 14,500. Thus, the applicable
percentage will be reduced by 8% points, from 35% to 27%.
b. Note: the applicable percentage for any taxpayer with AGI in excess of 43k is 20%
because a taxpayer with 42,001 or more of AGI has at least 15 full or partial 2k
increments of AGI in excess of 15k. Thus, until the end of 2010, the max credit for a
taxpayer with 1 qualifying individual and AGI over 43k is 600, which is 20% of 3k-if
the taxpayer has 2 or more qualifying individuals then it is 1,200.
vii. What if an employer reimburses you for child care expenses?
1. S129 provides an exclusion for child care expenses reimbursed by an employer pursuant to a
written “dependent care assistance program” as defined in S129(d). The requirements for
S129 program are similar to the S21 program. The amount that may be excluded under S129
is limited to 5k a year. S129(a)(2)(A).

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 2. Any amount excluded under S129 reduces the employment related expenses that may be
taken into account under S21(c) for purposes of computing the S21 credit. S21(c) i.e a
taxpayer can’t do both. One may sometimes be better than the other, however, so do the
math.
a. E.g. a taxpayer who has one child and excludes 5k under S129 is precluded from
taking a s21 credit.
b. Commuting Expenses
i. Commuting costs to and from work are thought to result from the taxpayer’s personal choice of where
to live and are generally treated as nondeductible personal expenditures. Reg. SS1.162-2(e), 1.262-
1(b)(5). Commissioner v. Flowers
1. Exceptions:
a. If a taxpayer has a regular work location but takes a temporary assignment at a
different location, the taxpayer can deduct his cost of traveling to and from the
temporary job site. Rev. Rul. 99-7 (the deduction is a Sec. 162(a) deduction, and not
a Sec. 162(a)(2) deduction).
b. If a taxpayer is “Away from home,” within the meaning of S162(a)(2), the costs of
commuting to and from work (as well as lodging and meals, subject to S274(n)) are
deductible if the expense is required by the exigencies of the taxpayer’s business. A
taxpayer claiming to be “away from home” has to establish his business connection
both to the location he calls “home” and the place where he is temporarily working.
Hantzis v. Commissioner. A taxpayer with no “home” cannot be “Away from home.”
Rpsenpan v. U.S. see meal and transportation expenses below for those.
i. 162(a)(2) allows a taxpayer to deduct travel expenses if the taxpayer is away
overnight and the travel expenses are (i) reasonable and appropriate; (ii)
incurred while the taxpayer is away from home; and (iii) motivated by the
exigencies of the taxpayer’s business, not the taxpayer’s personal
preferences.
ii. Note: You need a business home from which you are away. “the continued
maintenance of the first home, must have a business justification.” Reg.
SS1.162-2(e), 1.262-1(b)(5). For instance, if you work in NY, but maintain a
home in Boston, and rent a home in NY to be closer to work, you can’t
deduct the cost of the NY home because the Boston home is not necessary
i.e. there’s no nexus between the Boston residence and the job. If the
commute is attributable to personal preference, then the expense will likely
be denied a deduction.
c. There’s also an exception if the taxpayer’s job requires her to transport job-related
tools to and from work and that causes extra commuting costs. In that case, the
taxpayer can deduct her extra commuting costs that are attributable to transporting
the tools. Fausner v. Commissioner.
i. E.g. a taxpayer who has to carry heavy tools to and from work is forced to
take her car to transport them. Otherwise, he or she would have taken the
bus which costs less.
d. Transportation costs while on the job are generally deductible as well, but costs for
commuting to and from work are not. Reg. S1.162-2
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 e. The employer can opt to pay for the transportation costs as a form of retention or
otherwise, but the employee would then have income unless he could prove that it
was for the “convenience for the employer” etc. under the tests noted above.
c. Clothing Expenses
i. An employee is allowed to take an itemized deduction for the unreimbursed cost of clothing worn
exclusively at work if: (i) the employer requires as a condition of employment, that employees wear
the clothes at work; and (ii) the clothing is not suitable for general use. Rev. Rul. 70-474
1. What clothing is suitable for general use?
a. A person’s subjective views about clothing are irrelevant, rather per Pevsner v.
Commissioner, an objective test is used to determine whether clothing is suitable
for general use. In Pevsner, the manager of a YSL clothing boutique store was
denied a deduction for the cost of YSL clothes she bought to wear at work at the
urging of her employer. Ms. Pevsner did not wear the YSL clothes outside of work
because she led a simple lifestyle and she wanted the clothes to last. Applying an
objective test, however, the 5 th circuit held that the clothes were suitable for
general use. Similarly, in Mella v. Commissioner, the court denied a deduction for
the costs incurred by nationally ranked tennis pro for clothing and shoes because
such apparel is worn for a wide variety of sport and leisure activities.
d. Legal Expenses
i. Per S212 or S162 an individual may deduct legal fees that are incurred in a trade or business or related
to the production of income. Personal legal fees, on the other hand, are nondeductible. Certain legal
fees, such as those arising out of a divorce, could be incurred in part for personal reasons and in part
to protect business or investment interests. The deductibility of legal fees depends on the “origin”of
the claim, not the potential consequences of the claim. If the origin is personal, the legal fees are
nondeductible. See E.g. U.s. v. Gilmore(Where the S.C. ruled that the origin of the divorce claim was
personal and that the lit costs were, therefore, not deductible. Legal fees paid may be limited by SS67
and 68 (2%floor and the other rule that goes with it). Also, even if a taxpayer can establish that the
origin of the claim was business, the court may conclude that it was not ordinary and necessary and
thus not deductible under S162.
1. Note:
a. S212(3) permits a deduction for expenses incurred “in connection with the
determination, collection, or refund of tax.” This provision sometimes allows a
taxpayer to deduct legal fees incurred in exchange for personal tax advice, even tax
advice given with respect to a divorce. Zmuda v. Commissioner.
b. S62(a)(2) provides for an above the line deduction for legal fees in discrimination
cases.
c. Legal fees incurred in a business context must be capitalized, however, if they are
incurred in connection with the acquisition of property that has a useful life
extending substantially beyond the close of the year in which the legal expense is
incurred. S1.263(a)-5, Prop. Reg. S1.263(a)-2.
e. Travel and Entertainment Expenses (Professor notes that if you are confused about an exam question, look
at it from the perspective of S132. Ask, if the employer did this for an employee, would it be a nontaxable
fringe? If so, then generally it could be written off as a business expense.)

