b'\x0cBasic Income Tax\n2021-2022 Edition\n\nWilliam Kratzke\nProfessor of Law\nThe University of Memphis\n\nCALI eLangdell\xc2\xae Press 2021\n\n\x0cAbout the Author\nProfessor William Kratzke is a Cecil C. Humphreys Professor of Law at the\nUniversity of Memphis. He received his B.A. in Political Science and the Far\nEastern & Russian Institute from the University of Washington in 1971. This\nnaturally caused him to be interested in attending law school. He received his J.D.\nfrom Valparaiso University in 1974 and was a member of the Valparaiso University\nLaw Review\xe2\x80\x99s editorial board. He received his LL.M. from Georgetown University\nin 1977.\nProfessor William Kratzke teaches tax law courses at the University of Memphis.\nHe has been a faculty member there since 1979. He has taught courses across the\ncurriculum. In addition to tax courses, he has taught trademarks, torts, civil\nprocedure, world trade law, economic analysis, and other courses. He visited Santa\nClara University and the University of Mississippi. He received Fulbright Teaching\nAwards in 1997 (Moldova) and 2001-2002 (Russia).\nProfessor Kratzke has written in the areas of tax law, trademark law, tort law, and\nantitrust law.\n\ni\n\n\x0cNotices\nThis is the 2021-2022 Edition of this casebook, updated May 30, 2021 (following\nthe revised Eighth Edition for 2020-2021) and incorporating the Tax Cuts and Jobs\nAct. Visit http://elangdell.cali.org/ for the latest version and for revision history.\n\nThis work by William Kratzke is licensed and published by CALI eLangdell Press\nunder a Creative Commons Attribution-NonCommercial-ShareAlike 3.0 Unported\nLicense. CALI and CALI eLangdell Press reserve under copyright all rights not\nexpressly granted by this Creative Commons license. CALI and CALI eLangdell\nPress do not assert copyright in US Government works or other public domain\nmaterial included herein. Permissions beyond the scope of this license may be\navailable through feedback@cali.org.\nIn brief, the terms of that license are that you may copy, distribute, and display this\nwork, or make derivative works, so long as\n\xef\x82\xb7\n\nyou give CALI eLangdell Press and the author credit;\n\n\xef\x82\xb7\n\nyou do not use this work for commercial purposes; and\n\n\xef\x82\xb7\n\nyou distribute any works derived from this one under the same licensing\nterms as this.\n\nSuggested attribution format for original work:\nWilliam Kratzke, Basic Income Tax 2021-2022 Edition, Published by CALI\neLangdell\xc2\xae Press. Available under a Creative Commons BY-NC-SA 3.0 License.\nCALI\xc2\xae and eLangdell\xc2\xae are United States federally registered trademarks owned by\nthe Center for Computer-Assisted Legal Instruction. The cover art design is a\ncopyrighted work of CALI, all rights reserved. The CALI graphical logo is a\ntrademark and may only be used with this book or your version of the book, as\npermitted under the Creative Commons license. Please contact CALI for any other\nuse.\nThis material does not contain nor is intended to be legal advice. Users seeking\nlegal advice should consult with a licensed attorney in their jurisdiction. The editors\nii\n\n\x0chave endeavored to provide complete and accurate information in this book.\nHowever, CALI does not warrant that the information provided is complete and\naccurate. CALI disclaims all liability to any person for any loss caused by errors or\nomissions in this collection of information.\nThe author wishes to express thanks to his research assistants, Magdalene Smith,\nJay Clifton, Mary Kaitlyn Cornett, and Devon Spriddle.\n\niii\n\n\x0cAbout CALI eLangdell Press\nThe Center for Computer-Assisted Legal Instruction (CALI\xc2\xae) is: a nonprofit\norganization with over 200 member US law schools, an innovative force pushing\nlegal education toward change for the better. There are benefits to CALI\nmembership for your school, firm, or organization. ELangdell\xc2\xae is our electronic\npress with a mission to publish more open books for legal education.\nHow do we define "open?"\n\xef\x82\xb7\n\nCompatibility with devices like smartphones, tablets, and e-readers; as well\nas print.\n\n\xef\x82\xb7\n\nThe right for educators to remix the materials through more lenient\ncopyright policies.\n\n\xef\x82\xb7\n\nThe ability for educators and students to adopt the materials for free.\n\nFind available and upcoming eLangdell titles at elangdell.cali.org. Show support\nfor CALI by following us on Facebook and Twitter, and by telling your friends and\ncolleagues where you received your free book.\n\niv\n\n\x0cPreface\nThis book is a basic income tax text. I intend this text to be suitable for a three-hour\ncourse for a class comprised of law students with widely different backgrounds.\nCertain principles permeate all of tax law. I have found that certain axioms or\nprinciples will carry us a long way. For example, income is taxed once \xe2\x80\x93 or treated\nas if it has been taxed. Once it has been taxed, its investment gives the taxpayer\nbasis \xe2\x80\x93 which I define not as cost but as money that will not be subject to tax again.\nEtc. The text returns to these principles throughout. I usually put these matters in\ntext boxes.\nAt a minimum, I want students who have completed basic income tax to know these\nprinciples and to be able to apply them, i.e., to develop some \xe2\x80\x9ctax intuition.\xe2\x80\x9d This\nintuition will serve well the student who wishes to take more tax classes. I tried to\nidentify what I want students to know before enrolling in corporate tax or\npartnership tax \xe2\x80\x93 and to make certain that I covered these principles in the basic\ncourse. Such intuition will also serve well the student for whom the basic course is\na \xe2\x80\x9cone and done\xe2\x80\x9d experience. Like it or not, tax law affects most legal topics, and\nsuch intuition should at least give students working in other areas of the law an idea\nof when it is time to ask questions concerning lurking tax issues.\nAt the end of every chapter, I have included a short section entitled \xe2\x80\x9cWhat have you\nlearned?\xe2\x80\x9d This page may be examined before beginning the study of a chapter. I\nintend it to be a statement of learning objectives: a student should have a solid\nunderstanding of the items listed.\nIn some areas, I have relied heavily on the CALI drills by Professor James Edward\nMaule (Villanova University). These drills both review and, in some instances,\nteach a little substance. Each zeroes in on a specific topic and should take a student\nabout twenty minutes to complete if she has adequately prepared to do the drill. Of\ncourse, students can work through such drills at their own speed. With the\nassistance of CALI\xe2\x80\x99s LessonLink, professors and students alike can monitor\nstudents\xe2\x80\x99 understanding of the discrete topics of these drills.\nI have tried to make this text very readable \xe2\x80\x93 so that students can easily understand.\nI have aimed at law students who \xe2\x80\x9cknow\xe2\x80\x9d they have no interest in income tax \xe2\x80\x93 but\nwho may find that they in fact have a considerable interest in tax law. With my\nv\n\n\x0cpolitical science background, I was such a student. I am proof that one does not\nhave to have an accounting background to find income tax law both important and\ninteresting. Additionally, Magdalene Smith and Jay Clifton III were two such\nstudents; they assisted me greatly in making this text as accessible as possible to all\nlaw students. I thank them now for their work.\nI have alternated from one chapter to the next my usage of singular indefinite\npronouns. I have used the feminine forms for chapters 1, 3, 5, 7, and 9. I have used\nthe masculine forms for chapters 2, 4, 6, 8, and 10.\nWPK\nMemphis, Tennessee, July 2013, May 2016, and May 2017.\nMy use of pronouns referring to non-specific persons alternates between the\nfeminine and masculine chapter by chapter.\nIn December 2017, Congress enacted the Tax Cuts and Jobs Act. This statute\ncontains significant measures that alter several Code provisions important to this\ncourse. Some, but not all, of these measures are \xe2\x80\x9ctemporary,\xe2\x80\x9d i.e., for calendar years\n2018 to 2025. I anticipate that we will be in for a period of intense lobbying to make\nthese changes permanent. I note and briefly describe the provisions that have been\n\xe2\x80\x9csuspended\xe2\x80\x9d \xe2\x80\x93 anticipating that many of these changes will be made permanent.\nWPK\nMemphis, Tennessee, May 2018 and May 2019\nSince spring 2020, Congress has responded to the pandemic with various tax\nmeasures \xe2\x80\x93 most of them temporary. In several places, the text includes references\nto these measures, accompanied by a general description. The text employs certain\nshort-hand abbreviations to reference the following statutes:\nCARES Act: the Coronavirus Aid, Relied, and Economic Security Act,\nPub. L. No. 116-136, 134 Stat. 281 (2020).\nCAA: the Consolidated Appropriations Act, Pub. L. No. 116-260, 134 Stat.\n1182 (2020). This legislation includes the COVID-Related Tax Relief Act\nof 2020 (CRTRA), and it includes the Taxpayer Certainty and Disaster Tax\nRelief Act of 2020 (TCDTA).\nARPA: the American Rescue Plan Act of 2021, Pub. L. No. 117-2, 135 Stat\n4.\nvi\n\n\x0cTable of Contents\nAbout the Author ............................................................................................. i\nNotices ........................................................................................................... ii\nAbout CALI eLangdell Press ........................................................................ iv\nPreface ............................................................................................................ v\nChapter 1: The Government Raises Money: Introduction to Some Basic\nConcepts of Taxes and Taxing Income ......................................................... 1\nI. Introduction to Some Basic Concepts .................................................................. 1\nII. Tax and Life............................................................................................................. 7\nIII. Some Definitions Relevant to Taxing Income ................................................. 9\nIV. Layout of the Code ............................................................................................. 15\nV. Not All Income Is Taxed and Not All Income Is Taxed Alike ..................... 17\nVI. Illustration of the Tax Formula and Working with Some Tax Terminology\n........................................................................................................................................ 18\nVII. Statements of Tax Law and the Role of Courts ............................................ 23\nVIII. Some Income Tax Policy and Some Income Tax Principles .................... 25\nIX. What We Tax: What Is Income? ....................................................................... 27\nWrap-up Questions for Chapter 1 ............................................................................ 36\nWhat have you learned?.............................................................................................. 37\nChapter 2: What Is Gross Income: Section 61 and the Sixteenth Amendment\n...................................................................................................................... 38\nI. The Constitutional and Statutory Definitions of \xe2\x80\x9cGross Income\xe2\x80\x9d ................ 38\nII. The Constitutional and Statutory Definitions of \xe2\x80\x9cGross Income:\xe2\x80\x9d\nAccessions to Wealth .................................................................................................. 71\nIII. The Constitutional and Statutory Definitions of \xe2\x80\x9cGross Income:\xe2\x80\x9d\nRealization .................................................................................................................. 112\nIV. The Constitutional and Statutory Definitions of \xe2\x80\x9cGross Income:\xe2\x80\x9d\nDominion and Control ............................................................................................. 127\nWrap-up Questions for Chapter 2 .......................................................................... 135\nWhat have you learned?............................................................................................ 136\nvii\n\n\x0cChapter 3: Exclusions from Gross Income ................................................. 137\nI. The Society and Government that We Want ................................................... 138\nII. Social Benefits ..................................................................................................... 158\nIII. Employment-Based Exclusions from Gross Income .................................. 169\nWrap-up Questions for Chapter 3 .......................................................................... 192\nWhat have you learned?............................................................................................ 192\nChapter 4: Loans and Cancellation of Indebtedness .................................. 194\nI. Tax Consequences of Borrowing Money ......................................................... 194\nII. Cancellation of Indebtedness ............................................................................ 195\nIII. Settlements of Legal Disputes Over Obligations to Pay or Repay ............ 201\nIV. Section 108(a)\'s Other Provisions ................................................................... 215\nV. Transactions Involving Property Subject to a Loan ...................................... 218\nVI. Transactions Treated as Loans ........................................................................ 238\nWrap-up Questions for Chapter 4 .......................................................................... 241\nWhat have you learned?............................................................................................ 242\nChapter 5: Progressivity and Assignment of Income ................................ 243\nI. Compensation for Services ................................................................................. 244\nII. Income Splitting: the Joint Return ................................................................... 252\nIII. Income Derived from Property ...................................................................... 258\nIV. Interest Free Loans and Unstated Interest .................................................... 270\nWrap-Up Questions for Chapter 5 ......................................................................... 272\nWhat have you learned?............................................................................................ 273\nChapter 6: Deductions: Business Expenses .............................................. 274\nI. Expense or Capital ............................................................................................... 278\nII. Deductibility Under \xc2\xa7\xc2\xa7 162 or 212 ................................................................... 336\nIII. Depreciation, Amortization, and Cost Recovery ......................................... 408\nWrap-Up Questions for Chapter 6 ......................................................................... 424\nWhat have you learned?............................................................................................ 425\n\nviii\n\n\x0cChapter 7: Personal Deductions and the Standard Deduction.................. 426\nI. \xe2\x80\x9cTax Expenditures\xe2\x80\x9d ............................................................................................. 431\nII. Denial of Discretion in Choosing How or What to Consume .................... 448\nIII. Creating a More Efficient and Productive Economy .................................. 457\nIV. Deferral Until Consumption ........................................................................... 458\nWrap-Up Questions for Chapter 7 ......................................................................... 461\nWhat have you learned?............................................................................................ 462\nChapter 8: Tax Consequences of Divorce and Intra-Family Transactions 463\nI. Introduction .......................................................................................................... 463\nII. Before Marriage................................................................................................... 464\nIII. During Marriage ................................................................................................ 469\nIV. After Marriage: Tax Consequences of Divorce ............................................ 479\nWrap-Up Questions for Chapter 8 ......................................................................... 485\nWhat have you learned?............................................................................................ 486\nChapter 9: Timing of Income and Deductions: Annual Accounting and\nAccounting Principles ................................................................................ 487\nI. Annual Accounting .............................................................................................. 487\nII. Deferral Mechanisms ......................................................................................... 500\nIII. Basic Accounting Rules .................................................................................... 509\nWrap-Up Questions for Chapter 9 ......................................................................... 531\nWhat have you learned?............................................................................................ 531\nChapter 10: Character of Income and Computation of Tax ...................... 532\nI. Capital Gain .......................................................................................................... 533\nII. Sections 1245 and 1250: Depreciation Recapture.......................................... 541\nIII. Section 1231: Some Limited Mismatching .................................................... 546\nIV. More Matching .................................................................................................. 549\nWrap-Up Questions for Chapter 10 ....................................................................... 553\nWhat have you learned?............................................................................................ 553\n\nix\n\n\x0cChapter 1: The Government Raises Money: Introduction to Some\nBasic Concepts of Taxes and Taxing Income\nI. Introduction to Some Basic Concepts\nThe United States Government needs money to operate. There are many ways our\nGovernment may raise money, only one of which is to tax its own citizens on their\nincome. A few examples follow:\nTariffs: The Government might impose tariffs (i.e., taxes) on imports or exports.