Tax: Lilly Outline 1

General Notes about the Ideal Tax System

·         Fair

·         Efficient

·         Administratble

Part I:  What do you include?  What can you exclude?

Gross Income

§ 61 Gross Income Defined

·         A—all income, from whatever source derived, including but not limited to (a huge list of things)

·         Defined by the USSC as “instances of undeniable accessions to wealth, clearly realized, and over which taxpayers have complete dominion.  (Glenshaw Glass)

*The Treasure Trove Rule § 1.61-14

Cesarini:  Case about finding money in an old piano.  This shows that Congress intended to stretch § 61 as far as it could constitutionally go and the Court will apply the broadest possible interpretation.  The Court here finds that the plaintiffs received the currency in the same year they got the piano.  However, if they just realized that the piano was worth a lot, they would not be taxed until the property was sold or exchanged (until the gain was “realized”).

·         The timing rule:  it is gross income for the taxable year in which it is reduced to undisputed possession; and state law determines when possession is achieved. 

·         Taxable to the extent of its value in US dollars is GI for the year in which it is reduced to undisputed possession

·         Note—if they would have discovered the piano was a Steinway, there would be no difference in the finding.  There is no income tax event on the realization that the piano is expensive. 

*Taxes paid for you § 1.61-14

o   Old Colony:  Π was getting a salary, and his employer decided to pay the state and federal tax on his salary.  The court determines that this gross income, because it is an economic benefit that resulted in an increase of net worth.  However, it may not be income if a family member pays your taxes as a gift.

*Punitive damages § 1.16-14

o   Glenshaw Glass:  Punitive damages are gross income.  This includes treble damages and exemplary damages

*Frequent flyer miles

o   Charley:  Converting frequent flyer miles to cash is income.  As of 2000, there is NO GI from frequent flyer miles UNTIL they are cashed out

o   No gross income if you haven’t cashed out the miles

*Prizes are gross income too

*Illegally gotten income is still income

*Non-Cash Goods/Services § 1.61-2

·         If something is paid for other than in $$, the FMV of the property or service taken in payment must be included in GI

o   Housing provided for by ER and EE and family housed at no cost—FMV of rental value of housing provided is GI.  Rent avoided is the benefit received by reason of employment by a 3rd party (Dean)


o   Obviously, this is income—but anything tendered in exchange for allowing someone to live somewhere is rent

§  i..e., someone says “I’ll pay you $1,000 cash and build you a bathroom”  the bathroom is still rent., even if T builds the bathroom himself, doing all of the labor for free


o   When you harvest/eat your own crops, there is no income

o   If you sell them, you have income—if you sell them or exchange then for the equal amount of Tuna, you still have income.

*Services exchanged

o   If you exchange services, with no money changing hands, this is still income—you must report the FMV of the services received. 

o   However, services you perform for yourself (hee hee) are not income. 

*Buildings you own

o   If you live in a building you own, it is NOT considered gross income (Independent Life Ins. Co.)


§ 1.61-1(a)—income may be realized in other forms than cash (services, etc.) 

§ 1.61-2(a)(1)—wages, salaries, commissions paid salesmen, compensation for services on the basis of a percentage of profits, commissions on insurance premiums, tips, bonuses (incl. Christmas bonuses), termination or severance pay, rewards, jury fees, marriages fees,…are all gross income.

§ 1-61-2(c)—services rendered directly and gratuitously to an organization in § 170(c) are not income

§ 1-61-2(d)—if services are paid for in property, the FMV of the property taken in payment must be included in income as compensation

*Revenue Ruling 79-24

·         An individual who owned an apartment building received a work of art created by a professional artist in return for rent-free use of an apartment for six months by the artist—this is gross income and the fair market value should be reported



Gifts are generally included in the donor’s tax base (i.e., donors usually cannot generally deduct a gift)

§ 102

·         A—generally ARE excluded from GI

·         B—exceptions

o   (1):  Income from property

o   (2):  Where the gift, etc. is income from property, the amount of the income is not excluded

·         C—employee gifts are NOT excluded (from E to EE)

o   Lawyers are NOT considered to be the EEs of their clients

*The Dominant Intent Test

·         Motive required for a gift is “detached and disinterested generosity flowing from affection, respect, admiration, charity, or like impulses” (Duberstein)

o   This is a very fact-specific evaluation

o   Ex:  E gives her EEs a black and white TV set for Christmas; her son (also an EE) get a color one. 

§  Helpful additional info:  differences in timing, value, etc.

·         Anything that is a “quid pro quo” situation is included in GI b/c there is a lack of detached and disinterested generosity. 

o   If a poker player tips the dealer, he is tipping him for a good outcome—thus, it is income to the dealer….quid pro quo is not always rational.

*Employee Gifts

·         A transfer from an E to an EE does not qualify as a § 102 gift

o   Exceptions:  extraordinary personal services—if EE can show that the transfer was not made in recognition of the service

·         Reverend/congregation relationship is different from an E/EE relationship to some factfinders

·         In some cases, like when there are multiple transferors, you can split the gift into excludable gift parts and GI parts

o   Ex:  EE gets a $5,000 trip to HI for retirement.  ER gives $2,000 of the gift, and the fellow EEs give $3,0000.  The $2,000 from the employer is gross income (because it falls into § 102(c)) and $3,000 of it is considered a gift, excludable under § 102(a)

·         Income generated from the gift is taxable

o   Ex:  gift of stocks:  dividends are taxable when received; gift of apartment building—rent collected is taxable when received. 

*Bequests, Devises, Inheritances

Lyeth:  a taxpayer received an amount from the estate of his relative, but only got it by contesting the will and suing the estate.  Receipt by reason of heirship is analogous to receipt by reason of detached and disinterested generosity. 

Wolder:  an attorney asked, in exchange for his services, to be remembered in his client’s will, and he was.  The court found this was a payment of a debt for services performed—it was a deferred payment of a legal bill

·         Steps

o   Determine T’s position/relationship to donor

§  If the succession to a decedent’s estate comes from T’s position as successor by law as heir to the donor, then it’s excludable (Lyeth)

o   Substance over form

§  Bargained-for agreements:  look for a K.  When there is payment of services through bequest, there is still GI.  (Wolder)


§ 1.102-1(a):  property received as a gift or under a will or under statutes of descent and distribution are not income, even though the income from the property is income

§ 1.102-1(b):  income from any property received as a gift, or under a will is not excludeable from the above section

§ 1.102-1(f):  § 102 doesn’t apply to prizes and awards, including EE achievement awards or de minimis fringe benefits, or scholarships

Employee Benefits

This section is very code-reg dependent!

§ 132: provides a list of categories—when you see facts where E is delivering something to EE, check to see whether it fits any of the categories here.

NB:  This section does NOT include fringe benefits

*“No additional cost” services

Definition of an employee:  currently employed persons, retired and disabled ex-employees, surviving spouses of retired/disabled employees, spouses and dependants of employees.

o   § 132 (a)(1)—if E incurs no further cost by giving this benefit to EE, it can be excluded

o   § 132(b) requirements

§  (1) E is in business; E-EE relationship

·         Exception § 132(i) written reciprocal agreement—if there is one of these between E and EE, than the direct E/EE relationship is unnecessary but you still MUST have all other requirements (same line of business, neither E incurs substantial additional cost, non-discriminatory basis)

o   See part (e) of problem 1 on p. 98

§  (2) E works in SAME line of business as that in which he is employed

·         Note—a hotel EE whose chain is owned by a conglomerate who also owns a shipping business cannot exclude personal use of the shipping business b/c it is not the same line of business

·         Note—an EE who performs services that directly benefit more than one line of business CAN exclude things from each business

o   § 1.132-4(a)(1)(iv)

§  Comptroller example

§  (3) No substantial cost incurred by E

·         Forgoing revenue is a substantial additional cost

·         Filling up excess capacity is OK; reserving a seat or bouncing a guest is not

·         E generally incurs no substantial additional cost if the services provided to E are incidental

o   In-flight services, in-flight meals, maid services

·         E must include cost of labor incurred in providing services to EE when determining whether E has incurred a substantial extra cost

§  (4) For use by EE

·         Or spouse, or dependent children § 132(h)(2)

o   Note—Use by just a spouse/dependent child is treated the same way as use by EE under this statute

·         EE’s parents for AIR TRANSPORTATION ONLY §132(h)(3)

§  (5) Non-discrimination requirement § 132(j)(6)

·         Highly compensated EEs do not get the exclusion when the plan discriminates in favor of the highly compensated

o   5% owners; more than $80K; in top-paid group of EEs

o   Note—it doesn’t matter if the employee pays the bill and receives a rebate from E—that has no bearing on whether or not it is excluded from GI

