Income Tax

Stock Options - IRC § 422, 83

* revisit diagram on outline!! TWO ISSUES o Timing o Capital gain or ordinary income Employer-employee stock/option to buy stock = compensation for services rendered and taxable as ordinary income Timing: exercise of option = taxable event o Grant not taxed (unless has ascertainable FMV) o Tax treatment upon exercise (if not taxed at granting) § Ordinary income with basis = option price + amount included in income§ Subsequent gain is capital gain§ BUT if stock subject to substantial risk of forfeiture and nontransferable -> defer income Qualified Incentive Stock Options - § 422 o Incentive stock options (statutory stock option) § Taxpayer only taxed at capital gain at final sale of stock. NO deduction for employer Tax exercise of option as capital gain No tax on either the grant or receipt of the option Employer receives no deduction at any time EVER (§ 422A) § Requires: Option price no less than FMV stock when granted Term of option not greater than 10 years, nontransferable option Holding period of 2 years after granting and 1 year after exercise Employee can't own more than 10% employer's stock when option granted Not more than 100K stock per year can be subject to options Must be granted pursuant to shareholder-approved plan o §1234(a)(2)§ Capital gains to individuals (because same treatment as underlying asset) § Ordinary income to broker-dealers (because it's their trade/business) § Special rule for loss attributable to failure to exercise option § Option deemed to have been sold or exchanged on day it expired • Non-statutory transfers IRC § 83 o Non-cash compensation for services § Often subject to restrictions of transferability, risk of forfeiture § Think actual shares, unvested, but not stock options yet (popular in tech) o Symmetrical treatment § When employee includes, employer deducts o Valuation § If no "readily ascertainable FMV", not immediately taxable - § 83(e) § A stock/option which didn't have ascertainable FMV when granted is taxed when exercise, even if value became ascertainable after grant but before exercise o Mandatory includability -§83(a),(h) § If property transferred (a) without restrictions and (b) doesn't face "substantial risk of forfeiture ("vested") Taxpayer pays tax as ordinary income (and employer deducts) FMV of property - amount paid for it § At time of vesting, amount included constitutes ordinary income § Substantial risk of forfeiture • Exists where employee's rights to full enjoyment of such property are conditioned upon the future performance of substantial services by any individual o Elective includability-§83(b)election§ Taxpayer can elect includability as ordinary income • Even if there are restrictions on transfer or risk of forfeiture § But can't claim deduction later by reason of forfeiture (ouch!) § Why? Pay ordinary income tax now (low value today) Enjoy capital gain rate on later appreciation in property o If no mandatory election and inclusion not elected... § It's included as income (and deduced by employer) at a later time § When stock/option becomes non-forfeitable or transferable • Stock Options - § 83 (property transferred in connection with services) o §83 applies once option as readily ascertainable FMV § FMV is ascertainably only if option is actively traded on established securities market o If FMV is not ascertainable and option later exercise, §83(a),(b)applies § This is more common; taxpayer can't claim worth $0 § Taxpayer pays tax, employer gets deduction on: • FMV at exercise - stock price§ Later when sold, capital gain for employee on: Sale price - exercise price No further deduction for employer o If FMV is ascertainable at time of option grant,§83(a),(b)applies: § This is rare. Only ascertainable if: Option transferrable Exercisable immediately, and No restrictions or conditions affecting value § Taxpayer taxed on (and employer deducts) FMV of option itself • Treated as if taxpayer received cash and used it to purchase options § When option later exercised, § 83 doesn't apply Taxpayer's basis upon exercise is: o Amount included under§83(a) when option granted+price paid at exercise If option never exercised o Taxpayer can deduct amount previously taken into income o Company also loses prior deduction for option value • Employer deduction: under § 83, the treatment by employers and employees is symmetrical. When employee includes option in income, employer is allowed to deduct

Itemized Deductions and Standard Deduction - IRC § 63, 68

ABOVE THE LINE DEDUCTIONS BEFORE AGI - § 62(a) o Business expenses in taxpayer's trade or business-§162 § Costs of producing income § Most favorable business deduction o Losses from sale/exchange of property-§161 o Deductions from rent/royalties o Certain deductions of life tenants o Pension, profit-sharing, annuity plans of self-employed o Retirement savings (e.g. IRA contribution) o Alimony-§215 o Moving expenses-§217 o Education loan interest-§221o Higher education expenses-§222 o Health Savings Accounts-§223 BELOW THE LINE DEDUCTIONS AFTER AGI o Personal exemption-gone lolz; used to be $4050 for each person, including head of house hold and dependents o Standard OR Itemized Deductions § Standard deduction - § 63(c) • LOOK AT CURRENT TAX TABLE § Itemized deductions - § 63(d) • Subject to phase-out provisions of § 68 o Deductions for Medical expenses §213, investment interest §163(d), and casualty and theft losses § 165(a), (c)(2)(3) are excluded from phase-out

Legal Expenses

An individual may deduct legal fees incurred in trade or business related to production of income, under § 162 or 212 respectively. o Personal legal fees are nondeductible personal expenses under§262 Legal expenses incurred to protect business or investment interest under § 212 o Origins Test: Legal fees incurred in part for personal reasons and in part to protect business or investment interests are deductible if the "origin" not the consequences of the claim is business-related and not related to personal fees § EX: Taxpayer running family business denied deduction for legal fees pursuant to his divorce to defend against wife's claim on interest in business, because legal fees arose from personal expense (divorce) o But a taxpayer can add cost of personal litigation to basis of property being"protected"

Non-recourse Borrowing in Excess of Basis

Borrowing in excess of basis does not change basis in asset and does not trigger recognition of gain o Doesn't matter if you borrow recourse or non-recourse POLICY: Strong argument that under non-recourse, should be recognition of gain, but there's not. (Bought for $300, now it's worth $1000 and you borrow $500 non recourse, you're ahead by $200. If property falls below $500 you won't pay the loan, you'll walk away and come out ahead).

Business Gifts - IRC § 274(b) [general gifts], (j) [achievement], 102 [personal gifts]

Business gifts are income (§ 102) and personal gifts are excluded (and no deduction for the donor) o Covers both business gifts to employees and former employees (with some exceptions) Highly factual intensive determinative rule with deference to the fact finder o Gifts are defined by reference to the motives of the payor. IF payment, though voluntary, is "in return for services rendered"or proceeds from "constraining force of any moral or legal duty" or anticipates a "benefit" to the payor, then it's taxable to payee even if called a gift by payor (and no deduction)o Excludable if "detached and disinterested generosity" or made "out of affection, respect, or like impulses" o Gifts are based on primary motive of donor: "disinterested generosity" or quid pro quo § State of mind of transferor must be "out of affection, respect, admiration, charity, or like impulses" § Question of fact § The tax treatment of the donor effectively determines the correct description of the transfer. If the donor claims a business expense deduction, that is usually thought to preclude the altruistic motive essential for gift characterization and thus for income exclusion on the part of the donee. Exceptions that are excludable: o De minimis fringe benefits (not taxable when statute enacted) §132(c) o Employee Achievement Awards §274(j)(deductible for employer), §274(c) (includable for employee) § Must be an item of tangible personal property• Something useless like a trophy or plaque (what about a watch?) • $400 value limit for deduction/exclusion ($1.6k if qualified plan award) § Must be for length of service or safety achievement § Must include a meaningful presentation§ Must not be disguised compensation Tax symmetry required between payor and payee under § 274(b) o If payor claims a deduction as a business expense, it is NOT a gift to payee o If payee treated as exempt gift, then payor cannot deduct as business expense o Prohibits deduction of gifts to individuals (over$25) o Up to $25 can be deducted, and business cards/pens allowed (up to$4-yay!) Gifts to mistresses (Harris (1991)) not usually income, unless cash-for-sex exchanges o Case-by-case analysis required:payor/payee's intent, actual relationship, etc. Barter clubs: Treated as income. Exchange relationship (Rev. Rul. 17-24)

Alternative Minimum Tax

Calculate tax liability under regular income tax and under AMT. Pay higher of the two numbers o AMT takes income and adds things excluded because people were responding too enthusiastically to tax preferences POLICY: Intended to ensure that the powerful or privileged has significant tax despite the availability of tax-exempt income sources. This is basically a second tax system. AMT not used much after 2017 Tax Act because of elimination of deduction for SALT

Moving Expenses - IRC § 217

Can deduct moving expense for taking a new job, if new job adds at least 50 miles to commute and in the year following the move the taxpayer works at least 39 weeks at the new job § 217(c) What's deductible? o Cost of moving house hold goods and personal effects from former residence to new residence o Cost of traveling (including lodging but not meals) from former residence to new residence o Cost of moving family included §217(b)(2) Moving expenses are ATL and can be claimed in addition to the standard deduction § 62(a)(15) NOT subject to 2% of AGI limit in § 67

Home Offices - IRC § 280A

Can't deduct home office if self-employed unless exclusively used as principal place of business to meet with clients or patients, or it's in a separate structure Can't deduct home office if employed unless it is for the convenience of the employer o i.e. employer doesn't provide office or provided space is inadequate Taxpayer can qualify for deduction only if engage in "trade or business"

Mixed Business and Personal Expenditures

Clothing Expenses - IRC § 535 Deductible as a business expense only if: o Clothing of type specifically required as condition of employment o It is not adaptable to general usage as ordinary clothing (must have company logo) § And is NOT so worn Objective test used to determine if clothing is suitable for general use o Taxpayer's subjective views about clothing irrelevant • Ex: o Boutique sales woman not allowed to deduct cost of expensive clothing required as condition of employment because it was "Adaptable to general usage" o Tennis professional not allowed to deduct cost of clothing because it was in fact "fashionable" and very usable everyday o Amway salesperson allowed to deduct "leather uniform" because it had company label but not his boots because they were suitable for nonbusiness use

Constructive Receipts and Economic Benefit

Constructive Receipt (§ 867) o If tax payer has an unqualified legal right to a sum of income or property, plus the power to obtain it, taxpayer has"constructively received" it -> taxable as current income even if taxpayer hasn't actually received it (Reg. § 1.451-2(a)) § Prevent cash basis taxpayers from avoiding taxes by putting off actual receipt of income until tax circumstances more favorable • Ex: uncashed checks; interest not withdrawn from savings account (taxable when credited); unpaid corp salaries o Mandatory application, even if beneficial to taxpayer o Terms of contract control (deferred compensation) § If terms of contract provide for payment in year 2, constructive receipt doctrine will not apply because under terms of contract taxpayer has no right to payment until year 2 § Timing of employee's deduction matched with employee's income § 404(a)(5) • Economic Benefit Doctrine o Even if no constructive receipt, cash method taxpayer recognizes income as soon as payor confers an economic benefit on the employee § 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 § Key is that money is safe and can't be touched by creditors o Forfeitability: If risk of future payment is substantial, income won't have to be recognized currently by person electing deferred compensation § Ex: if need to render substantial future services to receive deferred compensation, no economic benefit o Deferring compensation by contract has two drawbacks: § 1) Employee runs risk that employer will not be able to make the payment (if contract structured so no risk of nonpayment, employee can't deduct under economic benefit doctrine) § 2) Employer can't deduct deferred compensation until employee includes it • Constructive Receipt v. Economic Benefit o Pulsifer: Father and 3 sons win prize money, Irish bank withholds sons' money until they turn 21. Although sons did not have an unrestricted right to the money and thus the economic benefit doctrine is inapplicable, the money was irrevocably set aside, and thus the constructive receipt doctrine mandated inclusion.

EducationExpenses

Cost of education is generally nondeductible as a personal expenditure o Individual allowed to deduct educational expenses if education maintains or improves skills required by individual in current trade or business § Education must be sufficiently related to maintaining or improving taxpayer's position in current line of employment § Ex: Carol • Police detective denied deduction for costs of college tuition because not an expense of being in profession of being a detective § Cost of education enabling someone to begin work in a profession is never deductible nor amortizable over any time • Lawyers, optometrists, judges, etc. are a profession § Ex: MBA. Sometimes deductible, sometimes not. Must have already established oneself in a trade or business (it's not a profession). If you get an MBA not having established yourself in a trade or business, it's not deductible. § Ex: LLM. Cost not deductible unless you've already established yourself in trade or business of being that type of lawyer § Ex: bar exam expenses. Not deductible because not established in trade or business of being a lawyer already. If law firm pays, it's a taxable benefit to you. o Other forms of relief include: § § 529 Plans State-run and can choose between variety of investment vehicles When eventually paid out in higher ed expenses for chosen beneficiaries, money will not be taxed § Hope Scholarship Credit - § 25A§ Lifetime Learning Credit - § 25A§ Deductible Interest on Student Loans - § 221§ These are ALL small dollar amounts relative to costs, and ability to take advantage of them falls away as income rises

Policy Arguments

Could result in lock-in o Realization: not going to tax taxpayer on gains as they accrue unless they've sold or exchanged an underlying asset o People are deterred from selling because of the tax, even if they would be selling to invest in a better investment o Keeps asset in less productive use since investors may pass on better investment opportunities Low cap gains rate makes it easier to move assets into more productive uses Promotes savings and new industries o Increases appeal of investing in capital assets Double-tax on corporate earnings o If corporation earns money, gets taxed at corporate rate o If it distributes money to shareholders, also get taxed o Dividends are not capital gain-special rate Bunching o Not fair to tax taxpayer all at once on gains earned over time o Only matters if some of gain pushed into a higher marginal tax bracket Inflation o Unfair to tax someone on purely inflationary gain Why limit deductibility of capital losses o Prevent false, early losses as a tax-deferral tool § Taxpayer could hedge, only selling those assets that lost money, thereby realizing losses but not yet gains o Cynical: Congress needs revenue?

Business Losses - IRC §165

Deduction for any loss sustained in trade or business (or other profit seeking activity or casualty loss) during taxable year and not compensated for by insurance and otherwise (§ 165(c)) o Not subject to §67 limitation except for business losses § Personal casualty losses and wagering losses on § 67(b) list of exclusions from application of 67 § Trade or business losses subject to § 67's limit o Amount of deduction=FMV(before)-FMV(after) BUT CAPPED AT BASIS o Effect on Basis: Adjust basis in amount deducted as a loss o Rationale: Must be able to recover capital investment.