\nTo sell their wares in the United States, foreign merchants at one time had to pay\nvery high tariffs. Tariffs protect domestic producers of competitive wares. This\nhardly helps domestic consumers of products subject to a tariff because they must\neither pay an artificially inflated price for an import or a noncompetitive price for\na (lower-quality?) domestic product. Export duties could also have a pernicious\neffect. They encourage domestic producers to sell more goods at home, rather than\nin foreign markets where they might have made more profits. Article 1, \xc2\xa7 9, cl. 5\nof the Constitution provides: \xe2\x80\x9cNo Tax or Duty shall be laid on Articles exported\nfrom any State.\xe2\x80\x9d Notice: import tariffs are a cost that mostly the buyers and sellers\nof the products subject to them alone pay. Furthermore, the economic interests of\ndifferent regions of the country are hardly uniform. The cotton-exporting southern\nstates early on preferred low tariffs while northeastern manufacturing interests\npreferred the protection that high import tariffs provided. See generally, DOUGLAS\nA. IRWIN, CLASHING OVER COMMERCE: A HISTORY OF US TRADE POLICY (2017)\n(recounting history of import tariffs in the United States). The burden of paying for\nGovernment is not spread very evenly if tariffs are the means of raising revenue to\nfinance the Government. Nevertheless, tariffs were the most important source of\nrevenue for our country\xe2\x80\x99s government in its early days. Now tariffs figure\nprominently in trade wars and not as revenue-raisers.\nGovernment Monopoly: The Government might choose to enter a business and\nlimit competition in that business. Most states have lotteries that they run with no\ncompetition other than what they are willing to tolerate, e.g., low-stakes bingo\ngames that charities operate. One argument favoring this means of financing\ngovernment is that there is no compulsion to buy lottery tickets, i.e., willing buyers\ncontribute to Government coffers. Many non-purchasers derive benefits from\nlottery proceeds at the expense of those willing to give up some of their wealth in\nthe forlorn hope of hitting it big. Governments may also engage in other businesses.\n1\n\n\x0cFor example, some states own the liquor stores that operate within its borders.\nGovernments may charge for services that they provide (e.g., access to parks) with\na view to making profits that are spent in pursuit of other government objectives.\nThere is always the risk that the Government might not be very good at running a\nparticular business. Government-operated airlines are notorious money-losers. And\nagain, why should consumers of certain products or services be saddled with the\nburden of paying for a government that (should) benefit(s) all of us?\nTaxing Citizens: Instead of trying to raise money only from consumers of\nparticular goods or services, Government may endeavor to spread the burden more\nevenly by taxing (most of) its citizens or residents. It may perhaps try to tax noncitizens or non-residents as well. This raises the questions of whom and what\ngovernment should tax \xe2\x80\x93 or more formally, what should be the \xe2\x80\x9ctax base.\xe2\x80\x9d There\nare various possibilities.\nThe Head Tax: A head tax is a tax that everyone who is subject to it must pay, e.g.,\nevery citizen or resident, every voter. The tax is equal in amount for all who must\npay it. A head tax is only avoidable at a cost unacceptable to most (but not all) of\nus: leave the country, renounce one\xe2\x80\x99s U.S. citizenship, surrender the right to vote.\nIts relative inescapability assures that most of those who derive some benefit from\nthe existence of a government help to pay for it. A head tax has an obvious\ndrawback. Its burden falls unequally on those subject to it. Some persons might\nhardly notice a head tax of $1000 per year while others might find such a tax to be\nan insurmountable hardship. Surely, we as a society have a better sense of fairness\nthan that. With one notable exception, we hear very little of head taxes in the United\nStates.\nThe notable exception was the poll tax that some southern states in the post-Civil\nWar era imposed as a condition of exercising the right to vote. The very purpose of\nsuch a tax was to discourage recently emancipated and almost uniformly poor Black\npersons from exercising their constitutional right to vote. The unfairness of the\nrelative tax burdens associated with this cost of voting led to adoption of the 24th\nAmendment to the Constitution, which made poll taxes unconstitutional.\nConsumption Taxes: As the name implies, consumption taxes tax consumption.\nThere are different variants of consumption taxes. Three important consumption\ntaxes are the sales tax, the excise tax, and the value added tax (VAT).\n\n2\n\n\x0cThe Ramsey Principle: Consumption taxes on\nitems for which demand is inelastic can raise a\nlot of revenue for the state. See F.P. Ramsey, A\nContribution to the Theory of Taxation, 37 ECON.\nJ. 47 (1927). For our purposes, \xe2\x80\x9cinelastic\ndemand\xe2\x80\x9d means that the quantity that buyers\nbuy does not change (much) as prices increase\nor decrease. A life-saving drug might be such\nan item. Taxes on items for which demand is\ninelastic almost by definition are unavoidable\nand so do not divert consumers\xe2\x80\x99 purchases to or\nfrom those items, i.e., they do not distort markets\nas much as other taxes might. Unfortunately, the\nthings for which demand is inelastic are often\nthings that poorer people must buy. Strict\nadherence to the Ramsey principle might create\nan excessive burden for those least well-off.\n\nSales Tax: A sales tax is a tax on\nsales and is usually a fixed\npercentage of the amount of the\npurchase. Sales taxes are relatively\neasy to collect. Sellers usually\ncollect sales taxes at the point of\nsale. Many states and localities rely\non a sales tax for a substantial\nportion of their revenue needs.\nSales taxes are collected on\namounts that citizens or residents\nspend, not on what they save.\nHence, such taxes are more\nburdensome to persons who must\nspend more (even all) of their\nincome to purchase items subject\nto a sales tax. While such taxes are\nnominally an equal percentage of\nall purchases, their effect is regressive (infra). Those who must spend all their\nincome on items subject to a sales tax pay a higher percentage of their income in\nsuch a tax than those wealthy enough to save some of their income.\nIn states that have sales taxes applicable to all purchases, every citizen or resident\nwho buys anything pays some sales tax.1 Perhaps this is fairer than alternatives.\nRecent financial crises have made clear that a state heavily dependent on sales taxes\nis vulnerable to economic downturns. Unemployment causes citizens or residents\nto reduce their purchases and so the sales tax that they pay. Economic downturns\nare the very occasions when states need more funds to finance services for which\ntheir citizens stand in greater need.\nExcise Taxes: An excise tax is a sales tax that applies only to certain classes of\ngoods, e.g., luxury items. Excise taxes on luxury items may be politically popular,\nbut those excise taxes do not raise much revenue because they are avoidable. The\ndemand for luxury items is usually highly elastic (see text box, The Ramsey\nPrinciple). Excise taxes on certain high-demand (arguably) non-necessities, e.g.,\nState legislatures may carve out exceptions. Purchases of food might be subject to a sales tax that is\nlower than for other goods. Purchases of services might not be subject to a sales tax.\n1\n\n3\n\n\x0ccellular telephones, raise much more revenue. Tourist-destination states find excise\ntaxes on services that out-of-state visitors typically purchase to be attractive, e.g.,\nrenting cars, staying in hotels, visiting tourist sites. There is nothing quite so\npolitically attractive as making someone who cannot vote in state elections\nwillingly fill the state\xe2\x80\x99s coffers.\nMost states impose excise taxes on \xe2\x80\x9csin\xe2\x80\x9d purchases, e.g., cigarettes, alcohol. The\npublic health costs associated with activities such as smoking or drinking may be\nhigh, so states tax heavily the purchases of products that cause it to have to provide\ncostly health services. Arguably, such taxes may discourage persons from making\nthe purchase in the first place.2\nValue Added Tax: This tax is imposed on all sale transactions, not solely the sale to\nthe ultimate consumer, i.e., it is imposed at every stage of production of a product.\nThe seller pays the VAT to the government minus whatever tax the seller was\nassessed upon acquiring the unfinished good. Thus, the tax base is only a\npurchaser\xe2\x80\x99s actual additions to the value of a product. The final consumer does not\nresell the product, and so pays a VAT on the full cost of the item. Many European\ncountries favor a VAT, often in combination with an income tax.\nA Progressive Consumption Tax: As we shall see infra from our discussion of the\nSchanz-Haig-Simons concept of income, it is quite possible for Government to\ncollect a tax on consumption once per year instead of incrementally upon each and\nevery purchase. The tax on such consumption could be made progressive, i.e., the\nrate of tax increases as the amount of a taxpayer\xe2\x80\x99s consumption increases (infra).\nWealth Taxes: We could tax wealth. There are two common wealth taxes: estate\ntaxes and property taxes. The estate tax is a tax imposed on the estates of decedents\nand the amount of the tax depends on the size of the estate. Property taxes are taxes\n\nHeavy smokers or drinkers are not deterred from indulging in their habits by such taxes. Light smokers\nor drinkers are more responsive to such taxes. The persons whom we might wish to deter are in fact\nnot likely to be deterred.\n2\n\n4\n\n\x0cSOI Tax Stats at a Glance: Summary of Tax Collections\nBefore Refunds by Type of Return, FY 2019\nGross Tax\nType of Return\n# of Returns Collections ($M)\nIndividual Income Tax\n154,094,555 1,922,182\nC Corporation Income Tax\nEmployment Taxes\nExcise Taxes\nGift Tax\nEstate Tax\n\n2,146,904 275,863\n31,566,173 1,207,554\n1,073,183\n80,757\n239,618\n\n1,563\n\n25,742\n\n16,002\n\nSelected Information from Individual Returns Filed\nTop 1% adj gross income (AGI) break (TY 2018)\n$540,009\nTop 10% AGI break (TY 2016)\n\n$151,935\n\nMedian AGI (TY 2016)\n\n$43,614\n\nPercent that claimed standard deduction (TY 2018) 87.3%\nPercent that itemized deductions (TY 2018)\n\n11.4%\n\nPercent e-filed (TY 2019)\n\n89.5%\n\nPercent using paid preparers (TY 2018)\n\n52.9%\n\nNumber of returns with AGI of $1M or more (TY 2018)\n541,410\nState with highest number \xe2\x80\x93 California (TY 2018)\nState with lowest number \xe2\x80\x93 Vermont (TY2018)\nEarned Income Tax Credit (TY 2018)\n# of returns with credit (millions)\nAmount claimed (billions of $)\nTaxpayer Assistance (FY 2019)\n# of call and walk-in contacts\n\n5\n\n91,560\n590\n26.5\n$64.9\n52,532,719\n\n\x0con property that taxpayers own. Municipalities often rely on property taxes to raise\nthe revenues they need. Notice that in the case of property taxes, the taxing\nauthority can tax the same \xe2\x80\x9cwealth\xe2\x80\x9d again and again, e.g., every year. This is quite\nunlike an income tax, infra. The burden of wealth taxes falls upon those who hold\nwealth in the form subject to tax. Both persons subject to the tax and those not\nsubject to the wealth tax may reap its benefits.\nWage Taxes: We could impose a flat percentage tax on all wages \xe2\x80\x93 no matter how\nhigh or how low. This is sometimes called a \xe2\x80\x9cpayroll\xe2\x80\x9d tax. Some states rely heavily\non a payroll tax. Payroll taxes are collected from employers and are therefore\ncheaper to administer than an income tax. Social Security taxes and Medicare taxes\nare wage taxes. The Social Security tax is 6.2% of employee wages that both\nemployer and employee must pay, \xc2\xa7\xc2\xa7 3101, 3111), limited to an amount indexed to\ntake account of inflation \xe2\x80\x93 about the first $120,000 of wage income, \xc2\xa7 3121(a)(1)\n(cross-referencing Social Security Act). The ceiling on the tax base of the Social\nSecurity tax creates a regressive effect (infra), i.e., those with incomes higher than\nthe ceiling pay an effective rate that is lower than the effective rate that those whose\nincome is below the ceiling must pay. The Medicare tax is 1.45% of employee\nwages that both employer and employee must pay. The Medicare tax is not subject\nto a limit. For high-income earners,3 there is an additional 0.9% tax on wages or\nself-employment income. \xc2\xa7\xc2\xa7 3101(b)(2), 1401(b)(2). The Social Security and\nMedicare programs mainly benefit senior citizens \xe2\x80\x93 and both are funded by a flat\ntax on wages of those currently working. Contrary to the claims of some politicians\nand commentators, everyone who works for her income pays some federal tax. The\nflat tax on all wages of low- to middle-income persons (combined 7.65% plus a like\namount paid by employers4) assures that many workers pay more in these flat taxes\nthan they do in progressive income taxes. This point makes the total burden of\npaying federal taxes of whatever type much less progressive than the brackets\nestablished by \xc2\xa7 1 of the Internal Revenue Code imply.\n\nTaxpayers who are married filing jointly are subject to this tax to the extent their wages or selfemployment income exceed $250,000. Taxpayers who are married filing separately are subject to this\ntax to the extent their wages exceed one-half that amount. All other taxpayers are subject to this tax to\nthe extent their wages exceed $200,000. I.R.C. \xc2\xa7\xc2\xa7 3101(b)(2), 1401(b)(2). Moreover, an individual is\nsubject to a 3.8% Medicare tax on her \xe2\x80\x9cnet investment income\xe2\x80\x9d to the extent her modified AGI\n(adjusted gross income) exceeds a threshold amount. I.R.C. \xc2\xa7 1411(a). The threshold amount is\n$250,000 for taxpayers who are married filing jointly, one-half that amount for taxpayers who are\nmarried filing separately, and $200,000 for all others. I.R.C. \xc2\xa7 1411(b).\n3\n\n4\n\nSelf-employed taxpayers must pay both halves of these taxes. See \xc2\xa7 1401.\n\n6\n\n\x0cIncome Tax: And of course we could tax income. We recognize that this is what\nthe United States and several states do. In the pages ahead, we examine the federal\nincome tax. We describe just what we mean by \xe2\x80\x9cincome.\xe2\x80\x9d It might not be what you\nexpect. We also describe the adjustments (i.e., reductions that are called\n\xe2\x80\x9cdeductions\xe2\x80\x9d) we make to the tax base and the reasons for these adjustments. An\nincome tax is difficult to avoid: a citizen or resident must have no income in order\nnot to be subject to an income tax. Thus, the burden of income taxes should be\nspread more evenly over those who derive benefits from government activities than\nthe burden of other taxes.\n\nII. Tax and Life\nThe United States taxes the income of its citizens and permanent residents. This\npersonal income tax accounts for about 55.1% of the United States Government\xe2\x80\x99s\ntax revenues.5 The Government\xe2\x80\x99s reliance on the personal income tax as a source\nof revenue has increased, and the proportion of its revenue from other taxes such\nas the corporate income tax or the estate and gift taxes has contracted. These facts\nalone provide some reason for law students to study the law of individual income\ntax.\n\nThis figure is derived from the accompanying table, SOI Tax Stats at a Glance. The portion of total\ntax revenues derived from corporate income taxes is 7.8%, from employment taxes (Social Security and\nMedicare) 34.3%, from excise taxes 2.3%, from gift taxes 0.04%, and from estate taxes 0.5%. Do these\npercentages surprise you?\n5\n\n7\n\n\x0cBeyond this, title 26 of the United States Code (the Internal Revenue Code), is\nperhaps the most comprehensive statement of policy in American law. It affects\neveryone with an income. It affects everyone with a job. It affects everyone who\nmight die. Tax law is hardly the exclusive domain of accountants and number\ncrunchers.6\nTax law is\nMultiple-Choice: In any law practice, there will be times when you can\none domain\nA. Practice a little tax law.\nof anyone\nB. Malpractice a little tax law.\nwho cares\nThere is no option C.\nabout such\nmatters as\n\xe2\x80\xa2Consider: P collected damages from D for injuries sustained in an\nfairness,\nautomobile accident. Tax consequences? Does it matter if P recovers only\neconomic\nfor her emotional distress? Same tax consequences if P collects damages\nbecause her employer discriminated against her on the basis of sex?\ngrowth, and\n\xe2\x80\xa2Consider: S is a law student. Her university awarded her a full tuition\nsocial policy.\nscholarship. Any tax issues?\nThe Code\n\xe2\x80\xa2Consider: H and W are divorcing. They will divide their property\ndefines\n(including their investments) and arrange for child support. Any tax\nbroadly the\nissues?\nincome on\n\xe2\x80\xa2Consider: A sells Blackacre to B for $30,000 more than A paid for it.\nwhich it\nAny tax issues? Do the tax issues change if B agrees to pay A in ten\nimposes a\nannual installments?\ntax. It\n\xe2\x80\xa2Consider: A wants to save money for her pension. If she understands\nprovides\nsome tax law, can she save some money \xe2\x80\x93 or even enlarge her pension?\nexceptions to\n\xe2\x80\xa2Consider: The federal government established a program whereby\nthese rules\nhomeowners who owe money on a mortgage can have the principal of\nfor those\ntheir loan reduced. Any tax issues?\ntaxpayers\n\xe2\x80\xa2Consider: E\xe2\x80\x99s employer permits E to purchase items that it sells for a\nCongress\ndiscount. Tax consequences?\ndeems\n\xe2\x80\xa2Consider: R is an employer who mistakenly paid E, an employee, a\ndeserving of\nbonus in December. After discovering the mistake, E repaid the bonus to\nexceptions.\nR. Any tax issues?\n\xe2\x80\xa2And so on. Do you really think that you can avoid issues such as these\nLegislative\nby ignoring them? See Robert W. Wood, 10 Tax Rules All Lawyers and\nexemption\nClients Should Know, 9 TAX NOTES 755 (Feb. 6, 2017).\nfrom an\notherwise\nYour author had a double major as an undergraduate \xe2\x80\x93 Political Science and the Far Eastern & Russian\nInstitute. His LL.M. is not in tax law. He learned income tax law the same way you are going to: by\nreading the Code, studying texts, and talking to people.\n6\n\n8\n\n\x0cuniversal tax implicitly states policies on many subjects.\nFar more persons will be subject to the Code\xe2\x80\x99s rules year after year than will be tort\nvictims or defendants, parties to a contract dispute, or victims of crime \xe2\x80\x93 although\nmany persons reading these lines consider those topics much more important to\ntheir legal studies and eventually their legal careers. Such persons may be right, but\nthey might be surprised at how much the individual income tax will affect their\npractices. Federal taxation is about money. Those who claim that they will avoid\ntax issues in their practices will find that they work for and with people who do care\nabout money, and they will find that avoidance of tax issues can make for some\nless-than-satisfied clients and colleagues.