*Working Condition Fringe Benefits

§ 132(d):  any property or service provided to EE such that if EE paid for the property or services, it would not be excludable under § 167 or § 162.  NB:  this one is only good for the actual employee—sorry to the spouses and kids


(1)   EE/E relationship

(2)   Any property/service provided to EE such that if EE paid for property/service, it would not be deductible under § 162 or § 167

(3)   Something about auto salesmen—qualified automobile demonstration use is a working condition fringe

(4)   Non discrimination requirement does NOT apply here

Note—think of it as part of “doing the work” i.e., EE attends a business convention in another town and E picks up EE’s costs

*De Minimis Fringe § 132(e)

(1) any property or service whose value is so small as to make accounting for it unreasonable or administratively impracticable

(2) an eating facility provided for EEs by E is treated this way if (a) it is located on or near the business premises AND (b) revenue derived from the facility normally equals or exceeds the direct operating costs of that facility

·         Occasional cocktail party; occasional copying, typing of letters—however, if E gives every employee a case of Scotch for Christmas, the FMV of the scotch is probably not low enough to make it impracticable to account for.

o   From § 1.132-6(e)(1)-(2)

*Qualified employee discount § 132(c)

(1)   discount cannot exceed

a.       for property, the gross profit percentage of the price at which the property is being offered by E to customers

b.      for services, 20% of the price E offers to customers

In practice

First, determine whether this is a service of product—if it is a SERVICE, you have income in the amount that is over 20%; if it is a PRODUCT, we have to do math (yikes)

(2)   gross profit percentage

a.       percent at which

                                                              i.      excess of aggregate sales price of property sold by E to customers OVER aggregated cost of property to E is of

                                                            ii.      aggregate sale price of property

b.      calculating GPP—determined on the basis of

                                                              i.      all property offered to customers in the ordinary course of line of business of E in which EE is performing services

                                                            ii.      E’s experience during a representative period

                                                          iii.      Formula:  (total sales – total cost to employer)/ (total sales) = percentage of allowable employee discount to be tax-free

*Qualified Transportation Fringe § 132(f)

(1) any of the following from E to EE

(A) transportation in a commuter highway vehicle if it is in connection with transportation between EE’s residence and place of employment

(B) transit passes

(C) qualified parking

·         NOTE—you can exclude up to $105

o   If E provides EE with $110 worth of vouchers for commuting on a public mass transit system, $5 of that per month is GI

o   This year, the parking limit got raised to $205

*Athletic Facilities § 132(j)(4)

o   If E puts a gym in the business for the use of EE and families, it IS income???  How to reconcile with p. 126? (I think I typed this wrong)

o   Requirements

§  Non-discrimination DOES NOT apply

§  Gym must be on premises (can be gym, golf course, pool, tennis courts, etc.)

§  Must be owned and operated by E

§  Substantially all of the use is by EE, spouses, and children

Rental Value of Parsonages

§ 107:  For ministers of the gospel, GI does not include (1) the rental value of a home furnished to him as part of compensation; (2) rental allowance paid to him as part of his compensation


Meals or Lodging furnished for the convenience of the Employer

§ 119(A) and see § 119(D)

·         A—excluded from the GI of EE any meals/lodging furnished to him, spouse, or dependents by or on behalf of E for convenience of E ONLY IF

o   (1) for meals, if they are furnished on business premises of E

§  § 1.119-1(c)(1):  business premises mean the place of employment of EE

·         Meals/lodging furnished in E’s home for a domestic servant IS meals/lodging on business premises and excludeable; meals to cowhands while herding E’s cattle on leaseland are also excluded

o   (2) for lodging, if EE is REQUIRED to accept such lodging on business premises of EE as a condition of his employment

Note—substance over form in tax; even if EE and E agree to a clause n K that requires EE to live on business premises, if isn’t at E’s convenience, no exclusion from EE’s GI

Note—regarding groceries—some courts say meals do NOT include groceries, so if E gives you an allowance for groceries, that allowance is GI.  However, some courts hold the other way

Note--Hatt:  For exclusions for meals/lodging, it does not have to be an unqualified corporation.  In this case, P was the owner and EE.  When the motivation is not to benefit EE but to conduct the business of E (within the meaning of § 119) then EE is not penalized for having to accept this income.

·         D—for an EE of an educational institution, GI does not include qualified campus lodging furnished to EE

o   Exceptions (see § 119(D)(2))

Constructive Receipt

Revenue Ruling 60-31:  Income although not actually reduced to T’s possession is constructively received by him during the taxable year in which it is credited to his account or set apart for him so that he may draw upon it at any time.  Income is NOT constructively received if T’s control of it is subject to substantial limitations or restrictions

Two situations

·         When E has set aside to a 3rd party and it is not subject to E’s creditors

·         When E has secured property so that creditors cannot get to it AND there are no substantial limitations

o   Things that are not substantial limitations

§  Requirement to take out money in certain sums, writing a notice of intention to withdraw, having to lose interest gained on the money withdrawn

·         Examples of constructive receipt

o   When interest coupons mature and are payable but have not been cashed

o   Athlete signing bonus to be paid in 5 year increments

·         Caveat—EE has to pay taxes on something which he doesn’t have money to pay taxes on it yet

·         To prevent triggering of constructive receipt

o   E must let creditors have priority to $$ set aside.


§ 1001(a):  the gain from sale or other disposition of property = excess of the amount realized (AR) over the adjusted basis (AB) as provided for in § 1011

·         Gain/Loss = AR -- AB

§ 1001(b):  amount realized (AR) = sum of any money received plus the fair market value (FMV) of property (other than money) received. 

·         AR = money received + FMV of property

(1)   DON’T take into account any amount received as reimbursement for real property taxes

(2)   DO take into account amounts representing real property taxes if they are to be paid by the purchaser

§ 1001(c):  the entire amount of gain or loss, determined under this section, on the sale or exchanged of property is recognized except as otherwise provided in this subtitle

§ 1011(a):  the adjusted basis is the cost at acquisition point (§ 1012) or the original basis (§1011) + adjustments (§ 1016)

*Adjustments to Basis

§ 1016:  you have to adjust for

(1)   expenditures, receipts, losses, or other items, but not for

a.       taxes or other carrying charges in § 266

b.      expenditures described in § 173

(2)   for exhaustion, wear and tear, obsolescence, amortization, and depletion to the extent that the amount

a.       allowed as deductions in computing taxable income

b.      resulting in a reduction for any taxable year, or any prior income BUT NOT less than the amount allowable under this subtitle

*More on the adjusted basis

·         for purchases at arms-length transactions

o   § 1012—the basis of property shall be the cost of such property

o   Cost = FMV of asset received

§  Initial basis attaches to the item itself, not the amount you’ve paid

·         Determining FMV

o   Appraisal

o   Value of the Asset surrendered (Philadelphia Park Amusement Co.)

§  More lessons from Philadelphia Park

·         Cost in § 1012 is a tax term with a tax meaning—think of it not as “how much I paid” but “how much value I received”

·         Options—if you pay for an option to buy land, then buy the land, then the option + price paid for the land = AB

o   If you buy/sell the option without purchasing the land, then the option is treated like an asset in itself

*Improvements by T on LL’s property

§ 109: these are not included in LL’s GI

·         This is the statutory response to the Bruin case (which I probably did not read)


·         Basis is FMV on acquisition


§ 1015(a):  basis of a gift in the hands of the DD is the same as it would be in the hands of D or last preceding owner by whom it was not acquired by gift UNLESS that basis is greater than the FMV of the property at the time of the gift; then the basis for determining LOSS is the FMV

·         There is no tax on making of the gift to D—so D has no loss

·         Taft:  If D gives property to DD with a FMV of $30 and an AB of $20 and DD sells for $35, then DD technically only has a gain of $5, but the government will tax from where D first got the property ($20) for a tax amount of $15.  This is constitutional

·         § 1015 does not apply to ante-nuptial exchanges because that is an arm’s length transaction; so we use § 1012 (Faried Es Sultaneh)

*Split Basis:  when one AB is used for gain and another is used for loss

·         Ex1:  Donor has an AB of 30, but at the time of gift, FMV is 20.  If Donee sells for $35,000, then the gain is

o   AR (35) – AB(30) = 5,000

·         Ex2:  Donor has an AB of 30 but at the time of gift, FMV is 20.  Donee sells for $15,000.  The loss is

o   AR(15) – FMV (20) = -$5,000

§  Note:  number should be NEGATIVE, genius

·         Ex3:  Same facts; Donee sells for $24,000. 

o   Gain:  30—24 = -6,000 (so no gain)

o   Loss:  24—20 = 4,000 (so no loss, either)