Casualty Losses - IRC § 165(c)(3), (h)

Deduction for unreimbursed personal loss from fire, storm, shipwreck, or other casualty, or theft o Negligence does not bar deduction under §165, but gross negligence or knowing violation of law does bar it o Requirement of physical damage depends on circuit- "sudden, unexpected" damage of living next to OJ and all the"looky-loos" doesn't count as capital loss when sell home in the 9th circuit o Suddenness requirement-distinction between ordinary, slow erosion and losses which are swift and unexpected § Termite damage is slow, not casualty loss § Cat freaking out and breaking a vase is not sudden or unexpected, so not casualty loss § BUT house getting hit by lightning is! • Measuring allowable loss: o Floor: No deduction for first $100 of each casualty/theft o Loss: Difference between FMV of property before and after casualty § FMV before can't be in excess of adjusted basis of property o Deduction claimed from loss reduces basis in property by that amount o Casualty gain also possible-§165(h)(2)(B) § If casualty gains exceed casualty losses, gains treated as capital gains and losses as offsetting capital losses § If casualty losses exceed casualty gains, net the loss and deduct the net amount subject to the 10% rule Claim must be timely filed per § 165(h)(4)(E) POLICY: Govt is basically offering free insurance with high co-pay; discourages buying insurance o No deduction for casualty insurance premiums

Qualified Pension Plans IRC § 401 - 407

Deferring compensation through contract doesn't allow immediate deduction by employer and employee's payment is uncertain; and people would otherwise not save enough (HUGE federal subsidy) so do a qualified pension plan! Under plan, funds set aside (usually through trust or annuity contract) for irrevocable benefit of employees o Employer gets deduction immediately(§404) o Employee not currently taxed on contributions or interest until she receives funds upon retirement though non-forfeitable (§402(a)) • Subject to nondiscrimination provisions; statutory limits on amount of contribution; high penalties for early withdrawal

Realization Requirement - IRC § 1001, 1031, 1091

Definitions: o Recognition: When you report an event on financial statements o Realization: When you convert an inventory into cash § Usually when you realize, you must recognize, but not always o Increase in value: e.g. capital asset increases in value, but you don't realize or recognize until later. No sale or exchange. General rule: Income must be realized before it becomes taxable (recognized). US does not tax on mere changes in property value. Instead, it taxes transactions. o Eisner: Stock dividends (dividends made of stock, not cash) are not taxable -> violates 16th Am. Tax on appreciation is deferred until realized. POLICY: Certain things are not taxed because IRS is worried about (1) liquidity and (2) valuation Satisfying the requirement o Hair trigger standard:All that is required to trigger a realizable tax able event is for property to be exchanged for cash or other property differing materially either in kind or extent o Cottage Savings: Two banks' mortgage portfolios dropped in value so, eager to realize a loss, they swapped equivalent mortgages to create "realization event." § This is realization and loss can be deducted because of "material difference" between properties exchanged. § Secured by different homes so banks ended up with "legally distinct entitlements" • Exceptions o §1001(c): Again must be recognized for tax purposes when its realized unless there is a specific code provision otherwise § Exclusion: Sale of primary residence § Deferral: Like kind exchange§ § 1031 and like-kind exchanges • If you sell the right kind of asset and replace with asset of like kind within certain period of time, gain does not need to be recognized for tax purposes • § 1091 puts in hands of individual taxpayers when they recognize gains and losses

Scholarships - IRC § 117

Exclusion from gross income only "qualified scholarships" by "degree candidates" Qualified to extent it covers tuition, fees, books, NOT room and board. § 117(b)(2) Does not extend to the extent scholarship is in compensation for services including teaching and research § 117(c) o Grad student stipend is taxable, not if "pure scholarship" (no work) But athletic scholarships are excluded. Rev. Rul. 77-263 o Why?We like collegiate sport participation o Scholarship can't. be pulled from student if s/he's injured, unable to play that year (and can't be included, even if they don't. play that year due to injury) Consider also § 74 (prizes and awards, generally) POLICY: Think of lower tuition as same as retail discount: no income on price reduction Note on third party paying for schooling: o Military payment for tuition is excludable o When a company pays for it, it's includable

Annual Accounting Rule

For practical and administrative reasons, income tax is based on annual, not transactional, accounting of 12-month intervals. Tax is assessed/paid on basis of events occurring between beginning and end of period. o But if have fluctuating income, this can lead to unfair results o So there are three exceptions: § Net operating loss (§ 172) § Claim of right rule (§ 1341) § Tax benefit rule

Inventory Accounting

General Idea: § 263A requires everything involved in production of capital asset be capitalized. Thus, taxpayer who keeps inventory of goods for sale must capitalize costs of supplies and materials instead of immediately deduct them; costs are added to taxpayer's inventory costs and deducted when inventory is sold o Taxpayer uses inventory accounting when producing, purchasing, or selling merchandise, and the production purchase or sale of such merchandise is an income-producing factor. Merchandise is defined as property held for sale to customers. § 471 thus requires manufacturers, wholesalers, and retailers to use inventory § 61(a)(2) provides that gross income includes gross income derived from business. For taxpayer using inventories, gross income derived from business equals gross receipts from sales less taxpayer's cost of goods sold o Cost of goods sold= cost of inventory at beginning of taxable year+ cost of goods purchased during year-cost of inventory remaining at end of year o Cost of goods purchased includes capitalized costs under 263A added to purchases o Cost of inventory remaining can be determined using LIFO or FIFO (last in first out or first in first out) § Taxpayer will choose based on rising or falling inventory prices, but FIFO applies UNLESS taxpayer elects LIFO § 472

Deductible Business Expenses v. Nondeductible Capital Outlays

General Rule: Expenses for asset with a useful life extending beyond year in which expense incurred must be capitalized, even if reasonable and ordinary. § 263 o Capital expense need not create specific long-term asset but may enhance overall business operations o Purpose of capitalization is to match expense with income § Ex: Encyclopedia Britannica cost, but exception for R&D costs which need not be capitalized and are current expenses (Rev Rul) o Applies to prepayments-if a tax payer prepays an expense that is attributable to later years, expense must be repaid as capital expense § Ex: prepaying for three years of insurance - allocate cost over 3 years o Rationale: MATCH EXPENSE WITH INCOME EVERY YEAR to truly reflect income from the year because year times are arbitrary UNICAP RULES - § 263A (uniform capitalization rule) o All expenses associated with constructing a capital asset are capital expenses § If taxpayer incurs otherwise deductible business expenses (e.g. wages) in constructing building or machinery, otherwise deductible expense must be capitalized o Applies to anyone producing Goods for Sale to Customers § Any taxpayer who produces real or tangible property for sale or acquire real or tangible property for sale to customers in ordinary course of business Exception: doesn't apply to freelance authors, photographers, and artists ONLY applies to taxpayers who acquire PERSONAL PROPERTY FOR RESALE if annual receipts from sales exceed $10M over 3 years Distinction between repair and maintenance - § 263 o Repairs immediately deductible because not an investment into longevity § If fix up something broken and restore it back to level of prior functionality, that's a deduction § § 162 permits taxpayers to currently deduct costs of ordinary and necessary business expenses (including incidental repairs) that do not materially add to value of property or appreciably prolong its life, but keep the property in an ordinarily efficient operating condition o If there's substantial improvement to a property that's a capital expenditure and those costs have to be capitalized. § If build something new or separable, or replace portion of existing item with parts that make it better, then have to capitalize § Consider future benefits created by the expenses, both duration and extent o Some component of foreseeability and timing-when event that needs to be taken care of occurred in terms of construction or during business operations o Can't double deduct repairs and losses § Loss: deductions must be "realized" -> must have identifiable event that justifies a current account § Repair: Decline in value due to wear and tear, to changes in economic environment, or to other circumstances does not give rise to a loss deduction -> recognize with depreciation (and change in basis) or when property is sold § If a deduction for loss is allowed, a deduction for repair to restore the property to pre-loss condition is denied.

Child Care - IRC § 21, 129, 262

General approach is to provide a personal exemption (§ 151), subject to phase out, a child tax credit (§ 24), and dependent care services (§ 21) § 262: No deduction for personal/living/family expenses § 21: Allows credit for certain childcare and dependent care services incurred to enable the taxpayer to work o If head of household has one or more qualified individuals as dependents, taxpayer allowed credit in amount equal to applicable percentage of employment related expenses • § 21(c) o Up to 3k per qualifying dependent or up to 6k per 2+ qualifying dependents-cap used to calculate credit § Qualifying individuals are dependents under age 13 or incapable spouses/dependents o Capped at lesser of taxpayer's earned income or spouse's earned income o Child care expenses for §21 calculation must be reduced by amounts reimbursed by employer and excluded under§129 Applicable percentage o 35%, reduced by 1% for each $2k of taxpayer's AGI exceeding $15k § Can't be reduced below 20% plateau (§ 21(a)(2)) - that is, for taxpayers with AGI>$43k, applicable percentage is 20% § 129 Exclusion for employee child care expenses provided onsite or reimbursed by employer pursuant to dependent care assistance program o Amount excluded limited to $5k/year§129(a) o Should not exceed: § If single parent, earned income of parent § If married, lesser of earned income of employee or earned income of spouse (if student, assume $3k income) o Any amount excluded here reduces figures for §21 credit

Cancellation of Debt - IRC § 61(a)(12); 108(a)(1), (b), (e)(4)-(5), (f), 1017(a)

Generally, loan proceeds are not income and loan repayments are not deductible If a loan is discharged for less than amount owed, borrower must include in income the amount of discount § 61(a)(12) o Never any adjustment for time value of money(inflation) o Follow money: principal amount?How much repaid?Difference is COD income § 108 Relief Provisions o Insolvent/bankrupt debtor§ § 108(a) - Debt-cancellation income excludable to extent taxpayer is insolvent § Instead, reduces taxpayer's basis in other assets (§ 1017(a))§ May also cut into taxpayer's NOL carry forwards in future years § If you prosper by selling assets and have gains, income will be recognized then o Adjustment of purchase money debt (e.g. lower price after complaining about car)§ § 108(e)(5) - reduction of debt incurred to purchase property and owed to seller is treated as a reduction in sales price, rather than income to purchaser o Student loan forgiveness§ § 108(f) - no COD income where student loan is discharged pursuant to provision for student to work for certain period of time in certain professions o Mortgage forgiveness § § 108(a)(1)(E), (h) - no COD income from primary residence, up to $2M, IF: From Mortgage Debt Relief Act of 2007, sunset, but regularly extended Only for acquisition indebtedness, not taxpayer's later HELOCs Only when decline in home value or taxpayer's financial position Applies where taxpayer does mortgage "workout" to reduce payments § Taxpayer must write-down basis in home Plus § 121's $250/500k shield for gain on primary residence And, if taxed, only at LTCG rate, not ordinary income (as COD) o Qualified (solvent) far min debtedness provision at §108 Disputed Debt o If lender. and borrower disagree about amount owed, and borrower ultimately pays lender less than amount lender demanded, difference is not includable Contested Liability Doctrine o If taxpayer disputes amount of debt, then settles, settlement amount= debt amount. If debt enforceable and cancelled, would clearly be taxable. § Under NJ law, debt incurred by compulsive gamblers not enforceable § If debt incurred with no offsetting proceeds (e.g. child support, reduced judgment amount), courts unclear if COD Gifts Not Treated as Debt o If lender (usually parents) cancels debt at a discount from disinterested generosity § Borrower doesn't include discount in income § 102(a)§ Gift tax issues may arise§ If functions as payment then ordinary income (e.g. if CEO's taxes paid)

Transactions Related to a Taxpayer's Business

IRC § 1221 o Capital assets exclude property, used in trade or business, of a character which is subject to the allowance for depreciation provided in § 167 or real property used in trade or business Property under § 1221 includes securities, leases, franchise, trade-names, goodwill, etc, aren't necessarily inventory or real/depreciable property, but may be source of gain/loss Business Purpose Test (Corn Products, 1955) o If property acquired for purpose" integral to tax payer's business", it is excepted from cap asset definition and treated as ordinary gain/loss§ Here, net proceeds from corn futures transactions was integral o This case created a new class of non-capital asset: stocks, securities acquired to achieve a business goal o POLICY: too many things can be treated as ordinary loss because they have a business purpose § Taxpayers routinely claimed business purpose for loss (ordinary) and investment purpose when asset disposed at a gain (capital) • Arkansas Best (1988)o Limited expansive interpretation of Corn Products, which didn't create a "general exemption from cap asset status for assets acquired for business purpose" § Today, ordinary gain/loss treatment only applies when asset is substitute for inventory specifically excluded under § 1221 • If it looks like a cap asset, it is, unless you can show that it's an inventory substitute like in Corn Products Houses are cap investments if bought by corporations - corps can't write off losses as ordinary Sale of a Business o Mixed transaction when selling un-incorporated business (proprietorship) § Look at individual assets that make up business, rather than business as a whole§ Figure out whether each asset is inventory, capital, § 1231, etc. Then assign a value to each asset (Williams v. McGowan) o §1060: Parties must agree upon these values, otherwise each party would do their own thing to make sale as self-advantageous as possible o Tax payer may want to incorporate (e.g.s-corp) before sale § Then, sell shares of s-corp to buyer § That way, sale generates cap gain/loss to taxpayer (seller) • Despite fact that some portion of change in value may be due to appreciation/depreciation of inventory and other non-cap assets o Selling right to future career earnings § Treated as ordinary income even though it doesn't fall within statutory exclusions from cap asset treatment (legislative intent) • Miller (1962): Widow sold rights to husband's story for movie o Ct denied cap gain treatment because no recognized right of privacy, not clear that Universal was required to pay widow to make movie § If husband were alive and sold rights, would've gotten cap gain treatment § Perhaps just buying taxpayer's rave reviews (ordinary income ok) o Today, widow would get cap gain treatment (like selling business)

Section 1231 Assets

IRC § 1231 o Bucketing provisions (§1231assets) § Applies to gains/losses in taxpayer's trade or business Very taxpayer friendly regime, adopted during WWII Congress encouraging capital investment o §1231 assets: gains capital, losses ordinary o Applies to which property? § Virtually all non-inventory property in taxpayer's trade or business § Land, buildings, machinery § EXCEPTION to § 1221: Real or depreciable property (other than RE) held in a trade or business, if held more than one year, is § 1231 property o Exceptions § § 1245 Recapture Taxpayer doesn't get cap gain treatment for gains above adjusted basis, but below original purchase price § 1245 recaptures prior deductions against ordinary income But gain over original basis is given § 1231 capital treatment § Un-recaptured § 1250 Gain Similar to § 1245, but weaker provisions (because it's real estate) Assumes straight line depreciation o Even though taxpayer was actually allowed to use ACRS Result: less recapture is ordinary income, more capital gain § Special recapture rule in § 1231 • Prevents taxpayer from timing strategies If taxpayer recognizes a net § 1231 gain in any year, but has taken an ordinary deduction for a net § 1231 loss within the last 5 years, the prior ordinary loss deduction is recaptured by re-characterizing that portion of the net § 1231 gain in the current year as ordinary Ex: Taxpayer sells business building at $50k loss in Y1. Taxpayer then sells business truck at a $10k gain in Y2. o No cap gain treatment on Y2's gain o Because taxpayer took $50k ordinary loss in Y1, the$10k gain in Y2 is ordinary gain