\n\nIII. Some Definitions Relevant to Taxing Income\nTax practitioners and scholars are conversant with certain terminology, concepts,\nand policies. We break into the seamless web of tax by considering in no\nparticular order some terms, concepts, and policies.\nTax Base: The tax base is what it is we tax. The tax base of the federal income tax\nis not all income, but rather taxable income. Section 63 defines \xe2\x80\x9ctaxable income.\xe2\x80\x9d\n\xe2\x80\x9cTaxable income\xe2\x80\x9d is \xe2\x80\x9cgross income\xe2\x80\x9d minus deductions named in \xc2\xa7 62, minus either\na standard deduction or itemized deductions, minus the deduction for \xe2\x80\x9cqualified\nbusiness income.\xe2\x80\x9d \xc2\xa7 63(a, b).7 In the remaining chapters, we examine the elements\nof this tax formula. Only the amount remaining after these subtractions is subject\nto federal income tax.\nGross Income and Adjusted Gross Income: \xe2\x80\x9cAdjusted gross income\xe2\x80\x9d is \xe2\x80\x9cgross\nincome,\xe2\x80\x9d i.e., all accessions to a taxpayer\xe2\x80\x99s, wealth minus what taxpayer spends on\nitems listed in \xc2\xa7 62. Notice that in the accompanying box (\xe2\x80\x9cThe Tax Formula\xe2\x80\x9d),\nthere is a line, i.e., \xe2\x80\x9cthe line.\xe2\x80\x9d The figure immediately beneath the line is \xe2\x80\x9cadjusted\ngross income\xe2\x80\x9d (AGI). In a very rough sense, \xc2\xa7 62 deductions are for obligatory\nexpenditures or for deferring income that will be subject to income tax at a later\ntime of consumption. Subtractions may be \xe2\x80\x9cabove the line\xe2\x80\x9d or \xe2\x80\x9cbelow the line.\xe2\x80\x9d\nTaxpayer is entitled to \xc2\xa7 62 deductions irrespective of and in addition to itemized\ndeductions or the standard deduction.\n\n7\n\nThe personal exemption deduction has been suspended until 2026. \xc2\xa7 151(d)(5).\n\n9\n\n\x0cWhen a subtraction is \xe2\x80\x9cbelow the line,\xe2\x80\x9d\nwhat happens above the line might be\nvery relevant. The Code limits certain\nitemized deductions to the amount by\nwhich an expenditure exceeds a given\npercentage of a taxpayer\xe2\x80\x99s AGI. For\nexample, a taxpayer\xe2\x80\x99s deduction for\nmedical expenditures is only the\namount by which such expenditures\nexceed 10% of a tax-payer\xe2\x80\x99s AGI.\nCongress can use such a limitation to\ncustomize such deductions. A 10%-ofAGI-floor on deductibility of medical\nexpenses provides some rough\nassurance that the amount of a medical\nexpense deduction requires a common\nlevel of \xe2\x80\x9cpain\xe2\x80\x9d among high- and lowincome taxpayers.\n\nThe Tax Formula:\n(gross income)\nMINUS deductions named in \xc2\xa7 62\nEQUALS (adjusted gross income (AGI))\nMINUS (standard deduction or itemized\ndeductions)\nMINUS (deduction for \xe2\x80\x9cqualified\nbusiness income\xe2\x80\x9d)\nEQUALS (taxable income)\nCompute income tax liability from tables\nin \xc2\xa7 1 (indexed for inflation)\nMINUS (credits against tax)\nLearn this formula.\n\nExclusions from Gross Income: We (say that we) measure \xe2\x80\x9cgross income\xe2\x80\x9d by a\ntaxpayer\xe2\x80\x99s \xe2\x80\x9caccessions to wealth.\xe2\x80\x9d However, there are some clear accessions to\nwealth that Congress has declared taxpayers do not count in tallying up their \xe2\x80\x9cgross\nincome,\xe2\x80\x9d e.g., employer-provided health insurance (\xc2\xa7 106), life insurance proceeds\n(\xc2\xa7 101), interest from state or local bonds (\xc2\xa7 103), various employee fringe benefits\n(e.g., \xc2\xa7\xc2\xa7 132, 129, 119). Many exclusions are employment-based.8 Congressional\nexclusion of clear accessions to wealth from the income tax base creates certain\nincentives for those able to realize such untaxed gain \xe2\x80\x93 and for those who profit\nfrom supplying the benefit (e.g., life insurance companies, providers of medical\nservices9) in exchange for untaxed dollars.\nDeductions from Taxable Income: Congress permits taxpayers who spend their\nmoney in certain prescribed ways to subtract the amount of such expenditures from\nSee William P. Kratzke, The (Im)Balance of Externalities in Employment-Based Exclusions from\nGross Income, 60 THE TAX LAWYER 1 (2006).\n8\n\nSee William P. Kratzke, Tax Subsidies, Third-Party Payments, and Cross-Subsidization: America\xe2\x80\x99s Distorted\nHealth Care Markets, 40 U. MEM. L. REV. 279, 311-12 (2009) (tax subsidized health insurance makes\nmore money available to health care providers).\n9\n\n10\n\n\x0ctheir taxable income. A deduction reduces only income otherwise subject to income\ntax. Hence, the person who gives her time to work for a charity may not deduct the\nfair market value (fmv) of the time because taxpayer would not otherwise be taxed\non the fmv of her time. In lieu of itemizing such expenditures, taxpayers may elect\nto reduce their taxable income by a standard deduction.\nIncome Phaseouts and Deduction Caps: When Congress wants to reduce the\nincome tax liability of a lower-income taxpayer for having made a particular\nexpenditure but not the income tax liability of a higher-income taxpayer who made\nthe same expenditure, it may phase the benefit out as a taxpayer\xe2\x80\x99s income increases.\nCongress may also limit (i.e., \xe2\x80\x9ccap\xe2\x80\x9d) the amount a taxpayer may deduct. An\nexample of both a phaseout and a cap is \xc2\xa7 221, the deduction for interest paid on\n\xe2\x80\x9cqualified education loans.\xe2\x80\x9d The maximum deduction for such interest is $2500.\n\xc2\xa7 221(b)(1). Section 221(b)(2) reduces the cap by a percentage that increases as a\ntaxpayer\xe2\x80\x99s \xe2\x80\x9cmodified adjusted gross income\xe2\x80\x9d increases above an amount indexed\nfor inflation. When the percentage reaches 100%, taxpayer may not deduct any\namount for paying qualified education loan interest. Consider: what is the profile\nof a taxpayer who would benefit most from deductibility of student loan interest\nand what is the profile of a taxpayer that would benefit least?\nCongress can apply phaseouts and caps to both credits and deductions. The precise\nmechanics and income levels of various phaseouts and caps differ. Income\nphaseouts and caps increase the complexity of the Code and so also increase the\ncost of compliance and administration. They can make it very difficult for a\ntaxpayer to know what her effective tax rate is \xe2\x80\x93 as any change in AGI or deductions\neffectively changes this rate. Income phaseouts are a tool of congressional\ncompromise. Perhaps Congress is so willing to enact income phaseouts because\nthere are many inexpensive tax preparation programs available to taxpayers that\nperform all necessary calculations.\nAssignment: Go to IRS.Gov, then to \xe2\x80\x9c1040 and Schedules 1-6.\xe2\x80\x9d Print these forms.\nThen go to \xe2\x80\x9cOther 1040 Schedules.\xe2\x80\x9d Print Schedule A. Examine these forms and\nnotice how they implement the \xe2\x80\x9ctax formula\xe2\x80\x9d described in the text box.\nProgressive Tax Brackets, Progressive Tax Rates, or Progressive Taxation:\nTaxpayers do not attach the same importance to every dollar that they earn. To a\nperson whose annual taxable income is $10 million, one dollar more or less has far\nless value (as gain or loss) than the same dollar has to a person whose annual taxable\n11\n\n\x0cincome is less than $1000.10 Hence, the person with $10 million of income who\nreceives one more dollar might feel the same level of sacrifice if she must pay $0.90\nof it in federal income tax \xe2\x80\x93\nand so keeps only $0.10 of\nProgressive Rates and Income Redistribution: An argument\nit \xe2\x80\x93 as the person with\nfavoring progressive tax brackets \xe2\x80\x93 aside from the\n$1000 of income who\ndeclining marginal utility of money \xe2\x80\x93 is that the effect of\nreceives one more dollar of\nprogressive tax brackets is to redistribute income in\nincome might feel if she\nfavor of those who have less. After all, Government has\nmust pay $0.05 of it in\nonly to spend the many dollars contributed by higherfederal income tax and so\nincome taxpayers for the benefit of those less well-off \xe2\x80\x93\nkeeps $0.95 of it. The Tax\nand there will be income redistribution. Any person who\nCode endeavors to require\nis even slightly aware of current social conditions knows\nequal\nsacrifice\nby\nthat the Tax Code has not proved to be a particularly\nestablishing\nprogressive\ntax\neffective instrument of income redistribution. Inequality\nrates. Look at \xc2\xa7 1 of the\nin wealth distribution is at near historically high levels.\nCode \xe2\x80\x93 preferably the latest\nHigh-income taxpayers pay less in taxes and keep more\ntable that the IRS has\nof their incomes than serious efforts at redistribution\npromulgated in a Revenue\nrequire. We all like tax cuts, but they can starve the\nProcedure that adjusts tax\nGovernment. There are candidates for public office who\nargue for a maximum marginal tax bracket much higher\nrates for inflation. An\nthan the current maximum of 37%.\nunderstanding of the tax\nformula should lead you to\nconclude that the first\ndollars of a taxpayer\xe2\x80\x99s income are not taxed at all. The next dollars above that\nthreshold \xe2\x80\x93 and only those dollars \xe2\x80\x93 are subject to a tax of 10%. The next dollars\nabove the next threshold \xe2\x80\x93 and only those dollars \xe2\x80\x93 are subject to a tax of 12%. And\nso on \xe2\x80\x93 at rates of 22%, 24%, 32%, 35%, and 37%. Tax brackets that increase as\ntaxable income increases are \xe2\x80\x9cprogressive\xe2\x80\x9d tax brackets. The highest individual tax\nbracket is 37%, but no taxpayer pays 37% of her taxable income in federal income\ntaxes; do you see why?\nRegressive Tax: A \xe2\x80\x9cregressive tax\xe2\x80\x9d is one where the percentage that taxpayers pay\ndecreases as their income increases. A flat tax is one where the percentage that\ntaxpayers pay is equal at all income levels. Some flat taxes are regressive in effect,\ne.g., a flat sales tax imposed on the purchase of necessities, supra.\n\n10\n\nWe refer to this phenomenon as the declining marginal utility of money.\n\n12\n\n\x0cEffective tax rate: Because we have a progressive rate structure, not every dollar of\ntaxable income is taxed at the same rate. Moreover, income derived from some\nsources is taxed differently than income derived from other sources. For example,\nan individual taxpayer\xe2\x80\x99s \xe2\x80\x9cnet capital gain\xe2\x80\x9d (essentially long-term capital gains plus\nmost dividends) is taxed at a lower rate than her ordinary income. It may be useful\nThe Upside Down Nature of Deductions and Exclusions: A taxpayer pays a certain\nmarginal rate of tax on the next dollar that she derives in gross income. Hence,\na high-income taxpayer who pays a 37% marginal tax rate gains $0.63 of\nadditional spending power by earning one more dollar. The higher a taxpayer\xe2\x80\x99s\nmarginal tax bracket, the less an additional dollar of income will net the\ntaxpayer. The same principle works in reverse with respect to deductions. The\nsame taxpayer might be considering contributing $1 to her public radio station\nfor which she would be entitled to a charitable contribution deduction. The public\nradio station would receive $1 while the taxpayer sacrifices only $0.63. On the\ndeduction side, the higher a taxpayer\xe2\x80\x99s marginal tax rate, the more an additional\ndollar of deduction will save the taxpayer in income tax liability. And the lower\na taxpayer\xe2\x80\x99s marginal tax rate, the less an additional dollar of deduction will\nsave the taxpayer in income tax liability. A taxpayer whose marginal rate of\ntax is 10% must sacrifice $0.90 in order that her public radio station receives $1.\nThe same principle applies to exclusions from gross income. A high-income\ntaxpayer saves more on her tax bill by accepting employment benefits excluded\nfrom gross income than a low-income taxpayer, infra. These results might be the\nopposite of what policy-makers desire, i.e., they are \xe2\x80\x9cupside-down.\xe2\x80\x9d The\nmagnitude of this \xe2\x80\x9cupside-downness\xe2\x80\x9d depends upon the degree of progressivity\nof tax rates. Raising tax rates on high income earners will increase the \xe2\x80\x9cupsidedownness\xe2\x80\x9d of deductions and exclusion. On the other hand, flat credits against\ntax liability will reduce the \xe2\x80\x9cupside-downness\xe2\x80\x9d of these incentives.\nfor policy-makers to know what certain taxpayers\xe2\x80\x99 \xe2\x80\x9ceffective tax rate\xe2\x80\x9d is, i.e.,\n(amount of tax)/(total income).\nMarginal Tax Rate: A taxpayer\xe2\x80\x99s marginal tax rate is the rate at which the next (or\nlast) dollar is taxed. Because we have a progressive rate structure, this rate will be\ngreater than the taxpayer\xe2\x80\x99s effective tax rate. Among the reasons that the marginal\ntax rate is important is that it is the rate that determines the cost or value of whatever\ntaxable-income-affecting decision a taxpayer might make, e.g., to work more, to\nhave a spouse work outside the home, to incur a deductible expense, to accept a\nbenefit that is excluded from her gross income in lieu of salary from an employer.\n13\n\n\x0cTax Incidence: \xe2\x80\x9cTax incidence\xe2\x80\x9d is a phrase used to name the person on whom the\nburden of paying a tax falls. The phrase is used to identify occasions where the\nostensible payor of a tax can shift the burden to another.11 For example, a property\nowner may be responsible for payment of real property taxes, but if the landowner\nsimply increases the rentals that her tenants must pay, the incidence of such a tax\nfalls on the tenants of the property owner.\nCredits against Tax Liability: A taxpayer\nmay be entitled to one or more credits\nagainst her tax liability. The Code allows\nsuch credits because taxpayer has a\ncertain status (e.g., low-income person\nwith (or without) children who works),\nbecause taxpayer has spent money to\npurchase something that Congress wants\nto encourage taxpayers to spend money\non (e.g., childcare), or both (e.g., lowincome saver\xe2\x80\x99s credit). The amount of\nthe credit is some percentage of the\namount spent; usually (but not always)\nthat percentage is fixed.\n\nThe Right Side Up Nature of Tax Credits:\nThe effect of a tax credit equal to a\ncertain percentage of an expenditure is\nprecisely the same as a deduction of the\nexpenditure from taxable income for a\ntaxpayer whose marginal tax rate is the\nsame as the percentage of the\nexpenditure allowed as a credit. Thus, if\nCongress wants to encourage certain\nexpenditures and wants to provide a\ngreater incentive to low-income persons\nthan to high-income persons, it can\nestablish the percentage of the\nexpenditure allowed as a credit at a\nlevel higher than the marginal tax\nbracket of a low-income taxpayer but\nlower than the marginal tax bracket of a\nhigh-income taxpayer, e.g., 14%. Such a\ncredit will benefit a lower-income bracket\ntaxpayer more than a deduction would\nand a higher-income taxpayer less than a\ndeduction would. If this is what Congress\ndesires, the effect of a tax credit is \xe2\x80\x9cright\nside up.\xe2\x80\x9d\n\nA credit reduces the taxpayer\xe2\x80\x99s tax\nliability dollar-for-dollar. The credit is\nusually a percentage of some\nexpenditure that the taxpayer made.\nSome credits are \xe2\x80\x9cnon-refundable.\xe2\x80\x9d This\nmeans that they cannot reduce a\ntaxpayer\xe2\x80\x99s tax liability to less than zero.\nOther tax credits are \xe2\x80\x9crefundable,\xe2\x80\x9d i.e.,\nthey can reduce a taxpayer\xe2\x80\x99s tax liability\nto less than zero in which case the\nGovernment will pay the taxpayer the excess. You can see that a refundable credit\n\nConstitutional scholars have observed that the phrase \xe2\x80\x9cdirect taxes\xe2\x80\x9d (see Art. I, \xc2\xa7 9, cl. 4 of U.S.\nConstitution) refers to taxes whose burden cannot be transferred to another, e.g., head taxes. Implicitly,\n\xe2\x80\x9cindirect taxes\xe2\x80\x9d are taxes whose burden can be transferred to another, e.g., excise taxes. The point at\nwhich a transferee is not willing to pay the \xe2\x80\x9cindirect tax\xe2\x80\x9d constitutes a practical limit on congressional\npower to increase such taxes.\n11\n\n14\n\n\x0cfunctions as a Government benefit program because the taxpayer\xe2\x80\x99s right to payment\ndoes not depend on owing the Government any money.\nOne Last Word about Employment Taxes: \xe2\x80\x9cEmployment taxes\xe2\x80\x9d are the social\nsecurity tax and the medicare tax that we all pay on wages we receive from\nemployers.12 Employers pay a like amount.13 Self-employed persons must pay the\nequivalent amounts as \xe2\x80\x9cself-employment\xe2\x80\x9d taxes. The Government collects\napproximately one third of its tax revenues through these taxes \xe2\x80\x93 much more than\nit collects from corporate income taxes, gift taxes, estate taxes, and excise taxes\ncombined. Eligibility to be a beneficiary of the social security program or medicare\nprogram does not turn on a person\xe2\x80\x99s lack of wealth or need. The federal government\ncollects a lot of money from working people so that all persons \xe2\x80\x93 rich and poor \xe2\x80\x93\ncan benefit from these programs.\nAlternative Minimum Tax: In response to news stories about certain wealthy people\nwho managed their financial affairs in such a way that they paid little or nothing in\nfederal income tax, Congress enacted the alternative minimum tax (AMT) scheme.\nI.R.C. \xc2\xa7\xc2\xa7 55-59. The basic scheme of the AMT is to require all taxpayers to\ncompute their \xe2\x80\x9cregular tax\xe2\x80\x9d liability and their \xe2\x80\x9calternative minimum tax liability.\xe2\x80\x9d\nThey compute their AMT liability under rules that adjust taxable income upward\nby eliminating or reducing the tax benefits of certain expenditures or of deriving\nincome from certain sources. They reduce the alternative minimum taxable income\nby a flat standard deduction that is subject to indexing. A (nearly) flat rate of tax\napplies to the balance. Taxpayer must pay the greater of her regular tax or AMT.\nCongress aimed the AMT at high-income persons who did not pay as much income\ntax as Congress thought they should.14\n\nIV. Layout of the Code\nThe Internal Revenue Code is at title 26 of the United States Code. It is the law that\nCongress passed and that the President signed (unless there was a veto over-ride).\n26 U.S.C. \xc2\xa7 3101(a) (for \xe2\x80\x9cOld-Age, Survivors, and Disability Insurance;\xe2\x80\x9d 6.2%); 26 U.S.C. \xc2\xa7 3101(b)\n(for \xe2\x80\x9cHospital Insurance;\xe2\x80\x9d 1.45% and 2.35% for amounts over a certain threshold).\n12\n\n26 U.S.C. \xc2\xa7 3111(a) (for \xe2\x80\x9cOld-Age, Survivors, and Disability Insurance;\xe2\x80\x9d 6.2%); 26 U.S.C. \xc2\xa7 3111(b)\n(for \xe2\x80\x9cHospital Insurance;\xe2\x80\x9d 1.45%).\n13\n\nWe will not spend any more time on the AMT. You should be aware that it exists and of its basic\napproach to addressing a particular (perceived) problem.\n14\n\n15\n\n\x0cThe first part of your statutory supplement includes some of these provisions. The\nsecond part of your statutory supplement includes some of the regulations that the\nDepartment of the Treasury has promulgated. These regulations construe the Code.