*Part Sale, Part Gift

·         § 1.1015-4(a)(1) AB for transferee is the GREATER of

o   (i) Amount paid by transferee OR

o   (ii) Transferor’s AB in the property at time of transfer OR

o   (iii)If transferor’s AB is greater than FMV of property and FMV of property is greater than amount paid by transferee, then FMV of the property is the unadjusted basis

*Property Acquired between Spouses or incident to Divorce

§ 1041 (a):  No gain or loss to (1) a spouse; or (2) a former spouse, if the transfer is incident to divorce

            (b) The transfer is treated like a gift, and the transferee has the transferor’s basis

§  No basis-splitting here

(c) Incident to divorce—definition

·         If it occurs within 1 year after the date on which the marriage ceases OR

·         Is related to the cessation of the marriage

There is a rebuttable presumption that the transfer is not incident to cessation of marriage when the transfer of property is more than six (6) years after the divorce

*Property Acquired from a Decedent

§ 1014(a):  if not sold, exchanged, or otherwise disposed of before the decedent’s death by such a person, the basis is

(1)   The FMV of the property at the date of decedent’s death OR

(2)   See code

·         E—Exception:  if decedent or decedent’s spouse receives a gift of property within 1 year before decedent’s death and if the property has appreciated, then the inheritor gets donor’s basis

o   This exception is only for APPRECIATED property, not DEPRECIATED property

§  Ex:  F gives D a house with an AB of $100.  D dies within the year and the house is given to T in D’s will.  The house’s FMV on the date of D’s death is $150.  T’s basis in the property is $100.  Note:  If the FMV on D’s death was $50, T’s basis in the property is $50 b/c the house has not appreciated.

*Amount Realized

§ 1001(b):  the sum of any money received PLUS FMV of property received

International Freighting:  even when there is no sale, when there is an exchange of something (like stock) for something (like services) with a 3rd party that is a tax event and gain/loss is realized on that event.  Here, T used stock of another company with basis of $16K to provide bonuses to EEs for services performed.  FMV of stock at the time of transfer was 24K.  The court held that T had a gain of 8K because the stock was used for services received; in effect, T gained 24K and gave it away to EEs as bonuses.  EEs had basis of 24K.

§ 212  Expenses for Production of Income

For individuals, there is a deduction for all ordinary and necessary expenses paid or incurred during the taxable year for

(1) the production or collection of income

(2) the management, conservation, or maintenance of property held for the production of income OR

(3) in connection with the determination, collection, or refund of any tax

§ 274(j) Items not deductible

--no deduction for expenses allocable to a convention, seminar, or similar meeting

*Disposition of Property with Debt

·         Recourse Mortgage—personal liability on debt

·         Non-Recourse Mortgage—no personal liability on debt; debt secured by collateral (property)

o   Example:  T has an asset used for security on a debt.  The debt is a non-recourse one.  If the property is worth 300, the debt is 180, and you have an AB of 100; and your amount realized is 300.  The basis is 100, leaving you with a 200 gain, and the debt goes away. 

o   Example 2:  If the property had instead been worth 170, then the payment on the debt doesn’t meet the full amount owed.  When the debt is non-recourse, all of the consequences are reckoned on the property.  Thus, it will be used to satisfy the full 180.  You will have a gain of 80 on the asset.

·         Rules

o   The discharge of debt under a recourse mortgage is GI, as there has been a clear accession to wealth over which there is complete dominion

o   The full amount of debt must be included in AR at the time of the disposition of property (Crane)

o   The full amount of the debt must be included into AR even when the FMV of the property is less than the amount of debt (Tufts)

o   GI can come from the cancellation of debt

Problem 1, p. 150

Mortgagor purchases a parcel of land from Seller for $100,000.  M borrows $80,000 from the bank and pays that amount and an additional $20,000 of cash to S giving Bank a non-recourse mortgage on the land.  The land is the security for the mortgage which bears an adequate interest rate

(a)    What is M’s cost basis in the land?

a.       Basis of $100,000.  This is derived from § 1012.  The borrowing of $80,000 does not create any income for M

(b)   Two years later, the land has appreciated in value to $300,000 and M has paid only interest on the $80,000 mortgage.  M takes out a second non-recourse mortgage of $100,000 with adequate rates of interest.  Does M have income when she borrows the $100,000?

a.       M has paid interest only on the $80,000, so there has been no payment on the principal; $80,000 is still the amount owed.  Now M has an extra $100,000?? 

(c)    If the $100,000 are used to improve the land?

a.       § 1016 adjustment.  The basis is increased by $100,000

(d)   What is M’s basis in the land if $100,000 of the mortgage proceeds are used to purchase stocks and bonds worth $100,000?

a.       No change in basis of property but stocks and bonds get a § 1012 basis change

(e)    What result under the facts of (d) if when the principal amount of the two mortgages is $180,000 and the land is still worth $300,000, M sells the property subject to both mortgages to P for $120,000 of cash?  What is P’s cost basis in the land?

a.       M’s AR = 300,000.  His AB = 100,000.  The gain is 200,000

b.      Even if M took the 300 and paid of the debt of 180, the gain would still be 200

(f)     If M gives the land subject to the mortgages and still worth $300,000 to his son?  What is Son’s basis in the land?

a.       AR = 180,000; gain of 80

b.      Son has a basis of 180

(g)    What if M gives the land to her spouse rather than son?  What is Spouse’s basis in the land?  What is Spouse’s basis in the land after Spouse pays off $180,000 in mortgages?

a.       Basis of 100.  The property served as security for debt for total amount of 180.  Basis of 100 with gain of 80 realized.  The spouse will take it under § 1041 with the same basis as the transferor. 

(h)   What result if land declines in value and M just transfers it back to the bank

a.       The FMV has declined to 180.  The total value of the property is the outstanding debt.  The AR includes 180 relief of liability achieved by transfer of property.  Realize and recognize a gain of 80 even though we don’t get any cash out of it.

(i)     What results to M if the land declines in value from $300,000 to $170,000 at the time of the quitclaim deed?

a.       180—from the Tufts case.  Even though the FMV is less than the debt, the AR is the debt.

FMV is more than the debt:  AR is the money received plus any amount of debt.  AR on property is at least the balance owed on the debt.

FMV is less than the debt:  two situations

  1. Disposition of property to 3rd party (not lender/creditor)—the value of the property as fixed in the transaction replaces will be amount of debt relieved
  2. Disposition of property to creditor/lender—apply bottom row of table (?)
    1. Recourse:  COD income if lender agrees to forgive debt for less than amount owed
    2. Non-recourse:  No COD income.  AR= balance of debt


AR Recourse

AR Non-Recourse

FMV is greater than debt

AR(prop) = $ received +amount of debt

AR (debt) = no cancellation of debt (COD)

Same as recourse—AR = $ received + full balance of debt

FMV is less than debt

AR (prop) = FMV of property

AR (debt) = COD

AR (prop) = Balance of debt

AR (debt) = no COD


*Gains/Losses when selling small pieces of big land

§ 1.61-6(a)

(i) If the lots were purchased as a single unit, then a FMV determination at purchase would have to be made post hoc and the percentages of value would then determine the basis for each lot

·         The equation is always AR – AB = gain/loss

·         AR = amount received for the small piece

·         AB = (FMV of piece at acquisition) / (sum of all pieces at acquisition) = x%

·         Then, take x% and multiply it with the (sum of all pieces at acquisition)

·         Since it’s based on percentage—if one of the lot’s prices is affected by something (like an easement) then all of the lots are affected

·         Note:  property also includes intangible things, such as goodwill

*Gift Tax

·         Allows you to step up in basis when a percentage of the gift tax is paid so you are not taxed twice.  The reasoning is that the increase in basis is limited to the amount that bears the same ratio to the amount of gift tax paid as the net appreciation in value of the gift bears to the amount of the gift.

% of gift tax paid = net appreciation in value/amount of gift

§ 1015(d)(6) In the case of any gift made after 12/31/76, the increase in basis provided by this subsection with respect to any gift for the gift tax paid under chapter 12 shall be an amount which bears the same ratio to the amount of tax so paid as

(i)  the net appreciation in value of the gift bears to  (ii)  the amount of the gift

So:  if you get a gift of land that was purchased by G for $200 and given to you when it was worth $300 and G paid $60 gift tax on the transfer and you sell it to S, then you have a basis of (net appreciation in value of gift= 100) / (amount of gift = 300) = 1/3 x the amount of gift tax (60) = 20 for a gain of 20.  S’s basis is 320 under § 1012. 