Below Market Loans and Imputed Interest - IRC § 7872

If interest rate too low: o Do OID Rules apply? o Is it disguised compensation?What are motives for transfer/terms o Is it a below-market loan subject to §7872? o Flag it as an issue, understand the concept, know policy. DON'T CALCULATE NUMBERS IRS will impute interest if rate is below Applicable Funds Rate (AFR, low %) • Parent to child • Employer to employee • Corporation to shareholder • See notes from Julia class • §7872 o Baby imputed interest rule § Applies to smaller, non-corp loans o Demand loans-repaid whenever lender calls for it, short-term AFR § Gift Demand Loans (motivated by disinterested generosity) Prevents shifting income; without special treatment, parent could gift to child in lower bracket, investment would be taxed less o Now, kiddie tax also reaches this scenario § 7872 re characterizes the loan o Child is treated as borrowing money from parent with interest, paying parent that interest, then receiving back from parent a gift of imputed interest o Child may deduct imputed interest if business, not consumption (because child taxed on net investment income) AFR short-term rate imputed, § 7872€, unless an exception Exceptions o §7872(c)-ignores gift loans if<$10k o §7872(d)-if principal <$100k, imputed interest capped at amount of borrower's net income § But if investment income < $1k, no interest imputed § 7872(d)(1)(E)(ii) § Purpose: when recipient spends money • Note: o If loan is>$100k, entire amount is subject to different regime (not a marginal-dollar calculation) § Non-gift Demand Loan (employer-employee) Ignore entirely if principal is less than $10k o Here, no $10-100k range (As for gift demand loans) When employer lends X $20k interest-free, imputed interest is due on loan under AFR (assume $2k) o Same as if Employer pays X extra $2k/yr which X uses to fund interest on third party loan from bank $2k/year is taxable to X. Employer's $2k of imputed interest is offset by $2k salary reduction (so net 0 income to employer) o Term Loans-apply appropriate AFR, depending on length of term § Gift Term Loans A gift of interest is deemed to be made on an annual basis for as long as loan runs Treated same as gift demand loan § 7872(a) o Only difference is higher rate imputed here § Non-gift (Compensation) Term Loans • If NPV of FCFs due on note < nominal amount of loan, difference constitutes income to borrower in Y0 o Apply OID Rules, using AFR(s) for appropriate term o Later imputed payments= income to lender § Borrower can only deduct if investment, not if used for personal consumption o Worse for employee/borrower, because income now o Better for employer/ lender because deduction now

Consumption Tax v. Income Tax

If it's never consumed, why should one be taxed on it? Consumption tax is fair to savers o Shouldn't takeaway incentives to save o Less benefit to deferred consumption under income tax system Some economists argue that get same results of a consumption tax under income tax, with exception of risk-free rate of return Difficult to implement consumption tax o Difficult to build into sales tax o Could have some exemptions (food, medicine, etc.) Difficult to achieve progressivity in consumption tax o Some people earn lower incomes and would pay higher tax percentage relative to income than higher earners o Ways to fix: § Give people opportunity to invest in IRA with no limit When people invest, get deduction Eliminate ordinary income/capital gains distinction Only when money removed is it taxed Debt financing would be viewed as dis-savings Simple to implement § Implement tax on wages alone • Make as progressive as you like § Value Added Tax (VAT) Could have wage tax (progressive or flat) Not going to tax the first $40-50k of wages Changes would create winners and losers (like current tax code lolz) Long transition costs - would need old/new money basketing for 30-40 years

Involuntary Conversions - IRC § 1033(a) (elective)

If taxpayer's property is destroyed, condemned, stolen, or involuntarily converted into similar property, no gain shall be recognized (mandatory nonrecognition) § 1033(a)(1) o Consider also casualty loss rules, if loss not reimbursed If replaced by money or property not similar to that destroyed (nonrecognition is optional) § 1033(a)(2) o Taxpayer may elect to not recognize gain if § Money reinvested in similar property (construed broadly) OR § In property of related use (construed narrowly, unless business real property where § 1031 like-kind test used) § 1033(a)(2)(A)(b) OR § In a corporation owning such property § 1033(a)(2)(A)(c) AND § Reinvestment must occur within 2 years of loss of original property § 1033(a)(2)(B) o Gain must only be recognized to extent it exceeds taxpayer's original cost§1033(a)(2) Basic calculation (§ 1033(b)) o Involuntary conversion § New property basis = basis in old property - any money rec'd nor properly spent + gain recognized - loss sustained = cost of new property minus realized but unrecognized gain (§ 1033(a)(2)(A) and 1033(b)) o Optional conversion § New property basis = cost of new property - amount of gain not recognized • If new property consists of more than one piece of property, basis shall be allocated to purchased properties in proportion to their respective costs § Recognized gain• Amount of proceeds - Cost of qualified replacement o If property converted into new property (not cash), there's mandatory nonrecognition of gain.(Unusual).

House Rentals and Vacation Homes - IRC § 280A

In general o §280A applies to rental property that is also used for personal purposes o Rule: Taxpayer is considered to use vacation home as residence if: • BUT NOTE Section 67(g) that Miscellaneous itemized deductions are now allowed from 2018-2025 o Previously had 2% threshold rule for miscellaneous itemized deductions o Now there is no way for employees that incurred unreimbursed ordinary & necessary business expenses can get deduction for their expenses § Must be a dwelling unit, no motels or inns§ Taxpayer uses it as a residence for the greater of 14 days or 10% of the number of days at FMV • Repairs and maintenance days spent at home do not count as use of residence§ Must be personal use by taxpayer or family or rental to others at less than fair rental value • Three options o 1)Not used as residence § Steps• 1) Deduct Otherwise Deductible Expenses o Mortgage Interest (only deductible if qualifying residence under§163(h)(3)(A) o PropertyTaxes § Above line deduction to extent they're incurred in connection with income producing rental activity § Any remaining property taxes are taken as below line itemized deduction § 62(a)(4) o Include expenses for property associated with production of income under §162 or §212: expenses (utilities, repairs, condo fees, etc), depreciation§ Subject to ratio § 280A(e): taxpayer may only deduct a fraction of not-otherwise allowable expenses if fewer days to qualify as residence use but still some personal use (fraction = days rented/ (days rented + used) ) o Deduct all other misc. expenses attributable to rental of property according to ratio § Limitation § 183(b)(2) if you never profit Deductions limited to income (Rent received) Subject to ordering rules of § 183(b) Limited to income from activity § Limitation § 469 Passive Activity Losses • Rental defined as passive activity so rental losses only deductible to extent of passive activity gains o EXCEPTIONS§ May recognize up to $25k of rental losses annually • Phaseout for taxpayers with incomes > $100k: $25k reduced by 50% of amount of income that exceeds $100k § PAL rules don't apply to individuals who work more than 750 hours a year in real property or business trades • PAL losses carried forward into next year o 2)Used as residence: Annual Rentals of 14 days or fewer § Can still deduct for interest (subject to § 163(h) limits on interest deduction) and taxes § But no deduction allowed for other expenses§ Rent not included in gross income - too trivial to track § 280A(g) o 3)Used as residence: Annual Rentals of 15+ days § Rent received is income §61(a)(5) § Hobby losses (§183) do not apply. Statutory result see § 280A(f)(3) § Take otherwise allowable deductions (interest and property taxes)§ Other deductions can only be taken to offset income from rental activity § 280A(c)(5) § Leftover can be carried forward to next year §280A(c)(5) § To determine if offset, add: Otherwise allowable (interest, property taxes) taken first and allocated either (r/365) or (r/(r+p)) Allocate remaining expenses on basis of r/(r+p) to extent there is still income to offset If rent for night or two, it's de minimis and fully excludable Or if rent house to film crew for two weeks, that's fully excludable (though deductible on film production side) 1) Is this a residence? o Must stay there fewer than (max of 14 days or 10% of rental days) 2) How to characterize rental activity? o Is it trade or business? § If so, then all expenses deductible o Is it passive investment activity? § Expenses deductible under § 212 but s.t. loss rules under § 469 o Not undertaken for profit because it always loses money? 3) Are they losing money? o To extent mortgage is treated as principal, it will not be treated as an expense; to extent mortgage is treated as interest, it will be treated as an expense o Even if it looks like they're breaking even, taxpayers always say it's an activity undertaken for profit, so they can claim depreciation Rental real estate, while a § 212 deduction, is none individuals can claim in calculating AGI Always considered a passive activity, unless it's a trade or business (§ 161)

Tax Benefit Rule - IRC § 111, 1016(a)(2)(B)

Inclusionary tax benefit rule o If taxpayer receives tax benefit from deduction but amount of offsetting gain is unclear, take income in amount of prior deduction(transactional rather than strict annual accounting) § Alice Phelan Sullivan Corp.: Taxpayer made charitable contribution of property s.t. condition that property be used for specific purpose. Took charitable deduction. 20 years later charity decided not to use property and returned it to taxpayer. • Taxpayer had income in amount of earlier deduction, NOT value of property in year it was returned o Literal recovery of deduction is also not necessary § Bliss Dairy Co.: Claimed deduction for amount of cattle feed. Later corporation liquidated assets (including feed) and distributed money to shareholders • Amount of earlier deduction must be included as income to corp. Exclusionary tax benefit rule § 111 o If a deduction didn't reduce taxpayer's liability for a given year and any loss carry overs resulting from it have expired without being used, recovery of amount deducted doesn't have to be included in income. § Permits a taxpayer to exclude a recovered item in the later year to the extent that it did not reduce the taxpayer's tax liability in the earlier year (e.g. didn't itemize) o Rationale: Protects taxpayer from marginal tax rate swings where claims deduction at 0% tax rate and then has to include income at positive tax rate

Limits on Investment Interest - IRC § 163, 465

Interest on indebtedness allocable to property held for investment, not in ordinary course of trade - must elect ordinary, not LTCG treatment o Usually involves interest, dividends, annuities, royalties, etc. Income: non-capital gain income from all portfolio investments o Can only offset interest against capital gain if don't elect preferential cap gain taxation Unlimited carry forward ? §465-At Risk Rule o No deduction for losses of an investment in excess of amount taxpayer had a risk in that investment. Applies to all investments and business activities. § Amount at risk = (Cash invested) + (Debt taxpayer personally liable for) • Doesn't include non-recourse loans o Unless it's qualified nonrecourse financing per §465(b): unrelated parties AND seller - financing if at market rates o Designed to prevent mis statement of income and mismatching of items of income/expense § Both can arise from using borrowed funds to invest in property that is expected to appreciate (sheltering)

Job-Seeking Expenses - 1.162(5), RevRul 63-77

Job-seeking expenses deductible if already established in profession. Reg § 1.162(5) o Must be seeking employment in same trade or business o Not deductible if first-timer of it significant lapse in professional life o Reg.1.212-1(f) If not deductible under job seeking expense, also not deductible under§212 Limits of deductibility is subject to § 67 POLICY: Should be able to deduct all job-seeking expenses as a cost of securing income Allowances for reimbursements by prospective employers o Don't count as wages and not included in income of job seeking individuals to extent they don't exceed expenses incurred o Note th asymmetry: not income, but deducted as costs associated with recruiting by employers BUT NOTE Section 67(g) that Miscellaneous itemized deductions are now allowed from 2018-2025 o Previously had 2% threshold rule for miscellaneous itemized deductions o Now there is no way for employees that incurred unreimbursed ordinary & necessary business expenses can get deduction for their expenses

Capital Asset Definition

Must distinguish between o Assets held for "business" purposes(non-capital)and o Assets held for "investment" purposes( capital) NOTE: Businesses not treated differently on capital vs ordinary gain, but businesses want losses to be categorized as ordinary (non- capital, non-§ 1221 asset) because these losses are unlimited • §1221 o Capital asset is property held by taxpayer, whether or not for business purposes o Long list of exclusions (subject to ordinary gain/loss) § Inventory § Self-produced property Copyright, literary, musical, or artistic composition, a letter or memorandum, or similar property Worry that famous taxpayers sell diary, treat as capital assets (Nixon) § Property held primarily for sale to customers in ordinary course of a trade or business FACTORS that point to ordinary, not capital (Winthrop) o Frequent or numerous sales o Significant improvements o Brokerage activities o Advertising o Purchase/ retention of property with a goal to short - term resale o Importance of activity in relation to the taxpayer's other activities and sources of income Biefeldt: Individual stock trading, no matter how frequent or central to one's livelihood, does not count as ordinary gain/loss o Normally securities sales conducted by entities such as commercial brokerages will generate ordinary income/loss under § 1221(a) o Taxpayer can't claim he is a "trader" because frequent transactions; taxpayer is a speculator, so gains/losses are capital in nature • Now, bankers must declare at purchase if assets are "ordinary" o Too easy to change motive after the fact. Good fix! § NOTE: Once an investment, not always an investment If taxpayer changes activity from passive to active participant, can change gain/loss treatment from capital to ordinary Biedenharn Realty - taxpayer purchased real estate for investment, but started selling portions of property over time o Ct held property held as a business, os gain ordinary • Solution? o Sell property to S-corp or partnership § Then, gain on development taxed as ordinary but earlier appreciation is capital o If taxpayer is feeling risky § Don't transfer, but do just less than what will make a court say entire gain is ordinary § Some development gets capital treatment

Net Operating Loss Carryovers - IRC § 172

OLD RULE: NOL in a trade or business suffered in any year can be carried back 2 years (carry-back) and carried forward 20 years (loss carry-forward). Income averaging system. (For capital losses see § 1212) o NEW RULE:§ Eliminated carry-back, except for certain industries we feel certain sympathy for (insurance companies and farmers) § Unlimited carry forward § Can only carry forward to 80% of income Cannot take standard deduction if have net operating loss § 172(d) Must take losses against income from all sources first before looking at any deductions If you have two businesses and get income from both, and one year have income from one and loss in the other, can combine the two to offset loss from one against gains from another (generally, there are exceptions. See gambling). o But can only carry forward/ back losses incurred in the same trade/business Cannot carry back personal deductions Can't carry back nonbusiness deductions except to the extent of nonbusiness income

Earned Income Tax Credit - IRC § 32

One of biggest subsidies to low income earners Refundable (i.e. govt will give you money you never paid in) Can be seen as encouraging people in certain range of income to earn more - the more they earn, the bigger subsidy they get, until a certain point o Does this actually work in practice to incentivize people? § Probably not.

Gratuities - Reg. 1.61-2(a)(1)

Ordinary tips and gratuities are income (paid for services rendered) Restaurants: tips assumed to be 8% of sales - § 6053 (complicated presumptions) o Employer must allocate balance to workers, tell IRS if total reporting falls short. Tips of all kinds, including tokens that lucky gamblers sometimes give dealers or wheel spinners, are income to the recipients. Reg. § 1.61-2(a)(1). In the case of exceptionally large tips, however, all bets are off. When the tip is way out of proportion to the service provided - the $1000 tip for a cup of coffee when the diner patron's regular waiter or waitress has a baby - donees might be able to persuade the IRS or a court that the gratuity is best seen as a tax-free gift. The IRS requires restaurants to attribute a minimum amount of tip income to its employees, based on a restaurant's gross receipts.