\nThe Code provisions appear in your supplement without any reference to title 26,\ne.g., \xe2\x80\x9csec. 61.\xe2\x80\x9d Regulations are denoted \xe2\x80\x9cReg.\xe2\x80\x9d The regulations that we study begin\nwith a \xe2\x80\x9c1,\xe2\x80\x9d followed by the Code section that they construe. Each regulation is\nnumbered according to the sequence in which Treasury promulgated it. Reg. \xc2\xa7 618 is the eighth regulation that Treasury promulgated that construes section 61.\nWe will be studying only certain portions of the Internal Revenue Code. You should\nlearn the basic outline of Code provisions that establish the basic income tax. The\ntable of contents to your statutory supplement provides such an outline. This will\ngive you a good hunch of where to find the answer to particular questions. Some\nprominent research tools are organized according to the sections of the Code.\nSpecifically \xe2\x80\x93\n\xc2\xa7\xc2\xa7 1 and 11 establish tax rates;\n\xc2\xa7\xc2\xa7 21-53 provide credits against tax liability;\n\xc2\xa7\xc2\xa7 55-59 establish the alternative minimum tax;\n\xc2\xa7\xc2\xa7 61-65 provide some key definitions concerning \xe2\x80\x9cgross income,\xe2\x80\x9d\n\xe2\x80\x9cadjusted gross income,\xe2\x80\x9d and \xe2\x80\x9ctaxable income;\xe2\x80\x9d\n\xc2\xa7\xc2\xa7 67-68 provide rules limiting deductions;\n\xc2\xa7\xc2\xa7 72-91 require inclusion of specific items (or portions of them) in gross\nincome;\n\xc2\xa7\xc2\xa7 101-139G state rules concerning exclusions from gross income;\n\xc2\xa7\xc2\xa7 141-149 establish rules governing state and local bonds whose interest\nis exempt from gross income;\n\xc2\xa7 152 defines who is a \xe2\x80\x9cdependent;\xe2\x80\x9d\n\xc2\xa7\xc2\xa7 161-199A establish rules governing deductions available both to\nindividuals and to corporations;\n\xc2\xa7\xc2\xa7 211-223 establish rules governing deductions available only to\nindividuals;\n\xc2\xa7\xc2\xa7 241-250 establish rules governing deductions available only to\ncorporations;\n\xc2\xa7\xc2\xa7 261-280H deny or limit deductions that might otherwise be available;\n\xc2\xa7\xc2\xa7 441-483 provide various rules of accounting, including timing of\nrecognition of income and deductions;\n\xc2\xa7\xc2\xa7 1001-1021 provide rules governing the recognition of gain or loss on the\ndisposition of property;\n16\n\n\x0c\xc2\xa7\xc2\xa7 1031-1045 provide rules governing non-recognition of gain or loss upon\nthe disposition of property, accompanied by a transfer and adjustment to\nbasis;\n\xc2\xa7\xc2\xa7 1202-1260 provide rules for defining and calculating capital\ngains/losses;\n\xc2\xa7\xc2\xa7 1271-1288 provide rules for original issue discount.\nThese are (more than) the code sections that will be pertinent to this course.\nObviously, there are many more code provisions that govern other transactions.\n\nV. Not All Income Is Taxed and Not All Income Is Taxed Alike\nThree Levels of Tax Law: Tax law will come at you at three\nlevels. The emphasis on them in this course will hardly be\nequal. Nevertheless, you should be aware of them. They\nare \xe2\x80\x93\n(1) Statute and regulation reading, discernment of precise\nrules and their limits, application of these rules to specific\nsituations;\n(2) Discerning and evaluating the policies underlying\nvarious provisions of the Internal Revenue Code;\n(3) Consideration of the role of an income tax in our\nsociety. What does it say about us that our government\nraises so much of its revenue through a personal income\ntax? Other countries rely more heavily on other sources of\nrevenue. A personal income tax raises a certain amount\nof revenue. Some countries raise less revenue and provide\ntheir citizens (rich and poor alike) fewer services. Other\ncountries (notably Scandinavian ones) raise more revenue\nand provide their citizens (rich and poor alike) with more\nservices. The tax share of national income in the United\nStates is about 30%; in Great Britain, it is about 40%; in\nSweden, it is about 55%. THOMAS PIKETTY, CAPITAL IN THE\nTWENTY-FIRST CENTURY 476 (2014). Moreover, the United\nStates provides middle- and high-income persons with\nmore services and benefits than most people realize.\n\n17\n\nThe tax formula begins\nwith a taxpayer\xe2\x80\x99s \xe2\x80\x9cgross\nincome.\xe2\x80\x9d Every ensuing\nmathematical operation\nis a subtraction. This\nmeans that if the Code\nshould deem a\nparticular accession to\nwealth not to be \xe2\x80\x9cgross\nincome,\xe2\x80\x9d that accession\nwill not be part of a\ntaxpayer\xe2\x80\x99s \xe2\x80\x9ctaxable\nincome.\xe2\x80\x9d Congress has\nchosen to exclude\ncertain accessions to a\ntaxpayer\xe2\x80\x99s wealth from\n\xe2\x80\x9cgross income.\xe2\x80\x9d See\n\xc2\xa7\xc2\xa7 101 to 139G.\nExclusions from \xe2\x80\x9cgross\nincome\xe2\x80\x9d is the subject\nof chapter 3.\nBeyond exclusions from\ngross income, Congress\nhas determined that not\n\n\x0call taxable income should be taxed the same. Notably, long-term capital gains15 (or\nmore accurately \xe2\x80\x9cnet capital gain\xe2\x80\x9d) plus most dividend income of an individual is\ntaxed at a lower rate than wage or salary income. Interest income derived from the\nbonds of state and local governments is not subject to any federal income tax.\nCertain other income derived from particular sources is subject to a marginal tax\nrate that is less than the tax rate applicable to so-called ordinary income. This\nencourages some taxpayers to seek income from tax-favored sources rather than\nfrom other sources.\n\nVI. Illustration of the Tax Formula and Working with Some Tax\nTerminology\nConsider a hypothetical family that is not unusual \xe2\x80\x93 whether or not it is typical. The\npoint here is to illustrate how the tax formula works and to work with some basic\ntax terminology that we already know. Take this illustration one step at a time. You\nmay not grasp all its details early in the semester. You will notice some of the\nCode\xe2\x80\x99s \xe2\x80\x9cmoving parts\xe2\x80\x9d and their inter-relatedness. Two \xe2\x80\x9cmoving parts\xe2\x80\x9d are the\nindexed tax rates that change every year and inflation-adjusted deduction limits that\nalso change every year. At the very front of your Code, you will find the current\nrates and limits. We apply the rates for 2021.\nBill and Mary are husband and wife. They have two children, Thomas who is 14\nand Stephen who is 10. Bill works as a manager for a large retailer. Last year, he\nearned a salary of $80,000. His employer provided the family with health insurance\nthat cost $14,000. Mary is a school administrator who earned a salary of $85,000.\nHer employer provided her a group term life insurance policy with a death benefit\nof $50,000; her employer paid $250 to provide her this benefit. Their respective\nemployers deducted employment taxes from every paycheck and paid each of them\nthe balance. In addition to the above items, Bill and Mary own stock in a large\nAmerican corporation, and that corporation paid them a dividend of $500. Bill and\nMary later sold that stock for $10,000; they had paid $8000 for it several years ago.\nBill and Mary have a joint bank account that paid interest of $400. Bill and Mary\npaid $4300 for daycare for Stephen. They also paid $3000 of interest on a student\nloan that Bill took out when he was in college. We will determine Bill and Mary\xe2\x80\x99s\ntax liability. Assume that they will file as married filing jointly.\n15\n\nThat is, gain on the sale of property that a taxpayer owns for more than one year.\n\n18\n\n\x0cHow much are Bill\xe2\x80\x99s employment taxes? How much are Mary\xe2\x80\x99s employment taxes?\n\xe2\x80\xa2Answer: Employment taxes are 6.2% for \xe2\x80\x9csocial security\xe2\x80\x9d and 1.45% for\n\xe2\x80\x9cMedicare.\xe2\x80\x9d The total is 7.65%. The tax base of employment taxes is\nwages. So:\n\xe2\x80\xa2Bill: Bill\xe2\x80\x99s wages were $80,000. 7.65% of $80,000 = $6120.\n\xe2\x80\xa2Mary: Mary\xe2\x80\x99s wages were $85,000. 7.65% of $85,000 = $6502.50.\nHow much is Bill and Mary\xe2\x80\x99s \xe2\x80\x9cgross income?\xe2\x80\x9d16 You should see that this is the first\nline of the tax formula. We need to determine what is included in, and what is\nexcluded from, \xe2\x80\x9cgross income.\xe2\x80\x9d See \xc2\xa7\xc2\xa7 61, 79, and 106.\n\xe2\x80\xa2Answer: Since Bill and Mary will file jointly, we pool their relevant income\nfigures. Employment taxes do not reduce Bill and Mary\xe2\x80\x99s gross income.\nThus, they must pay income taxes on at least some of the employment taxes\nthat they have already paid.\n\xe2\x80\xa2Bill and Mary must include the following: Bill\xe2\x80\x99s salary (\xc2\xa7 61(a)(1)) of\n$80,000; Mary\xe2\x80\x99s salary (\xc2\xa7 61(a)(1)) of $85,000; dividend (\xc2\xa7 61(a)(7)) of\n$500; capital gain (\xc2\xa7 61(a)(3)) of $2000; interest income (\xc2\xa7 61(a)(4)) from\nthe bank of $400. TOTAL: $167,900.\n\xe2\x80\xa2Bill and Mary do not include the amount that Bill\xe2\x80\x99s employer paid for the\nfamily\xe2\x80\x99s health insurance (\xc2\xa7 106)(a)), $14,000, or the amount that Mary\xe2\x80\x99s\nemployer paid for her group term life insurance (\xc2\xa7 79(a)(1)), $250. Bill and\nMary certainly benefitted from the $14,250 that their employers spent on\ntheir behalf, but \xc2\xa7\xc2\xa7 106 and 79 provide that they do not have to count these\namounts in their \xe2\x80\x9cgross income.\xe2\x80\x9d\nHow much is Bill and Mary\xe2\x80\x99s adjusted gross income (AGI)? See \xc2\xa7\xc2\xa7 221 and\n62(a)(17).\n\xe2\x80\xa2Section 221 entitles Bill and Mary to deduct interest on the repayment of a\nstudent loan. While the couple paid $3000 in student loan interest,\n\xc2\xa7 221(b)(1) limits the deduction to $2500.\n\xe2\x80\xa2Section 221(b)(2) requires the computation of a phasedown. Section\n221(b)(2)(A) provides that the deductible amount must be reduced by an\namount determined as per the rules of \xc2\xa7 221(b)(2)(B). Section 221(a)(2)(B)\n\xe2\x80\x9cGross income,\xe2\x80\x9d \xc2\xa7 61, is a topic that we take up in chapter 2. It encompasses all \xe2\x80\x9caccessions to\nwealth.\xe2\x80\x9d However, there are some \xe2\x80\x9caccessions to wealth\xe2\x80\x9d that we do not include in a taxpayer\xe2\x80\x99s \xe2\x80\x9cgross\nincome.\xe2\x80\x9d We consider some of those in chapter 3. The Code defines these exclusions in \xc2\xa7\xc2\xa7 101 to\n139G. The Code also defines the scope of certain inclusions in \xc2\xa7\xc2\xa7 72 to 91 \xe2\x80\x93 and implicitly excludes\nwhat is outside the scope of those inclusions.\n16\n\n19\n\n\x0cestablishes a ratio. Section 221(f) requires that the IRS keep the ratio up-todate by indexing. Every year, the IRS announces in a revenue procedure the\nvalues to be used when a relevant Code provision requires indexing. For tax\nyear 2021, the \xc2\xa7 221(b)(2)(B) amount for taxpayers married filing jointly is\n$140,000. Rev. Proc. 2020-45, 2020-46 I.R.B. 1016, at \xc2\xa7 3.30.\n\xe2\x80\xa2Since Bill and Mary are married filing a joint return, \xc2\xa7 221(a)(2)(B)(i)\nestablishes a numerator of: $167,900 \xe2\x88\x92 $140,000 = $27,900.\n\xe2\x80\xa2Section 221(b)(2)(B)(ii) establishes a denominator of $30,000.\n\xe2\x80\xa2The ratio that \xc2\xa7 221(b)(2)(B) prescribes is $27,900/$30,000, i.e.,\n0.93.\n\xe2\x80\xa2Section 221(b)(2)(B) requires that we multiply this ratio by the\namount of the deduction otherwise allowable, i.e., $2500 and then\nreduce $2500 by the resulting amount. $2500 x 0.93 = $2325. $2500\n\xe2\x88\x92 $2325 = $175. For paying $3000 in student loan interest, Bill and\nMary may deduct only $175.\n\xe2\x80\xa2Section 62(a)(17) provides that this amount is not included in taxpayers\xe2\x80\x99\nAGI.\n\xe2\x80\xa2Thus: Bill and Mary\xe2\x80\x99s AGI = $167,900 \xe2\x88\x92 $175 = $167,725.\nHow much is Bill and Mary\xe2\x80\x99s \xe2\x80\x9ctaxable income\xe2\x80\x9d? See \xc2\xa7 63.\n\xe2\x80\xa2Answer: Section 63(a and b) defines \xe2\x80\x98taxable income\xe2\x80\x9d as EITHER \xe2\x80\x9cgross\nincome\xe2\x80\x9d minus allowable deductions OR AGI minus a standard\ndeduction.17\n\xe2\x80\xa2We are told of no deductions that would be \xe2\x80\x9citemized,\xe2\x80\x9d so Bill and Mary\nwill elect to take the standard deduction. This is another figure indexed for\ninflation. For tax year 2021, the standard deduction for taxpayers who are\nmarried and filing jointly is $25,100. Rev. Proc. 2020-45, 2020-46 I.R.B.\n1016, at \xc2\xa7 3.16.\n\xe2\x80\xa2Do the math: $167,725 MINUS $25,100 equals $142,625 of \xe2\x80\x9ctaxable\nincome.\xe2\x80\x9d\nHow much is Bill and Mary\xe2\x80\x99s income tax liability? See \xc2\xa7\xc2\xa7 1(a, h, and j), 1222(3\nand 11).\n\xe2\x80\xa2Answer: Remember, not all income is taxed alike. Long-term capital gain\nand many dividends are taxed at a maximum rate of 20%. \xc2\xa7 1(h)(1)(D) and\nSection 63(b) provides for a reduction of taxable income by personal exemptions and of the\ndeduction provided in \xc2\xa7 199A. The personal exemption deduction has been suspended, and \xc2\xa7 199A\nprovides a deduction for certain pass-through entities. We leave these aside for purposes of this\nillustration.\n17\n\n20\n\n\x0c\xc2\xa7 1(h)(11). Bill and Mary received $2000 in long-term capital gain and $500\nin dividends. Bill and Mary\xe2\x80\x99s taxable income will be greater than $80,800\nand will not be greater than $501,600, so this portion of their taxable income\nwill be taxed at the rate of 15%, i.e., $375. See Rev. Proc. 2020-45, 202046 I.R.B. 1016, at \xc2\xa7 3.03.\n\xe2\x80\xa2The tax on the balance of their taxable income will be computed using the\ntables at \xc2\xa7 1(j) of the Code, indexed for inflation:18 $142,625 MINUS\n$2500 equals $140,125. Go to \xc2\xa7 1(j)(2)(A). Bill and Mary\xe2\x80\x99s taxable income\nis more than $81,050 and less than $172,750. Hence their federal income\ntax liability on their ordinary income equals $9328 PLUS 22% of ($140,125\n\xe2\x88\x92 $81,050) = $9328 + $12,996.50 = $22,324.50.\n\xe2\x80\xa2Do you see the progressiveness in the brackets?\n\xe2\x80\xa2Total tax liability = $375 + $22,324.50 = $22,699.50.\nAre Bill and Mary entitled to any credits? If so, what is the effect on their income\ntax liability? See \xc2\xa7\xc2\xa7 21 and 24.\n\xe2\x80\xa2Answer: Section 21 provides a credit on a portion of up to $8000 (up from\n$3000 pre-pandemic) for the \xe2\x80\x9cdependent care\xe2\x80\x9d expenses for a \xe2\x80\x9cqualifying\nindividual.\xe2\x80\x9d Stephen is a \xe2\x80\x9cqualifying individual,\xe2\x80\x9d \xc2\xa7 21(b)(1)(A). Thomas is\nnot a \xe2\x80\x9cqualifying individual,\xe2\x80\x9d but Bill and Mary did not spend any money\nfor Thomas\xe2\x80\x99s \xe2\x80\x9cdependent care.\xe2\x80\x9d The credit is now 50% (up from 35% prepandemic) of the amount that Bill and Mary spent on such care that is\nsubject to a phasedown of 1 percentage point for each $2000 of AGI by\nwhich Bill and Mary\xe2\x80\x99s AGI exceeds $125,000 (up from $15,000 prepandemic), down to a minimum credit of 20%. \xc2\xa7 21(a)(2). Bill and Mary\xe2\x80\x99s\nAGI of $167,725 is $42,725 more than $125,000. This means that their\ndependent care credit will be reduced from 50% to 29%. And, 29% of $4800\nis $1392. Bill and Mary may claim a tax credit for dependent care expenses\nof $1392 (up from 20% of $3000, i.e., $600, pre-pandemic; they received\nno credit for the amount they spent in excess of $3000 pre-pandemic).\n\xe2\x80\xa2Bill and Mary may also claim a \xe2\x80\x9cchild tax credit\xe2\x80\x9d for each of their children.\n\xc2\xa7 24(a). Both Thomas and Stephen are \xe2\x80\x9cqualifying\xe2\x80\x9d children. \xc2\xa7 24(c)(1).\nSection 24(h)(2) provides a $3000 credit for each of the children. There will\nbe no phasedown of the credit because Bill and Mary\xe2\x80\x99s \xe2\x80\x9cmodified adjusted\ngross income\xe2\x80\x9d does not exceed $400,000. \xc2\xa7 24(h)(3). Total credit: $4000.\n\xe2\x80\xa2Total tax credits = $1392 + $6000 = $7392.\n\xe2\x80\xa2The effect of a tax credit is to reduce taxpayers\xe2\x80\x99 tax liability \xe2\x80\x93 not their AGI\n18\n\nThe latest tax brackets are in the front pages of your student edition of the Code and Regulations.\n\n21\n\n\x0cor \xe2\x80\x9ctaxable income.\xe2\x80\x9d $22,699.50 minus $7392 equals $15,307.50.\nWhat is Bill and Mary\xe2\x80\x99s effective income tax rate?\n\xe2\x80\xa2Answer: Bill and Mary\xe2\x80\x99s federal income tax liability is $15,307.50. Their\neffective tax rate computed with respect to their \xe2\x80\x9cadjusted gross income\xe2\x80\x9d is\n$15,307.50/$167,725, i.e., 9.13%.\n\xe2\x80\xa2Notice that we could use a different income figure to determine\ntheir effective tax rate, e.g., \xe2\x80\x9cgross income,\xe2\x80\x9d \xe2\x80\x9cgross income plus\nexclusions,\xe2\x80\x9d \xe2\x80\x9ctaxable income.\xe2\x80\x9d We have included employment taxes\nin this determination.\nWhat is Bill and Mary\xe2\x80\x99s marginal tax bracket?\n\xe2\x80\xa2Answer: 22%. You should recognize this as the multiplier that we obtained\nfrom the tax table.\n\xe2\x80\xa2Question: If Bill and Mary made a deductible contribution of $1, how much\nwould this save them in federal income tax liability (if they itemized their\ndeductions)?\n\xe2\x80\xa222% of the amount they contributed, i.e., $0.78.\n\xe2\x80\xa2Question: If the neighbors offered to pay Bill $1000 to paint their house,\nhow much would Bill actually net if he took them up on the offer?\n\xe2\x80\xa2$1000 \xe2\x80\x93 (22% of $1000) = $780 (disregarding employment taxes).\n\n22\n\n\x0cVII. Statements of Tax Law and the Role of Courts\nThe Tax Code is federal\nstatutory law. There are\nseveral features concerning\nits\ninterpretation\nand\nenforcement that require\nunderstanding a few more\nterms and their importance.\nThink of statements of tax\nlaw and their authoritative\nweight as a pyramid. Every\nstatement noted on the\npyramid must be consistent\nwith every statement above\nit. Inconsistency with a\nhigher statement is a ground\nto challenge enforcement.\nAs we move down the\npyramid, the binding power\nof\nthese\nstatements\ndiminishes.\n\nEnforcement of the Tax Laws and Court Review: The\nIRS, a part of the Department of the Treasury,\nenforces the federal tax code. It follows various\nprocedures in examining tax returns \xe2\x80\x93 and we leave\nthat to a course on tax practice and procedure or to\na tax clinic. When it is time to go to court because\nthere is no resolution of a problem, a taxpayer has\nthree choices:\n1. Tax Court: The Tax Court is a specialized court\ncomprised of nineteen judges. It sits in panels of three\njudges. There is no jury in Tax Court cases. Taxpayer\ndoes not have to pay the amount of tax in dispute to\navail herself of court review in Tax Court. Appeals\nfrom Tax Court are to the United States Court of\nAppeals for the Circuit in which the taxpayer resides.\n2. Court of Claims. The Court of Claims hears cases\ninvolving claims \xe2\x80\x93 other than tort claims \xe2\x80\x93 against the\nUnited States. It sits without a jury. Taxpayer must\npay the disputed tax to avail herself of review by the\nClaims Court. Appeals from a decision of the Court of\nClaims are to the United States Court of Appeals for\nthe Federal Circuit.