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 i. Taxpayers are allowed to deduct travel and entertainment expenses that serve a genuine business
purpose, but are not allowed for expenses that are incurred primarily for personal reasons.
ii. Travel: Section 162(a)(2) allows a taxpayer to deduct travel expenses, including the costs of meals and
lodging, if the following three requirements are met:
1. The travel expenses are reasonable and appropriate
2. The expenses are incurred while the taxpayer is away from home (a taxpayer is away from
home only if the taxpayer is away overnight-U.S. V. Correll and if the taxpayer has no home
they cannot be away from home for purposes of S162).
3. The expenses are motivated by the exigencies of the taxpayer’s business, and not the
taxpayer’s personal preferences.
4. Note: Normally a taxpayers home will be obvious because the taxpayer will live and work in
the same area, but if the taxpayer lives in one area and works in another, then courts
consider all of the facts and circumstances to determine whether the expenses is motivated
by the exigencies of the taxpayers business rather than the personal preference (Hantzis v.
Commissioner). If the taxpayer maintains two residences and incurs duplicate living
expenses because of the exigencies of the business the expenses are likely deductible. If
otherwise, then they are probably not.
a. E.g. In Hantzis, the court upheld the service’s disallowance of a law student
taxpayer’s cost of living in NY during a 10 week summer law firm clerkship despite
the fact that she and her husband lived in Boston. Ms. Hantzis was not engaged in a
trade or business in Boston, where she lived and attended law school, but was
engaged in a trade or business sin NY, where she worked, so the court concluded
that her home, for purposes of S162(a)(2) was NY-Thus, she could not deduct the
costs of living in NY as away from home travel expenses.
iii. Meal, recreation, and entertainment: the aforementioned expenses incurred in a business setting
may be deducted even if the taxpayer is not away from home. These deductions are limited to 50% of
the amount spent (may be taken per diem in conjunction with the 50% rule), but if an employer
reimburses an employee he may deduct the full amount. S274(n) (does not apply to items deductible
as de minimis fringe benefits). However, per S274(a)(1), the costs of such expenses may only be
deducted if:
1. (i) The item was directly related to the active conduct of the taxpayer’s trade or business (as
opposed to the creation of goodwill) ; or (ii) the item preceded or followed a “substantial
and bona fide business discussion” and was associated with the taxpayer’s trade or
business.
a. Note: under the second part of the S274(a)(1) test, a taxpayer may be able to
deduct the cost of taking a client to a concert or sporting event that is not directly
related to the taxpayer’s business, simply by holding a business discussion at a
restaurant before or after the event.
iv. Limitations for travel, meal, recreation, and entertainment:
1. General rule: S162 may still limit the deductibility of these things under the ordinary and
necessary rule. E.g. in Moss v. Commissoiner, the court ruled that daily lunches where a
taxpayer and the other partners in his small firm met to discuss and coordinate work were
not deductible. The court felt that such frequent lunches were not necessary to coordinate
such a small number of partners, and thus not ordinary and necessary.
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 a. As a result, the partners began meeting in the office and ordering in, this allowed
them to deduct the costs of lunch under the “premises of the employer” portion.
2. Entertainment: Except for certain charitable sports events, deductions for entertainment
are limited to the face value of the tickets. S274(n)(2)(B). Deduction for luxury sky boxes are
limited to the cost of seats in non-luxury boxes. S274(1)(2).
3. Dues paid to clubs or organizations : Dues or fee paid to athletic, sporting, or social clubs are
not deductible. The taxpayer may also not deduct fees paid to other types of clubs unless
the taxpayer “Establishes that the facility was used primarily for the furtherance of the
taxpayer’s trade or business and that the item was directly related to the active conduct of
such trade or business.” S274(a)(2)(C). Even if this standard is met, however, no deduction
may be taken for membership dues “in any club organized for business, pleasure,
recreation, or other social purpose.” S274(a)(3)
a. Regulation S1.274-2 indicates that a club is within the S274(a)(3) limitation if the
club’s principal function is to entertain its members. On the other hand, the
limitation does not apply to trade or professional organizations (e.g. bar
associations).
b. Even if the club dues are deductible under S274(a), any portion of the dues
attributed to meals is subject to the S274(n) 50% limitation.
4. Conventions outside NA: No expenses for attending a convention outside of the North
American may be deducted unless the taxpayer is able to show that it is reasonable to hold
the meeting outside of North America. S274(h)(1).
5. Conventions on Cruise ships: Deductions are limited for conventions held on cruise ships
and for other luxury water transportation. S274(h)(2), (m)(2)
6. Travel: No deduction is permitted for travel as a form of education. S274(m)(2).
7. Travel: If business travel is mixed with personal sightseeing etc., the deductibility hinges on
whether the primary purpose of domestic travel is business related. If so, then the entire
amount may be deducted except for any additional costs associated with the personal
component. On the other hand, for foreign travel exceeding 1 week, if 25% or more of the
total travel time is spent on personal activities, then all costs of the trip must be allocated
between personal and business. S274(c), Reg. S1.162-2(b)(1).
8. Travel: Automobile travel deductions are determined by mileage rather than cost. Temp.
reg. S1.274-5%(b)(6)(i)(B).
9. Travel-accompanying the taxpayer : if a spouse, dependent, or other person accompanies
the taxpayer on business travel, the travel expense of the person accompanying the
taxpayer are not deductible unless: (i) the person accompanying the taxpayer is an
employee of the taxpayer (or the taxpayer’s employer); (ii) the person accompanying the
taxpayer is traveling for a bona fide business purpose; and (iii) the travel expenses of the
person accompanying the taxpayer are otherwise deductible.
10. General rule: No deduction or credit is permitted, unless the taxpayer substantiates the
expense by adequate records. S274(d). There is an exception for reimbursed employee
expenses and expenses under $75 (other than lodging).
11. S274(e) provides exceptions to S274(a) for certain expenses.
a. S274(e) proves that S274(a) does not limit an employer’s deduction for expenses
associated with a bona fide business meeting of employees, stockholders, partners,
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 or directors. A meeting held principally to discuss business, not for social purposes,
is a bona fide business meeting. S274(e)(5). Reg. S1.274-(f)(2)(vi).
v. Gifts
1. No deduction is allowed under S162 or 212 for the cost of gifts over 25$. The $25 amount is
a cap on the amount an individual person can receive per year. Thus, if you give him a $15
gift on one occasion, and a $20 gift on another, you have exceed the limitation by $10.
f. Educational Expenses
i. The cost of college education is generally nondeductible because courts consider the cost to be a
personal expenditure. See e.g. Carroll v. Commissioner (in which a police detective was denied a
deduction for the costs of his college tuition because the court concluded that the college education
was a personal expense, not an expense of being in the profession of being a detective).