[(appreciation amount)/(total amount of gift)] * (amount paid for gift tax) = (amount you can add to existing basis to adjust basis)

*Discharge of Indebtedness

§ 61(a)(12)

(i) a taxpayer may realize income by the payment or purchase of his obligations at less than their face value

(ii)  when the amount or value of debt is greater than the quantum of debt which eliminates the debt, it is GI.  If the debt is paid off at less than face value, the difference is GI.  (Kirby Lumber)  It doesn’t matter if the mortgage is assumed because the responsibility to repay has disappeared. 


§ 101:  excludes proceeds of life insurance from GI of recipients

Two types of life insurance

1.  Term insurance:  this is cheap.  The policy lasts for a term only, usually less than life expectancy.

2.  Whole Life/Permanent Policy Insurance:  as long as you pay your premiums, you have insurance.  You have an investment element in your premiums; if you elect to cancel the insurance, you can get back a “refund” of your premium payments.

·         A—100% of the amounts received under a life insurance policy that are paid by reason of death of insured are excluded from the recipient’s income.

P. 155, 1 (a)

If B accepts the $100,000 in cash, all of it is excluded from his GI

o   (2) if the policy is transferred for valuable consideration, by assignment or otherwise, the amount excluded from GI by paragraph (1) will not exceed an amount equal to the sum of the actual value of such consideration and premiums and other amounts subsequently paid by transferee. 

§  Exceptions to this

·         (A) if such K or interest has a basis for determining gain or loss in the hands of a transferee determined in whole or in part by reference to such basis of such K or interest therein in the hands of the transferor OR

·         (B) if such transfer is to the insured, to a partner of the insured, to a partnership in which the insured is a partner, or to a corporation in which the insured is a shareholder or officer

*Exceptions to §101(a) “100% exclusion” rule

1.  If beneficiary takes the cash surrender value.  Calculation:  (Cash surrender value) – (Total of premiums paid so far) = GI

2.  Conversion to lifetime annuities for the insured.  Calculation:  (Sums received)  -- (Premiums paid) = GI

3.  Viatical settlements—if policy holder has bought/sold policy for value during the life of the insured, the § 101(a) exclusion is lost. 

4.  Beneficiary-elected interest payments—if B leaves all the proceeds with the insurer and only draws interest on the amount that would otherwise be paid as a lump sum, these payments are fully taxable.  (§ 101(c)).  This does not apply when the recurring payments eat into the principal amount of the insurance.  In that situation, § 101(d) applies.

·         C—if any amount excluded from gross income by subsection (a) is held under an agreement to pay interest thereon, the interest payments shall be included in gross income

*Exceptions to the exceptions (100% exclusion applies again)

1.  Viatical settlements between spouses and divorced couples:  when it is a transfer between spouses or property settlement incident to dissolution of marriage under § 1041, then § 1041 provides for the exclusion from GI

2.  Viatical settlements between business partners:  when transfer is gratuitiously made by or to the insured or business partners, then the proceeds are excludable (§ 101(a)(2)(B); § 101-1(b)(2)

P. 155, 1 (b)

If B leaves all the proceeds with the company and they pay her $10,000 interest in the first year, the $10,000 is included in his GI

·         D—payment of life insurance proceeds at a date later than death

o   (1) Amounts held by an insurer with respect to any beneficiary shall be prorated over the period or periods with respect to which such payments are to be made.  These prorated amounts are excluded from gross income.  Any other payments are gross income

o   (2) Amount held by the insurer with respect to any beneficiary means an amount to which subsection (a) applies which is

§  (A) held by any insurer provided for in the life insurance contract, whether as an option or otherwise, to pay such amount on a date or dates later than the death of the insured AND

§  (B) equal to the value of such agreement to such beneficiary

·         (i) as of the date of death of the insured AND

·         (ii) as discounted on the basis of the interest rate used by the insurer in calculating payments under the agreement and mortality tables

·         Calculation: (Lump sum amount) / (life expectancy of B—according to INS co’s tables) = amount that is excludable per year.  The rest will be taxed as GI

o   Note:  if B lives beyond calculated expectancy, he can continue to take the exclusions even after the full amount has been received.  If B dies before the entire amount is received, he’s SOL. 

o   (3) This subsection does not apply to any amount that (C) applies to

P. 155, 1 (c)

If B is I’s Daughter and she elects to be paid $12,000 in the current year, and $12,000 per year for the rest of her life with a life expectancy of 25 years, you look at the amortization schedule, and divide the Principal over the payment period.  $4,000 of each annual payment is considered part of the principal, and is thus excluded from tax, but the other $8,000 is considered income.

P. 155, 1 (d) If I’s Daughter lives beyond her 25 year expectancy and gets $12,000 in her 26th year, the exclusion from § 101(D) applies forever.  $4,000 will be tax-free, and $8,000 will be taxed.  Note:  if you die in year 9, there is no adjustment for dying early, so try to outlive the insurance company’s estimate.

·         G—Treatment of certain accelerated death benefits

o   (1)  Definition of amounts paid by reason of death of an insured

§  (A) any amount received under a life insurance K on the life of an insured who is a terminally ill individual

§  (B) any amount received under a life insurance K on the life of an insured who is a chronically ill individual

o   (2) Viatical Settlements

§  (A) If any portion of the death benefit under a life insurance K on the life of an insured described in (1) is sold or assigned to a viatical settlement provider, the amount paid for the sale or assignment of such portion shall be treated as an amount paid under the life insurance K by reason of death of the insured

§  (B) (i) A “viatical settlement provider” is any person regularly engaged in the trade or business of purchasing, or taking assignments of, life insurance Ks on the lives of those in (1) if

·         (I) such person is licensed for such purposes in the State in which the insured resides OR

·         (II) for people living in states where viatical settlement providers don’t have to be registered, if the provider meets the requirements of (ii) or (iii)

§  (ii) Terminally ill insureds.  Definition

·         (I) person meets the requirements of §§ 8-9 of the Viatical Settlements Model Act of the National Association of Insurance Commissioners AND

·         (II) meets the requirements of the Model Regulations of the National Association of Insurance Commissioners in determining amounts paid by such person in connection with such purchases or agreements

§  (iii) Chronically ill insureds.  Definition

·         (I) meets requirements similar to those in clause (ii)(I) AND

·         (II) meets standards, if any, of the National Association of Insurance Commissioners for evaluating the reasonableness of amounts…

o   (3) Special Rules for Chronically Ill Insureds

§  (A) Paragraphs (1) and (2) shall not apply to any payment received for any period unless

·         (i) such payment is for costs incurred by the payee for qualified long-term care services provided for the insured for such period AND

·         (ii) the terms of the K giving rise to such payment satisfy

o   (I) the requirements of §7702(b)(1)(B) AND

o   (II) the requirements, if any, applicable under (B)

§  (B) Other requirements

·         (i) §7702B(g) and §4980C

·         (ii) standards adopted by the National Association of Insurance Commissioners which specifically apply to chronically ill individuals

·         (iii) standards adopted by the State in which the policyholder resides

§  (C) Per Diem payments

·         A payment doesn’t fall outside of (A) because they are made on a per diem or other periodical basis

§  (D) Limitation on exclusion for periodic payments: See § 7702B(d)

o   (4) Definitions

§  (A) Terminally ill individual—an individual who has been certified by a physician as having an illness or physical condition which can reasonably be expected to result in death in 24 months or less after date of certification

§  (B) Chronically ill individual—excludes terminally ill individuals

§  (C) Qualified long-term care services—see § 7702B(c)

§  (D) Physician—see §186(r)(1)

o   (5) Exception for business related policies—this subsection doesn’t apply to any amount paid to any taxpayer other than the insured if the taxpayer has an insurable interest with respect to the life of the insured by reason of the insured being financially interested in any trade or business carried on by the taxpayer


An annuity is an arrangement under which one buys a right to future money payments; agreement for lifetime payments. 