\n3. Federal District Court. Taxpayer may choose to\npay the disputed tax and sue for a refund in the\nfederal district court for the district in which she\nresides. Taxpayer is entitled to a jury, and this is often\nthe main motivation for going to federal district court.\nAppeals are to the United States Court of Appeals\nfor the federal circuit of which the federal district\ncourt is a part.\n\nAt the pinnacle of the\npyramid is the United States\nConstitution.\nEvery\nstatement of tax law below\nthe Constitution must be\nconsistent\nwith\nit.\nImmediately below the\nConstitution is the Internal\nRevenue Code, enacted\npursuant to the lawmaking\nauthority of Congress. Courts may construe provisions of the Code. Depending on\nthe level of the court and the geographic area (i.e., federal circuit) subject to its\n\n23\n\n\x0crulings, those decisions are binding constructions of the Code\xe2\x80\x99s provisions.19 The\nIRS may announce that it does or does not acquiesce in the decision of any court\nlower than the Supreme Court. Outside of the Code with its highly specific and at\ntimes technical language and court and administrative construction of it, there is\nvery little federal income tax law. After all, taxpayers should not be made to guess\nwhat rule of tax liability a court (or other enforcement body) may decide to\nprescribe and enforce.\nImmediately below the Code on the pyramid are regulations that the Secretary of\nthe Treasury promulgates. These regulations are usually interpretive in nature. So\nlong as these regulations are consistent with the Code20 and the Constitution, they\nare law. The same rules of court construction of the Code apply to construction of\nregulations.\nA revenue ruling is a statement of what the IRS believes the law to be on a certain\npoint and how it intends to enforce the law. Since the tax liability of a taxpayer is\n\nSee Marbury v Madison, 5 U.S. 137, 177 (duty of courts to say what the law is and to expound and\ninterpret it). In other countries, court constructions of a code are persuasive authority only. A code\nstill prevails in such countries over court pronouncements insofar as they might guide persons other\nthan parties to a case.\n19\n\nIn Mayo Found. for Med. Educ. and Res. v. U.S., 562 U.S. 44 (2011) the Supreme Court held that\nreviewing courts should give Chevron deference when passing upon the validity of Treasury Department\n(i.e., IRS) regulations. 562 U.S. at 55-56 (upholding regulation providing that employee normally\nscheduled to work 40 or more hours per week does not perform such work incident to and pursuant to\ncourse of study; employer not exempt from paying employment taxes). Chevron, U.S.A. Inc. v. Natural\nRes. Def. Council, Inc., 467 U.S. 837 (1984) established a two-part framework by which courts\ndetermine whether to defer to administrative rulemaking: (1) Has Congress addressed the precise\nquestion at issue? If not: (2) Is the agency rule \xe2\x80\x9carbitrary or capricious in substance, or manifestly\ncontrary to the statute.\xe2\x80\x9d If not, then the reviewing court is to defer to the agency rule. 562 U.S. at 5253. In King v. Burwell, 576 U.S. 473, (2015), the Court refused to defer to the IRS on the question\nwhether the tax credits of 26 U.S.C. \xc2\xa7 36B were available to those who purchased health insurance\nthrough federal exchanges rather through than state exchanges. An IRS regulation said \xe2\x80\x9cyes.\xe2\x80\x9d The\nCourt nevertheless made its own determination because this was an extraordinary case.\n20\n\nThe tax credits are among the Act\xe2\x80\x99s key reforms, involving billions of dollars in spending each\nyear and affecting the price of health insurance for millions of people. Whether those credits\nare available on Federal Exchanges is thus a question of deep \xe2\x80\x9ceconomic and political\nsignificance\xe2\x80\x9d that is central to this statutory scheme; had Congress wished to assign that\nquestion to an agency, it surely would have done so expressly.\n576 U.S. at 485-86.\n\n24\n\n\x0c(generally) the business of only the taxpayer and the IRS,21 this can be very\nvaluable information. A revenue procedure is an IRS statement of how it intends\nto proceed when certain issues are presented. The IRS saves everyone the expenses\nof litigating such questions as whether an expenditure is \xe2\x80\x9creasonable,\xe2\x80\x9d\n\xe2\x80\x9csubstantial,\xe2\x80\x9d or \xe2\x80\x9cde minimis\xe2\x80\x9d in amount by announcing bright line construction of\nsuch terms. Revenue rulings and revenue procedures are not law, and courts may\nchoose to ignore them.\nA private letter ruling is legal advice that the IRS gives to a private citizen upon\nrequest (and the fulfillment of other conditions). These rulings are binding on the\nIRS only with respect to the person or entity for whom the IRS has issued the letter\nruling. Publication of these rulings is in a form where the party is not identifiable.\nWhile not binding on the IRS with respect to other parties, the IRS would hardly\nwant to establish a pattern of inconsistency.\nOther statements of the IRS\xe2\x80\x99s position can take various forms, e.g., technical advice\nmemoranda, notices. These statements are advisory only, but remember: the source\nof such advice is the only entity who can act or not act on it with respect to a\ntaxpayer.\n\nThree Principles to Guide Us Through Every Question of\nIncome Tax: There are three principles (which are less\nthan rules but close enough):\n1. We tax income of a taxpayer once and only once.\n2. There are exceptions to Principle #1, but we\nusually must find those exceptions explicitly defined\nin the Code itself. We define exceptions with\nprecision.\n3. If there is an exception to Principle #1, we treat\nthe untaxed income as if it had been taxed and we\naccomplish this by making appropriate adjustments\nto \xe2\x80\x9cbasis.\xe2\x80\x9d\nLearn these principles.\n\nVIII. Some Income\nTax Policy and Some\nIncome Tax Principles\nThe United States has\nadopted an income tax code,\nand the discussion now\nzeroes in on the statute that\nCongress has adopted and\nsome broad policy issues that\nthe Code raises. The Code\nitself implicitly embodies\ncertain\nprinciples\n(see\n\nSee Simon v. Eastern Kentucky Welfare Rights Organization, 426 U.S. 26, 40-45 (1976) (taxpayer\nunable to show that tax benefit given to other taxpayers caused injury to itself that any court-ordered\nrelief would remedy).\n21\n\n25\n\n\x0caccompanying text box). A tax code that requires taxpayers to pay income tax on\nless than all of their accessions to wealth and to pay different rates on different\ntypes of income necessarily raises questions of policy, equity, and fairness.\nTax Expenditures: Congress may choose not to make\ncitizens pay income tax on receipt of certain benefits\nor on purchase of certain items. For example, an\nemployee who receives up to $14,300 (inflationadjusted amount for 2020) from an employer for\n\xe2\x80\x9cqualified adoption expenses\xe2\x80\x9d may exclude that\namount \xe2\x80\x93 as adjusted for inflation and subject to a\nphaseout \xe2\x80\x93 from her \xe2\x80\x9cgross income.\xe2\x80\x9d \xc2\xa7 137. A\ntaxpayer who pays such expenses may claim a credit\nequal to the amount that she paid. \xc2\xa7 36C. A taxpayer\nwho benefits from either of these two provisions enjoys\na reduction in the federal income tax that she\notherwise would have to pay. We can view that\nreduction as a government expenditure. In fact, we call\nit a \xe2\x80\x9ctax expenditure.\xe2\x80\x9d These two tax expenditures\nwere expected to be $0.4B in tax year 2020. Joint\nCommittee on Taxation, Estimates of Federal Tax\nExpenditures for Fiscal Years 2019-2023 (JCX-55-19)\nDecember 18, 2019, 27. The tax expenditure for\nemployer contributions for employee health care was\nexpected to be $173.9B. Id. See EDWARD D. KLEINBARD,\nWE ARE BETTER THAN THIS: HOW GOVERNMENT SHOULD\nSPEND OUR MONEY 241-63 (2015) (\xe2\x80\x9cThe hidden hand\nof government spending\xe2\x80\x9d).\n\nFairness and Equity: Issues of\nfairness as between those who\nmust pay an income tax arise.\nIf two taxpayers have equal\nincomes, a reduction in one\ntaxpayer\xe2\x80\x99s taxable income\nreduces\nthat\ntaxpayer\xe2\x80\x99s\nincome tax liability. If the\ngovernment is to raise a\ncertain amount of money\nthrough an income tax, a\nreduction in one taxpayer\xe2\x80\x99s\ntax liability necessarily means\nthat someone else\xe2\x80\x99s tax\nliability must increase. Thus,\nreduction of some taxpayers\xe2\x80\x99\ntax liability is a matter of\nconcern for everyone else. The\ngovernment may choose to\ndiscriminate in its assessment\nof tax liability. The policy\nconsiderations that justify\nreducing one taxpayer\xe2\x80\x99s tax\nliability but not another\xe2\x80\x99s are\nthe essence of tax policy.\n\nThree Guiding Principles: This leads us to observe that there are three norms\nagainst which we measure income tax rules:\n1. Horizontal equity: Taxpayers with equal accessions to wealth should pay\nthe same amount of income tax. Like taxpayers should be taxed alike. Of\ncourse, we can argue about which taxpayers are truly alike.\n2. Vertical equity: Unlike taxpayers, i.e., taxpayers with different\naccessions to wealth, should not be taxed alike. Those with more income\nshould pay more and pay a higher percentage of their income in taxes.\nIncome tax rates should be progressive.\n26\n\n\x0c3. Administrative feasibility: The tax system only applies to persons who\nhave incomes. The rules should be easy to understand and to apply \xe2\x80\x93 for\nboth the taxpayer and the collection agency, the Internal Revenue Service.\nThe first two of these principles are corollaries, i.e., each is little more than a\nrestatement of the other. Consider how closely we can come to defining \xe2\x80\x9cincome\xe2\x80\x9d\nin a way that meets that meets the first two norms.22\n\nIX. What We Tax: What Is Income?\nWe may think of \xe2\x80\x9cincome\xe2\x80\x9d as the amount of money we receive for working at a job\nor for investing money that we have saved. However, if we wish to tax alike all\ntaxpayers whose situations are alike, our notion of income must expand. Surely two\nworkers whose wages are the same should not be regarded as like taxpayers if one\nof them wins $1M in the state\xe2\x80\x99s lottery. The difference between these two taxpayers\nis that one has a much greater capacity to consume (i.e., to spend) and/or to save\nthan the other. This suggests that pursuing the policies of horizontal and vertical\nequity requires that we not limit the concept of \xe2\x80\x9cincome\xe2\x80\x9d to the fruits of labor or\ninvestment. Rather we should treat the concept of \xe2\x80\x9cincome\xe2\x80\x9d as a function of both\nspending and saving. The economist Henry Simons propounded this very important\ndefinition:\nPersonal income may be defined as the algebraic sum of (1) the market\nvalue of rights exercised in consumption and (2) the change in the value of\nthe store of property rights between the beginning and end of the period in\nquestion.23\nDerivation of the same formula is also attributed to Georg von Schanz and to Robert\nMurray Haig. We may refer to this formula as the Schanz-Haig-Simons formula,\nthe Haig-Simons formula, or the SHS formula. The SHS formula reflects that a\ntaxpayer who receives income can either save (invest) or spend it.\n\nSee Boris I. Bittker, A \xe2\x80\x9cComprehensive Tax Base\xe2\x80\x9d as a Goal of Income Tax Reform, 80 HARV. L. REV. 925,\n934 (1967) (arguing that many of the changes necessary to create truly comprehensive tax base would\nbe unacceptable).\n22\n\n23\n\nHenry C. Simons, Personal Income Taxation 50 (1937).\n\n27\n\n\x0cIf Algebra or Economics Scare You \xe2\x80\x93\nThe algebra inherent in the SHS formula is not as daunting as might appear. The\nphrase \xe2\x80\x9crights exercised in consumption\xe2\x80\x9d merely reflects what a taxpayer spent (or\nwould have spent if she received something for which she did not have to pay) to\npurchase something. The phrase \xe2\x80\x9cadditions to the storehouse of property rights\xe2\x80\x9d\nmerely reflects a taxpayer\xe2\x80\x99s saving money, perhaps by depositing some of her\nincome in a savings account or in a more sophisticated investment.\nThe SHS definition is an (enormously convenient) \xe2\x80\x9calgebraic sum.\xe2\x80\x9d If it is true that:\n(Income) = (Consumption) + (Additions to the store of property rights)\nthen it is equally true that\n(Income) \xe2\x88\x92 (Additions to the store of property right) = (Consumption).\n\nThe Unit of Measurement of Income, Consumption, and\nSavings \xe2\x80\x93 USD: Inflation in the United States or\nelsewhere affects the relative value of savings held\nin different currencies. We measure taxable income\nby the currency of the United States, i.e., dollars.\nSimilarly, we measure basis in assets by dollars. We\nassume that the value of a dollar does not change\nbecause of inflation. (We might alter the ranges of\nincome subject to particular tax rates \xe2\x80\x93 i.e., to index\n\xe2\x80\x93 but we do not alter the number of dollars subject to\nincome tax.) We do not adjust the amount of income\nsubject to tax because the value of a dollar fluctuates\nagainst other of the world\xe2\x80\x99s currencies. Instead, we\nrequire that transactions carried out in other\ncurrencies be valued in terms of dollars at the time of\nthe relevant income-determinant events, i.e.,\npurchase and sale. This applies to transactions\ninvolving virtual currencies such as bitcoin. See Notice\n2014-21, 2014-16 I.R.B. 938 (Q&A 3; \xe2\x80\x9cA taxpayer\nwho receives virtual currency as payment for goods\nor services must, in counting gross income, include the\nfair market value of the virtual currency measured in\nU.S. dollars ...\xe2\x80\x9d).\n28\n\nThis point is quite useful to\nthose who (believe that they)\nwant the government to tax\nconsumption rather than\nincome, perhaps because they\nbelieve that those who save\nrather than spend deserve to\nand will pay less in taxes than\nthey do under the current\nsystem. The algebraic quality\nof this definition assures that\nno matter what our tax base\nis, we would never have to\nbear the expense or endure\nthe inconvenience of keeping\ntrack of what we individually\nspend\non\nconsumption.\nAnyone who has received a\nW-2 from an employer or a\n1099-INT from a bank knows\nthat we can expect an\nemployer or a bank to provide\n\n\x0cthe pertinent information about wages or savings with an acceptable degree of\naccuracy. From this information, a taxpayer can determine what she spent on\nconsumption by manipulating the SHS formula as above. When a(n odd) question\narises outside the ambit of W-2s or 1099s, e.g., whether a taxpayer should include\nin her taxable income the value of a meal that she does not have to purchase for\nherself, we simply adjust an element of the formula, and adjustment will drive an\nadjustment of at least one other element of the formula. Income, consumption, and\nsavings are functions of each other.\nSome Obvious or Not-so-Obvious Implications of the SHS Definition of \xe2\x80\x9cIncome\xe2\x80\x9d\nIf we choose to tax what we spend and what we save during a particular time period,\nthen we are taxing only increments to a taxpayer\xe2\x80\x99s overall well-being. Our tax code\ndemands an annual accounting and assessment even though this can be\ninconvenient \xe2\x80\x93 and even inaccurate \xe2\x80\x93 for some taxpayers. What happens during the\nyear is treated as an increment to what happened before, e.g., we added to a savings\naccount that we already had, we consumed only a portion of an asset we already\nown. We do not tax accumulated wealth \xe2\x80\x93 property taxes and estate taxes do that.\nA concept integral to our income tax is \xe2\x80\x9cbasis,\xe2\x80\x9d and its function is to measure what\nhappened before and to assure that our income tax does not tax accumulated wealth\nbut only increments to it.\na. Taxing Income Is Taxing Consumption Plus Increments to the Power to\nConsume\nFocus now on additions to \xe2\x80\x9cthe store of property rights\xe2\x80\x9d that a taxpayer may\naccumulate during a relevant period and not on the consumption element of the\nSHS definition. Taxing a taxpayer\xe2\x80\x99s increments to savings and investment is\nequivalent to taxing additions to taxpayer\xe2\x80\x99s unexercised power to consume.\nTaxation of income is therefore the taxation of consumption plus increments to the\npower to consume.\nPeople save money only if they value future consumption more than current\nconsumption and believe that they can spend their savings on future consumption.\nCongress may encourage taxpayers to save for later consumption by not taxing the\n\n29\n\n\x0cincome that taxpayers willingly \xe2\x80\x93 and provably \xe2\x80\x93 save for certain items of\nconsumption, e.g., saving for retirement through individual retirement accounts\n(IRAs) or \xe2\x80\x9c401(k)s.\xe2\x80\x9d\nb. Income, Consumption, and Value: The Consequences of Foregoing\nValue\nThe measure of value is what a person is willing to pay for something she does not\nhave or the price at which a person is willing to sell something she does have. A\nperson cannot value something more than what she is able to give in exchange. A\nperson should pay no more than the value she places on an item she wants or sell\nan item for less than the value she places on it.24\nBuyers try to purchase items at prices less than they value them. The excess is\n\xe2\x80\x9cbuyer surplus.\xe2\x80\x9d Sellers try to sell items at prices higher than those at which they\nare willing to sell them. The excess is \xe2\x80\x9cseller surplus.\xe2\x80\x9d \xe2\x80\x9cBuyer surplus\xe2\x80\x9d plus \xe2\x80\x9cseller\nsurplus\xe2\x80\x9d equals \xe2\x80\x9ccooperative surplus.\xe2\x80\x9d The cooperative surplus that buyer and\nseller create may or may not be shared equally \xe2\x80\x93 in fact there is no way to determine\nwith certainty how they share the surplus. Those buyers or sellers with more market\npower than their counterparts \xe2\x80\x93 perhaps they have a monopoly or a monopsony \xe2\x80\x93\nmay capture all or almost all the cooperative surplus. Nevertheless, every voluntary\ntransaction should increase the overall wealth of the nation, i.e., the sum of the\nvalues we all place on what we have.\nWe assume that taxpayers who\nvoluntarily enter transactions\nknow best what will increase\nsurplus value to themselves, and\nthat the choices each taxpayer\nmakes concerning what to buy\nand what to sell are no concern\nof any other taxpayer. We also\nassume that all taxpayers make\npurchasing choices with income\nthat has already been subject to\ntax. Section 262(a) implements\n24\n\nTaxing Only the Creation of Value? Exchanges\noften generate income that the Code subjects to\nincome tax. Arguably, the Code should not\nsubject to tax the payoff from exchanges that\neveryone understands (probably) reduce a\ntaxpayer\xe2\x80\x99s wealth, but this is not the case. For\nexample, court-ordered damages that a\nplaintiff deems inadequate to compensate for\nthe loss of an unpurchased intangible (e.g.,\nemotional tranquility) may nevertheless be\nsubject to income tax. See \xc2\xa7 104(a).