1. We don’t look to an individual’s state of mind to determine the usefulness of the course,
rather, an objective view is taken.
ii. On the other hand, an individual is allowed to deduct educational expenses if the education either (i)
maintains or improves skills required by the individual in his trade or business; or (ii) meets express
requirements of the individual’s employer or legal requirements imposed by applicable law or
regulations as a condition of doing work of the type performed by the taxpayer. Note that, educational
expenses incurred to meet the minimum educational requirements of a new trade or business are
nondeductible. Reg. S1.162-5(a) and (b). Really need to look at this reg as it provides examples on
what is “required.”
iii. Congress has, however, enacted a variety of specific provisions that affect the tax treatment of
education expenses. Some of the provisions create an above the line deduction or credit; other
provisions permit the deferral or exclusion of income. If a student is not claimed as a dependent on his
parents’ tax return, than he or she can take the credit, but if otherwise, the parents takes the credit
regardless of who actually paid the expenses. S25A(g)(3) These include:
1. S25A Hope Scholarship Credit
a. Provides a nonrefundable 100% credit on the first 1k of “qualified tuition and
related expenses” and a 50% credit on the next 1k of such expenses. S25A(b)(1)(A),
(B) (the dollar cap is adjusted for inflation e.g. in 07 it was 1100). Qualified tuition
and related expenses do not include the cost of books, room and board, student
activity fees, or insurance unrelated to the student’s course of study. S25A(f)(1)(B)
Similarly, education expenses related to sports, games, or hobbies are not eligible
unless those activities are part of the student’s degree program. S25A(f)(1)(B)
b. Limitations/qualifications:
i. A student qualifies for the credit if he is enrolled on at least a half-time basis
at a qualified education institution (which includes accredited post-
secondary schools that award bachelor’s degrees, associate’s degrees, and
certain vocational credentials). S25A(b)(2)(B), (b)(3), (f)(2)
ii. The creditable education expenses are reduced by scholarships that are
excluded from income and certain forms of educational assistance (e.g.
grants). S25A(g)(2).
iii. The scholarship may only be taken for the first two years of post-secondary
education and is disallowed if the student is convicted of a federal or state
felony drug offense. S25A(b)(2)(D).
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 iv. If the student is claimed by his parent’s on their tax return, then he cannot
claim the credit. Instead, the parents would claim the credit.
v. Phased out for individual taxpayers with modified AGI between 40-50k and
80-100k for joint filers. S25(h)(2).
vi. Cannot be claimed in the same year as the lifetime credit, but can claim one
in one year and the other in another.
vii. Claimed in for the year in which the expenses are actually paid, subject to
the requirement that the education commence or continue in that year or
during the first 3 months of the following year. S25A(g)(4)
viii. Credit is denied if student is convicted of a felony or state felony drug
offense.
2. S25A Lifetime Learning Credit
a. Provides a nonrefundable credit equal to 20% of up to 10k of “qualified and related
expenses” paid by the taxpayer. S25A(c)(1). Thus, the maximum annual credit is 2k.
The hope credit can be taken for each year of undergraduate or graduate education.
The same rules regarding qualified to tuition noted under the hope credit apply here
as well.
b. Limitations/qualifications
i. The creditable education expenses are reduced by scholarships that are
excluded from income and certain forms of educational assistance (e.g.
grants). S25A(g)(2).
ii. Phased out for individual taxpayers with modified AGI between 40-50k and
80-100k for joint filers. S25(h)(2).
iii. Cannot be claimed in the same year as the hope credit, but can claim one in
one year and the other in another.
iv. If the student is claimed by his parent’s on their tax return, then he cannot
claim the credit. Instead, the parents would claim the credit.
3. S221 deduction for interest on student loans
a. A taxpayer can deduct interest payments on qualified education loans. S221(a). The
deduction is an above the line deduction that may be taken even if the taxpayer
does not itemize deductions. S62(a)(17). S221(b)(1). The term qualified education
loan means any indebtedness incurred to pay “qualified higher education expenses.”
S221(d)(1). Qualified higher education expenses include tuition, books, fees,
supplies, and equipment required for attendance at an eligible educational
institution.
b. Limitations/qualifications
i. The maximum deduction allowed is 2,500.
ii. Deduction is not allowed to any individual who may be claimed as a
dependent on another taxpayer’s tax return. S221(c)
iii. Deduction is phased out for individual taxpayers with modified AGI between
50k and 65k and for joint filers with modified AGI between 100k and 130k.
S221(b)(2)(B). (adjusted for inflation e.g. in 2007 it was 55-70k and 110-
140k respectively-Rev. Proc. 2006-53).

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 iv. The education expenses must relate to a period when the taxpayer is
enrolled on at least a half-time basis and must have been incurred on behalf
of the taxpayer’s spouse or dependents, determined as of the time the debt
was incurred. S221(d)(1)(A), (d)(3).
v. The qualified higher education expenses are reduced by (i) scholarships that
are excluded from income and certain forms of educational assistance, and
(ii) education expenses included under SS127, 135, 529, or 530. S221(d)(2).
vi. A qualified education loan does not include any indebtedness owed by the
taxpayer to a person who is related to the taxpayer. S221(d)(1).
4. S222 deduction for certain higher education expenses
a. Allows for a 3k deduction for taxpayers with AGI that does not exceed 65k (130k for
joint returns. If the taxpayer makes more than that, then they do not qualify.
b. Limitations/Qualifications
i. The amount of qualified tuition and related expenses is reduced by any
amounts excluded under SS135, 529, or 530.
ii. A taxpayer who may be claimed as a dependant on another taxpayer’s
return and married taxpayers filing separately are not allowed to take the
deduction.
iii. Cannot take a S222 deduction and a Hope Scholarship Credit or Lifetime
Learning Credit in the same year. S22(c)(2)(A) .
5. 530 Coverdell Education Savings Account deferral and exclusion provisions
a. Permits annual ESA contributions of up to 2k. S530(b)(1)(A)(iii). Contributions made
to an ESA are not deductible, but ESA earnings are tax exempt and distributions
made from the ESA are excluded by the beneficiary to the extent of the beneficiary’s
qualified education expenses. S530(a) and (d)(2)(A).
i. The term qualified education expenses includes qualified higher education
expenses and are qualified elementary and secondary education expenses.