Y = your (or the insured’s) investment in K (money put in)

X = total expected return on the K (money expected to get out)

Z = payment received (you will have a number of Zs determined by your K)

Formula:  Y/X = %; X = (payment amount) * ( life expectancy.)  Apply % to Z = amount excluded from GI.  The rest of Z will be GI

§ 72(a)(b)(c)

·         A—Included in GI

·         B—Exclusion Ratio

o   (1)  GI does not include the amount of the investment in the K which bears the same ratio to such amount as the investment in the K—you don’t get taxed on your capital

o   (2) Exclusion limited to your investment:

o   (3) Deduction where annuity payments cease before entire investment recovered

§  (A) If

·         (i) after annuity starting date, payments cease by reason of death of annuitant AND

·         (ii) there is unrecovered investment in the K, that amount shall be allowed as a deduction to the annuitant for his last taxable year

§  (B) Payments to other persons

§  (C) Net operating loss deductions

§ 1.72—4(a), --9 (Table V)


  1. Determine whether your damages are listed under a statute or if it is a common-law damage.  Statutory damages preempt common-law damages rules
  2. Common-Law Damages
    1. The “in lieu of” Test

                                                              i.      Damages are taxed according to what they are replacing if they are replacing lost sums.  “In lieu of what were the damages awarded?” (Raytheon)

    1. Look at the underlying nature of the claim

                                                              i.      Lost profits/income—damages for these are GI because the profit you would have gotten would have been GI

                                                            ii.      Recovery to property

1.      Money received for damaged property is NOT GI unless the amount you received IS GREATER THAN your original basis in the property.  Any excess of damages in relation to your basis is GI

a.       NOTE:  any money you receive for damaged property that is equal to or greater than your basis in the property adjusts your basis in the property for gain/loss purposes

2.      Punitive damages are GI (Glenshaw Glass)

    1. Goodwill is treated as if it is property—any damages received in excess of cost is gross income.  If the damages awarded exceeds your basis in goodwill, you get taxed. 
    2. Example:  T owns a building.  D interacts with the building and causes it damage.  The FMV of the building is 80.  T’s AB in the building is 10.  T sues D and wins damages as follows

                                                              i.      12 for damage to the property:  This money was received by virtue of owning the property.  His basis in the building was 10.  According to the statute, any excess in damages in relation to the basis is GI.  There is a gain of 2 (12 damages – 10 AB) included in T’s GI.

                                                            ii.      15 for lost rent due to damage:  Lost rent = lost profits.  T would have been taxed on this, so this is GI.

                                                          iii.      100 punitive damages:  According to Glenshaw Glass this is GI. 

  1. Statutory Damages—damages and recoveries for physical/personal injuries.  Note:  These do NOT follow the common law approach.  They are EXCEPTED from the “in lieu of” test.
    1. GI does not include money from workmen’s comp. for personal injuries OR sickness. (§ 104 (a)(1))

                                                              i.      Requirements:  state system of worker’s comp. and damages are for a worker’s comp. situation. 

    1. Tort damages for personal injuries and physical sickness, excluding punies.  (§ 104(a)(2))

                                                              i.      These can be received in lump sum or series of payment. 

                                                            ii.      Emotional Distress:  you can exclude amounts received for this if the damages are associated or attached with a personal injury OR if they are incurred as a result of the injury.  However, emotional damages causing physical symptoms = GI.

                                                          iii.      Under § 213, if money is spent to treat the emotional distress, it may be deducted…

1.      § 213—generally, there is a deduction for expenses paid during the taxable year, not compensated for by insurance or otherwise, for the medical care of T, his spouse, or a dependant to the extent that the expenses are more than 7.5% of his adjusted GI.

                                                          iv.      NOTE:  This is not fair to Ps because they are taxed on the entire amount of the settlement even though 1/3 of those go to pay attorney’s fees

    1. Amounts received through accident or health insurance (§ 104(a)(3))

                                                              i.      If these are received by an EE, they are not GI to the extent they are attributable to contributions by the employer or were paid by the employer

    1. Pensions, annuities, etc. from serving in the armed forces are excluded.  (§ 104(a)(4))
    2. Some punitive damages are excludable (§ 104(c))

                                                              i.      Civil wrongful death actions where the applicable State law (as of 9/13/95) says that only punitive damages may be awarded in such an action.



Note:  none of these statutes (§ 71, §215, § 1041) cover services or “use” of one spouse’s property by the other.  We are aiming for a universal federal standard, but Congress says you can “have it your way.”    This section shifts the liability to the spouse on the receiving end of the payments and allows a deduction to the payor spouse (so Britney’s in luck; not so much for K-Fed)

§ 71  Alimony and Separate maintenance payments

(a)     These are specifically included in GI by the statute

(b)    These include any payment in cash if such payment is (§ 71(b)(1))

a.       Received by (or on behalf of) a spouse incident to a divorce instrument

b.      The instrument does NOT designate such payment as that which is not includable in GI, and is not allowed as a deduction under § 215 (§ 71(b)(1)(B))

                                                  i.      The IRS will look to see what the intention of the parties is--

c.       For people who are separated, the payee spouse and the payor spouse cannot be members of the same household at the time such payment is made

d.      Payments do not continue past death of either spouse

e.       The payments MUST be in cash for this section to apply—if it is not cash, like a painting or something, we may have a § 1041 analysis to apply. 

§ 215—allows a deduction for payor of alimony as long as the alimony is included in the GI of the recipient.

*Flushing out the general requirements

·         Payments must be in CASH (cash, check, money order)

·         Must go to the spouse for his/her benefit (direct payment)

·         Indirect payments are subject to the Ownership Test

o   Ownership test:  who owns the asset?

§  If the paying spouse is making payments on his property, no shift

§  If he is making payments on the other spouse’s property, there can be a shift

·         Must be pursuant to divorce instrument or decree

·         Amount CANNOT be labeled as “non-alimony” in the divorce instrument or support decree

·         They must not live in the same household

·         No liability to make payments after death of payee spouse

·         Payment is NOT child support

§ 1041 Property Settlements

·         See the section about gains/losses, specifically § 1041(c).  Basically, there is no gain or loss on a transfer of property (just an exchange of each other’s basis) from an individual to a former spouse if incident to divorce.

Child Support

·         This is NOT within the parameters of GI for § 71, so they are not GI to the payee spouse and cannot be deducted from payor.  You can disguise child support as alimony because there is only a problem when it is deemed child support.  Under this new statute, child support is NOT limited to minor children—thus, you can pay child support to your kids until they are very old (sweet).

·         Things that are child support

o   If the agreement says so

o   If there are contingencies put on payments pursuant to child’s life (attainment of a certain age, marriage, dying, leaving school) as so they are clear that the payments are for the child

·         Two situations for when payments that would ordinarily be alimony will be presumed to be child support

o   When the payments are reduced not more than 6 months before or after the date the child reaches the age of majority

o   When the payments are reduced on two or more occasions which occur not more than one year before or after a different child of the payor spouse attains a certain age between 18-24.

§  Age must be the same for each child; does not have to be a whole number

§  Calculation:  on the date that reduction in payment first occurs, calculate the oldest kid’s age.  On the date the second reduction occurs, calculate the next youngest kid’s age.  Then look at the two ages and try to find a middle point—the middle point is an age.  If both kids are within that age by a year, then §71/215 doesn’t apply.  If they are not within the age by a year, then §71/215 applies. 

·         Try to find an illustration

·         Payments for less than the amount fixed in the instrument are applied to child support first and only the amount in excess of child support payment is GI to payee.

o   Example:  Britney owes K-Fed $1,000 in child support and $1,000 in alimony.  K-Fed has no GI because the entire $1,000 is treated as child support.

Sale of Principal Residence

This section is most useful if you live somewhere where there’s an enormous appreciation amount (so not San Diego).  If you sell your place of principal residence, you can exclude it from your GI.  NOTE:  Just about anything can be a residence as long as it has a bathroom and a kitchen.

*General Requirements (4)

·         If, in the 5 year period ending on the date of the sale, you have owned and used the property as your principle place of residence for periods aggregating 2 years or more, you get to exclude this from GI.  (§ 121(a))

·         You are allowed to exclude no more than $250,000.  § 121(b)(1)

·         Has not used the exclusion in the last two years

o   You can opt-out of the exclusion either at the time, or retrospectively (limit of 3 years back)

·         Is not an ex-pat

*Marriage/Joint Returns

·         However, if you file a joint return (as husband and wife) you can exclude up to $500,000 § 121(b)(2)(A) IF

o   Either spouse meets the ownership requirement § 121(b)(2)(A)(i)

o   Both spouses meet the use requirements § 121(b)(2)(A)(ii)

o   Neither spouse is ineligible under paragraph (3)

·         If the spouses do not meet the requirements above, you can only exclude up to what each spouse would be entitled to exclude if they had not been married.  For a determination like this, each spouse is treated as owning the property during the spouse that either spouse owned the property.

·         Paragraph (3) limitations

o   If you have used this section with a 2 year period ending on date of sale, you cannot use this section to exclude the gain.