Passive Activity Loss Deductions - IRC § 469(a)-(d)

Passive activity losses can only be used to offset gains from other passive activity losses No deductions for shelter/passive activity until income is realized o Destroys deferral benefit of tax shelters against ordinary income o Doesn't limit "internal sheltering"-delaying tax on passive gains Passive activity losses: From a trade/business in which taxpayer did not "materially participate" § 469(d)(1) (must be regular, continuous, and substantial; § 469(h))o Rental activity is passive-§469(e)(2) § Unless in real estate business - § 469(c)(7) • Then taxpayers can deduct up to $25k annually § Limited phase-outs - § 469(j)(6)(A)• Phased out once AGI>$100k at 50% for each above $100k • Passive losses from one investment may be used to offset other passive income o Net passive losses may be carried forward indefinitely and deducted when investment that generates loss is sold § When taxpayer ultimately disposes of entire interest in passive activity, taxpayer can deduct remaining losses carried forward from earlier years - § 469(g) o Passive losses can't be used to offset other income from non-passive investments or"portfolio income"

Patents and Copyrights - IRC § 1235, 1221

Patents special and get LTCG even if sold in less than a year (does not apply to transfer of patents by gift, inheritance, or devise) o Upon transfer of "all substantial rights" to a patent, even if no capital investment (all mental work) Taxpayer can treat amounts received upon sale of patent as capital gain, if: o Taxpayer not related to creator and not employer of creator AND o Taxpayer acquired patent from creator prior to reduction to practice IRC § 1221 o Capital assets exclude patents, inventions, models, or designs (whether patented or not), secret formulas or processes, copyrights, literary, musical or artistic compositions, letters or memos, or similar property, held by: § (a) A taxpayer whose personal efforts created such property § (b) In the case of a letter, memo, or similar property, a taxpayer for whom such property was prepared or produced § (c) A taxpayer in whose hands the basis of such property is determined, for purposes of determining gain from a sale or exchange, in whole or part by reference to the basis of such property in the hands of an (a) or (b) taxpayer § ONCE SOLD THESE BECOME CAPITAL ASSETS o At the election of the taxpayer, taxpayer can choose to not have the capital asset exclusion apply for musical compositions or copyrights in musical works sold or exchanged by taxpayer

Contract Rights

Payment to terminate lease agreement is capital gain, not ordinary income o Surrender of employment contract for compensation is ordinary income Sale of right to income from property (for a limited time - carveout interest) o Doesn't constitute sale or exchange of property o Doesn't generate capital loss/ gain o Doesn't allow taxpayer to offset basis in property against amount received Sale of right to income from personal services o Treated as ordinary income, not capital gain o EXCEPTION: Where taxpayer's business is a separate entity(s-corp or partnership) and taxpayer gets compensated for his work by selling shares in the company § Goodwill can get capital treatment if inherent to non-corp enterprise § Slightly contradicted in class of sale of part of business - may be ordinary income • Baker (2000): Ct held insurance agent did not own capital asset to sell to State Farm o Didn't receive termination payment as payment for any asset o No cap assets upon which taxpayer could attach sale of goodwill, so termination payment does not equal capital gain o To quality for sale of goodwill, taxpayer must demonstrate that he sold business or a part of it, to which goodwill attaches. Goodwill is not property on its own. o POLICY: This is strange because labor is root of value agent is being compensated for, but also at root of goodwill value when business sold

Personal and Dependency Exemptions - IRC § 151, 152

Personal exemptions are subtracted from taxpayer's AGI and may be taken in addition to itemize deduction or standard deduction § 63(b), (d) As of 2017, there is no more personal exemption - instead the standard deduction has increased!

Reasonable Compensation

Reasonable compensation paid to employees is deductible under § 162(a)(1) o Unreasonable compensation is not deductible o Test: unreasonable only if compensation arrangement involves tax avoidance o Disguised dividend (closed corp): if shareholder provides himself with exorbitant salary recharacterize salary as disguised dividend o $1M cap on executive salary compensation § Used to be deductible if performance-based (but 2017 Tax Act changed that - thank you!)

Compensation for Damage or Injury - IRC § 104-06

Rule: Damages awards for (a) lost profits, (b) damage to property (to extent it exceeds basis), (c) loss of goodwill, and (d) punitive damages are taxable in the year received § 104: Physical personal injury generally tax free o Attributable awards, settlements, insurance proceeds o Must arise from personal physical injuries/sickness (no libel, etc.) to be excludable § Doesn't have to be your physical injury (i.e. wrongful death suit) o Medical expenses: Excludable even if arise from non-physical injury, but taxable if taxpayer deducted expenses earlier, under§213 o Emotional distress: Excludable only if it is the byproduct of other physical injury or sickness § But taxable if medical expenses already deducted under § 213 § Also taxable if employer paid and deducted premiums (but see § 106 - HSA) o Punitive damages are taxable because they are a windfall, used to punish tortfeasor § Exception: Some states don't have wrongful death actions and instead allow for punitive damages, in those cases it's excludable § 104(a)(1): Workers Comp is always excluded from gross income o Forced trade being losing hand and getting income-> should these be treated differently for. tax purposes? They never chose the transaction § 104(a)(2): Excludes deferred payments and structured settlements whether paid in lump sum or periodic payments o Even if later payments include interest, it's tax free, which benefits tort victim, but because tort feasor can't deduct until paid, may be disadvantage to him o Complicated settlement structure that encourages tort victims. to structure settlements to provide periodic payments o EXCEPTION: If periodic payments are in form of an annuity that is fully turned over. to the recipient, the periodic payments are taxable just like other annuity payments§ But if the tortfeasor holds on to the annuity, payment is excluded § 105: Amounts employees received as reimbursement for medical expenses and the value of service received under an employer- provided health care plan are excludable, but health plan cannot discriminate in favor of highly paid employees § 106: value of health and accident insurance premiums paid by the employer to cover employees is excludable (largest subsidy in US system) Lost profits damages awards are taxed in year received because they would have been ordinary income Involuntary Conversion § 1033: For damaged/destroyed property, recovery is taxable to extent it exceeds basis o Ex: house bought for $600k, worth $700k, destroyed, $700k recovered, then $100k taxable. o Recognition of gains may be deferred if amounts reinvested in similar use property o Goodwill: If paid for goodwill and then lost it, taxpayer has no gain up to the adjusted basis. § Note: Purchased goodwill is depreciable over 15 years (§ 197) § Because taxpayer can't replace goodwill, no deferral possible (Raytheon, 1944) Lost wages are not taxed if in a suit for recovery, although it seems they should (see also workers comp)

Public Policy Limitations

SEE 2017 Updates - immediate expensing of most tangible personal property under Section 168(k) § 167 allows depreciation deductions for business or investment property provided property has limited useful life Depreciation determined under § 168 o Straight line Method: allocated total cost of asset ratably over each year of useful life of property § Must be used for real property o Declining Balance Method and Double Declining Balance are special recovery methods that can also be used o Applicable recovery period §168(c,e), and applicable convention§168(d) First determine: o Useful life of asset o Salvage value of asset (often assumed to be 0) o Method for allocated cost of asset less salvage value over useful life § 167 allows deduction for exhaustion, wear, and tear of property used in trade or business or for production of income o Applies to both durable and intangible property § Depreciation for intangible property is amortization Exception: Property with an unlimited useful life, like land, can't be depreciated or amortized o Costs of such property recovered only when property is sold

Ordinary and Necessary Business Expenses

Section 162 allows deduction for all ordinary and necessary expenses paid or incurred during taxable year in carrying on any trade or business - generally allowable to corporations or other forms of businesses Typically when these expenses are incurred, these expenses are deductible above the line Section 212 allows deduction for all ordinary and necessary expenses paid or incurred during the taxable year for individuals. o Individual expenses for non-businesses includable o 212 has been gutted temporarily by 2017 Tax Act Section 183 allows deduction for "hobby" expenses o If someone earns income but not in an activity under taken for profit, the costs of those activities are deductible but only to the extent of income from those activities Section 262 says personal expenses are not deductible o Often considering distinction between Section 162 and Section 262 Why Section 162? o Gross revenue doesn't matter, should only tax people on net income-that's what's fair, so that's why we allow deductions for ordinary and necessary business expenses o Section 162 offers deduction for ordinary and necessary business expenses for individual engaged in a trade or business § Note that an individual may be engaged in multiple trades or businesses All ordinary and necessary trade/business (§ 162(a)) and investment expenses (§ 212) are subtracted from gross income in order to determine net income Above the line vs. below the line o If expenses are incurred by an employer, the business expense is subtracted from gross income to determineAGI (above the line) under § 62(a)(1) o If the business expenses are incurred by an employee and not reimbursed by employer, expenses are subtracted from AGI to determine taxable income (below the line) § Disadvantage of below the line deduction: Taxpayer must itemize (lose only if take standard deduction) Unreimbursed employee business expenses s.t. § 67's two percent AGI floor • Ordinary and Necessary (§ 162) o Necessary: Appropriate and helpful to the taxpayer's business § Sufficient nexus to carrying on trade or business § Can't be voluntary expense • Ex: payment of client's debts but Cf. when another lawyer paid up when his client misbehaved and deduction was allowed because expenditures were made to retain or protect taxpayer's business o Ordinary: Common and accepted in particular business activity § Common and accepted in that line of business § Normal expenses are appropriately deducted, even if expensive § Expenditure can't be so unusual as never to have been made by other persons in same business, when confronted with similar conditions § Appropriate time and place § Hard to find something not ordinary • Ex: artist assaulting passenger because of medication while on travel is not ordinary; for a long time costs to settle sexual harassment lawsuits were considered ordinary (no longer - thanks 2017 tax act) o Carrying on tax payer's trade or business § Must be directly related to conduct of trade or business • Ex: artist assaulting passenger was not directly related

Capital Gains & Losses. Computation - IRC § 1211

Short term o Held for<1year o Gains taxed at tax payer's marginal rate Long term o Held for >1 year o Gains taxed at applicable capital rate § If taxpayer's ordinary rate would be 10-15%, then 0% capital gain § 15-35%, then 15% capital gain§ 39.6%, then 20% capital gain o NOTE: cap gains may bump taxpayer into new bracket, changing LTCG rate IRC § 1211 o Step one: Bucket short term capital gain/ loss, and long term capital gain loss o Step two: Combine these two, but remember character of net losses § Can deduct only up to $3k of capital losses per year • Excess carries forward indefinitely § The $3k loss first reduces short term capital loss carryovers• Taxpayer would rather have it reduce long term first, because short term could cancel out gain taxed at a higher rate the next year

Kiddie Tax - IRC § 1(G)

Tax treatment of kids in general: o Not lumped in with married couple tax unit; taxed as individuals on their own earned income o Special rule for unearned income to prevent income shifting by parents to take advantage of kid's lower marginal rate Unearned income § 1(g) o Coverage: § Children under XX at end of taxable year with > $1400 in unearned (i.e. interest or dividend income) o Child's unearned income is taxed at parent's top marginal rate o Parent's election to file § Parents may elect to simply file this unearned income on their own return under § 1(g)(7) if child has unearned income only and it is in an amount between $500 and $5000 (indexed for inflation post 1996) § If parent makes the election, must pay $75 to make up for second $500 that would have been taxed at 15% on child's return o As of 2019, taxed at special rate (not added to parents AGI to determine rate)- see section1(j)

Illegal Income

Taxable even if taxpayer-criminal is required to return funds to the victim o Profits from illegal racketeering under RICO-includable in gross income even though title to money vests in government o Compare CEO's unauthorized withdrawal of corp funds for merger NOT income because he did it with intention of repaying and benefitting the corp. § Special treatment for white collar criminals? Or is it important that he (a) intended to repay), (b) pledged own assets which were worth more at the time to cover debt to corporation, and (c) board acquiesced o Exceptions:§ If taxpayer repays embezzled funds within same taxable year, not taxed§ Not taxed if taxpayer intends to repay, has reasonably certainty of repayment, and makes arrangement for repayment Costs of obtaining illegal income are deductible if they meet § 162(c) o Note that §280(e) disallows deductions for amounts incurred in connection with drug trafficking (even if legal under state law). Costs of goods are deductible, business expenses are not. POLICY: Government profits at expense of victim o Makes government partner in the crime, but Congress could change law to give victim priority over recovery (not the IRS receiving priority) o Note 5th Am issue of taxing illegal income used to convict criminally (due process) - should individual be required to refile?

Social Security Payments - IRC § 86

There's a phaseout of SS benefits exclusion as taxpayer's AGI rise so Half of the SS benefits may be taxed for taxpayers till generating income o Taxpayers in the highest bracket will have 85% of benefits included in income o Rationale is incoherent § 86 includes a complicated formula o Depends on taxpayer's AGI and other income/ deductions; phases out tax-free status

Transferring Property vs. Transferring Income from Property

Transfer of Personal Service Income o Personal service income cannot be shifted excepted by the performance of gratuitous services § Ex: Lucas (Assignment to taxpayer's wife of half of taxpayer's income on personal service didn't shift income to his wife) o Assignment of deferred income § Even if income from personal services is deferred, as with premiums from insurance agent's past contracts, the income is not "property" and therefore cannot be shifted to another taxpayer by gratuitous assignment. The taxpayer (insurance agent) is entitled to that money as a result of his labor. He can't assign it away. § Ex: Eubank (assignment to family trust of commissions to be received in future for services rendered in past by taxpayer didn't shift commission income to assignees) Transfer of Income-Producing Property o 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 § Gifts of Partial Interest in Property • Horizontal Interest (Can be shifted) o An interest in property that is coterminous in time with donor's interest o Ex: a 10% undivided interest in property is a horizontal interest as it extends as far in time as donor's remaining interest in property o No carving out of taxpayer's property-property, once given away, can never revest in donor o Ex: Blair (life income beneficiary assignment of a fixed annual dollar amount for life of income is a successful assignment for tax purposes because he assigned all of his interest in the trust and retained nothing) • Vertical Interest (cannot be shifted) o A gift of property that is not coterminous in time with the interest retained by the donor but that reverts back to the donor, i.e. a "carve-out" of taxpayer's property § Ex: Horst (Father gave coupon payments to son but retained corporate bond: father's attempt to divert interest income to son is unsuccessful and interest paid to son included in father's gross income) § Ex: Schaffner (income beneficiary of trust assigned to her children specified dollar amounts of trust income, but amounts assigned were paid out of income of trust for following year. Thereafter, the trust income would again be paid to the donor). § 2019: Can give child income producing asset they have ownership of • Start with $100k unearned income; subtract two numbers 1 is the standard deduction for those claimed as dependents $63(c)(5)(a) = $1100 (code is wrong, it's adjusted for inflation, in 2019 it's $1100); second is greater of the same or the itemized deduction, here it's $1100 bc no itemized deduction. So deduct $2200 from $100k = $97.8k is net unearned income. Add tax on net unearned income ($97.8k) on trust rate (which comes to $34,544 - that's how much her tax is on this) but there's also the $2200 that was used to calculate net unearned income and tax on $2200 and can now take the standardized deduction of $110 on $2200, so her taxable portion is $1100, which is taxed at 10%. So she owes a total of $34,654.

Tenant Improvements - IRC § 61, 109, 1019

Under § 61(a)(5), rents are taxable income o As a lessor, when lessee pays rent, that's income to lessor § Lessor can claim deductions for property taxes and depreciated property, effectively recovering their cost over time. Can also reduce basis for any improvements. § 109 excludes from a lessor's income the value of improvements realized on the termination of a lease, provided that the improvements were not a form of rent o Were improvements part of negotiation?If so, then rent, and §109 doesn't apply o Ex: as part of lease, Paradise agrees to build night club that cost $600k and had expected useful life of 30 years. When lease ends after 15 years and Palm takes over, Palm has $600k basis in club depreciable over 15 years § 1019 denies the lessor a basis for the property, i.e. lessor takes over but with basis of $0 o Ex: If palm takes over night club that cost $600k and expected useful life of 30 years: § Not taxable income to Palm immediately. Palm takes over club with basis of $0 can't take any depreciation in future § Paradise would have depreciated some of the cost over the course of 15 year lease, and then written off the rest upon termination These provisions only apply to buildings or permanent fixtures o If furniture /equipment is taken over, Bruun prevails § Lessor counts the value of those physical assets as income (in the amount of lessee's basis upon termination) upon termination and can then depreciate according to "estimated useful life" over a number of years• If furniture has fully depreciated by time lessor takes over, depreciation schedule starts again when lessor take over -> no such thing as using it up twice o §109 overrules Bruun (taxpayer/lessor realized gain from lessee-installed improvements upon termination of lease and must include as income for the year. Improvements effectively constituted "rent")

Welfare Payments - IRC § 61, 85

Welfare payments are not includable o Consider outside the scope of §61"income" definition o Likely taxpayer would not qualify for a bracket high enough to pay tax anyway o TANF Program requires work for benefits § These benefits are more likely to be income under § 61 § IRS guidance says most payments excludable if from welfare agency Disaster relief and compensation to crime victims are not taxable (again, outside scope of § 61) Unemployment insurance, however, is FULLY TAXABLE under § 85. o Seen as the equivalent of wages.