S530(b)(2)(A).
ii. Qualified higher education expenses include tuition, books, fees, dormitory
costs, supplies, and equipment required for attendance at an eligible
educational institution. S530(b)(2)(A)(i), 529(e)(3).
iii. Qualified elementary and secondary education expenses include expenses
for tuition, fees, room and board, uniforms, transportation, and
supplementary items and services (including extended day programs) that
are required or provided by a public, private, or religious school in
connection with the student’s education S530(b)(3)(A).
b. Limitations/Qualifications
i. No contributions may be made to an ESA after the beneficiary reaches the
age of 18. S530(B)(1)(A).
ii. The 2k annual permitted contribution is gradually phased out (i) for
individual taxpayers with modified AGI between 95 and 110k (190-220k for
joint filers). 530(c).
iii. While a taxpayer taking a tax free distribution from an ESA can claim either
the Hope Scholarship or Lifetime Learning Credits, the distribution from the
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 ESA cannot be used for the same expenses for which the credit is claimed. In
other words, there is no double counting of education expenses. S530(d)(2)
(C)(i).
6. S529 Qualified Tuition Program deferral and exclusion provisions
a. A QTP is a plan offered by a state or private educational institution to allow families
to either prepay a beneficiary’s future tuition or to contribute to an account that will
be used in the future to pay a beneficiary’s education expenses. Contributions made
to QTPs are not deductible, but QTP earnings are tax exempt. In addition,
distributions made from a QTP are excluded by the beneficiary to the extent of the
beneficiary’s qualified higher education expenses. S529(a) and (c)(3)(B).
i. The term qualified higher education expenses include tuition, fees, books,
supplies, equipment required for enrollment or attendance at an eligible
education institution (e.g. a university, college, or jc) and reasonable room
and board for a beneficiary who is at least a half-time student. S529(e)(3).
b. Note: Very substantial amounts can be contributed to a QTP because contributions
are permitted up to the amount necessary to fund the qualified higher education
expense. However, a contribution to a QTP is treated as a gift to the beneficiary
from the contributor for gift tax purposes.
c. Limitations/Qualifications
i. The qualified higher education expenses are reduced by scholarships that
are excluded from income and certain forms of educational assistance (e.g.
grants). SS529(c)(3)(B)(v)(I) and 25A(g)(2).
ii. A taxpayer taking a tax free distribution from a QTP can also claim either the
Hope Scholarship Credit or the Lifetime Learning Credit, but the distribution
from the QTP cannot be used for the same expenses for which the credit is
claimed. S529(c)(3)(B)(v)(II).
7. S135 exclusion for income from certain U.S. savings bonds used to pay higher education
expenses
a. Allows qualifying taxpayers to exclude income from certain U.S. savings bonds if the
proceeds are used to pay qualified higher education expenses, which are narrowly
defined to include tuition and fees. S135(a), (c). Has a phaseout rule keyed to the
taxpayer’s modified AGI. S135(b)(2).
8. S127 exclusion for employer-provided education assistance
a. Allows employees an annual exclusion up to $5,250 of qualified employer-provided
educational assistance benefits. S127(a).
9. S117 exclusion for qualified scholarships
10. S108(f) exclusion for income from the discharge of student loans where the student
performs public service work.
11. Note: the penalty tax on early withdrawals from a traditional IRA or Roth IRA does not apply
if the withdrawal is made to pay higher education expenses for the taxpayer or the
taxpayer’s children or grandchildren.
15. CAPITAL GAINS AND LOSSES
a. The tax treatment of capital gain and losses

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 i. The code defines capital gain or loss as the gain or loss on the sale or exchange of a “capital asset”.
Capital gains are taxed at lower rates than ordinary income and capital losses can be deducted to the
extent of the capital gains recognized in the same year. If capital losses exceed capital gains, a
noncorporate taxpayer can deduct up 3k of his capital losses in a given year and carry forward
indefinitely the excess capital losses disallowed. SS1211(b) and 1212(b)(1).
ii. Corporations
1. Capital gain recognized by corporations does not receive favorable treatment. S1201
2. Corporate taxpayers are not allowed to deduct their capital losses in excess of their capital
gains, but may carry the excess capital loss back three years and forward five years.
S1212(a)(1).
b. Short term v. Long Term Capital Gains
i. Capital gain (or loss) is long term if the taxpayer held the capital asset for more than one year and
short term if the taxpayer held the capital asset for a year or less. Long term capital gain is taxed at the
S1(h) preferential rates, but short term capital gain is taxed at ordinary income rates.
c. Capital Gain Rates-grouped into 3 categories
i. 28 percent group
1. Long term capital gain in the 28% group is taxed at the lower of 28% or the taxpayer’s
marginal ordinary income rate (the income from the capital item is added to the taxpayer’s
income for the year so each threshold amount could be taxed at various %s). S1(h)(1). The
28 percent group includes (i) capital gain from the sale or exchange of “collectibles,” and (ii)
a portion (usually half of the capital gain) on the sale of “S1202 stock.” S1(h)(4).
a. Collectibles: Collectibles include artwork, antiques, rugs, gems, metal, stamps,
alcoholic beverages, coins, and any other tangible personal property specific by the
Secretary. SS1(h)(5)(A) and 408(m).
b. Section 1202 stock: Section 1202(a) provides that a taxpayer can exclude from
income 50% of the gain from the sale or exchange of “qualified small business stock”
held by the taxpayer for more than 5 years. Thus, 50% of qualifying S1202 stock is
tax free and the other 50% is taxed at 28%. However, S1202(b) may limit the
amount of S1202 gain to which the S1202(a) 50% exclusion applies. In that case, the
portion of the gain to which the S1202(a) exclusion applies less the excluded
amount is in the 28% group and the taxable portion of the gain to which the
S1202(b) limitation applies is in the other gain group. S1(h)(4), (7)
i. Qualified small business stock is defined as stock issued by a “C” corporation
with assets of $50 million or less (although stock of corporations engaged in
certain types of business such as law, accounting, health, consulting,
athletics, brokerage services, mining, banking, and farming, do not qualify).
ii. 25 percent group
1. Capital gain in this group is taxed at the lower of 25% or the taxpayer’s marginal ordinary
income rate (the income from the item is added to the taxpayer’s income for the year so
each threshold amount could be taxed at various %s). S1(h)(1). Long term capital gain from
the sale of depreciable real property held for more than one year is in the 25% category to
the extent that the capital gain is attributable to unrecaptured depreciation, which is the
straight line depreciation that the taxpayer has taken on the real property. S1250
iii. The other gain group
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 1. Long term gain in this group (also called adjusted net capital gain S1(h)) is taxed at 15% if
the taxpayer’s marginal ordinary income rate is 25% or higher; if it is less than that, the rate
on this type of gain is generally 0%. S1(h)(1). Gain in this group includes (i) any long-term
capital gain that is not in the 28% group or the 25% group and (ii) qualified dividend income.