*Other Exceptions

·         You can claim a reduced maximum exclusion if the primary reason for the sale is change in employment, health, or unforeseen circumstances.  § 121(c)(2)(B)

o   If the primary reason is location of employment, the employer doesn’t matter

o   § 1.121—3(c)(2) Distance safe harbor requirements

§  If your new place of employment is at least 50 miles farther from residence sold or exchanged than the former place of employment OR

§  If you had no job before; if the distance between the new place of employment and the residence sold or exchanged is at least 50 miles

§  Even if the safe harbor is not met, you can still be qualified for a reduced maximum exclusion if under the facts/circumstances, the primary reason for the sale is change in place of employment.  (See examples in the regs).

o   If the primary reason is health

o   §1.121—3(d) Sale or exchange by reason of health

§  If T, spouse, or co-owner has to move to get treatment or facilitate diagnosis of disease, illness, or injury

o   § 1.121—3(d)(2)  If the treating physician recommends a change of residence for reasons of health, you fall into the health safe harbor. 

o   Unforeseen circumstances include natural or man-made disasters, acts of war or terrorism resulting in a casualty to the residence, cessation of employment as a result of which EE is able to collect unemployment, change in employment where you are unable to pay, divorce, multiple births from the same pregnancy.  (There are more, and they are in § 1.121—3(d)(2)

·         Calculating reduced maximum exclusion § 1.121—3(g)

o   Fraction * maximum dollar limitation ($250,000 for singles, $500,000 for joint return)

§  Fraction = [shortest of (time owned, time used as principal residence, time between now and last §121 exclusion) in months or days] / [730 days or 24 months]

Income Earned Abroad

§ 911:  If an individual so elects, his foreign earned income as well as his foreign housing cost may be excluded. 

·         Things not included in foreign earned income

o   Pension/annuities paid by the US, included in GI according to § 402(b). § 911(b)(1)(B)(i-iii) OR

o   Received after the close of the taxable year following the taxable year in which the services to which the amounts are attributable are performed. § 911(b)(1)(B)(iv)

·         Limitations

o   Foreign earned income cannot exceed amount of foreign earned income computed on a daily basis at an annual rate equal to exclusion amount for the calendar year in which the taxable year begins § 911(b)(2)(A)

·         Exclusion amount

o   See table—for 2002 and beyond, it’s $80,000 § 911(b)(2)(D)(i)

·         Notes from class

o   The former benefit that the income came off of the bottom and that you restarted the tax scale is no more—now the income is added to the top.

o   Ex:  You have $80,000 excludable under § 911.  You also have $30,000 in dividends/interest, which are not excluded.  You will be in the $80,000-$100,000 tax bracket for your dividends/interest, instead of the $0-$30,000

*Housing Abroad

·         Reasonable expenses incurred or paid during the taxable year can be excluded.  These include utilities and insurance, but not interest and taxes that are deductible under § 163-164.  § 911(c)(3)(A)(i)-(ii)

Municipal Bond Interest

§ 103:  Interest on any state or local bond is not GI. 

·         Exceptions:  private, nonqualified bonds; arbitrage bonds; bonds not in registered form


Part II:  Who pays the tax?

Assignment of Income

·         If you earn the income or own the income-producing asset, you CANNOT assign the income for tax distribution/fragmentation benefit.

*Income from Services

·         Whoever earns the money pays the income tax on it, even if the compensation goes to someone else.  You cannot get rid of income by assigning it/giving it to someone else (Lucas)

·         You may choose not to get what you’re worth.  If you are going to do an arrangement like this, it is best to have it in place before the services are performed.  (Giannini).

·         You may NOT accept the funds and redirect them.

*Income from Property

·         The property is the generator of income.  The owner of the property which is generating the income is the taxpayer regardless of who receives the income. 

o   You can give the property to someone else before it generates income, if you want to get rid of it.

o   You can put the property in a trust and have your children pay the tax on interest received from the trust.

·         The fruit is taxed to whomever owns the tree.  (Helvering)

*Ways to Shift Income

·         Hire your family—you still get business deductions (salary, operation expenses) and your children will be taxed at a minimal amount

·         Trusts

·         Entities for tax purposes (corporations, LLC, partnerships, etc.)


Part III:  What can we deduct?

Deductions adjust GI to determine Taxable Income (TI).  Hence, GI – Deductions = TI

You MUST have statutory authorization to take a deduction, since they are not constitutionally required.

Business Deductions

Three categories of amount spent/incurred for decutions

  1. Amounts not allowed to be deducted EVER
    1. § 165—cannot deduct the loss for the sale/exchange of a personal asset (Unless the loss is due to a casualty)
    2. § 262—personal & family living expenses

                                                              i.      Exceptions:  Interest payments, medical expenses, state income/property taxes

  1. Amounts allowed to be deducted, but not now (deferred deductions)
    1. Capital expenditures
    2. § 195—Start Up expenditures (these get amortized)

                                                              i.      You have to set aside the expenses incurred in starting up the business and amortize them over 180 months during the operational stage of business.  If the business ends before all deductions are taken, the rest can be taken out as a full deduction on the last business return.

    1. § 167—depreciation
  1. Amounts eligible for deduction in FULL this year.
    1. § 162—trade or business expenses; operation expenses
    2. § 274
    3. § 212—expenses for production of income

§ 162:  Trade or Business Expenses (deductible in FULL for the current taxable year)

Six (6) requirements for a deduction

  1. Ordinary and Necessary
    1. This means “appropriate and helpful” (Welch)

                                                              i.      Ordinary = foreseeable in the life of the business.  The expense should be reasonable—what is reasonable is determined by the expected reaction to that type of expense in a like situation.  Ordinary transactions have a common or frequent occurrence in the type of business involved.

1.      The standard of reasonableness is very important

2.      Extraordinary things:  attorney’s fees incurred by president of a corporation in slander suit,…

                                                            ii.      Necessary = something that is “appropriate and helpful”

  1. In a trade or business (not defined in the code)
  2. Expense
    1. NOT a capital expenditure.  Those are governed by § 263. 
    2. Difference between expense and capital expenditure is one of degree not of type (INCOPCO).  You do NOT need a specific asset to require capitalization—you can do this with significant future benefits. 
    3. Routine maintenance is an expense if it is merely to maintain it in an operational condition.  § 162
    4. However, anything done to improve the property or prolong its live/propensity or anything that is an “enhancement” in the property is a capital expenditure (Midland Empire Packing)
  3. Carrying on trade/business
    1. Expenses deductible under § 162 are limited to amounts incurred while business is up and running. 

                                                              i.      § 162 deductions are not limited to successful businesses.  Business that lose money can also take deductions.

    1. Things that are NOT “carrying on trade/business”

                                                              i.      Investigatory phase—where you are looking into the industry, but not narrowed in on a particular transaction (Morton Frank)

1.      Fear not—some of these expenses can be put in to § 195 start-up expenditures and amortized

                                                            ii.      Transactional phase—attempting to purchase a specific business

    1. For EEs

                                                              i.      It is clearly established that an EE is carrying on a trade or business in his role as an EE

                                                            ii.      EEs can deduct unreimbursed expenses incurred in their capacity as EEs if the expenses meet the § 162 requirements (subject to § 274 limitations)

                                                          iii.      EEs seeking new employment—once EE has entered into a trade/business he can deduct expenses related to looking for a new job, even if he loses his original job.

1.      not allowed if T has been unemployed for such a period of time that there is a lack of continuity between the past employments and their endeavors to find new employment. 

                                                          iv.      EE education expenses § 1.162—5:  these are deductible only if incurred to maintain or improve a skill required by a current trade or business

  1. Actually paid/incurred
  2. During the taxable year

Capital Expenditures

§ 263:  The general rule is that any expenditure that will yield value beyond one year is a capital expenditure. 

·         § 263 applies to expenditures that are improvements or upgrades which prolong the operating life beyond which it would otherwise have (unlike a repair-maintenance outlay which only keeps the property in operation condition)

·         These do NOT have to be tied to property (INDOPCO)

·         Cash outlays for lawyer’s fees, investment banking fees, and SEC fees in connection with a corporate acquisition are capital expenditures not necessary and ordinary deductible expenses.

·         The following expenditures must be capitalized

o   Amounts paid to acquire, create, or enhance an intangible asset

§  Stock, partnership interest, bonds, debt instruments, options, patents/copyrights, franchise, goodwill, computer software

o   Amounts paid to facilitate the acquisition, creation, or enhancement of an intangible. 

Start-Up Expenditures

§195:  At the election of the taxpayer, these can be treated as deferred expenses.  They will be allowed as a deduction prorated equally over a period of 180 months beginning in the month when active trade of business begins.

·         You can deduct a maximum of $5,000 with a phase-out over 180 months while business is happening

·         Start-up is any amount investigating or creating a business

·         You cannot amortize a start-up expenditure that couldn’t be deducted under § 162. 

·         Only amounts that could have been deductible under § 162 can be amortized under § 195

·         This section is NOT applicable to persons seeking FIRST TIME EMPLOYMENT.

o   Exception:  Hundley case—P was a major league baseball player who was taught the tools of the trade by his father. He agreed give Dad 50% of his signing bonus if he got signed.  The court found these were deductible because they paid for services actually rendered in carrying on a business. 