§125 Cafeteria Plans

o Ex: Health Savings Accounts, Dependent Care Accounts o Employee chooses among variety of non-cash, non taxable fringe benefits or takes taxable cash § Good for employers: give cash and/or dependent care to those who want one or the other § Good for employees: if just a benefit, some of the employees wouldn't use the benefit § Avoids constructive receipt issue; taxpayer just gets the non-cash benefit o Offerings limited to: § $50k of group-term life insurance § 79 § Dependent care assistance (up to $5k) § 129 § Adoption assistance § 137 § Medical insurance and payments § 105(b), 106 § Excludable accident/health benefits, and § 401(k) contributions o Two Principles/Requirements:(1)Nondiscrimination for highly compensated executives (defined in §125(e)), and (2) Use it or lose it - if you don't use all of the $5k childcare allowance, you can't cash out the rest at the end of the year o Health insurance: Most important fringe benefit. Costs treasury 1/5 of income tax revenue. § Employer can write off and employee need not report in gross income. § 106(a) § Self-employed: similar benefit as write-off. § 162(1). § (1) Reimbursed Medical Expenses and Value of services under employer-provided health care plan excluded (§ 105) (a) Non-discrimination requirement (b) Compare to § 213 - deduction for unreimbursed medical expenses o Subject to 7.5% AGI floor§ (2) Value of health, accident insurance premiums paid by employer excluded o Life insurance §79 § (1) Group term life insurance paid by employer is excluded (§ 79) (a) To the extent that death benefits not greater than $50k (b) Non-discrimination requirement § (2) BUT if employer buys life insurance for employee -> value of life insurance is income to employee (Reg. § 1.61-2(d)(2)(ii)(a) o Dependent Care Assistance Programs(§129) § (a) If employer pays for dependent care that would make employee eligible for a tax credit under § 21 then such payments are excluded from gross income § (b) Employee may take no other deduction or credit (§ 129(e)(7) • (1) if take exclusion under § 129, then can't claim § 21 credit § (c) Exclusion capped at $5000. § 129(a)(2)(A) § (d) Earned income limitation - cannot exceed either spouse's earned income, whichever is less • (1) Special rule for students/disabled spouses - see § 21(d)(2)o (a) If spouse is full time student or "qualifying individual" § (i) $200/month for 1 child or ment/phys incapable spouse ($400 for more than 1) deemed earned income

§119 Requirements to be excludable

o Must be on business premises § Lodging: Employee required to accept lodging as condition of job § Must be for employer's convenience • Meals: Waiters eating meals both before and after time of work are ok § Must actually be furnished by employer, cannot be cash • Kowalski: highway patrol meal allowance to spend anywhere not excludable o Step 1:Constraint/requirement § Was taxpayer required to live/eat there? What were alternatives? § Look at extent of benefit • Gross cost v. cost of living elsewhere § Employment contract not determinative (or else, incentive to collude) Step 2: Valuation § General rule: FMV of in-kind benefit§ Turner case is rare: Court tried to value steamship tickets as subjective value to taxpayer. General rule is FMV of an in-kind benefit • Odd cases/exceptions: o §119(b)(4):>50% of employees qualify?Then everyone OK to get it for free too and not have to include it(casinos) o §119(d):lodging for instructors at education institutions is NOT income o §132(e)(2):special rule for employer-provided eating facilities-deduction for facility costs; employees pay only variable cost of foods o Farms: form matters, no deduction for house/meals unless incorporated as business

Miscellaneous Itemized Deductions

o Now there is no way for employees that incurred unreimbursed ordinary & necessary business expenses can get Note that these deductions are available below the line and only available to extent that aggregate exceeds 2% of taxpayer's AGI The following are NOT misc deductions: • Section 67(g) that Miscellaneous itemized deductions are now allowed from 2018-2025 o Previously had 2% threshold rule for miscellaneous itemized deductions deduction for their expenses o §163 interest, §164 taxes, §165 casualty/ theft losses, §170 and §642(c) charitable contributions, §213 medical expenses, impairment-related work expenses, § 691 estate tax, short sale of personal property, § 1341 restoration of amount held under claim of right, § 72 annuity termination, § 171 bond premium amortization, and § 216 cooperative housing arrangements

Bequests and Inheritances - IRC § 1014-15

§ 1014 - Gifts at death o Inheritance: When someone dies intestate o Bequest: Receive property from a will § Basis = FMV at time of decedent's death§ Stepped up or stepped down basis: Huge tax break for rich But if property would be a loss, taxpayer will sell before death Taxpayer can borrow against gain while alive (no tax!) o A gift passed back to its donor returns to original basis. §1014(e) § Taxpayer can't give property to dying uncle, with bequest back (1 year rule) § Otherwise, taxpayers would do this repeatedly and never pay tax on the gain o Consider also, community property states, favorable for taxpayers § Basis for joint property rests at one spouse's death o Compensation deferred?Line gets fuzzy if promise to bequest for services § 1015 - Inter vivos gifts o Basis carries over § Donee takes over at donor's basis. Taft v. Bowers (1929) o GAIN: If FMV of property at sale is greater than donor's basis § Donee takes the donor's basis (gain deferred until donee sells property) § Donor can reduce tax (non-capital assets) by shifting to lower-rate donee o LOSS: If FMV of property at sale is less than donor's basis: § For donee's gain upon donee's sale, donee takes donor's basis § For donee's loss upon donee's sale, donee takes basis of FMV at time of transfer § Idea: Donor can't shift a tax shield in this way. Mistake for donor to transfer property that has lost valueInstead, should sell then transfer proceeds to donee o Note §267: Taxpayer can't realize loss on sale of asset to a related taxpayer o Ex: Buy stock for $10k, at time of gift, value is$5k § Donee sells for $12k • Recognized gain of $2k § Donee sells for $4k • Recognized loss of $1k § Donee sells for $8k Neither loss/gain Forces donor to take the loss prior to gift; can't gift a tax shelter

Medical Expenses

§ 106 Health insurance premiums paid by employer o NOT includable in taxpayer's gross income o Single largest tax expenditure § 213 allows for itemized deduction for large unreimbursed medical/dental expenses for taxpayer, spouse, or dependent (large means > 10% of AGI, 7.5% for those over 65) o Includes costs of transport to medical treatment (primarily for and necessary to medical. care) o Lodging can't be lavish or extravagant o Includes annual costs of insurance premiums o Doesn't include general health-benefiting activities o Doesn't include elective cosmetic surgery §213(a) + AMT limits deduction to amount > 10% of AGI (statute alone is 7.5%) o Encourages employees to take portion of salary as in-kind medical benefits. Better to have employer-provided healthcare o Distinguish between recurring expenses that taxpayer can plan for and extraordinary, casualty-like outlays Medical care definition: o Expenditure for "cure, mitigation, treatment, or prevention of disease, or for purpose of affecting any structure or function of the body" - § 213(d)(1)(A) § Cost of boarding school while parent sick is not deductible • Family living expenses inevitably increase when parent is ill, but not covered in this section § Cost of mowing lawn when have allergies and dr recommended the expense is not deductible Home improvements for medical care (e.g. elevators, swimming pools) are deductible only to the extent they don't increase value of home Nursing care only deductible if unsafe to be left alone, but IRS doesn't really enforce this (lets families decide) o Consider if it's better for taxpayer to take Dependent Care Credit(§21) instead (credits often better than deductions depending on marginal rate) § 223(c)(2) allows deduction for contribution to HAS, which must have $1k+ deductible. o Purpose is to discourage wasteful spending o In reality, it covers §213's broad range of "medical cost" so may encourage excess spending. It's also away for the rich to save while avoiding tax.

§132 Cafeteria Plans

§ 132(a) Excludes from gross income any fringe benefit which qualifies as a: o No additional-cost service§132(b) § Service offered to employee must be offered to customers in ordinary course of line of business of company; no additional cost or foregone revenue • Ex: Free seating to airline employees on flights that would not otherwise have sold out. 1.1.32-2(c). Reciprocal agreements with other airlines allowed. 132(i) • Must work in line of business as the perk (think conglomerates) • Cannot apply only to the executives or highly compensated employees. 132(j) o Qualified employee discount of taxpayer's employer's services§132(c) § Property: Discount can't exceed company's profit margin at normal offer price § Services: Discount can't exceed 20% of price to customers § Must work in the line of business as the perk (think conglomerate) § Can't apply onto to executives or highly compensated employees. 132(j) o Working condition fringe§132(d) § Defined as a service the cost of which would be deductible by taxpayer as a business expense if paid directly by her. Under 162 ("ordinary and necessary" business expenses) or 167 (depreciable) § Ex: company car use for work, subscription to magazine relating to job o De minimis fringe§132(e) § Benefit of such low value to make accounting unreasonable/impracticable § 132(e)(1) § Eating facility counts if it's on premises of employer, and revenue >= costs of facility § 132(e)(2) § What counts: occasional parties or tickets, coffee, donuts, phone calls § What doesn't count: ANY cash benefit, season tickets, country club, gym, etc. o Qualified transportation fringe§132(f) § Employer provided parking or mass transit (doesn't have to be employer owned) § Okay if employee pays and is reimbursed • BUT if employee pays for parking can't exclude or deduct from income • If employee chooses between cash and free parking, if chooses cash it's taxable, but parking is not § 132(f)(4) o Qualified moving expense reimbursement§132(g) correlates with§217 o Qualified retirement planning services§132(m)o Qualified military base realignment and closure fringe o On-premises gyms and athletic facilities(under§132(j)(4)"special rules") • All other benefits are included in gross income, unless otherwise excluded o Ex:Flight attendant and spouse fly to Europe on standby § § 132(a)(1) no additional cost service§ § 132(h)(2) use by spouse or child can be treated as use by employee§ § 132(h)(3) special rule for parents in the case of air transport shall be treated as use by employee o Ex: SVP buys dish washer with discount§ § 132(a)(2) qualified employee discount - discount can't exceed employer's gross profit percentage • Excessive discount is included in income o Ex: Gym membership § Distinguish between on-site gym (excludable) and offsite (includable) § If a reimbursement is given for off-site that's taxed o Ex: Works from 5-midnight and takes taxi ride home every night § § 132(?)(4) - partial exclusion of transportation benefits in unusual circumstances where unsafe for employee to use other means • This is not unusual circumstances because it's every night§ § 132(b)(2)(d)(2)? - Three conditions required to make it excludable 1.132-6(d) o Ex: Frequent flier miles§ Accumulated through business travel but used for personal trip. IRS gave up trying to monitor/enforce. But conceptually, should be income because it's a benefit given by a business

Cash Accounting Methods and Accrual Accounting Methods - IRC § 441, 446, 448(a), 451, 455, 461

§ 441: Taxable year = taxpayer's annual accounting period; calendar year; or election of fiscal year per § 441(f) § 446(a): Tax due based on income, using method taxpayer uses to keep his books Cash method: o Simple: have income when you receive money or money equivalent o When you receive benefit in connection with some profit seeking activity, you have income o Used by individuals and small businesses, not Corps or partnerships or tax shelters(§448(a)) o Prepaid expenses must be capitalized if benefit will last beyond that tax year o Ex: Awarded bonus in Dec2016, but receives it in 2017. That's 2017 income. o Exceptions: § OID Rules, constructive receipt, deferred compensation, and capitalization/depreciation requirements Accrual method: o Qualify for deduction when you perform actions that give rise to expense, even if you haven't yet paid it o Have income when earned, even if haven't been paid yet o Used by almost all businesses, partnerships with income>$5M § Income = "fixed and determinable" If obligation is disputed, no inclusion in income (Burnet) If amount is disputed, but a reasonable estimate can be made, include when accrued (Continental Tie & Lumber) § Expenses follow all-events test (§ 461) • When all events have occurred that 1) established a taxpayer's liability and 2) the amount of that liability with sufficient definiteness, that taxpayer can claim a deduction with respect to that event o Ex: Awarded bonus in Dec 2016, but doesn't receive it until 2017. That's 2016 income. Delayed payment: o Not for disputed payments. (Georgia School-Book Depository,1943) § It is the right to receive money which in accrual accounting justifies the accrual of money receivable and its return as accrued income § Here, all events test had been met. Solvency of debtor is important factor and since there was no "reasonable expectancy" that claim would not be paid, income had to be taxed o Delay in the receipt of cash in the absence of doubt about ultimate payment is not enough to prevent accrual of income Prepaid income - § 455, 456 o In what year does accrual method taxpayer include advance receipts as income? o Income received, but partially unearned o §456: Membership orgs can include prepaid dues ratably as services performed, but taxpayer must elect it§456(c) § Logic is this truly matches income to cost of producing it • If AAA reports pre-paid fees in Y1, without considering cost in Y2, it will overstate its income in Y1 o §455 similarly allows accrual method for prepaid subscription income § But again the taxpayer must elect it under § 455(c) • Prepaid expenses / current deduction of future expenses § 461o Is the item fully deductible in Y0 under §162?Or is it a capital expenditure that must be depreciated over its useful life under §263? o §461(g):PrepaidInterestLoans § Don't get deduction up front, get deduction year by year as interest would have accrued (for cash method taxpayers) • Exception: points on mortgages, only to extent points used with sufficient frequency in certain locality § Lender gets the interest up front, but payer can't deduct it up front. Lender (whether accrual or cash) has to take amount into income up front (mismatch between lender and payer side). Not good public policy and doesn't make economic sense. § Likewise, in cases of prepaid rent, landlord (even if on accrual method) has to take full amount of cash payment into income immediately. Unable to benefit from accrual method, whereas the payor (tenant, if for business) can only claim rent deduction over time as property is used - again a mismatch § This is accelerated income recognition but deductions as they accrue • Benefits US Treasury o §461(h)(2)prevents accrual taxpayers from taking advantage of all-events test § Introduces "economic performance" Occurs as the property or services to which an obligation relates are provided Can't actually deduct the amount up front Can only take the deduction as you make payments o §461(h)(3)contains a"recurring item exception" § No economic performance requirement if item is otherwise deductible § Item is recurring in nature and taxpayer consistently reports the item § All events test is otherwise met § Economic performance occurs by earlier date of filing return for that year, or 8.5 months after year-end when deduction taken § Either Item not material, OR Accruing the item under the all-events test provides better matching of income and expense than economic performance standard • Deposits vs. advance payments o IRS denies deductions for cash reserves set aside for estimated future expenses, even where pretty close to accurate o GeneralDynamics(1987) § GD couldn't deduct estimated reimbursements for employee's health care claims from Y0 (December health care expenses that employees submit reimbursements for in January) § Estimates are never good enough for expenses, but more lax standard for estimating income o IndianapolisPower(1990) § Required advance payments of utility bills that were not currently taxable to utility, since they were security deposits from people with suspect credit histories. Customers could demand repayment if they establish good credit, and interest was earned on deposits; seen as loan. § Similar to landlords collecting security deposits; but not so if characterized as last months' rent o WestPacFoods(2006) § Advance cash discount not income, because inventory not yet sold § Treated as liability/loan, subject to repayment, not income§ Complete dominion over payments, but accession to wealth o If taxpayer has potential to cancel and get refund, court more likely to find that it is a loan/deposit, not an advance payment.