\n\nA person tends to value what she already has more than what she does not have.\n\n30\n\n\x0cthis assumption by denying deductions to taxpayers for purchases of items for\npersonal consumption, including expenditures for basic living expenses. The\nstatement that an expenditure is \xe2\x80\x9cpersonal\xe2\x80\x9d implies a legal conclusion concerning\ndeductibility. If the money used to purchase items for personal consumption is\nsubject to income tax, as a matter of policy the choices of any taxpayer with respect\nto such purchases should be unfettered. This observation supports not taxing the\nmoney taxpayer spends to make purchases that she has no option not to purchase.\nOn the seller\xe2\x80\x99s side, we should not have a tax code that favors selling one type of\ngood or service over another. Sellers should be encouraged to utilize their resources\nin whatever trade or business maximizes their own seller surplus, even illegal\nones.25 This is good for buyers because sellers should choose to produce those\nthings whose sale will create buyer surplus. A seller\xe2\x80\x99s choice of which good or\nservice to offer should not depend on the cost of producing or providing that good\nor service, but on the net profit she can derive from its sale. A necessary implication\nof this is that we should tax only the net income of those engaged in a trade or\nbusiness \xe2\x80\x93 not gross proceeds. Section 162 implements this policy by allowing a\ndeduction for ordinary and necessary trade or business expenses. One engaged in a\ntrade or business generates profits by consuming productive inputs, and the cost of\nthose inputs should not be subject to tax. If a taxpayer\xe2\x80\x99s trade or business consumes\nproductive inputs only slowly, i.e., over the course of more than a year, principles\nof depreciation26 require the taxpayer to spread those costs over the longer period\nduring which such consumption occurs. See, e.g., \xc2\xa7\xc2\xa7 167 and 168. Those who\nengage in activities that cannot create value but which really amount to a zero-sum\ngame, e.g., gambling, should not be permitted to reduce the income on which they\npay income tax to less than zero. See \xc2\xa7 165(d).27\n\nThe only exception to this principle is the trade or business of trafficking in certain controlled\nsubstances. See \xc2\xa7 280E.\n25\n\n26\n\n... or amortization or cost recovery.\n\nBut see Commissioner v. Groetzinger, 480 U.S. 23 (1987) (full-time gambler who makes wagers solely\nfor his own account is engaged in a \xe2\x80\x9ctrade or business\xe2\x80\x9d within meaning of \xc2\xa7 162).\n27\n\n31\n\n\x0cAn Observation about the Tax Cuts and Jobs Act:\nIn December 2017, Congress made significant\nchanges to the Code. It eliminated some\ndeductions altogether, e.g., the deduction for\nalimony paid. It suspended for eight years\nseveral deductions, e.g., the deductions for\npersonal exemptions, for \xe2\x80\x9cmiscellaneous\ndeductions,\xe2\x80\x9d and for moving expenses. At the\nsame time, it doubled the standard deduction.\nFor example, the standard deduction for a\nmarried couple filing jointly doubled to\n$24,000 for tax year 2018. It also decreased\nthe income tax brackets. The effect of these\nprovisions will be to make many more\ntaxpayers \xe2\x80\x9cchoose\xe2\x80\x9d the standard deduction\nover itemization. For them \xe2\x80\x93 irrespective of\nwhat their marginal tax bracket is \xe2\x80\x93 the income\ntax code has become more neutral. For\nexample, the Code will no longer encourage\nthem to give more to charity or to spend more\non a more expensive house. Those who choose\nto itemize will be those with higher incomes who\nmake sizable expenditures for items that\nremain deductible. To the extent that the Code\ninfluences their choices, their marketplace\nchoices will have greater impact on the\neconomy than the choices of those taxpayers\nwho do not \xe2\x80\x9cchoose\xe2\x80\x9d to itemize. Now, if\nCongress wishes to influence the purchasing\nchoices of those who can claim only the\nstandard deduction, it must either provide a\ncredit or provide that an expenditure is an\nadjustment to gross income (see \xc2\xa7 62). See\ndiscussion of tax formula. See discussion of tax\nformula, supra.\n\nIf the choices of buyers and\nsellers concerning what to buy\nand what to sell are matters of\nself-determination, then their\nchoices should theoretically\ngenerate as much after-tax value\nas possible. A \xe2\x80\x9cneutral\xe2\x80\x9d tax code\nwill tax all income alike,\nirrespective of how it is earned or\nspent. In theory, such \xe2\x80\x9ctax\nneutrality\xe2\x80\x9d distorts the free\nmarket the least and causes the\neconomy to create the most value\npossible. We recognize (or will\nsoon recognize) that the tax code\nthat the nation\xe2\x80\x99s policy-makers,\ni.e. Congress, have created is not\nneutral. Rather, we reward\ncertain\nchoices\nregarding\npurchase and sale by not taxing\nthe income necessary for their\npurchase or by taxing less the\nincome resulting from certain\nsales. Such deviations from\nneutrality cost the U.S. Treasury\nbecause\nthey\nrepresent\ncongressional choices to forego\nrevenue and/or to increase the tax\nburden of other taxpayers who do\nnot make the same purchase and\nsale choices. Such deviations of\ncourse take us into the realm of\ntax policy.\n\nDeviations from neutrality can\nripple through the economy.\nThey cause over-production of some things that do not increase the nation\xe2\x80\x99s wealth\nas much as the production of other things would. We tolerate such sacrifices in\n32\n\n\x0coverall value because we believe that there are other benefits that override such\nforegone value. When deviations are limited to transactions between two parties\nwho can negotiate the purchase and sale of an item or benefit only from each other,\ne.g., employer and employee, one party may be able to capture more of the\ncooperative surplus for itself than it otherwise might. An employer might provide\na benefit (e.g., group health insurance) to its employees, reduce employee wages\nby what would be the before-income-tax cost of the benefit, and pocket all the tax\nsavings. Such capture might be contrary to what Congress intended or anticipated.\nBasis \xe2\x80\x93 Or Keeping Score with the Government\nWe tax only increments to consumption and saving during a particular period \xe2\x80\x93 not\nwhat came before. The tool by which we assure that \xe2\x80\x9cwhat came before\xe2\x80\x9d is not\nagain subject to income tax is \xe2\x80\x9cbasis.\xe2\x80\x9d Section 1012(a) tells us that a taxpayer\xe2\x80\x99s\n\xe2\x80\x9cbasis\xe2\x80\x9d in something is its cost.\nTaxpayer will pay for the item\nThe Essence of Basis: Adjusted basis represents\nwith money that was already\nmoney that will not again be subject to income tax,\nsubject to tax upon its addition\nusually because it is what remains after taxpayer\nto her store of property rights.\nalready paid income tax on a greater sum of\nSection 1011(a) tells us that\nmoney. More pithily: basis is \xe2\x80\x9cmoney that has\n\xe2\x80\x9cadjusted basis\xe2\x80\x9d is basis after\nalready been taxed\xe2\x80\x9d (and so can\xe2\x80\x99t be taxed\nadjustment. Section 1016 tells\nagain).\nus to adjust basis upwards or\ndownwards\naccording\nto\nIf Congress chooses to allow a taxpayer to\nwhether\ntaxpayer\nconverts\nmore\nexclude the value of a benefit from her gross\nassets from her store of property\nincome, we must treat the benefit as if taxpayer\nrights in connection with the\nhad purchased it with after-tax cash. By doing so,\nproperty (\xc2\xa7 1016(a)(1)), i.e.,\nwe assure ourselves that the value of the benefit\nimproves it; or consumes some\nwill not \xe2\x80\x9cagain\xe2\x80\x9d be subject to tax. This means that\nof it in connection with her trade\ntaxpayer will include in her adjusted basis of any\nor business, or in connection\nproperty received in such a manner the value of\nwith an activity engaged in for\nthe benefit so excluded. If the amount excluded\nfrom gross income is not added to taxpayer\xe2\x80\x99s\nprofit (i.e., depreciation (cost\nbasis, it will be subject to tax upon sale of the item.\nrecovery) or amortization)\nSee, e.g., \xc2\xa7 132(a)(2) (qualified employee\n(\xc2\xa7 1016(a)(2)).28\ndiscount). That is hardly an \xe2\x80\x9cexclusion.\xe2\x80\x9d\n28\n\nThe deduction of \xe2\x80\x9cmiscellaneous deductions\xe2\x80\x9d has been suspended until 2026. \xc2\xa7 67(g).\n\n33\n\n\x0cThe Relationship Between Basis and Deductions\nfrom Taxable Income. An important point\nconcerning the fact that adjusted basis is income\nthat has already been subject to tax is that\ndeductions, i.e., reductions in taxable income\nallowed to the taxpayer because taxpayer\nspent income in some specified way, are only\nallowed if taxpayer has a tax basis in them.\nSection 170 permits a deduction of\ncontributions made to charitable organizations.\nBut: a charitable deduction only reduces the\ntaxable income in which taxpayer has adjusted\nbasis. This explains why the taxpayer may\ndeduct the costs of transportation to get herself\nto the place where she renders services to a\ncharity, but not the value of her services for\nwhich the charity pays her nothing. Presumably\ntaxpayer incurred the costs of transportation\nfrom after-tax income, but paid no income tax\non income she did not receive from the\ncharitable organization.\n\nSection 61(a)(3) informs us that\na taxpayer\xe2\x80\x99s \xe2\x80\x9cgross income\xe2\x80\x9d\nincludes gains derived from\ndealings in property. Intuitively,\nwe know that a gain derived\nfrom a dealing in property is the\nprice at which taxpayer sells\nproperty minus the price that she\npaid for the property. Section\n1001(a) instructs us how to\nmeasure gains derived from\ndealing in property. Subtract\n\xe2\x80\x9cadjusted basis\xe2\x80\x9d from the\n\xe2\x80\x9camount realized,\xe2\x80\x9d i.e., the\namount of money and the fair\nmarket value of any property\nreceived in the transaction. The\nsubtraction of \xe2\x80\x9cadjusted basis\xe2\x80\x9d\nassures that its amount is not\n(again) subject to income tax.\n\nThe purchase of something from\na taxpayer\xe2\x80\x99s after-tax \xe2\x80\x9cstore of property rights,\xe2\x80\x9d to the extent that it is not for\nconsumption, represents only a change in the form in which taxpayer holds her\nwealth. It does not represent an addition to wealth and so does not fall within the\nSHS definition of \xe2\x80\x9cincome.\xe2\x80\x9d It should never again be subject to income tax lest we\nviolate the first of our guiding principles by taxing twice the income necessary to\npurchase the item.\nWhile the Code specifically defines \xe2\x80\x9cbasis\xe2\x80\x9d and \xe2\x80\x9cadjusted basis,\xe2\x80\x9d the concept of\n\xe2\x80\x9cbasis,\xe2\x80\x9d as frequently used in this text, is that it is a means of keeping score with\nthe government. A taxpayer\xe2\x80\x99s score is the amount of after-tax income a taxpayer\nhas invested \xe2\x80\x93 or is credited with having invested \xe2\x80\x93 in an asset that will not again\nbe subject to income tax. The upshot of all this is that adjusted basis represents the\ncurrent score in the game between taxpayer and the Government of what wealth\nhas already been subject to tax and so should not be subject to tax again.\n\n34\n\n\x0cSHS Accounting for Spending From Savings\nAn implication of the SHS conception of income is that we might have to follow\ntaxpayer\xe2\x80\x99s after-tax money into and later out of her store of property rights to spend\non consumption. If a taxpayer takes money from savings and spends it on instant\ngratification so that she acquires no asset in which she has an adjusted basis,\nintuitively we know that she does not have any income on which she must pay\nincome tax. The SHS definition of income accounts for this by an off-setting\ndecrease to taxpayer\xe2\x80\x99s store of property rights and increase in rights exercised in\nconsumption.\nBorrowing Money\n\nInvestment, Basis, Depreciation, and Adjustments to\nBasis. An investment in an income-producing asset\nrepresents merely a change in the form in which a\ntaxpayer holds after-tax wealth. Changing the form\nin which taxpayer holds wealth is not a taxable\nevent. We assure ourselves that the change is not\ntaxed by assigning basis to the asset. When the\ninvestment is in an asset that will eventually but not\nimmediately be used up in the production of other\nincome, income-producing consumption and \xe2\x80\x9cdeinvestment\xe2\x80\x9d occur simultaneously. The cost of incomeproducing consumption is deductible and so reduces\ntaxable income. The expense of generating income\nthrough the use of assets that are not immediately\nand completely consumed is separately accounted\nfor in whatever name as depreciation, amortization,\nor cost recovery. The accompanying de-investment\nrequires a reduction in the adjusted basis of the\nincome-producing asset. \xc2\xa7 1016(a)(2).\n\nA taxpayer who borrows\nmoney may use that money\neither to exercise a right of\nconsumption or to increase her\nstore of property rights. In\neither case, SHS might\nprovide that taxpayer has\nrealized income. However, an\nobligation\nto\nrepay\naccompanies any loan. This\nobligation counts as a\ndecrease in taxpayer\xe2\x80\x99s store of\nproperty rights. Hence, the\naddition to income is precisely\noffset by this decrease in the\nvalue of taxpayer\xe2\x80\x99s store of\nproperty rights. Incidentally,\nthe Code nowhere states that\nloan proceeds are not included\nin a taxpayer\xe2\x80\x99s gross income,\nbut we all understand that to\nbe the rule.\n\nAND: taxpayer may use loan proceeds to purchase an item for which she is credited\nwith basis, just as if she had paid tax on the income used to make the purchase.\n35\n\n\x0cDoesn\xe2\x80\x99t this seem to violate the first principle of income taxation noted above? No.\nTaxpayer will repay the loan from future income that will be subject to tax.\nTaxpayer pays for her basis with money to be earned and taxed in the future.\nRepayment of loan principal is never deductible. Sometimes the cost of borrowing,\ni.e., interest, is deductible.\nIn the pages ahead, we\nexamine various topics\nconcerning income tax. In\nall cases, try to fit them into\nthe principles described in\nthis chapter.\n\nWrap-up Questions for\nChapter 1\n\nBuilding a Stronger Economy: Not taxing loan\nproceeds but permitting a taxpayer to use loan\nproceeds to acquire basis has tremendous implications\nfor economic growth, long ago taken for granted.\nHowever, countries where credit is scarce have low\ngrowth rates. Not taxing loan proceeds until the time\nof repayment decreases the cost of borrowing. Basic\nrule of economics: When the cost of something goes\ndown, people buy more. When the cost of borrowing\nmoney goes down, they borrow more; they invest\nwhat they borrow (or use it to make purchases for\nconsumption); the economy grows.\n\n1. A major issue in recent\npresidential campaigns has\nbeen whether the income tax\non high income earners\nshould be increased or decreased. Can you think of any standard by which to\ndetermine the appropriate level of progressivity in the Code?\n\n2. The more progressive the Code, the greater the \xe2\x80\x9cupside-downness\xe2\x80\x9d of\ndeductions. How might this be a good thing? What would be the advantage of\ngranting tax credits instead of deductions or exclusions?\n3. What are phaseouts? Why would Congress enact them? How do they affect a\ntaxpayer\xe2\x80\x99s effective tax rate?\n4. Taxpayer received a tax-free benefit, perhaps a gift from a company that wanted\nto increase its business. Why must taxpayer have a fmv basis in the item?\n5. If taxpayer receives a benefit but has no choice regarding its consumption \xe2\x80\x93 the\nmanager of a lighthouse must live with his family in the lighthouse \xe2\x80\x93 should\ntaxpayer be taxed on the value of the benefit? Why or why not?\n6. Taxpayer owned some commercial property. Taxpayer recorded the property on\nits corporate books at a certain value. Over the course of several years, the value of\n36\n\n\x0cthe property fluctuated up and down. Taxpayer did not pay income tax on the\nincrease in the property\xe2\x80\x99s value. Why should taxpayer not be permitted to deduct\ndecreases in the property\xe2\x80\x99s value?\nTax law and the pandemic: The Covid-19\npandemic caused economic hardships and\ndislocations that rippled through the\neconomies of the entire world. Congress\nresponded with various income tax\nmeasures to ease the financial burdens that\nthe pandemic caused, notably the $1200,\n$600, and $1400 tax credits for most\nAmericans. These credits took the form of\ncash payouts. Most of these tax measures\nwere (are) temporary. Congress did not\nchange the fundamental structure of the\nincome tax code, although tax relief\nmeasures altered the tax burdens that\ntaxpayers must bear. As we shall see,\nCongress clearly has used the Internal\nRevenue Code as an instrument with which\nto address this crisis. It will take several\nyears to unwind all these \xe2\x80\x9ctemporary\xe2\x80\x9d\nmeasures. In this text, many (though not all)\nthese measures will be noted, usually in a\ntext box.\n\nWhat have you learned?\nCan you explain or define \xe2\x80\x93\n\xe2\x80\xa2tax base, deductions, exclusions,\nincome phaseouts\n\xe2\x80\xa2tax formula, credit against tax\n\xe2\x80\xa2progressive tax rates\n\xe2\x80\xa2marginal tax rates\n\xe2\x80\xa2upside-down nature of deductions\nand exclusion\n\xe2\x80\xa2right-side up nature of tax credits\n\xe2\x80\xa2employment taxes\n\xe2\x80\xa2the Tax Code, regulations,\nrevenue\nrulings,\nrevenue\nprocedures, private letter rulings\n\xe2\x80\xa2tax disputes and the Tax Court, the\nCourt of Claims, and the Federal\nDistrict Court\n\xe2\x80\xa2tax norms of horizontal equity,\nvertical equity, and administrative\nfeasibility\n\xe2\x80\xa2Schanz-Haig-Simons definition of\nincome and its elements\n\n\xe2\x80\xa2three guiding principles of the income tax\n\xe2\x80\xa2tax expenditures\n\xe2\x80\xa2income tax treatment of personal expenditures (\xc2\xa7 262)\n\xe2\x80\xa2tax neutrality, distortion\n\xe2\x80\xa2basis\n\xe2\x80\xa2tax treatment of loans\n\n37\n\n\x0cChapter 2: What Is Gross Income: Section 61 and the Sixteenth\nAmendment\nThe Tax Formula:\n\xe2\x9e\x94 (gross income)\nMINUS deductions named in \xc2\xa7 62\nEQUALS (adjusted gross income (AGI))\nMINUS (standard deduction or itemized\ndeductions)\nMINUS (deduction for \xe2\x80\x9cqualified business\nincome\xe2\x80\x9d)\nEQUALS (taxable income)\n\nWe now consider elements of the tax\nformula. This chapter introduces you\nto the concept of \xe2\x80\x9cgross income,\xe2\x80\x9d the\nvery first item in the tax formula. We\nalso consider the constitutional\nunderpinning of the federal income\ntax because the constitutional basis\nof the income tax has been\nintertwined with the concept of gross\nincome itself.