S1(h)(3).
a. Qualified Dividend Income: A dividend is not a qualified if the taxpayer held the
stock on which the dividend is paid for 60 days or less during the 121-day period
beginning on the date that is 60 days before the stock becomes ex dividend. SS1(h)
(11)(B)(iii), 246(c)(1).
d. Netting Capital Gains and Losses (S1222)
i. First, the taxpayer’s capital gains and losses are divided into 4 categories: (1) short-term capital gain
and loss; (2) capital gain and loss in the 28% group; (3) capital gain in the 25% group (the 25% group
will only have gain in it because losses are deemed ordinary under S1250); and (4) capital gain and loss
in the other gain group.
ii. Second, the taxpayer computes her net-short term capital gain or loss by netting her short term
capital gains and losses
iii. Third, the taxpayer computes her net long-term capital gain or loss. The taxpayer nets the gains and
losses within the 28% group, the 25% group, and the other gain group (long-term capital loss
carryovers from other tax years are netted in the 28% group. Notice 97-59).
1. If there is a net loss in the 28% group, that loss is applied first to reduce any net gain in the
25% group, then to reduce any net gain in the other gain group.
2. If there is a net loss in the other gain group, that loss is applied first to reduce any net gain
the 28% group, then to reduce any gain the 25% group.
iv. Fourth, if the taxpayer has a net long-term gain and a net short term loss following the netting
process, the next step is to compute the taxpayer’s net capital gain by netting the taxpayer’s net long-
term capital gain and net short-term capital loss for the year. S1222(11). If the net long-term gain
exceeds the net short-term loss, the rate categories specified in S1(h) apply to the net capital gain. If
the short-term loss exceeds the long-term gain, a noncorporate taxpayer may deduct the short-term
loss to the extent of the long-term gain +3k under S1211. Any excess loss (whether derived from , is
referred to as a net capital loss. Also, if the taxpayer has a net long-term loss and a net short-term
gain, the taxpayer nets the net-long term loss and the net short-term gain.
1. The net short term loss is applied first to reduce any net long-term gain in the 28% group,
the remainder, if any, is then applied to reduce any net-long term gain the 25% group, and
the remainder, if any, is applied to reduce any net long-term gain the other gain category.
v. Policy: Because a taxpayer controls the loss side and gain side of capital gains i.e. they can determine
when the gain or loss will be realized (with exceptions e.g. a hurricane destroys one’s house), if they
were allowed to take capital loss deductions against ordinary income, they’d leave their unrealized
gains unrealized and take their lossesthe cherry picking dilemma.
vi. Exam Point: for noncorporate taxpayers, capital losses are deductible against ordinary income up to
3k. Thus, if one has an unrealized capital gain and a short term capital loss (lets say you have 3k worth
of Microsoft stock that you could sell in 2008 for a loss or hold off and sell it in 2009 for a loss as well)
in 2008, it would be better to take the capital gain in 2008 and the capital loss in 2009 (or vice versa)
since the capital loss in 2009 would be deducted against ordinary income at a higher rate than the

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 capital gain income in 2008. This is because you only have to net losses against gains in the same tax
year, but if they are taken in separate tax years then that is not the case.
e. What Qualifies As A Capital Asset?
i. Section 1221(a) defines capital asset as “property” that does not fall within any of the following eight
ordinary asset categories:
1. Accounts receivable or notes receivable acquired in the ordinary course of a trade or
business
2. Certain U.S. govt. publications (see code section for details)
3. Supplies of a type regularly used or consumed by the taxpayer in the ordinary course of
business
4. Hedging transactions which are identified as such in advance
a. Net proceeds from hedging transactions (purchasing futures) (i) to manage risk of
price changes or currency fluctuations with respect to ordinary property held or to
be held by the taxpayer or (ii) to manage risk of interest rate or price changes or
currency fluctuations with respect to borrowings are treated as proceeds from the
sale of inventory and generate ordinary income or loss as opposed to capital gains.
Arkansas Best Corporation v. Commissioner.
b. The taxpayer has the option to determine its preferred tax treatment of a hedging
transaction, but must do so before the hedging transaction is entered into. If it
would prefer to treat the transaction as capital then it would not identify it as a
hedging transaction in advance. If it wants to treat it as an ordinary gain/loss then it
must do so in advance of the transaction. When the hedging transaction results in a
loss, the taxpayer would probably want it deemed ordinary income. However, If the
taxpayer failed to identify the item as a hedge in advance (assuming the price would
go up) and the price of the hedged commodity declines, the amount paid to get ouf
the K would be deemed a capital loss. As an alternative, the taxpayer could exercise
the hedge and later sell the item at a loss as to have ordinary loss rather than a
capital loss.
5. Depreciable or real property used in the taxpayer’s trade or business (applies to virtually all
noninventory business property)
a. Such property is excluded from the class of capital assets under S1221(a)(2) only to
be subject to a still more favorable set of rules under S1231 provided that the
taxpayer has held it for more than 1 year. This property generates capital gain when
sold at a profit and ordinary loss when sold at a loss. Each year, gain or loss on any
item of section 1231 property is netted against gain or loss on other items of section
1231 property. If, in a given year, a taxpayer has a net gain on S1231 sales or
exchanges, the combined S1231 gains and losses are capital (the depreciation and
recapture rules below may recharacterize them as ordinary). On the other hand, if in
the year, a taxpayer has a net loss on S1231 sales or exchanges, the S1231
combined gain and losses are ordinary.
i. E.g. if x recognizes a 30k gain on the sale of vacant land used in his trade and
a 20k loss on machines used in his trade then he has +10k net result, so
both the loss and gain are deemed capital, and he has a net 10k capital gain.

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 ii. Exception: A leasehold may presumably constitute “property used in a trade
or business” and therefore qualify as Section 1231. While ordinarily §1231
property only includes real or depreciable property used in a trade or
business, in Rev. Rul. 72-85, 1972-1 C.B. 234, the Service determined that a
leasehold of land used in a trade or business is §1231 property.
b. Special Rules:
i. Recapture rule: if, in a given year, a taxpayer recognizes a net S1231 gain,
but has taken an ordinary deduction for a net S1231 loss within the last five
years, the prior ordinary loss deduction is “recaptured” by recharacterizing
that portion of the net S1231 gain in the current year as ordinary. S1231(c)
1. e.g. in year 1 X recognizes a gain of 10k on the sale of a truck used
to transport widgets and a loss of 50k on a building used to produce
widgets. The result is a net 40k S1231 loss which will be
characterized as ordinary. On the other hand, if X sells the building
at the close of year 1 and the truck at the start of year 2, section
1231(c) will characterize the 10k of S1231 gain recognized in year 2
as ordinary (instead of capital gains) so that, over the two years,
Widgets, Inc. recognizes a 50k ordinary loss and a 10k ordinary gain
for a net 40k ordinary loss.