Gross Income §61

• "Gross income means all income from whatever source derived" • Includes cash or cash-receipt equivalents but not unrealized gains o Including (but not limited to)the following items:(1) Compensation for services, including fees, commissions, fringe benefits, and similar items; (2) Gross income derived from business; (3) Gains derived from dealings in property; (4) Interest; (5) Rents; (6) Royalties; (7) Dividends; (8) Alimony and separate maintenance payments; (9) Annuities; (10) Income from life insurance and endowment contracts; (11) Pensions; (12) Income from discharge of indebtedness, etc. § Accession to wealth standard (Glenshaw Glass, 1955) § Overruling loose "From capital or labor" definition from Macomber (1920) • Fails to account for windfalls and difficult to apply in absolute fashion § Congress draws boundary lines on income, not Court (Glenshaw Glass) § (1) Undeniable accessions to wealth; (2) Clearly realized; (3) Over which the taxpayers have complete dominion; (4) Regardless of source o Also include misc.items (i.e.punitive damages, illegal gain, treasure trove) Reg.1.61-14 o Some push for broader definition of income (base-broadening)-unlikely § Haig-Simons: Sum of taxpayer's personal expenditures and gains in wealth

Annuities - IRC § 72

• A contract with an insurance company under which the annuitant makes a current payment in return for the promise of a larger payment (stream or one-time) in future o Interest is tax-deferred o Don't buy as a substitute for life insurance, but buy as a substitute for a pension • §72 o Must calculate exclusion ratio-§72(b)§ What you put in over what you expect to get out over life of investment Put in $10, expect to get $100 back Exclusion ratio = 1/10 o 1/10 return of investment, 9/10 income Unrealistic because not straight line ratio (think mortgages); taxpayer wins § Deferred annuity Taxpayer not taxed on increase in principal investment until payouts $100k at 50 y.o., payments start at 62 y.o. only $100k still used But if loan against this, then income at that time - § 72(e) o Exclusion is limited to investment-§72(b)(2) o 10%penalty § If taxpayer takes out before 59.5 y.o. (loan or distribution) - § 72(q) § Also if only a few payments structure - more like bond than annuity o Mortality gains/losses-§72(b) § If taxpayer dies too early, taxpayer's estate can deduct unrecovered investment § If taxpayer dies too late (survives past actuarial table, once basis exhausted), then taxpayer can't continue writing off exclusion ratio portion (might cause tax spike) o POLICY: For political reasons, issuer of annuity ignores differences between men and women and these tables haven't been updated in over 30 years, which is GOOD because once you fully recover amount paid in it's all includable anyway and you recover your investment sooner than you actuarily should have because the life expectancy is too short, so you get recovery faster

Capital Recovery

• A tax deferred is a tax reduced in real terms. Taxpayers want to defer tax payment. • Ex: Taxpayer bought piece of land on river for use as a private fishing club, later city diverted water that made it useless for fishing. Settled with city for $50k. IRS said this was income. o Paid $61k for land, received $49k as settlement. Court says it's capital recovery and not income. • Partial sale of property general rule: Taxpayer must allocate basis to the property sold, based on the relative value of the sold and unsold portions of the property at the time of purchase. • Rare circumstances where taxpayers allowed to ignore allocation rule and treat entire proceeds of a partial sale as tax-free recovery of capital, reducing cost basis equally. In rare circumstances, taxpayers are allowed to ignore allocation rule and treat (a) when allocation would be difficult/impracticable/impossible; (b) when sale or part of transaction was involuntary, and (c) where amount received was less than cost basis. • A pollution payment can be seen as either (a) rental payments for perpetual license to pollute (amount = ordinary income, pre-payment of rental income) or (b) purchase price for estate in land - a perpetual easement to pollute (treated as having sold portion, cap gain to extent proceeds exceed the allocable share)

Nonrecourse Loans and Property Transactions - IRC § 1001(a)-(c)

• Acquisition indebtedness (recourse or non-recourse) adds to your basis in property for the purpose of claiming deductions o If claiming non-commercial RE with nonrecourse loans, then not at risk so doesn't add to basis for purpose of claiming deductions 1) Say you purchase an apartment building, to use as an apartment building, for 200k. You paid 50k in cash, and the other 150k with a nonrecourse loan. This counts as commercial real estate, So if you're taking depreciation deductions, you'd be depreciating from a basis of 200k 2) Alternatively, say you purchase a piece of equipment for 200k, to rent out. You paid 50k in cash, and the other 150k with a nonrecourse loan. This is not commercial real estate, so your deductions and losses are limited to the amount "at risk," which in this case is only 50k.In which case, if you're taking depreciation deductions, you'd be depreciating from a basis of only 50k. As you make payments of principal, your adjusted basis increases and therefore your capacity to claim depreciation deductions. If, however, if the 150k loan was a recourse loan, you'd be depreciating from a basis of 200k. • § 1001(a): gain or loss = difference of amount realized and adjusted basis § 1001(b): amount realized = cash + FMV of other property received § 1001(c): gain or loss recognized when property is sold or exchanged Recourse: Lender has recourse to assets beyond items purchased with borrowed money Non-recourse: Debt for which asset purchased when the borrowed funds acts as the only security for the lender; no personal liability (common in commercial RE) o Taxpayer's basis includes. debt, but only for acquisition, not later HELOC Crane (1947) o Amount realized= cash received+face value of assumed mortgage § Basis = full purchase price § Debt relief in connection with encumbered property is included in taxpayer's amount for computing gain/loss in property transaction § Non-recourse debt treated same as recourse debt, though taxpayer not on hook o Unsettled: If FMV at time of sale <outstanding debt § Tufts (1983) held didn't change Crane rule Same even if encumbered property is worth less than the amount of debt at the time the taxpayer disposes of property Court opted for tax symmetry § But some courts: Exclude non-recourse debt, OR Exclude to extent principal exceeds FMV at time of transfer Symmetry o Non-recourse loan is "real" because taxpayer takes depreciation against it § So debt relief should also be included in amount realized upon sale o Good for taxpayers because it allows deferral of taxes § Trade current depreciation deductions on encumbered property for deferred gain on later disposition Borrowing against equity appreciation o Doesn't change basis in asset and doesn't trigger recognition of gain § Whether borrow recourse or non-recourse, doesn't make difference o With non-recourse, strong argument should be gain § If buy for $300 and now worth $1k and borrow $500 against the property on non-recourse, you're now ahead by at least $200. • If property falls below $500, don't pay loan and walk away and come out ahead § If you borrow non-recourse and amount you borrow exceeds adjusted basis, you should have gain, but THIS ISN'T THE RULE. • § 465 At Risk Limitation so Deductions for loss from business activities are limited to amount of taxpayer's at risk investment. Losses disallowed can be carried forward to next year § At risk amount includes cash contributed by taxpayer to activity and debt for which taxpayer is personally liable. Not non- recourse debt.• Amount-at-risk is increased by income included and not withdrawn from the activity § Closes tax shelters (but not very well) • Prevents buying a paper clip for $1B without concern about loss since liability is limited to losing the clip. And seller of clip only risks opportunity to collect on a bogus sale price. oDoesn't apply to corporations which are non-publicly-held o Exception § § 465(b)(6) - big carve out for commercial real estate (obviously) § Nonrecourse borrowing to finance commercial real estate is not subject to at-risk rules, when bona fide third-party bank loan (not seller financing)• Since this was primary basis for such loans before the statute, it didn't do much to affect tax shelters § 469 also serves to bucket "passive-activity" losses § 1245 and 1250 - recaptured gain

State and Local Taxes

• As of 2017 Tax Act, SALT only deductible up to $10k/taxpayer. This acts as another marriage penalty, since if you're married and file jointly, can only deduct $10k

Fringe Benefits - IRC § 132, 125 (Cafeteria Plans)

• Background: § 132 was codification of a cease-fire. Employers had already invested in these benefits, but from a policy standpoint, none of these should be excludable. • Win-win: employee is not taxed and employer can deduct cost • If fall within certain categories, benefit excludable by employees • Spouses and children allowed to be considered an "employee" for § 132(a)(1) and (2) (under § 132(h)) • POLICY: Problem with taxing fringe benefits o Subjective valuation problem o Enforcement: problems are enforcement are associated with fact that individual items are often small and information is easy to falsify o Political acceptance: tax becomes politically unacceptable if practice has come to be accepted

Bad Debt Deduction - IRC § 166

• Bad debts, which arise from taxpayer's trade or business, differ from nonbusiness bad debts in that they can be deducted to extent of worthlessness at any time when they become partly or totally worthless and they can generally be deducted from gross income o Business debt §166(d)(2)-a debt created or acquired in connection with the trade or business of the taxpayer who is claiming the deduction, or the worthlessness of which has been incurred in the taxpayer's trade or business. CAN ONLY DEDUCT TO ADJUSTED BASIS OF DEBT § Business debt deductible when becomes wholly or partially worthless • Non-business debt deduction only allowed when debt becomes wholly worthless o Cash method taxpayer can deduct bad debts only if an actual cash loss has been sustained or if amount deducted was included in income o Limited size of deduction up to$3k/year. o Limitations: Must itemize; subject to §67 (2% AGI floor); taxpayer must show truly a debt and not a gift

Income Shifting

• Can shift labor income to children INDIRECTLY o Not always possible o First way is to have parent do work directly for child and not charge labor (in-kind benefits), yielding higher income for child § Permitted in code because no way administratively to get at it o Alternatively, can form a partnership § Parent can gift child money or capital through s corp with child or through money or capital that is transferred as material income producing asset of a partnership or s corp, that income generated by partnership or s corp will flow to child and be child's income provided that the parent performing services for the partnership or s corp is paid reasonable compensation • Not as much income shifting as when child has own business and employs parent at 0 wage o Parents can transfer labor inform of gift of copy right or patent ( not directly compensated, but given a property right), children can derive income from that property right§ Most of this income will now get picked up in kiddie tax • Applies to unearned income of dependent children o Also, can transfer income by employing children if they have family owned business and can pay them more than they're worth • Family Partnerships - IRC § 704o Partnerships have pass- through taxation § Partnership isn't taxed as separate entity. Income/losses are allocated to partners, who are taxed as individuals• Losses and credits of firm are similarly allocated among partners and deduced by them on their individual returns § A family partnership can shift income rather easily o §704(e) Income from transfer of partnership interest to a family member will be taxed to a family member only if: § Capital (property) is a material income producing factor in partnership (Safe Harbor Rule) E.g. transfer of interest in a partnership that owns property OR Recipient of interest must perform significant services for partnership

Commuting Expenses - IRC § 162(a)(2)

• Commuting costs are nondeductible personal expenditures o Result from taxpayer's choice of where to live o Exceptions § Travel expenses deductible if taxpayer away overnight and travel expenses are reasonable and necessary, incurred while away from home, and incurred in pursuit of a trade or business Taxpayer with no "business home" can't be "away from home" Can't be as a result of personal choice of where to live Must establish business connection with location referred to as "home" and the business connection with place temporarily working o Duplication § Courts will look to see if there's duplication, i.e. taxpayer paying twice for living expenses • Absent duplication, difficult to deduct - hard to justify as a business expense when everyone must pay for living expenses at least once Temp vs. indefinite jobs o Temporary jobs are deductible but jobs but indefinite duration are not o Limits temporary jobs to those lasting a year or loss Two places of employment or business o May deduct living expenses while at the more minor business place

Loss Recovery

• Consider also § 165 (unreimbursed losses, generally) • Clark v. Comm'r (1939): Counsel reimburses for mistake on previous return o No way to carry that loss of tax over payment forward or deduct it. Not taxable. o "In paying obligation, he sustained a loss which was caused by the negligence of his tax counsel. The money was paid to petitioner as compensation to petitioner for his loss" • IRS adopted Clark where taxpayer paid too much as the actual facts turned out, but does not apply if: o Tax payer under reports, then must makeup difference later o And if the mistake is not reimbursed, taxpayer cannot take a deduction for loss o Not to reimbursement by tax advisor for structuring your taxes in a non-optimal way. May turn on whether the wronged party would have succeeded in a malpractice action against the advisor

Nonqualified Deferred Compensation

• Conventional, unfunded, deferred compensation contracts ("mere promises to pay") o Given intended effect for tax purposes § Employer deduction and employee tax when payment made § No nondiscrimination provisions or contribution limits § Constructive receipt applies

Charitable Contributions

• Deductions on donations to charitable organizations subject to 60% of AGI on cash contributions to (A) charities. Different caps for A/B charities and cash or LTCG. o (A) charity refers to §170(b)(1)(A) charities that generally provide some type of public benefit service, like universities, hospitals, or religious organizations o (B) charity refers to §170(b)(1)(B) charities that are generally private foundations-don't do any good in themselves but the good they do is to give money to other charities that do good work If you are unable to deduct full amount of contribution because of cap, can roll remaining amount forward for 5 years Deductions of art and donated items that are not caps are subject to a lot of restrictions on appraisals and documenting to get deduction (obviously not a true science) Charitable contributions subject to the restriction that they CANNOT BE QUID PRO QUOS o IRS Rev Rul: If a donation is required to obtain any benefit, then that's the price of the quid pro quo, therefore no portion of that contribution is deductible o BUT required minimum donations are donations that are deductible o The value of putting your names on things like building is $0, so you can deduct all of that too • Religious orgs count as charities o Some strange opinion from Walz: tax break is not same as govt writing check for religious org so it doesn't violate Establishment Clause § Does seem fishy that can get tax break for donating to religious org (would be public money that's getting diverted to religion at acquiescence of govt)

Gambling - IRC §165(d)

• Gambling winnings are taxed • Gambling losses are not deductible unless it's in the same year and you itemize and give up standard deduction. Can claim losses but only to the extent of winnings (gamblers taxed on net gambling income). If have net gambling loss, can't claim it as a loss and can't carry it forward (See 165(d)) o "Basketing": net gambling winnings taxed, but net gambling losses are non-deductible o Other basketed deductions: hobby losses §183, capital losses §1211, personal casualty losses §165(h), passive losses§469, investment interest § 163(d) • POLICY: gambling losses are conceptualized as consumption (price paid for enjoyment of gambling) o Hard to differentiate between investment in stocks or high yield securities that are high risk. In Jasinski, court rejected that investing in high risk junk bonds is gambling, and loss cannot be deducted against interest bonds yielded • Note that expenses incurred in wagering, such as transportation, do not constitute losses deductible against gambling gains o Whitten: contestant on Wheel of Fortune couldn't deduct his travel expenses from his wagering gains

Individual Retirement Accounts (IRAs) IRC § 408, 219

• IRA o Deduct now; tax total later. Deduction unavailable to those covered by qualified retirement plan, and who have gross income over certain amount. Contribution amount is deductible, but only $5.5/yr. Above the line, and available even if take standard deduction. o Amount contributed is deductible from current income-just like under-qualified plan § 219 (old fashioned) § 408(a) Roth IRA (income limit higher - available to more people) (contributions taxable but not the payout) (no deductions for money set aside but grows tax free and no future income) o Can contribute $5.5k/yr (but after tax dollars so effectively higher limit than IRA) o Roth IRA and regular IRA are equivalent mathematically o Grant taxpayer immediate deduction for costs of contributions is equivalent to exempting investment return to tax when full cost of contributions were not deducted, ASSUMING constant marginal tax rate § 408(o) plan: No deduction at contribution (Tax now) and interest taxed at withdrawal. But tax-free compounding! § 529 Plan: Similar to Roth IRAs for higher education - no deduction, no tax later after growth. Must be run by a state and must put in money as a gift § 530 Plan (Coverdell): Individual savings account; no deduction, but also not taxed at withdrawal if used for education, including primary and secondary education

Expenses of Earning Income

• If person incurs expenses, when can they incur deduction for those expenses? o From policy perspective, all about timing. Tax payers want deductions ASAP o When expenses incurred, three possibilities: § 1) Immediate deduction: Cost might be incurred over relevant accounting period. Cost would be immediately deductible to offset income during that period. Almost always what taxpayer wants. § 2) Capitalization and cost recovery: If expenditure yields benefit that extends beyond current year, expenditure must be capitalized. Taxpayer acquires basis in expenditure sand is able to claim deductions against that basis. § 3) Inventory accounting: The expenditure is part of cost of producing good which is then sold by business. All costs of producing goods need to be rolled into each widget sold in order to figure out total profit o Need to determine which of three buckets expense falls into to determine when a deduction occurs

Section 1245 Recapture

• If taxpayer sells depreciated property at a gain (FMV > adj basis) then recapture excess depreciation up to original basis as ordinary income; remainder is capital gain o Idea is you were not entitled to those depreciation expenses since property didn't depreciate by as much as you claim, so bring it back into ordinary income.