Specific Deductions

*Reasonable Allowances for Salary

§ 162(a)(1)

·         Reasonable salaries can be deducted.  However, if a salary is deemed unreasonable, the business AND the EE pay taxes on all of it. 

o   What is “reasonable”?  The Return on Investment Test

§  The amount of salary balanced against the rate of return (adjusted for risk); regardless of the seemingly exorbitant nature of the salary.  A very profitable company in a challenging field may pay a lot for their CEO

·         If the return on investment is high due to some fact outside the control of the employee, then the presumption disappears. 

§  The factors test was deemed unreliable because there is no direct correlation between the factors and the determination of a reasonable salary. (Exacto)

·         The Corporate Salary Cap § 162(m):  $1M per/EE salary cap on corporate deductions

o   Exception:  Compensation in excess of $1M is deductible if

§  It is performance based compensation and

§  Voted on by shareholders

o   Private companies that are not corporations do NOT have the limit—any reasonable salary is deductible.

§  Primary concern in this area is whether the company is actually paying a salary or a dividend to the employee in question

·         Why?  Because salary is deductible by the company and dividends are not. 

·         Contingent Salaries § 1.162—7(b)(2):  These are okay if three requirements are met

o    Made pursuant to a free bargain (arms-length transaction)

o   Under reasonable circumstances

o   At the time of execution

·         Contingent salaries meeting these qualifications are deductible even if they yield higher payments than would ordinarily be paid

·         In situations where the company is family owned, there is not arm’s length bargain (Harold’s Club)

·         Golden Parachutes:  payments made to an officer/highly compensated EE (top 1% or highest paid 250 EEs) § 280G(c) or to a shareholder who leaves the company after a change of control. 

o   If the payment is 3 times the base salary, (average of past 5 years salary) or more, the payment is unreasonable and not allowable as a deduction under § 162

o   The recipient of the golden parachute is also taxed an additional 20% on the excess amount. 

Business Travel Away From Home

§ 162(a)(2)

·         Section focuses on amounts that would not ordinarily be deductible because they are personal expenses

·         You need to substantiate deductions under this section

·         Whoever pays for the expenses gets the deduction—if E reimburses EE for expenses, E gets the deduction § 274(c)(3) and (k)(2)

·         Requirements (from Rosenspan)

o   Traveling

§  §262—commuting to and from work is not excluded or deductible. 

§  § 162---home to workplace exceptions

·         If you leave home and travel outside your metro area on a daily basis to a work site that is temporary (not more than 1 year), then you may deduct expenses

o   T must have a principal place of business though

·         If T has a principal place of business and other regular places of business, daily transportation to the temporary work locations are deductible

o   Ex:  home to courthouse for an attorney

·         If you work at home as your principle place of business within the meaning of § 280A(c)(1)(A) then T may deduct transportation expenses to temporary work locations regardless of the distance

§  Traveling entirely outside of the area with work purpose at destination

·         Airfare—deductible if the principle reason for the trip is business.  This is an all or nothing deduction

o   A reasonable standby day will qualify as a business day even if no business is conducted on that day (weekends, holidays) § 1.274—4(d)(2)(v).  This section is for time spent outside of the US.

o   First class travel is okay

§  Luxury water transportation (cruises) § 274(m)

·         You only get a deduction of 2x the federal per diem amount

o   If a conference is held on a cruise ship, this is only deductible if the ship is registered in the US and all ports/calls are on US lands.  §274(h)(2)

§  Travel as a form of education is not deductible  § 274(m)(2)

§  § 274(M)(3)—you can only deduct spouse or guest if they are an employee and

·         They are essential

·         They would be subject to the deduction if they went alone

§  Certain foreign travel § 274(c)

·         You can receive a foreign (outside of the US) expense if less than a week (7 days).  However, you CANNOT take the deduction if

o   The travel is in excess of 7 days OR

o   Personal time is greater than 25% of the total time on the business trip

§  Meals

·         § 262—eating because you’re hungry or on lunch break are not excluded or deductible

·         § 162 (further limited by § 274(k))

o   Meals while traveling entirely outside of home area:  meals will not get a deduction unless the trip is long enough to require sleep.  Even then, you still only get to deduct ½ of the cost. 

o   If the meal immediately follows or is during a business transaction, you still get only ½ deduction

o   No deduction for networking during meals

o   Meals cannot be lavish or extravagant (§ 274(k)(1)(b))

o   At best, meals get 50% deduction (§ 274(n)(1))

o   Get a receipt or other proof! (§ 274(d))

§  Lodging

·         Personal days (where no business is conducted) are not deductible

·         Business days and nights are deductible

·         A reasonable standby day will qualify as a business day

·         Sleeping in your own home is not excluded/deductible.  § 262

o   Away from home

§  To be away from home, you must have a home.  Nomads get no § 162 consideration. 

§  Generally, the Tax Home is the same as the business headquarters of T.  (Flowers)

§  Deductions on a “second home” are allowed as long as there is business conducted at that location, even if it is a different business (Andrews)

o   Pursuant to business

§  T’s trade or business

Other Deductions


·         50% deduction but the activity must be directly related to business.  Business must be conducted during the entertainment, or directly preceding or following a substantial and bona fide business discussion (including business meetings at a convention or otherwise)

o   Must establish that the business was substantial in relation to the entertainment. However, it is not necessary that more time be devoted to business than entertainment.  § 1.274—2(d)(ii)(3)

·         Tickets § 274(1)—the deduction is limited to the face value of the ticket.  If the ticket says $20 and you paid the vendor $22 then you are $2 out of luck.  Don’t forget—only 50% of the $20 is allowed as a deduction.

·         Luxury Skyboxes § 274(l)(2)—the deduction is limited to the face value of the non-luxury box ticket.

·         Entertainment facilities—NO deduction for facility used in connection with the activity

o   Ex:  dues to an athletic, social, or sporting club/organization/facility


·         Dues paid to professional organizations directly related to your business ARE deductible unless some of the dues go towards a political affiliation/contribution

o   Ex:  bar fees, union dues

*Business Gifts

·         Deduction limited to $25

·         See EE fringe benefits


·         These are deductible if

o   They are required as a condition of employment

o   They are not a type that is applicable to a general usage

§  Firemen, policemen, athletes, flight attendants

*Dry Cleaning of qualified uniforms deductible


·         Generally deductible UNLESS

o   Identifiable as being for a political purpose

o   They can be a capital expenditure if you purchase a piece of property or construct a billboard to last for several years

*Political contributions are NOT deductible.

Business Losses

·         Deductible if authorized

§ 165

·         Allows deduction for any loss sustained during taxable year which has not been compensated for by insurance (§165(a))

·         Limited to trade or business loss (§ 165(c))

·         To calculate, use the AB for determining loss in § 1011


This is the only personal loss allowed to be deducted. 

*Total destruction

*For things that are not totally destroyed, loss is measured by the value before and after the storm, limited by the AB of the property. 

*Insured Items and Offsets

·         Back to the boat example.  If your boat is now worth nothing, but you recovered $4,000 in insurance for the boat, you only have a loss of $2,000, because it is offset by the insurance payment. 

*Business Assets

·         Ex:  You have a basis of $6,000 in the asset, and it is totally destroyed when it has a FMV of $4,000.  There is no insurance.  Under the rule in the reg, total destruction of property where the FMV is less than the basis, you will be allowed to take the full basis. 

*Stock Loss

·         § 165(g):  if you can’t get anyone to buy your stock, you get a loss when you can establish factually that the stock is worthless


§167 and §168 treat depreciation like an operating expense by allowing an annual deduction for wear, tear, exhaustion, and obsolesce of property.  Depreciations are allowed for property held for producing income. 


  1. Determine the useful life of the property (§ 168(c)) & § 168(e) OR § 167 (§ 1.167(a)-1(b))
  2. Determine the cost of the asset (basis + adjustments)
  3. Determine the recovery period § 168(e)
  4. Choose your method of depreciation according to its recovery period (unless you are in § 167 in which case you cannot use § 168(g))
    1. SL or 200% or 150% or § 168(g)

                                                              i.      Remember:  you can elect to depreciate more slowly but not more quickly. 

  1. Apply conventions (for §168 depreciations)
  2. Do any extra deductions apply?
    1. § 168(k); § 179

                                                              i.      Remember:  real property does NOT get §168(k) or § 179 treatment


§ 167:   Basic authorization and calculation of depreciation

  1. You can get depreciation deductions for
    1. Property used in a trade/business or
    2. Property held for the production of income

                                                              i.      Inventory and property held for sale to customer do NOT count

    1. Business and investment property can be depreciated if you can determine its useful life (apartment buildings, offices, etc.)