2. Purpose: If the recapture rules were not in place, individuals could
make money off of arbitrage. For instance, you buy a building and
take depreciation deductions (which are based on the assumed
diminution in value of the property) which helps reduce the tax
liability at the 35% rate. If you then sell it for the same price you
bought it for, absent some rule, you’d be taxed on the profit at 15%
you’d make the difference between the two respective tax
ratesarbitrage. This is of course if the depreciation never
happened, if it does happen, then it doesn’t matter i.e. the value of
the property actually declines. Thus, congress said that if you have
gain from the sale of property attributable to previous depreciation
deductions on property which did not depreciate, then you are
taxed at a special rate to the extent of your depreciation
deductions.
ii. Depreciation rule:
1. Definition of Depreciable Property: property is S1245 property if (i)
depreciation is allowed on the property under S167 and (ii) the
property is one of the types specified in S1245(a)(3), including
personal, tangible, and real property.
a. Personal Property: S1245 recharacterizes capital gain from
the sale of a depreciable asset (other than real property) as
ordinary income to the extent of prior depreciation on the
asset sold (the taxpayer’s adjusted basis will account for this
so really a moot point). Section 1245 applies to both
depreciation on tangible property and amortization on
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 intangible property (e.g. copyrights have limited lives and
are thus amortized) For exam purposes, to be precise
recapture is subject to the lesser of (i) the gain recognized
on the sale or (ii) the prior depreciation taken on the
property sold.
i. e.g. x pays 10k for a truck used in his business, he
takes depreciation deductions over 5 years equal to
10k. Thus, his basis is 0. He then sells the car in year
6 for 13k thereby recognizing 13k of capital gains.
However, because he already took 10k worth of
depreciation deductions, 10k would be taxed as
ordinary income under S1245, and 3k would be
taxed as capital gains under S1231.
b. Real Property: If the asset sold is real property, S1250
imposes a limited form of recapture. Generally, S1250
requires recapture of gain only to the extent of depreciation
in excess of straight line depreciation. However, real
property placed in service since 1986 is depreciable only by
the straightline method. S168(b)(3). Thus, there is generally
no depreciation in excess of straight line and hence no
portion of gain on the sale is subject to S1250 recapture.
(although the depreciation deductions do reduce the
taxpayer’s basis).
iii. Involuntary conversions: Section 1231 property also includes any recognized
gain from the compulsory or involuntary conversion (as a result of
destruction in whole or in part, theft or seizure, or an exercise of the power
of requisition or condemnation or the threat or imminence thereof) into
other property or money of:
1. Property used in the trade or business, or
2. Any capital asset which is held for more than 1 year and is held in
connection with a trade or business or a transaction entered into for
profit
6. Certain commodities or derivative financial instruments held by a commodities or derivative
dealer
a. Only securities sales conducted by entities such as commercial brokerages meet the
Van Suentendael standard to generate ordinary income and loss under S1221(a)(1).
Van Suentendael held that securities bought or sold by a day trader did not qualify
for the exclusion from capital asset status because they are not sold to
“customers.”Dealers can also avoid this characterization by so electing at the time
of purchase, and segregating such securities held for investment from those held for
business purposes; the actions must establish to the satisfaction of the secretary
that such instrument has no connection to the activities of such dealer as a dealer.
i. Note: In the long run, due to inflation and other factors, stock held for
investment is generally sold at a gain. The govt. savings from forcing
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 taxpayers such as Van Suetendael to recognize capital loss on the sale of
stock at a loss has been more than offset by the cost to the govt. of allowing
more successful speculators to recognize capital gain when stock is sold at a
profit.
7. A copyright, a literary musical, or artistic composition, a letter or memorandum, or similar
property, held by
a. (i) the person who created the asset; (ii) a transferee of the asset, if the transferee’s
basis in the asset is determined by reference to the creator-transferor’s basis
(means that if the artist gives it away as a gift, then it is not a capital asset in the
hands of the donee, but if it is transferred at death, the beneficiaries basis is
determined under S1014, and the asset is a capital asset); or (iii) in the case of a
letter, memorandum, or similar property, a taxpayer for whom such property was
prepared or produced.
b. Note:
i. Goodwill, Trademarks, trade names, etc . do not fall into this category and
are capital assets. E.g. professor makes a Brooklyn donut shop in l.a. and
over time the “Brooklyn donut shop” name has a value. If the professor
wants to sell his business, the actual property i.e. the building ovens etc. are
taxed at ordinary rates, but the Goodwill would be deemed a capital asset.
The sale of an unincorporated business is treated as the sale of each of its
individual assets, some of which are capital assets and some of which are
not. Williams v. Mc Gowan. The purchase price for the business is allocated
among the assets of the business based on the classification of the assets
and their fair market value. SS1060, 338(b)(5)
1. Exception: if the professor had incorporated his Brooklyn Donut
Shop, he would be selling shares of the corporation to the purchaser
and that would be deemed capital gains in its entirety.
ii. Musical compositions or copyrights in musical works: at the election of the
taxpayer, musical compositions or copyrights in musical work can be
deemed capital assets by the person who created the asset. S1221(b)(3).
However, royalty payments received by a musician continue to be taxed at
ordinary income rates.
iii. Patents: transfer of all substantial rights to a patent or an undivided interest
therein which includes part of all such rights, by any holder shall be
considered the sale or exchange of a capital asset held for more than 1 year
regardless of whether or not payments in consideration of the transfer are
(i) payable periodically or (ii) contingent on the productivity, use, or
disposition. S1235. (It must be noted that under the complex rules
governing contingent installment sales, some portion of payments received
in later years may be treated as interest income.)
1. Holder: is any individual whose efforts made such property, or any
other individual who has acquired his interest in such property in
exchange for consideration in money or money’s worth paid to such
creator prior to actual reduction to practice of the invention
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 covered by the patent if such individual is neither (i) the employer
of such creator, nor (ii) related to such creator (def. of related is
found 267(b)).
c. Exam Point: while a novel, for example, would seem to be a capital asset in the
hands of a person who did not create it or assume the basis of the transferor, it
would in fact not be a capital asset if its owner uses it in its trade or business-then it
would likely fall into either the inventory or ordinary course of trade or business
category. However, it may still be a S1231 asset . S1231(b)(1).