Timing of Income

• In general, taxpayers want to defer income because of the time value of money. If you can hold onto money now and pay taxes later, you can invest in the meantime and make more money. o But maybe want to pay tax now if think rates will rise o People generally like to defer until retirement, if possible, since usually in lower bracket then

State & Local Bond Interest - IRC § 103, 265(a)(2)

• Interest on state/local bonds is not included in gross income § 103 (except when AMT applies) o Thus, bond. holders pay "putative interest" (accept lower rate)(federal subsidy) o POLICY: Vertical equity-only makes sense for highest-bracket taxpayers to take this benefit because they benefit most from tax exclusion • Bond factors o Interest rates-if rates go up, value of bonds fall; if rates go down, bond srise o Credit worthiness of issuer-affects interest rate o Duration-the longer the duration, the higher the interest o Repayment schedule-not all bonds pay equal installments o Security-secured vs. unsecured o Indenture restrictions-more security • §103 o Tax payers may exclude interest they receive on certain state, municipal, or other bonds § Although it is constitutionally acceptable for fed govt to tax state bonds, it chooses not to § These bonds pay lower interest than taxable bonds, but people invest of them for tax status § Issuing states must report to fed govt to get exempt status § 149(a) o Private equity bond-§103(b)(1) § If state re-lends money to private businesses, interest is not exempt E.g. industrial revenue bonds used to attract business Some borderline exceptions, like airports, docks, etc. • Tax Arbitrage Provision - § 265(a)(2) o Prohibits taxpayers from deducting cost of borrowing money which is then used to purchase tax-exempt obligations o Otherwise it would be attractive to keep borrowing at inefficient levels o POLICY: But§265(a)(2)is complicated because it is difficult to trace money § "Temporal proximity" text used by IRS (not a stacking rule)

Unrecaptured 1250 Gain

• More preferable; for commercial real estate; taxed at "special" cap gains rate (not normal cap gains rate) and the amount taxed is the difference between price sold for and the adjusted basis

Claim of Right - § 1341

• Must recognize income as soon as taxpayer has claim of right to property or income and can freely dispose of that right o Tax law follows the money o It is immediately taxable even if have to return the money o Subject to interpretation: Courts must determine when a party has an unrestricted right to the money. • Ex: o Amounts received by mistake are taxable when received even though they may have to be repaid(Lewis) o Money received because of a favorable trial court judgment is income when received, despite the possibility that it will have to be returned should an appeal be successful (Burnet) o Embezzled money is immediately income to the embezzler, even though he is under duty to repay • Through § 1341, Congress mitigates problem of overtaxation if property is later forfeited o Taxpayer has choice of tax brackets in which to take deduction. Provided amount repaid>$3k, taxpayer can either: § Deduct in current year or take a credit in amount that would have been taxed o If get charitable contribution returned, have to claim it as income to offset deduction taken earlier (Except if no deduction taken) § BUT If it's property that's returned, doesn't matter if property is returned worth more or less § Basis is whatever it was at time of original contribution o §1341 does not apply to arithmetic errors, refunds pursuant to contractual right, or embezzlers

Child Support Payments - IRC § ??

• No income to payee and no deduction for payor o POLICY: Child expenses are required with or without divorce • Can't rely on parties' labels for certain payments - must look to terms • Diez-Arguelles (1984): Taxpayer (wife) tried to deduct for unpaid support under § 166(d) (non-business bad debts) but court denied because only deductible to the extent of the taxpayer's basis in the bad debts o The taxpayer was not "out of pocket" anything as a result of ex's failure to pay child support (tax payer had no basis in the debt) o Would have been deductible bad debt if taxpayer had transferred money as a loan • Legal fees to obtain child support are also not deductible (McClendon)

Golden Parachute Payments

• Normal business practice to provide compensation to executives in case company is taken over. If the PV of the parachute payment exceeds 3x the annual compensation paid to the executive over the preceding 5 years, there is a surtax imposed on the payment and a deduction denied to the corporation making payments

Original Issue Discount

• OID Rules o OID Required When: § Zero coupon bond: doesn't pay interest, pays in redemption price § Provides interest, but less than applicable federal interest § Stated interest does exceed AFR, but it is not paid at least annually o OID Effect: § Imputes interest where parties have not accounted for interest § Puts all parties on accrual method § Treats lender as if he is accruing income as a result§ Obligor entitled to deduct the amount the obligee is required to accrue o Concern: Arbitrage § Due to different acctg systems and gains treatment § Ex: Taxpayer buys bond ($700), redeems ($1k) in Y5 (claims ordinary income in Y5) § 1271: payments are ordinary income, not capital gain, replace interest § 1272: requires taxpayer to declare non-cash appreciation annually, not all in Y5 o For zero-coupon bond, enough interest, but can't wait until Y5 o Exception§ § 1274(c)(3): Sales of principal residences, farms less than $1M, and sales for payments totaling less than $250k • § 483 applies (gain is ordinary, but no annual interest required) o Method§ If no/low interest stated on loan, discount to NPV using AFR § Unstated interest = gross payment/loan, minus NPV§ Split transaction in two Property transaction: Price = NPV of FCFs (minus basis?) Debt transaction: ongoing annual taxation of imputed interest • §483 o WillapplyinsomecaseswhereOIDrulesdon'to Personalpropertybetweenindividuals,butnotthingslikesecurities o Incomeistreatedasordinaryincome,notcapitalgain § For cash-method taxpayers, doesn't change timing, no imputed payments • Market Discount Bonds - § 1276 o Whentaxpayerbuyspre-issuedbondatadiscount(rateswentup) § Difference is ordinary income Between amt realized when redeemed and basis In same way that interest is ordinary income to you But bond seller's loss is capital loss, unless broker-dealer § Difference in buying bond is not a capital gain, but interest • Gain (difference between amount realized when redeemed and basis) is locked in as soon as taxpayer bought bond § Gain is not taxed until redemption § 1276(b) No annual interest imputed. Deferral itself is good for taxpayer Compare: zero coupon bond (interest is imputed) § 1276(a) o If do not hold until maturity § Can't avoid rule (can't get capital treatment) § Taxed on imputed interest during period held § § 1276(b) gives taxpayer two choices for how to impute interest here Simple method o #of days between time bought and redemption date o #of days between time bought and times old o Multiplied by market discount = portion of interest More complicated o Apply OID rules-tougher but better for taxpayer o Interest accrues in ever-increasing amounts

Prizes IRC § 74, Reg. 1.61-14

• Prize = un-bargained for benefit, not part of a contract o Old rule: prizes you don't seek aren't taxable (no longer true) o New rule: Prizes and awards (including those nots ought)are taxable as gross income.§74 (a)Prizes should be reported as a fair market value income (as reported by prize giver who gets deduction) because they're either a windfall (income) or you had to work to get the prize (return to labor, also income). § Valuation: Usually, FMV (resale value) § All or nothing approach. Approach in Turner is rare by arbitrarily trying to capture subjective value to taxpayer of non- transferable cruise tickets • POLICY: prizes aren't always cash. And prizes aren't always by choice. Prize doesn't relate to social benefits received. • Exceptions to the inclusion of prize winnings in income: o Awards for Olympic medals are excluded (74(b)), but exclusion doesn't apply if athlete is successful and earning more than$1M. o §74(b):(1) selected without entering;(2) no additional services required/expected;(3)immediately donate to charity or the government -> then fully excludable (e.g. Nobel Prize if you do 3) o §74(c): Certain employee achievement awards (see business gifts) o §117: qualified scholarships

Taxing Individuals vs. Married Couples or Domestic Partnerships

• Progressive Rate Structure o Encourages high income taxpayers to shift income to low-bracket family members • Possible tax goals for married couples o POLICY-can't achieve all three simultaneously § Tax income progressively § Tax all married couples with equal combined income § Provide no tax incentive or disincentive to marry • Early cases o Lucas v. Earl(1930)-despite contract splitting all property between H/W, H taxable at rate of his full income § Income fruits attributed to a different tree from that on which they grew. Cannot stand! § Line drawing concern; CT didn't want to consider parties' motives o Poe v. Seaborn (1930)-in WA, a community property state, attributing half of H's income to W was ok, since she had legal title to it anyway § Unlike Earl, where income would have belonged to H absent the contract, here the earnings were always community- owned o Matter of defaults? § US SC held no splitting in "pick your own default" states (Harmon) § BUT CAN ALWAYS CHANGE PROPERTY RIGHTS BY CONTRACT • CONGRESS steps in to correct the SC-created geographical tax advantage to CP states o Married couples in all states can file joint returns § Compute total tax by first computing a tax on half the total and then doubling amount § Thereby providing two starts at the bottom of the rate structure § This reduced tax for all but families where both spouses earned the same o Congress later responded by reducing rates for singles § Reduced relative advantage of marriage o Biggest tax benefits today are for traditional married couples where one spouse makes all the money o 2017 Tax Act: Congress eliminated marriage penalty for married couples with joint incomes of $600k and less, effectively going back to double-wide bracket from 1948 • Domestic partnerships / same-sex marriage o IRS originally refused to all DPs to file joint returns o Changed mind once CA extended CP status to DPs (+thanksObama) o Same sex marriage: can file joint returns post-Windsor § DP status may disappear (bad for them, because can't both start at bottom)

Hobby Losses - IRC § 183

• Taxpayer may deduct losses only if hobby is "engaged in for profit". If it's not engaged in for profit, the losses are deductible to the extent of gains from such activity ("basketing" under § 183(b)) o Activity engaged in for profit §183(c) § As any activity other than one w.r.t. which deductions are allowable under § 162 or § 212 § Rebuttable presumption: Activity engaged in for profit if, in 3 or more of 5 consecutive years, the activity earns a profit (§ 183(d)) o If tax payer fails to satisfy the test for the presumption, consider whether purpose of making a profit, NOT objective consideration of likely to make a profit § Must simply prove sincerity to make a profit, not realism o Factors to consider(Reg1.183-2) § Whether taxpayer carried on in businesslike manner and kept complete and accurate books; degree to which taxpayer prepared for the act either by study or consultation with experts; time and effort expended in carrying on activity; likelihood that assets used in activity will appreciate in value; success or failure of taxpayer in carrying on similar activites; history of income and losses in activity (losses in start-up phase doesn't necessarily indicate it's not engaged in for profit); financial status of taxpayer (if taxpayer of modest means probably not foolin around); degree to which activity is recreational or for personal pleasure • § 183 doesn't alter eligibility for personal deductions such as property tax, charitable contributions, etc., it just serves as a blanket deduction

Travel and Entertainment Expenses - IRC § 162(a)(2) and § 274

• To be deductible, an entertainment or travel expense must meet requirements of both § 162 and § 274 o First, ask if expense is ordinary and necessary under §162 or §212? § Generally, to be deductible under § 162 the primary purpose of the expense must be business related § To be deductible under § 212, must be ordinary and necessary in profit-seeking activity o Are there limitations under §274 or §162(a)(2)? § §274 is a disallowance provision for business entertainment, recreation expenses • Are there any exceptions??? o §162(a)(2)BusinessTravelExpenses § Allows taxpayer to deduct travel expenses, including meals and lodging, if three requirements are met: expenses are reasonable and appropriate; incurred while taxpayer is away from home (OVERNIGHT REQ'D); expenses motivated by business and not personal preferences

Correlation with Prior Related Transactions

• Transactional component to determine whether character is ordinary or capital o Analogous to Tax Benefit Rule o Cts look to whether current transaction is connected to a prior one and tries to create symmetry of cap/ordinary treatment for related transactions o Similarly, corp insiders are forced, under SEC§16(b) to repay to corp their gain on purchase+ sale within 6 months of company's stock, must treat payment as capital loss. Merchants National Bank (1952) o Bank wrote off 100% of bad debt as ordinary loss. Later, sold notes to third party and claimed cap gains. Ct held Bank had ordinary income up to its prior deduction. Beyond was cap gains. Arrowsmith (1952) Taxpayers liquidated corp and properly took gain as LTCG. Later, taxpayers had to pay tort (via successor liability) - claimed ordinary business loss. Court held loss was only capital, because tied to previous transaction. Opposite facts, same rule as Merchants National Bank. Doesn't really make sense because of corporate overlay - essentially, taxpayer is significantly worse off than would be if corp had not paid and shareholders did after liquidation.

Marital Separation and Divorce - IRC § 1041

• Transfer of property § 1041: o §1041 no gain or loss is recognized from the transfer of property between spouses or former spouses if related to divorce o Under §1041(b), a property settlement that's treated as a transfer between spouses incident to divorce is treated as a gift, even if it's not a gift § Transfer must be related to cessation of marriage, or the transfer must occur within 1 year of cessation of marriage • If it occurs more than after cessation of marriage, it's not part of marital settlement and is a realization event § Good for divorcing couples because they can postpone payment of tax, perhaps indefinitely § Forces couples to consider aspects of settlement to benefit them (if one takes on tax liability as a result of receiving share, may ask for more to cover tax liability) § As non-recognized property, property transferred has a substituted basis in hands of transferee (gets gift treatment and basis carries over) (exception is appreciated bonds realized by transferor) • POLICY: Creates equity between community and common law states o As of 2019, there is no deduction for the payor spouse and the receipt of alimony is not income for the recipient spouse § This means more money for the US treasury (not a transfer to lower taxed spouse)§ Also means amount of alimony payments can go down since they no longer need to cover taxes § Don't worry about rules 215 or 71.