                                                              i.      Intangible assets can be depreciated when their useful life is determinable.  This is called amortization instead of depreciation and is controlled by § 197

  1. You must know the following to be able to depreciate an asset
    1. Adjusted basis

                                                              i.      Salvage value—when depreciating under § 167, subtract salvage value from asset before depreciating.  When depreciating under §168, the salvage value = 0. 

    1. Useful life

                                                              i.      Property with no determinable useful life CANNOT be depreciated, regardless of how it is used. 

                                                            ii.      Under § 168, you use the § 168(c) and § 168(e) tables to determine the recovery period

                                                          iii.      If § 168 doesn’t apply, you are kicked back to § 167.

1.      if § 167(h)—which is not even in our code section-- does not apply, then use the useful life or class life of your property as the recovery period.

    1. Method of depreciation (see below)
  1. § 168 tells you how much to deduct for depreciation for most property.
    1. This is a mandatory section.  If it applies, you must use the section. 
  2. If § 168 does not govern, depreciation is determined by the useful life/class life ADR (asset depreciation range) system instead of the § 168 system, which uses shorter recovery periods.
    1. The only thing that changes here is the useful life—instead of using the § 168 tables, you just use the class life of the property.

§ 168:  Accelerated Cost Recovery System (ACRS)—this is only for tangible property!

·         Recovery period—determine the recovery period to determine the number of years to depreciate over

o   Table § 168(c)

o   Methods of depreciation

o   Conventions

§  Half year—the applicable convention is the 1/2 year convention unless otherwise provided

·         Under the 1/2 year convention, the property is deemed to be in service in the midpoint of the year.  So in the first and last years, you get a 1/2 depreciation

§  Mid-Month—applies to nonresidential real property, residential real property, and any railroad grading or tunnel bore

·         Under the mid-month convention, property is deemed to be placed into service in the midpoint of such month it is placed in service

§  Mid-quarter—applies when the aggregate bases of depreciable property put into use during the last 3 months of the year exceed 40% of the total amount of depreciable property put into use in the year.

Methods of Depreciation

*Straight Line Depreciation § 168(b)

·         Same deduction every year during the recovery period.  Don’t forget your convention, though!

o   Ex:  $500 depreciation over 5 years, 1/2 year convention

§  1--$50 depreciation

§  2--$100

§  3--$100

§  4--$100

§  5--$100

§  6--$50

*ACRS (Accelerated Cost Recovery System)

·         200% declining balance—2 X SL until SL produces bigger deduction

·         150% declining balance—1.5 X SL until SL produces bigger deduction

*Extended SL depreciation § 168(g)

·         Use straight line depreciation method with recovery life listed in § 168(g)(2)(C) and applicable convention in § 168(d)

Extra Deductions

These are taken before the depreciation methods are applied.  These adjust the basis.

§ 168(k)—not in our materials

§ 179 bonus depreciations—these can be taken at your election (they are optional)

·         Allows T to treat some property as an expense and can be deducted in the year it is put into service.  § 179 applies to the aggregate amount of all the properties.  § 179 deductions can only be taken on § 168 properties that the ACRS applies to.

·         See the statute

Part VI:  Tax Shelters and Limitations

·         There are no deductions for these


·         § 183:  The Hobby Loss Provision

o   Goal:  don’t allow hobby losses to offset other income.  Otherwise, people could just take on a hobby and offset normal income all the time. 

o   To deduct the annual loss, T must demonstrate that at least a significant purpose of the venture was to earn a profit

o   How to determine this

§  Look at

·         Facts and circumstances OR

·         Rebuttable presumption:  § 183 is satisfied if T produced a profit for 3 of the last 5 years

o   2/7 years if we’re talking about racehorses

§  Amount of deduction

·         You can reduce your income to 0 for that activity, but you cannot offset other income

o   Note:  if you get through § 183, § 465 now applies.  § 465 treats the activity as an asset with a basis. The amount you can deduct through losses is limited by the amount at risk in the business.

·         § 465:  At Risk Limitations

o   Your deductible loses from a specific business or investment activity are limited to the amount you have at risk in the activity.  This section applies to individuals and closely held corporations

§  Definition of “at risk”

·         You have to be personally liable (no non-recourse loans)

·         Debt to relatives and other with interest in the venture and activity does not count

§  This section applies to all business and investment activities

§  Running tab—when you claim the deduction, you decrease the amount at risk for future deductions

·         This is a timing provision

o   If you get through § 465, then § 469 applies

·         § 469:  Passive Activity Losses

o   A person engaged in a passive activity cannot deduct the losses except against income from other passive activities

§  Definition:  A business in which T does not materially (regularly, continuously, or substantially) participate

·         Automatically considered passive activities:  limited partnership interests, rental activities

o   Objective test

§  From § 1.469—5T

·         T’s participation is material if he participates more than 500 hours per year

·         Or at least 100 hours and his participation is not less than that of other individuals

o   Married individuals can combine the work of both to meet these tests

o   Limited Deductions

§  Passive activity losses can only be used to offset income generated by those passive activities (PIG)

§  Any remaining loss can be carried over to the next year. 

·         When you exit the activity, you can claim the loss for these carryovers

Capital Gains/Losses

These are identified for special treatment.  Capital gains are income, they just get taxed at special (lower) rates.  Capital loss deductions are restricted.

·         Definition:  A capital gain/loss is

o   A gain or loss from

§  A sale or exchange of

·         Exception:  worthless stock is treated as a sale or exchange, dividends get same capital gains tax rate

§  A capital asset as defined in §1221

·         Excludes sales of stock, real property, publications of the US government

·         Accounts or notes are not capital gains

·         Your personal property—house, car (watch our for § 121 principle place of residence)

·         If it is not a capital asset, § 1222 doesn’t apply---use ordinary gain or loss

·         Tag things as STCG/L or LTCG/L

o   ST:  whether a gain or loss is short term depends on the amount of time you have had the asset.  If the length of holding was 12 months or less, it is short term.

§  If it is a short-term capital gain, T’s normal tax rate will apply

o   LT:  if the length of holding was more than 12 months

§  If there is a long-term capital gain, special tax rates apply


§  This is the only thing you get a break on

·         Special rates for capital gains

o   28%--collectibles

§  Stamps, most coins, antiques, gems, artwork, etc.  § 1(h)(4)(a), §1(h)(1)(e)

o   25%--sale of depreciable real property and § 1250 gains  § 1(h)(1)(D)

o   15%--applies to “adjusted net capital gain”. Basically this applies to everything else that the other percentages don’t apply to—including gains on stocks, bonds, investment land, other types of capital assets § 1(h)(1)(C)

o   10% and 15%--§1(h)(1)(b).  When T has inadequate ordinary income (when their income tax rates are less than 25%) there is special treatment. 

§  If T makes only a little bit of money, he gets taxed at 15%  on his entire Taxable Income, then the 10% applies to his capital gains until those capital gains take him out of the lowest tax bracket. 

Limitations for Losses

·         General rule:  capital losses cannot be used to deduct anything but capital gains. 

o   Exception:  when you are an individual (so not a corporation) and you have net capital losses, you can use at most $3,000 of those losses to offset your other income.

o   FIRST:  net all gains and losses within the rate classifications

o   SECOND:  any net losses let will wipe out gains in favor of T.  Use your losses to wipe out the highest taxed gains first, and then trickle down the list.

§  Ex:  You sold an asset that would have been taxed at 15% if you had made a gain, but you had a loss of $1,000.  You didn’t sell any other assets other than this collectable.  You sold the collectable asset and made a gain of $1,000 (since it is a collectable, you will be taxed at 28% on the gain). 

·         Result:  Net loss of 1,000 in 15% classification; net gain of 1,000 in 28% classification.  You can use your 1,000 loss from the 15% bracket against your gain made in the 28% and thus 0 capital gain. 

·         Other things

o   You cannot take a loss for the sale of your house or car


·         Earned income tax creit

·         Congress repays/overpays low-income taxpayers to reward them for engaging in productive work. 

·         Refunds portions of tax collections to those who qualify by giving them credits that offset their tax and may generate additional amounts for refunds

o   Also refunds SS and medicare taxes

·         Process

o   Calculate tax

o   Offset it with credits

·         As your income goes up, you’re phased into the taxable bracket

Alternative Minimum Tax

·         My notes say “do the reading” –crap

·         A way of requiring you to take your regular taxable income and add back elements that Congress originally thought you shouldn’t have gotten but Congress thinks will better reflect your income

·         Results:  these, plus your additional income, are subject to a flat tax of 28%

·         Clausen—this affects high-tax state citizens, people with large families

o   A middle income family with 10 children were forced into the AMT even though they didn’t make a lot of money

·         Never intended to catch people like the Clausens, but does, unfortunately

·         CA has the same system, but indexed its alternative minimum tax so that it doesn’t catch the low income people.