8. Stock in a trade of the taxpayer or other property of a kind which would properly be
included in the inventory of the taxpayer if on hand at the close of the taxable year, or
property held by the taxpayer primarily for sale to customers in the “ordinary course of his
trade or business”. This category has the following special rules.
a. Real Estate: Take for instance, a person who on the side, buys a house, fixes it up,
and resells it. Then does it a few times. Is he not entitled to the preferential tax
treatment of capital gains? This activity probably does not meet the ordinary course
of trade or business standard, but as the relative and absolute importance of the
individual’s side real estate transactions grow e.g. after retirement, so does the
likelihood that it will be characterized as a noncapital asset. See e.g. Biedenharn
Realty Co. V. United States (sale of farm property bought as an investment that was
later subdivided and sold in lots was deemed ordinary income).
b. There is no dispositive differentiating factor, but factors that point toward inclusion
in S1221(a)(1) include:
i. Frequent or numerous sales
ii. Significant improvements
iii. Brokerage activities
iv. Advertising
v. Purchase and retention of the property with a goal to short-term resale
vi. The importance of the activity in relation the taxpayer’s other activities and
sources of income
c. Given that the aforementioned factors are not dispositive, a great deal depends on
the jurisdiction and trier(s) of fact. See the following examples:
i. Subdivisions: Compare Houston Endowment, Inc. v. United States (5th Cir.
1979) (holding that the property was a non capital asset, under S1221(a)(1),
where the taxpayer, a lender, obtained property through foreclosure, did
not subdivide the property, but did install utilities, and sold over 200 parcels
over 27 years) with Byram v. U.S. (5th Cir. 1983) (holding that property was a
capital asset where (i) the taxpayer made seven single sales in a single year
but made no improvements and (ii) there were no sales efforts by the
taxpayer or broker but the taxpayer had sold 15 other parcels in a three-
year period).
1. Note: it is possible, though unlikely, where a taxpayer conducts
multiple sales to varying parties, that part of the sales be treated as
capital gains and part as ordinary income.

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 ii. Condo Conversions: The service has been lenient in giving capital asset
treatment to gain recognized on condominium conversions see e.g. Gangi v.
Commissioner (gain from the sale of condos was capital where the taxpayers
constructed an apartment building for rental use, operated it as such for 8
years, then converted the apartments to condos and advertised the sale of
the condos, in order to maximize their profit on the liquidation of the
investment when the taxpayer and the other investor in the building
decided to part company.)
d. Prewrite for arguing ordinary income (you can do two things here (a) argue that its
1231 property-depreciable or real property used in a trade or business <e.g.
apartment complex from which rental income is derived>); or 1221(a)(1) property-
held primarily for sale <e.g. condos sold to customers>: For characterization as
ordinary income one may argue that they purchased and held the building with an
eye to developing a steady stream of rental income and that the property qualifies
as S1231 property (real or depreciable property held in a business). The case could
be strengthened by factors that indicate a business (as opposed to an investment)
motive and operation. The presence of rents, the employment of a professional
manager or full-time custodian, adverting for tenants, and development of a plan of
renovation would all be helpful. The possibility of ordinary loss increases if the
building is renovated. In general, the more time the taxpayer spends on the project,
the greater the extent of renovation, and the more employees directly employed on
the project, the more likely it would be deemed as ordinary property. At some
point, the renovation itself becomes a trade or business and the property falls out of
the capital asset category through application of S1221(a)(1) (primarily held for sale
in the ordinary course of business). If the property is renovated, and then rented
out, ordinary loss treatment becomes even stronger. The taxpayer cam maximize
the possibility of ordinary loss treatment by keeping careful business records of the
time he spends on the project and by formally treating the project as a separate
enterprise. Maintaining a separate bank account for the building rents, for example,
may help to characterize the project as a business. There are also a host of
formalistic things the taxpayer could do to make the investment seem more like a
business. He might e.g. adopt a business name for the property, and file a DBA
notice in a journal of general circulation. He might also order separate stationary for
the building, open and maintain a separate bank account in the name of the
business, and so on. He could also join associations of real estate professionals and
subscribe to periodicals. want to do this if there is a loss
i. Counter: The service on the other hand is going to try to argue that the
property is primarily held for sale to customers. They will do this pointing to
things that would put the taxpayer in that trade or business (w/o trying to
employ the depreciable or real property route to get the taxpayer to the
favorable treatment of 1231) e.g. the sheer number of sales, amount of gain
recognized, relative importance of the profit during the years in question,
looking for improvements.

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 ii. See E&E question 4 pg. 453 if a similar question appears on the exam for
prewriting.
e. Prewrite for arguing capital asset: The taxpayer will argue that the property was
either a capital asset or S1231 property (held primarily for use in a trade or
business); in either case it would generate capital gain. The taxpayer may be
expected to argue that they did not purchase the building with an eye to selling off
the individual units, but instead bought the building either as a long-term
investment or in the hope of producing a steady stream of rental income. They are
likely to emphasize their lack of other real estate investments, direct involvement in
the sales, and relatively small cost of improvements. want to do this if there is a
gain
i. Counter: same argument as above
ii. Rights to Income and Carved Out Interests
1. Preface: In most cases, whether a transaction involves a sale or exchange of property will be
self-evident. In some cases, however, whether a transaction is best characterized as a sale of
property (generating capital gain) or the collection of rents, dividends, or salary (generating
ordinary income) will be unclear. Consider a bondholder who “sells” his right to the next
two interest payments on a bond he owns (the right to collect interest has value, can be
legally sold, and may well constitute property interest under state law). Perhaps, the sale
should be characterized as a sale of property because the property does not fall within any
of the enumerated exceptions to capital asset treatment. On the other hand, had the
bondholder simply collected interest, he would have been taxed on the interest at ordinary
income rates.
2. Rule: For tax purposes, the sale of the right to income from property, for a limited period of
time, by a taxpayer who holds the rights to the income from the property thereafter (i) does
not constitute a sale or exchange of property (ii) does not generate capital gain or loss, and
(iii) does not allow the taxpayer to offset her basis in the property against the amount
received. In sum, a carved-out interest is not treated as a separate property right. Hort v.
Commissioner; Commissioner v. P.G. Lake. Taxpayers cannot avoid an income inclusion by
assigning that interest and cannot convert ordinary income into capital gain by selling that
interest.