\n\nYou will notice that after adding up\nall the items encompassed by the\nphrase \xe2\x80\x9cgross income,\xe2\x80\x9d every\nsucceeding arithmetical operation is\na subtraction. If an item is not\nencompassed by the phrase \xe2\x80\x9cgross\nincome,\xe2\x80\x9d it will not be subject to federal income tax. The materials that follow\nconsider various aspects of gross income: its definition, whether certain items that\ntaxpayer has received constitute \xe2\x80\x9cgross income,\xe2\x80\x9d the timing of \xe2\x80\x9cgross income,\xe2\x80\x9d and\nvaluation.\nCompute income tax liability from tables\nin \xc2\xa7 1(j) (indexed for inflation)\nMINUS (credits against tax)\n\nI. The Constitutional and Statutory Definitions of \xe2\x80\x9cGross Income\xe2\x80\x9d\nArticle I of the Constitution, which grants legislative powers to the Congress,\ncontains several provisions concerning federal taxes.\nArticle I, \xc2\xa7 2, clause 3: Representatives and direct Taxes shall be\napportioned among the several States which may be included within this\nUnion, according to their respective Numbers \xe2\x80\xa6\nArticle I, \xc2\xa7 7, clause 1: All Bills for raising Revenue shall originate in the\nHouse of Representatives; but the Senate may propose or concur with\nAmendments as on other Bills.\n38\n\n\x0cArticle I, \xc2\xa7 8, clause 1: The Congress shall have Power To lay and collect\nTaxes, Duties, Imposts and Excises, to pay the Debts and provide for the\ncommon Defence and general Welfare of the United States; but all Duties,\nImposts and Excises shall be uniform throughout the United States[.]\nArticle I, \xc2\xa7 9, clause 4: No Capitation, or other direct, Tax shall be laid,\nunless in Proportion to the Census or Enumeration herein before directed to\nbe taken.\nThe Constitution does not delegate to any other branch of the government any\nauthority to impose taxes.\nIn Article I, \xc2\xa7 9, cl. 4, the Constitution refers to \xe2\x80\x9cdirect\xe2\x80\x9d taxes, and restricts\ncongressional power to impose them to those taxes that are assessed proportionately\nto the states\xe2\x80\x99 populations. The founding fathers regarded consumption taxes as\n\xe2\x80\x9cindirect taxes\xe2\x80\x9d and believed them to be superior to \xe2\x80\x9cdirect taxes\xe2\x80\x9d in terms of\nfairness and for purposes of raising revenue. See Alexander Hamilton, FEDERALIST\nNO. 21.\nAn income tax is a \xe2\x80\x9cdirect tax.\xe2\x80\x9d Pollock v. Farmers\xe2\x80\x99 Loan & Trust Co., 158 U.S.\n601, 630 (1895) (tax on income from property). Congress has never tried to assess\nan income tax state by state in proportion to their respective populations. Hence,\nimposition of an income tax required an amendment to the Constitution. That came\nin 1913:\nAmendment 16: The Congress shall have power to lay and collect taxes on\nincomes, from whatever source derived, without apportionment among the\nseveral States, and without regard to any census or enumeration.\nRead \xc2\xa7 61(a) of the Code. Notice that \xe2\x80\x9cgross income\xe2\x80\x9d encompasses \xe2\x80\x9call\xe2\x80\x9d income\n\xe2\x80\x9cfrom whatever source derived.\xe2\x80\x9d The language of the Code tracks that of the\nSixteenth Amendment, and it has been noted many times that in taxing income,\nCongress exercised all the constitutional power that it has to do so. However, that\npoint left open the question of what exactly is \xe2\x80\x9cincome[], from whatever source\nderived.\xe2\x80\x9d Taxpayers have argued many times that the \xe2\x80\x9cincome\xe2\x80\x9d that Congress\nwants to tax is beyond the scope of \xe2\x80\x9cincome\xe2\x80\x9d as the term is used in the Sixteenth\nAmendment. See Ann K. Wooster, Annot., Application of 16th Amendment to U.S.\nConstitution \xe2\x80\x93 Taxation of Specific Types of Income, 40 A.L.R. FED.2d 301 (2010).\n39\n\n\x0cWe consider here two cases in which the Supreme Court undertook to provide a\ndefinition of \xe2\x80\x9cgross income,\xe2\x80\x9d the phrase that Congress used in \xc2\xa7 61(a). We then\nconsider a case in which the United States Court of Appeals for the Seventh Circuit\nconsidered the scope of congressional authority to impose an income tax. In\nMacomber, notice the justices\xe2\x80\x99 differing views on the internal accounting of a\ncorporation.\n\xe2\x80\xa2What does the Court mean by \xe2\x80\x9ccapitalization?\xe2\x80\x9d\n\xe2\x80\xa2What does the Court mean by \xe2\x80\x9csurplus?\xe2\x80\x9d\n\xe2\x80\xa2By way of review: a demurrer is a creature of code pleading and is the\nequivalent of a motion to dismiss for failure to state a claim. In Macomber,\ntaxpayer sued for a refund. The Commissioner (Eisner) demurred. The\nfederal district court overruled the demurrer, so taxpayer-plaintiff prevailed.\nThe Supreme Court affirmed.\nEisner v. Macomber, 252 U.S. 189 (1920).\nMR. JUSTICE PITNEY delivered the opinion of the Court.\nThis case presents the question whether, by virtue of the Sixteenth Amendment,\nCongress has the power to tax, as income of the stockholder and without\napportionment, a stock dividend made lawfully and in good faith against profits\naccumulated by the corporation since March 1, 1913.\nIt arises under the Revenue Act of September 8, 1916, 39 Stat. 756 et seq., which,\nin our opinion \xe2\x80\xa6 plainly evinces the purpose of Congress to tax stock dividends as\nincome.29\n29\n\nTitle I. \xe2\x80\x93 Income Tax\n\nPart I. \xe2\x80\x93 \xe2\x80\x9cOn Individuals\xe2\x80\x9d\n\xe2\x80\x9cSec. 2. (a) That, subject only to such exemptions and deductions as are hereinafter allowed, the\nnet income of a taxable person shall include gains, profits, and income derived, ... also from\ninterest, rent, dividends, securities, or the transaction of any business carried on for gain or\nprofit, or gains or profits and income derived from any source whatever: Provided, that the term\n\xe2\x80\x98dividends\xe2\x80\x99 as used in this title shall be held to mean any distribution made or ordered to be\nmade by a corporation, ... out of its earnings or profits accrued since March first, nineteen\nhundred and thirteen, and payable to its shareholders, whether, in cash or in stock of the\ncorporation, ... which stock dividend shall be considered income, to the amount of its cash\n\n40\n\n\x0cThe facts, in outline, are as follows:\nOn January 1, 1916, the Standard Oil Company of California, a corporation of that\nstate, out of an authorized capital stock of $100,000,000, had shares of stock\noutstanding, par value $100 each, amounting in round figures to $50,000,000. In\naddition, it had surplus and undivided profits invested in plant, property, and\nbusiness and required for the purposes of the corporation, amounting to about\n$45,000,000, of which about $20,000,000 had been earned prior to March 1, 1913,\nthe balance thereafter. In January, 1916, in order to readjust the capitalization, the\nboard of directors decided to issue additional shares sufficient to constitute a stock\ndividend of 50 percent of the outstanding stock, and to transfer from surplus\naccount to capital stock account an amount equivalent to such issue. ...\nDefendant in error, being the owner of 2,200 shares of the old stock, received\ncertificates for 1,100 additional shares, of which 18.07 percent, or 198.77 shares,\npar value $19,877, were treated as representing surplus earned between March 1,\n1913, and January 1, 1916. She was called upon to pay, and did pay under protest,\na tax imposed under the Revenue Act of 1916, based upon a supposed income of\n$19,877 because of the new shares, and, an appeal to the Commissioner of Internal\nRevenue having been disallowed, she brought action against the Collector to\nrecover the tax. In her complaint, she alleged the above facts and contended that,\nin imposing such a tax the Revenue Act of 1916 violated article 1, \xc2\xa7 2, cl. 3, and\nArticle I, \xc2\xa7 9, cl. 4, of the Constitution of the United States, requiring direct taxes\nto be apportioned according to population, and that the stock dividend was not\nincome within the meaning of the Sixteenth Amendment. A general demurrer to\nthe complaint was overruled upon the authority of Towne v. Eisner, 245 U. S. 418,\nand, defendant having failed to plead further, final judgment went against him. To\nreview it, the present writ of error is prosecuted.\n....\nWe are constrained to hold that the judgment of the district court must be\naffirmed[.] ...\n....\n\nvalue.\xe2\x80\x9d\n\n41\n\n\x0c[I]n view of the importance of the matter, and the fact that Congress in the Revenue\nAct of 1916 declared (39 Stat. 757) that a \xe2\x80\x9cstock dividend shall be considered\nincome, to the amount of its cash value,\xe2\x80\x9d we will deal at length with the\nconstitutional question, incidentally testing the soundness of our previous\nconclusion.\nThe Sixteenth Amendment ... did not extend the taxing power to new subjects, but\nmerely removed the necessity which otherwise might exist for an apportionment\namong the states of taxes laid on income. Brushaber v. Union Pacific R. Co., 240\nU. S. 1, 240 U. S. 17-19; Stanton v. Baltic Mining Co., 240 U. S. 103, 240 U. S.\n112 et seq.; Peck & Co. v. Lowe, 247 U. S. 165, 247 U. S. 172-173.\nA proper regard for its genesis, as well as its very clear language, requires also that\nthis amendment shall not be extended by loose construction, so as to repeal or\nmodify, except as applied to income, those provisions of the Constitution that\nrequire an apportionment according to population for direct taxes upon property,\nreal and personal. This limitation still has an appropriate and important function,\nand is not to be overridden by Congress or disregarded by the courts.\nIn order, therefore, that ... Article I of the Constitution may have proper force and\neffect, save only as modified by the amendment, and that the latter also may have\nproper effect, it becomes essential to distinguish between what is and what is not\n\xe2\x80\x9cincome,\xe2\x80\x9d as the term is there used, and to apply the distinction, as cases arise,\naccording to truth and substance, without regard to form. Congress cannot by any\ndefinition it may adopt conclude the matter, since it cannot by legislation alter the\nConstitution, from which alone it derives its power to legislate, and within whose\nlimitations alone that power can be lawfully exercised.\nThe fundamental relation of \xe2\x80\x9ccapital\xe2\x80\x9d to \xe2\x80\x9cincome\xe2\x80\x9d has been much discussed by\neconomists, the former being likened to the tree or the land, the latter to the fruit or\nthe crop; the former depicted as a reservoir supplied from springs, the latter as the\noutlet stream, to be measured by its flow during a period of time. For the present\npurpose, we require only a clear definition of the term \xe2\x80\x9cincome,\xe2\x80\x9d as used in\ncommon speech, in order to determine its meaning in the amendment, and, having\nformed also a correct judgment as to the nature of a stock dividend, we shall find it\neasy to decide the matter at issue.\nAfter examining dictionaries in common use (Bouv. L.D.; Standard Dict.;\nWebster\xe2\x80\x99s Internat. Dict.; Century Dict.), we find little to add to the succinct\n42\n\n\x0cdefinition adopted in two cases arising under the Corporation Tax Act of 1909\n(Stratton\xe2\x80\x99s Independence v. Howbert, 231 U. S. 399, 231 U. S. 415; Doyle v.\nMitchell Bros. Co., 247 U. S. 179, 247 U. S. 185), \xe2\x80\x9cIncome may be defined as the\ngain derived from capital, from labor, or from both combined,\xe2\x80\x9d provided it be\nunderstood to include profit gained through a sale or conversion of capital assets ...\nBrief as it is, it indicates the characteristic and distinguishing attribute of income\nessential for a correct solution of the present controversy. The government,\nalthough basing its argument upon the definition as quoted, placed chief emphasis\nupon the word \xe2\x80\x9cgain,\xe2\x80\x9d which was extended to include a variety of meanings; while\nthe significance of the next three words was either overlooked or misconceived.\n\xe2\x80\x9cDerived from capital;\xe2\x80\x9d \xe2\x80\x9cthe gain derived from capital,\xe2\x80\x9d etc. Here, we have the\nessential matter: not a gain accruing to capital; not a growth or increment of value\nin the investment; but a gain, a profit, something of exchangeable value, proceeding\nfrom the property, severed from the capital, however invested or employed, and\ncoming in, being \xe2\x80\x9cderived\xe2\x80\x9d \xe2\x80\x93 that is, received or drawn by the recipient (the\ntaxpayer) for his separate use, benefit and disposal \xe2\x80\x93 that is income derived from\nproperty. Nothing else answers the description.\nThe same fundamental conception is clearly set forth in the Sixteenth Amendment\n\xe2\x80\x93 \xe2\x80\x9cincomes, from whatever source derived\xe2\x80\x9d \xe2\x80\x93 the essential thought being expressed\nwith a conciseness and lucidity entirely in harmony with the form and style of the\nConstitution.\nCan a stock dividend, considering its essential character, be brought within the\ndefinition? To answer this, regard must be had to the nature of a corporation and\nthe stockholder\xe2\x80\x99s relation to it. We refer, of course, to a corporation such as the\none in the case at bar, organized for profit, and having a capital stock divided into\nshares to which a nominal or par value is attributed.\nCertainly the interest of the stockholder is a capital interest, and his certificates of\nstock are but the evidence of it. They state the number of shares to which he is\nentitled and indicate their par value and how the stock may be transferred. They\nshow that he or his assignors, immediate or remote, have contributed capital to the\nenterprise, that he is entitled to a corresponding interest proportionate to the whole,\nentitled to have the property and business of the company devoted during the\ncorporate existence to attainment of the common objects, entitled to vote at\nstockholders\xe2\x80\x99 meetings, to receive dividends out of the corporation\xe2\x80\x99s profits if and\nwhen declared, and, in the event of liquidation, to receive a proportionate share of\n43\n\n\x0cthe net assets, if any, remaining after paying creditors. Short of liquidation, or until\ndividend declared, he has no right to withdraw any part of either capital or profits\nfrom the common enterprise; on the contrary, his interest pertains not to any part,\ndivisible or indivisible, but to the entire assets, business, and affairs of the company.\nNor is it the interest of an owner in the assets themselves, since the corporation has\nfull title, legal and equitable, to the whole. The stockholder has the right to have\nthe assets employed in the enterprise, with the incidental rights mentioned; but, as\nstockholder, he has no right to withdraw, only the right to persist, subject to the\nrisks of the enterprise, and looking only to dividends for his return. If he desires to\ndissociate himself from the company, he can do so only by disposing of his stock.\nFor bookkeeping purposes, the company acknowledges a liability in form to the\nstockholders equivalent to the aggregate par value of their stock, evidenced by a\n\xe2\x80\x9ccapital stock account.\xe2\x80\x9d If profits have been made and not divided, they create\nadditional bookkeeping liabilities under the head of \xe2\x80\x9cprofit and loss,\xe2\x80\x9d \xe2\x80\x9cundivided\nprofits,\xe2\x80\x9d \xe2\x80\x9csurplus account,\xe2\x80\x9d or the like. None of these, however, gives to the\nstockholders as a body, much less to any one of them, either a claim against the\ngoing concern for any particular sum of money or a right to any particular portion\nof the assets or any share in them unless or until the directors conclude that\ndividends shall be made and a part of the company\xe2\x80\x99s assets segregated from the\ncommon fund for the purpose. The dividend normally is payable in money, under\nexceptional circumstances in some other divisible property, and when so paid, then\nonly (excluding, of course, a possible advantageous sale of his stock or winding-up\nof the company) does the stockholder realize a profit or gain which becomes his\nseparate property, and thus derive income from the capital that he or his predecessor\nhas invested.\nIn the present case, the corporation had surplus and undivided profits invested in\nplant, property, and business, and required for the purposes of the corporation,\namounting to about $45,000,000, in addition to outstanding capital stock of\n$50,000,000. In this, the case is not extraordinary. The profits of a corporation, as\nthey appear upon the balance sheet at the end of the year, need not be in the form\nof money on hand in excess of what is required to meet current liabilities and\nfinance current operations of the company. Often, especially in a growing business,\nonly a part, sometimes a small part, of the year\xe2\x80\x99s profits is in property capable of\ndivision, the remainder having been absorbed in the acquisition of increased plant,\nequipment, stock in trade, or accounts receivable, or in decrease of outstanding\nliabilities. When only a part is available for dividends, the balance of the year\xe2\x80\x99s\nprofits is carried to the credit of undivided profits, or surplus, or some other account\n44\n\n\x0chaving like significance. If thereafter the company finds itself in funds beyond\ncurrent needs, it may declare dividends out of such surplus or undivided profits;\notherwise it may go on for years conducting a successful business, but requiring\nmore and more working capital because of the extension of its operations, and\ntherefore unable to declare dividends approximating the amount of its profits.\nThus, the surplus may increase until it equals or even exceeds the par value of the\noutstanding capital stock. This may be adjusted upon the books in the mode adopted\nin the case at bar \xe2\x80\x93 by declaring a \xe2\x80\x9cstock dividend.\xe2\x80\x9d This, however, is no more than\na book adjustment, in essence \xe2\x80\x93 not a dividend, but rather the opposite; no part of\nthe assets of the company is separated from the common fund, nothing distributed\nexcept paper certificates that evidence an antecedent increase in the value of the\nstockholder\xe2\x80\x99s capital interest resulting from an accumulation of profits by the\ncompany, but profits so far absorbed in the business as to render it impracticable to\nseparate them for withdrawal and distribution. In order to make the adjustment, a\ncharge is made against surplus account with corresponding credit to capital stock\naccount, equal to the proposed \xe2\x80\x9cdividend;\xe2\x80\x9d the new stock is issued against this and\nthe certificates delivered to the existing stockholders in proportion to their previous\nholdings. This, however, is merely bookkeeping that does not affect the aggregate\nassets of the corporation or its outstanding liabilities; it affects only the form, not\nthe essence, of the \xe2\x80\x9cliability\xe2\x80\x9d acknowledged by the corporation to its own\nshareholders, and this through a readjustment of accounts on one side of the balance\nsheet only, increasing \xe2\x80\x9ccapital stock\xe2\x80\x9d at the expense of \xe2\x80\x9csurplus\xe2\x80\x9d; it does not alter\nthe preexisting proportionate interest of any stockholder or increase the intrinsic\nvalue of his holding or of the aggregate holdings of the other stockholders as they\nstood before. The new certificates simply increase the number of the shares, with\nconsequent dilution of the value of each share.