Home Mortgage and Consumer Interest

• Two tax break options:o If borrowing money to buy a home, interest that can be deducted is capped at interest on $750k (used to be $1M and still is for those who borrowed before 2017 Tax Act) o If two+ people take out mortgage on same piece of property, can all deduct interest on up to $750k

Child Tax Credit

• Until 2017, got deduction for personal exemption but eliminated in 2017. But the child tax credit doubled for many people. And it's a credit, which is worth more than a deduction. It's lost in year in which your child turns 17. And it disappears when AGI goes above certain amount - begins to get phased out when AGI hits $400k.

Windfalls

• When treasure trove is reduced to undisputed possession, it's income to you when you get it (Reg. 1.61-14(a)) o If you get lucky and win a prize, that's income. You're better off than your peers and not unfair to ask you to contribute more to cost of government o Punitive damages, treble damages, another person's payment of taxpayer's income taxes, illegal gains, and treasure trove are all included in income • Glenshaw Glass (1955) o Treble damages (and punitive damages) are income under §61 o "Undeniable accessions to wealth, clearly realized, and over which[X] has complete dominion"-NOT Eisner" gain from capital, labor, or both" standard o After Glenshaw, cts defer to Congress as to meaning of "income" • Ex: person catches baseball and gifts it to player that hit it o Person who caught pays tax on baseball and then pay gift tax for gifting it § This didn't seem right so IRS now considers person who caught it was inanimate object that was hit by ball and ball bounced back to player so no tax owed (she had right to ball but refused to assert right so it was never her property) • Ex: Slay deer, butcher and consume venison o No income because difficult to enforce (POLICY want rules that are enforceable) • Ex: Jeter hitting ball and keeping it o Gets professional salvers benefit (doesn't pay tax on it until he sells it) • Cesarini (cash in piano) o Held pursuant to Glenshaw Glass and Reg.161-14re:"treasure troves,"cash was income to tax payer in year of discovery • Turner (steamboat tickets) o Winner of tickets must include subjective value of tickets since tickets value to taxpayer not equal to retail cost

Gifts-IRC §102

• income does not include gifts, so long as the gifts are not gifts of income itself. • § 102(a): Gross income does not include value of property acquired by gift, bequest, devise, or inheritance o Payee must show it was a gift, not consideration (thus not taxable) o Mere absence of obligation doesn't mean no gift, per se. Old Colony Trust o U.S.v.Harris(1991):Mistress gift payments case § Gifts are not income as long as not cash-for-sex payments o Payments made out of moral duty are not a gift • § 102(b): 102(b) says that gifts of income from property are not tax free but accrue to the recipient of the income. Examples would be gifts of fractional interests in lease payments or distributions of trust income. If the income was earned by the donor prior to the making of the gift, however, it cannot be shifted to the donee. • Distinctions: o The less close the familial relationship or friendship and the more easily we can imagine the transaction mediated by cash, the more likely we (and the IRS) are to view the transaction as generating income rather than as the giving or exchange of gifts. The low visibility of most of these exchanges and the spottiness of enforcement, however, tend to weigh heavily in favor of gift classification in borderline cases Gifts from Employers to Current or Former Employees:o § 102(c): the general rule that income does not include gifts does not apply to amounts transferred by or for an employer to or for the benefit of an employee. So, with few exceptions, an employer cannot make a gift to an employee, regardless of the disinterestedness of the employer's motive. Tax law here makes a rigid assumption - one that undoubtedly is accurate in the great majority of instances. • Exceptions: o gifts between family members who happen to be in an employment relationship, so long as they can show that the transfers "are not made in recognition of the employee's employment." Prop. Reg. § 1.102-1(f)(2). If you work in your parents' business, they can still give you tax-free birthday gifts. The Proposed Regulation says nothing about transfers between friends when one works for the other. o Likewise, § 132(e) allows de minimis fringe benefits to be excluded from an employee's income. Thus, small holiday gifts of property, not cash, are not income to employees. o Section 74(c) allows employees to exclude the value of employee achievement awards. These awards are defined in § 274(j). They must consist of "tangible personal property" - not cash, even if employees would prefer money. They must be based on how long or safely an employee has worked and cannot be a bonus for superior work, except as regards safety. And they must be given as part of a "meaningful presentation" and not smack of "disguised compensation." Why allow employers to deduct these expenses? Or employees to exclude the value of these objects? They have much the same rationale - "justification" might be too strong - as excludable fringe benefits under § 132. • Gaps: o Section 102(c) does not on its face - or indeed in its legislative history - deal with payments to former employees or to relatives of former employees, such as gifts to surviving spouses.o As the casebook notes, courts have disagreed on whether these gifts, especially those to surviving spouses, are taxable to recipients. If a business claims a deduction for the transferred amounts, however, it is difficult for the recipient to claim successfully that she or he received a gift. • Treatment of the Employer: o Section 102(c) does not on its face - or indeed in its legislative history - deal with payments to former employees or to relatives of former employees, such as gifts to surviving spouses. As the casebook notes, courts have disagreed on whether these gifts, especially those to surviving spouses, are taxable to recipients. If a business claims a deduction for the transferred amounts, however, it is difficult for the recipient to claim successfully that she or he received a gif

Life Insurance - IRC § 101(a)

• § 101(a) o Blanket exclusion for insurance proceeds. payable by reason of death (crazy though because we tax gambling proceeds so what's the difference? - want to incentivize life insurance plans, not gambling) o Premiums paid are not deductible Two parts: o Term insurance portion o Savings portion (often limited w.r.t. ratio to term portion) If taxpayer survives life insurance policy and receives face amount o Taxpayer can offset the proceeds with total amount of premium she paid o Difference is included in income o Term insurance portion which taxpayer paid in that's not going to be taxed, although it probably should have (big subsidy for owners of policy) Terminally ill policyholders o §101(g) allows exclusion of insurance payments to the person; can also sell o Buyer's holding of policy viewed as regular investment (only approved buyers) Employer-purchased life insurance o If employer is beneficiary-§264(a)(1) § Premiums not deductible to employer § Benefit payment not income to employer o If employee/family is beneficiary § Premiums are additional compensation • Deductible to employer, taxable to employee § Benefit payments are not income • Exception is Employer-purchased group term life insurance (§ 79) o Employees can exclude value of insurance from gross income to extent that insurance provides death benefits not greater than $50k § Premiums for coverage > $50k is income to employee § Only portion of premium that pays out over $50k is included (i.e. full amount of premium is not included) o Can't discriminate in favor of highly-paid employees • From govt standpoint, this is neutral in aggregate o So many people have non-deductible losses, only a few have a non-taxable gain

Like-Kind Exchanges IRC § 1031

• § 1031: If property held for productive use in a trade or business or for investment and exchanged solely for property of like kind which is also held either for productive use in a trade or business or for investment means there is no recognition of gains or losses (§ 1031(a)(1)) o This is not elective. Gain is postponed, not eliminated o If you're cashing out, pay tax now. If you're fully invested, you get a break. o This does not apply to: stock in trade or other property held primarily for sale; stocks, bonds, notes; securities or evidences of indebtedness or interest; interests in partnership; certificates of trust or beneficial interests; choses in action (§ 1031(a)(2)) Like-Kind Property: Refers to nature and character of property, not grade or quality. Reg 1.031(a)-1(b) o Improved property is still like-kind with unimproved real property if same general class. o Very lenient definition for real estate (nearly everything allowed), but much more strict for personal/intangible property Effect of Boot (§ 1031(b)) o Boot =any non-like-kind property included in the exchange. Boot is taxable if received o If the tax payer gets the like-kind exchange and, in addition, boot, then the gain is recognized to the extent of boot. §1031(b) § Ex: Hotel with basis of 30k and value of 100k. Taxpayer exchanges for apartment building with value of 85k plus 15k cash. Recognized gain is 15k. If basis is 90k, then recognized gain is 10k. Boot is capped by the realized gain. If basis is 110k, then realized loss of 10k, but none of it is recognized. o Realized gain is a cap on recognized gain (can't recognize more than you realize) o Realized gain= Value of Property received+boot-adjusted basis of relinquished property § Transferor of boot must recognize gain/loss in boot (cash excepted) § Transferee takes FMV of boot as basis in boot § If taxpayer gets like-kind exchange and boot, but has a loss, then no loss is recognized for like-kind property (will be made up for upon disposition of property) § 1031(c) Basis of new property (§ 1031(d)) o Basis of new property acquired= basis of old property-FMV of cash or boot+ gain recognized+cash/boot paid out(§1031(d)) § If there's no boot, then new property basis = same basis as old property (carryover basis) o Gain recognized: Gain recognized equals lesser of realized gain or FMV of boot received. If the transaction results in a loss, then loss is not recognized even if boot is received (§ 1031(c)) • Effect of Mortgages o Any net reduction in debt is treated as cash, so it counts as additional boot recognized in exchange § Net debt relief = debt relieved of - debt assumed - cash paid in exchange § Debt relief/assumption counts as cash for consideration purposes so it impacts payor of boot and recipient of boot o Realized Gain=(FMV property rec'd+ cash rec'd+debt relief)-(Basis of original property+debt assumed+cash paid)=total consideration rec'd - (basis + total consideration paid)§ Debt relief/assumption = cash for consideration purposes o Basis of New Property=Adj basis of original property+debt assumed+cash paid-(cash/boot rec'd+debt relief)+gain recognized = original basis + consideration paid - boot received + gain recognized Exchanges between Related Persons § 1031(f) o If either party voluntarily disposes of property received within two years of exchange, then other party must recognize the full amount of gain realized in the exchange at that time Rationale for nonrecognition (POLICY) o Gain/ loss shouldn't be recognized if transaction doesn't generate cash to pay the tax with (but release from mortgage debt doesn't produce cash but is treated as cash boot) o Difficult to value gain/loss§ Not necessarily about burden of valuing assets, since will have valued property to agree to terms of exchange o Gain shouldn't be recognized because it encourages the mobility of capital § Must be a benefit to those with appreciated property who want to defer recognition of gain o Gain/ loss shouldn't be recognized if taxpayer's investment doesn't significantly change o Easy to get around non elective feature of §1031 if you want to recognize a loss-transfer property into cash before re-investing

Home Sales - IRC § 121, Reg. 1.165-9

• § 121(c): Gain from sale or exchange of property is NOT INCOME if: o (a) During the 5 year period ending on the date of the sale or exchange, property has been owned and used by the tax payer as the taxpayer's principal residence for periods aggregating 2 years or more § But 2 year period may be waived if sale us due to change in place of employment, health or "unforeseen circumstances" § 121(c)(2)(B) § Ex: If taxpayer only lived in principal residence for 1 year before transferring work to another area, can exclude 1⁄2 of allowed gain. § 121(c)(1) o Excluded even if gain due to tax payer's labor (home flipped) and not the result of market changes o Major renovations count as capital improvements added to basis § Minor improvements are simple repairs not added to basis unless immediately before sale • Limitations: o Only first $250k gain excluded from income §121(b)(1)§ First $500k excluded if joint return and both spouses lived in home for 2 out of past 5 years. § 121(b)(2) o Taxpayer can only use §121 exemption once every 2 years.§121(b)(3)(A)§ But limitation is waived if sale or exchange occurs due to change in place of employment, health or "unforeseen circumstances" § 121(c)(2)(B) • Unclear what "unforeseen circumstances" are (IRS has not clarified) o Proportion of period used for commercial purpose is taxed§121(b)(5) Reduced Exclusion § 121(c)(1) o If taxpayer fails to meet requirements of§121(a)[2years] or§121(b)(3)[only one exemption every 2 years], multiply allowable exclusion by (months since used)/24§ The reduced exclusion is available if taxpayer had to move because of a change of place of employment, health, or other unforeseen circumstances Under Reg § 1.165-9, the loss on a sale of residential property is not deductible (seen as consumption) o If the property is converted to a rental or other income-producing activity and then sold, a loss sustained on the property (since conversion) is deductible under § 165(a), or the basis fo the original price, whichever is lower. o This hybrid system makes no sense-conflicting ideals of consumption and aninvestment

Open Transactions and Installment Sales - IRC § 453

• § 453 is a special accounting method for reporting gain from the sale of property in exchange for deferred payments o Tax payer includes a ratio of each payment as income and deducts restas capital recovery o Rule benefits cash method taxpayers so long as transactions are sufficiently small o Rule is departure from realization requirement-allows tax to be deferred o Rationale=installment sales provisions are justified on concerns that can't meet tax burden for sellers of property (NOT dealers) o Installment method applies automatically to a sale of property if the seller realizes a gain on sale and at least one payment for the property will be received by the seller after the close of the taxable year of the sale (can opt out, but applies automatically) § And ONLY AVAILABLE where seller agrees to take deferred payments on a sale Gross profit ratio = gross profit / contract price o Gross profit=selling price-seller's adjusted basis in property sold § Selling price = amount to be paid by buyer (other than interest) § If property is subject to debt assumed by buyer, selling price includes amount of debt o Contract price=selling price-debt assumed by buyer Open Transaction (actual payment is uncertain) o Reg 15A.4531 gives 3 rules for determining timing of basis recovery and gain inclusion where amount paid for property is contingent § If max payment for property can be determined -> selling price for computing § 453 inclusion ratio § If max payment can't be determined, but number of years of payments is determinable, taxpayer's basis is allocated equally over that period § If neither a max payment nor time period for payment is determinable, then recover basis equally over 15 years Recapture Provision (§ 453(i)) o In any installment sale, any recapture income (i.e. any deductions taken for a capital asset) must be recognized in year of sale § Any gain in excess of recapture income is included under the ratio Other Considerations o To extent that debt relief>basis in property->gain must be recognized immediately o Taxpayer may elect out of 453->453(d)(only if taxpayer faces an unusually low tax bracket in year of sale) o Interest must be paid on large transactions-If large transaction (i.e. more than$5M), 453A requires taxpayer to pay interest on the deferred tax

Non-Cash Benefits (Lodging, Food) - IRC § 61, 119(a)-(b)

• § 61 treats compensation in cash and in kind alike (Also see Reg. 161-1(a)) • POLICY: Statutory exclusions to § 61 definition of gross income reflect policy considerations or practical limitations: o Policy issues § Insurance: Policy in favor of "forced savings" § Home sales: Promote home ownership o Administrative difficulties: measurement costs, compliance § Employer-employee non-cash benefits § Gifts and bequests • Barter exchanges are taxed at FMV of each item Rev. Rule. 79-24 • Payment of income tax on behalf of employee = income to employee o"Dischargetothirdpersonofanobligationisequivalenttoreceiptbythepersontaxed" o Still used in Exec. Comp. because it lowers stated salary level in required reporting • You have additional income when employer provides lodging or food to you, but it is not includable when it is furnished on business premises for the convenience of the employer (excluded under § 119 - codification of Benaglia) o Food must be provided in-kind for it not to be income (if you get cash for food, it's income) o If you provide luxury condos and let employees live there for free it's not includable o Free food at Apple and Google, even on weekends, is not income because it's for the convenience of the employer o Use additional cost test for benefits provided to spouse • POLICY: Consider enforceability • Starting in 2026, companies cannot deduct cost of meals