E.g. In Commissioner v. Ferrer, the actor Jose Ferrer entered into an agreement with
LaMure, who wrote a book and a play about the artist Toulouse-Lautrec. Ferrer’s
rights under the agreement included the right to produce the play, the right to block
a movie based on the book until the play was no longer running, and the right to
share in amounts La Mure might receive from a movie based on the book. Later,
John Hutson then decided he wanted to make a movie of the book, so he entered
into an agreement with both Lamrure and Ferrer. Ferer argued, and the tax court
agreed, that such amounts were received in exchange for the assignment of the
dramatic production K between Ferrer and Lamure, and thus were capital gain.
a. Lessor/Lesee: in Hort v. Commissioner a 140k payment relieved by a lessor from a
lessee to cancel a lease on commercial property that the lessor continued to own
was ordinary income. The lessor was also not allowed to reduce the 140k amount
received by any of his basis in the property. The lease cancellation was deemed
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 advance rent; since rent would have been ordinary, the lease cancellation should be
ordinary income. The cancellation payment was for a carved out interest because
the lessor continued to own the property.
i. Exam Point: On the other hand, a lease cancellation payment received by
the lessee is treated as the sale or exchange of a property interest, so the
payment may be capital (either by ways of S1221 or S1231) since the
payment made would be for the entire interest of the lease.
1. S1231: The leasehold may presumably constitute “property used in
a trade or business” and therefore qualify as Section 1231 property
net gain on the sale of which constitutes capital gain and loss which
constitutes ordinary income. While ordinarily §1231 property only
includes real or depreciable property used in a trade or business, in
Rev. Rul. 72-85, 1972-1 C.B. 234, the Service determined that a
leasehold of land used in a trade or business is §1231 property.
b. Salary & Personal Service Income : Sales of what otherwise would be treated as
salary or personal services income do not fall within any statutory exclusion from
capital asset treatment, but by virtue of both S1221 and a uniform set of court
decisions, the salary would be treated as ordinary income. This is the case whether
it is a contingency fee (that may well constitute property under state law) or any
other right to ordinary income by virtue of a K. Similarly, the sale of a not-yet
received paycheck for work already performed would generate ordinary income due
to S1221(a)(4), which excepts accounts receivable from the capital asset definition.
i. see e.g. Commissioner v. P.G. Lake where the court ruled no capital gain on
sale of right to receive ordinary income characterized as a working interest-
<also look out for the loan idea>, the income from which would be deemed
ordinary income (Even even if the taxpayer sells the right to his entire career
earnings.
ii. Exam Point: on the exam, try to characterize the right of salary as two
things: (1) see if there is somewhat of a retained interest to characterize it
as a “carved out interest” or (2) try to characterize it as an odd accounts
receivable fee (denied capital treatment under S1221(a)(4)). (The closer the
sale to the income-generating event, the more likely it will be classified as
an A/R).
c. Bond: A Sale of bonds that has appreciated in value from a decline in tax rates
would reap capital gains on the difference between the taxpayer’s basis and the sale
price. On the other hand, the right to some of the payments i.e. some of the bond
coupons, would be a carved out interest and would not be capital gains.
i. What if the bondholder sold it back to the treasury ?
1. If the bondholder sells back his or her bond to the treasury, they
would still have capital gains.
d. Futures K: The sale of a futures K on a commodity, e.g. oil, that has since
appreciated in value would also be deemed capital gains.
e. Lottery Ticket: the sale of a future income streams from lottery winnings would not
be capital gains income. In Wolmach, the court deemed said earnings as a substitute
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 for ordinary income and not a carved out interest. While the court didn’t have a
good argument, they went about it on the unearned income basis.
f. Liabilities with value: Liabilities, even if favorable e.g. core deposits, are generally
not deemed to be “assets” and therefore the sale of a liability cannot reap capital
gains treatment.
iii. The sale of a business
1. The sale of the stock of an incorporated business generates capital gain or loss regardless of
the numbers of shareholders. On the other hand, the sale of an unincorporated business is
treated as the sale of each of the individual assets of the business, some of which are capital
assets and some of which are not. Williams v. McGowan. The purchase price of the business
sis allocated among the assets of the business based on the classification of the assets and
their fair market value. SS1060, 338(b)(5). The seller then computes the amount of gain or
loss on each asset and the character of the gain or loss.
a. Exam Point for sale of K: Where there is a sale of a K right to income owned by an
unincorporated business, the seller could argue that he has, in effect, sold the assets
of a separate business or a separate business itself (the treatment of gain is the
same for both). If the taxpayer continues to operate a similar business, the service is
likely to characterize the transaction as the sale of the right to ordinary income from
the existing business (this is especially true if the taxpayer operates a similar
business) and that the right is a carved out interest. The service could also attempt
to argue that the K right is the product of personal services or because a sale so
close to the income-generating event is in effect a sale of A/R. The taxpayer could
draw further support for the distinction of the businesses if the K right requires a
different set of skills, is different in nature than the other business, etc.
iv. Policy: a decision in favor of capital gain treatment encourages other taxpayers to undertake the same
kind of artificial and expensive transaction. Interest would then produce (through anticipatory sales)
capital gain rather than ordinary income-a step that seems out of character with legislative intent and
common understanding.
f. Policy Rationale for the preferential tax treatment :
i. One argument is that, the gain included in the year in which the asset is sold may throw the taxpayer
into a higher tax bracket than the taxpayer would have been in had the gain been taxed over a
number of years.
ii. Another argument is that the gain realized on the sale of a capital asset reflects both true economic
gain from the asset, which should be taxed, and inflationary gain from the asset, which should not be
taxed. Given that, the rate applied to capital gain does not properly reflect the length of time the
taxpayer held the capital asset with respect to inflation (only a distinction for short term and long term
capital gains), the problem could be solved more precisely by indexing the tax basis of assets to reflect
inflation, then taxing gain from the sale of the asset at ordinary tax rates.
1. Capital gains is a clumsy instrument to adjust for inflation. It isn’t very well calibrated to the
problem. If the problem is inflation, you want to index the basis to inflation so that the basis
rises as inflation does
iii. Capital gain proponents have also argued that the lower rate is necessary to mitigate the lock-in effect
and improve the mobility of capital. The idea is that since taxpayers can defer the tax on gain until the
gain is realized, they will refuse to sell assets that they would sell but for having to pay tax on the sale;
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 this lock-in effect causes immobility of capital and inefficient uses of capital. While the preferential
rate may reduce the lock-in effect, it does not eliminate it because the realization requirement and
S1014 (the stepped-up basis at death rule) both deter taxpayers from selling their assets.
1. Two Solutions: have mandatory realization rules-mark to market rate. At the end of every
year, require valuing at the end of every year where loss or gain are assessed and attributed
to the property. By doing so, you would not need a low capital gain rate to offset the lock in
effect.
iv. Incentivizes risk taking.
v. Income bunching-professor doesn’t like this 1
vi. Double taxation-professor likes this 1
vii. See. Pg. 444 of E&E if necessary for remainder.
viii.

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