\nA \xe2\x80\x9cstock dividend\xe2\x80\x9d shows that the company\xe2\x80\x99s accumulated profits have been\ncapitalized, instead of distributed to the stockholders or retained as surplus\navailable for distribution in money or in kind should opportunity offer. Far from\nbeing a realization of profits of the stockholder, it tends rather to postpone such\nrealization, in that the fund represented by the new stock has been transferred from\nsurplus to capital, and no longer is available for actual distribution.\nThe essential and controlling fact is that the stockholder has received nothing out\nof the company\xe2\x80\x99s assets for his separate use and benefit; on the contrary, every\ndollar of his original investment, together with whatever accretions and\naccumulations have resulted from employment of his money and that of the other\nstockholders in the business of the company, still remains the property of the\n45\n\n\x0ccompany, and subject to business risks which may result in wiping out the entire\ninvestment. Having regard to the very truth of the matter, to substance and not to\nform, he has received nothing that answers the definition of income within the\nmeaning of the Sixteenth Amendment.\n....\nWe are clear that not only does a stock dividend really take nothing from the\nproperty of the corporation and add nothing to that of the shareholder, but that the\nantecedent accumulation of profits evidenced thereby, while indicating that the\nshareholder is the richer because of an increase of his capital, at the same time\nshows he has not realized or received any income in the transaction.\nIt is said that a stockholder may sell the new shares acquired in the stock dividend,\nand so he may, if he can find a buyer. It is equally true that, if he does sell, and in\ndoing so realizes a profit, such profit, like any other, is income, and, so far as it may\nhave arisen since the Sixteenth Amendment, is taxable by Congress without\napportionment. The same would be true were he to sell some of his original shares\nat a profit. But if a shareholder sells dividend stock, he necessarily disposes of a\npart of his capital interest, just as if he should sell a part of his old stock, either\nbefore or after the dividend. What he retains no longer entitles him to the same\nproportion of future dividends as before the sale. His part in the control of the\ncompany likewise is diminished. Thus, if one holding $60,000 out of a total\n$100,000 of the capital stock of a corporation should receive in common with other\nstockholders a 50 percent stock dividend, and should sell his part, he thereby would\nbe reduced from a majority to a minority stockholder, having six-fifteenths instead\nof six-tenths of the total stock outstanding. A corresponding and proportionate\ndecrease in capital interest and in voting power would befall a minority holder\nshould he sell dividend stock, it being in the nature of things impossible for one to\ndispose of any part of such an issue without a proportionate disturbance of the\ndistribution of the entire capital stock and a like diminution of the seller\xe2\x80\x99s\ncomparative voting power \xe2\x80\x93 that \xe2\x80\x9cright preservative of rights\xe2\x80\x9d in the control of a\ncorporation. Yet, without selling, the shareholder, unless possessed of other\nresources, has not the wherewithal to pay an income tax upon the dividend stock.\nNothing could more clearly show that to tax a stock dividend is to tax a capital\nincrease, and not income, than this demonstration that, in the nature of things, it\nrequires conversion of capital in order to pay the tax.\n....\n46\n\n\x0cConceding that the mere issue of a stock dividend makes the recipient no richer\nthan before, the government nevertheless contends that the new certificates measure\nthe extent to which the gains accumulated by the corporation have made him the\nricher. There are two insuperable difficulties with this. In the first place, it would\ndepend upon how long he had held the stock whether the stock dividend indicated\nthe extent to which he had been enriched by the operations of the company; unless\nhe had held it throughout such operations, the measure would not hold true.\nSecondly, and more important for present purposes, enrichment through increase\nin value of capital investment is not income in any proper meaning of the term.\n....\nIt is said there is no difference in principle between a simple stock dividend and a\ncase where stockholders use money received as cash dividends to purchase\nadditional stock contemporaneously issued by the corporation. But an actual cash\ndividend, with a real option to the stockholder either to keep the money for his own\nor to reinvest it in new shares, would be as far removed as possible from a true\nstock dividend, such as the one we have under consideration, where nothing of\nvalue is taken from the company\xe2\x80\x99s assets and transferred to the individual\nownership of the several stockholders and thereby subjected to their disposal.\n....\nThus, from every point of view, we are brought irresistibly to the conclusion that\nneither under the Sixteenth Amendment nor otherwise has Congress power to tax\nwithout apportionment a true stock dividend made lawfully and in good faith, or\nthe accumulated profits behind it, as income of the stockholder. The Revenue Act\nof 1916, insofar as it imposes a tax upon the stockholder because of such dividend,\ncontravenes the provisions of Article I, \xc2\xa7 2, cl. 3, and Article I, \xc2\xa7 9, cl. 4, of the\nConstitution, and to this extent is invalid notwithstanding the Sixteenth\nAmendment.\nJudgment affirmed.\n\n47\n\n\x0cMr. Justice Holmes, dissenting. [omitted]\nMR. JUSTICE BRANDEIS delivered the following opinion, in which MR.\nJUSTICE CLARKE concurred.\nFinanciers, with the aid of lawyers, devised long ago two different methods by\nwhich a corporation can, without increasing its indebtedness, keep for corporate\npurposes accumulated profits, and yet, in effect, distribute these profits among its\nstockholders. One method is a simple one. The capital stock is increased; the new\nstock is paid up with the accumulated profits, and the new shares of paid-up stock\nare then distributed among the stockholders pro rata as a dividend. If the\nstockholder prefers ready money to increasing his holding of the stock in the\ncompany, he sells the new stock received as a dividend. The other method is slightly\nmore complicated. Arrangements are made for an increase of stock to be offered to\nstockholders pro rata at par, and at the same time for the payment of a cash dividend\nequal to the amount which the stockholder will be required to pay to the company,\nif he avails himself of the right to subscribe for his pro rata of the new stock. If the\nstockholder takes the new stock, as is expected, he may endorse the dividend check\nreceived to the corporation, and thus pay for the new stock. In order to ensure that\nall the new stock so offered will be taken, the price at which it is offered is fixed\nfar below what it is believed will be its market value. If the stockholder prefers\nready money to an increase of his holdings of stock, he may sell his right to take\nnew stock pro rata, which is evidenced by an assignable instrument. In that event\nthe purchaser of the rights repays to the corporation, as the subscription price of the\nnew stock, an amount equal to that which it had paid as a cash dividend to the\nstockholder.\nBoth of these methods of retaining accumulated profits while in effect distributing\nthem as a dividend had been in common use in the United States for many years\nprior to the adoption of the Sixteenth Amendment. They were recognized equivalents. ...\n....\nIt thus appears that, among financiers and investors, the distribution of the stock,\nby whichever method effected, is called a stock dividend; that the two methods by\nwhich accumulated profits are legally retained for corporate purposes and at the\nsame time distributed as dividends are recognized by them to be equivalents, and\nthat the financial results to the corporation and to the stockholders of the two\nmethods are substantially the same, unless a difference results from the application\n48\n\n\x0cof the federal income tax law.\n....\nIt is conceded that, if the stock dividend paid to Mrs. Macomber had been made by\nthe more complicated method [of] issuing rights to take new stock pro rata and\npaying to each stockholder simultaneously a dividend in cash sufficient in amount\nto enable him to pay for this pro rata of new stock to be purchased \xe2\x80\x93 the dividend\nso paid to him would have been taxable as income, whether he retained the cash or\nwhether he returned it to the corporation in payment for his pro rata of new stock.\nBut it is contended that, because the simple method was adopted of having the new\nstock issued direct to the stockholders as paid-up stock, the new stock is not to be\ndeemed income, whether she retained it or converted it into cash by sale. If such a\ndifferent result can flow merely from the difference in the method pursued, it must\nbe because Congress is without power to tax as income of the stockholder either\nthe stock received under the latter method or the proceeds of its sale, for Congress\nhas, by the provisions in the Revenue Act of 1916, expressly declared its purpose\nto make stock dividends, by whichever method paid, taxable as income.\n....\n... Is there anything in the phraseology of the Sixteenth Amendment or in the nature\nof corporate dividends which should lead to a [conclusion] ... that Congress is\npowerless to prevent a result so extraordinary as that here contended for by the\nstockholder?\nFirst. The term \xe2\x80\x9cincome,\xe2\x80\x9d when applied to the investment of the stockholder in a\ncorporation, had, before the adoption of the Sixteenth Amendment, been commonly\nunderstood to mean the returns from time to time received by the stockholder from\ngains or earnings of the corporation. A dividend received by a stockholder from a\ncorporation may be either in distribution of capital assets or in distribution of\nprofits. Whether it is the one or the other is in no way affected by the medium in\nwhich it is paid, nor by the method or means through which the particular thing\ndistributed as a dividend was procured. If the dividend is declared payable in cash,\nthe money with which to pay it is ordinarily taken from surplus cash in the treasury.\n...\n... [W]hether a dividend declared payable from profits shall be paid in cash or in\nsome other medium is also wholly a matter of financial management. If some other\n49\n\n\x0cmedium is decided upon, it is also wholly a question of financial management\nwhether the distribution shall be, for instance, in bonds, scrip or stock of another\ncorporation or in issues of its own. And if the dividend is paid in its own issues,\nwhy should there be a difference in result dependent upon whether the distribution\nwas made from such securities then in the treasury or from others to be created and\nissued by the company expressly for that purpose? So far as the distribution may\nbe made from its own issues of bonds, or preferred stock created expressly for the\npurpose, it clearly would make no difference, in the decision of the question\nwhether the dividend was a distribution of profits, that the securities had to be\ncreated expressly for the purpose of distribution. If a dividend paid in securities of\nthat nature represents a distribution of profits, Congress may, of course, tax it as\nincome of the stockholder. Is the result different where the security distributed is\ncommon stock?\n....\nSecond. It has been said that a dividend payable in bonds or preferred stock created\nfor the purpose of distributing profits may be income and taxable as such, but that\nthe case is different where the distribution is in common stock created for that\npurpose. Various reasons are assigned for making this distinction. One is that the\nproportion of the stockholder\xe2\x80\x99s ownership to the aggregate number of the shares of\nthe company is not changed by the distribution. But that is equally true where the\ndividend is paid in its bonds or in its preferred stock. Furthermore, neither\nmaintenance nor change in the proportionate ownership of a stockholder in a\ncorporation has any bearing upon the question here involved. Another reason\nassigned is that the value of the old stock held is reduced approximately by the\nvalue of the new stock received, so that the stockholder, after receipt of the stock\ndividend, has no more than he had before it was paid. That is equally true whether\nthe dividend be paid in cash or in other property \xe2\x80\x93 for instance, bonds, scrip, or\npreferred stock of the company. The payment from profits of a large cash dividend,\nand even a small one, customarily lowers the then market value of stock because\nthe undivided property represented by each share has been correspondingly\nreduced. The argument which appears to be most strongly urged for the\nstockholders is that, when a stock dividend is made, no portion of the assets of the\ncompany is thereby segregated for the stockholder. But does the issue of new bonds\nor of preferred stock created for use as a dividend result in any segregation of assets\nfor the stockholder? In each case, he receives a piece of paper which entitles him\nto certain rights in the undivided property. Clearly, segregation of assets in a\nphysical sense is not an essential of income. The year\xe2\x80\x99s gains of a partner is [sic]\n50\n\n\x0ctaxable as income although there, likewise, no segregation of his share in the gains\nfrom that of his partners is had.\n....\nThird. The government urges that it would have been within the power of Congress\nto have taxed as income of the stockholder his pro rata share of undistributed profits\nearned even if no stock dividend representing it had been paid. Strong reasons may\nbe assigned for such a view. [citation omitted]. The undivided share of a partner in\nthe year\xe2\x80\x99s undistributed profits of his firm is taxable as income of the partner\nalthough the share in the gain is not evidenced by any action taken by the firm.\nWhy may not the stockholder\xe2\x80\x99s interest in the gains of the company? The law finds\nno difficulty in disregarding the corporate fiction whenever that is deemed\nnecessary to attain a just result. [citations omitted]. The stockholder\xe2\x80\x99s interest in the\nproperty of the corporation differs not fundamentally, but in form only, from the\ninterest of a partner in the property of the firm. There is much authority for the\nproposition that, under our law, a partnership or joint stock company is just as\ndistinct and palpable an entity in the idea of the law, as distinguished from the\nindividuals composing it, as is a corporation. No reason appears, why Congress, in\nlegislating under a grant of power so comprehensive as that authorizing the levy of\nan income tax, should be limited by the particular view of the relation of the\nstockholder to the corporation and its property which may, in the absence of\nlegislation, have been taken by this Court. But we have no occasion to decide the\nquestion whether Congress might have taxed to the stockholder his undivided share\nof the corporation\xe2\x80\x99s earnings. For Congress has in this act limited the income tax to\nthat share of the stockholder in the earnings which is, in effect, distributed by means\nof the stock dividend paid. In other words, to render the stockholder taxable, there\nmust be both earnings made and a dividend paid. Neither earnings without dividend\nnor a dividend without earnings subjects the stockholder to taxation under the\nRevenue Act of 1916.\n\n51\n\n\x0cCapital and Surplus: The opinions in this case provide\na primer on corporation law. A corporation\xe2\x80\x99s\nshareholders are its owners. They pay money (or\ntransfer other property) to the corporation to purchase\nshares that represent ownership of the corporation\xe2\x80\x99s\nproductive capital. Once the corporation begins to\noperate, it earns profits. The corporation might choose\nnot to retain these profits and to distribute them to its\nshareholders as dividends. Alternatively, the\ncorporation might not distribute the profits. Instead, it\nmight hold the profits for later distribution and/or use\nthe profits to acquire still more productive capital\nassets. Corporation law required that the \xe2\x80\x9ccapital\nstock account\xe2\x80\x9d and the \xe2\x80\x9csurplus account\xe2\x80\x9d be separately\nmaintained.\n\xe2\x80\xa2Sections 301 and 316 still implement this scheme.\nDividends are taxable as income to a shareholder\nonly if a corporation has \xe2\x80\x9cearnings and profits.\xe2\x80\x9d\n\nFourth. ...\nFifth. ...\n....\n\nSixth. If stock dividends\nrepresenting profits are\nheld exempt from taxation\nunder\nthe\nSixteenth\nAmendment, the owners\nof the most successful\nbusinesses in America\nwill, as the facts in this\ncase illustrate, be able to\nescape taxation on a large\npart of what is actually\ntheir income. So far as\ntheir profits are represented by stock received as dividends, they will pay these\ntaxes not upon their income, but only upon the income of their income. That such\na result was intended by the people of the United States when adopting the\nSixteenth Amendment is inconceivable. Our sole duty is to ascertain their intent as\ntherein expressed. In terse, comprehensive language befitting the Constitution, they\nempowered Congress \xe2\x80\x9cto lay and collect taxes on incomes from whatever source\nderived.\xe2\x80\x9d They intended to include thereby everything which by reasonable\nunderstanding can fairly be regarded as income. That stock dividends representing\nprofits are so regarded not only by the plain people, but by investors and financiers\nand by most of the courts of the country, is shown beyond peradventure by their\nacts and by their utterances. It seems to me clear, therefore, that Congress possesses\nthe power which it exercised to make dividends representing profits taxable as\nincome whether the medium in which the dividend is paid be cash or stock, and that\nit may define, as it has done, what dividends representing profits shall be deemed\nincome. It surely is not clear that the enactment exceeds the power granted by the\nSixteenth Amendment. ...\n\n52\n\n\x0cNotes and Questions:\n1. In Macomber, consider the different views of the excerpted opinions of a\ncorporation. Recall that under the SHS definition of income, an increment to an\ninvestment is the manifestation and measure of taxable income, but a mere change\nin the form in which wealth is held is not a taxable event. Consider how the two\nopinions implicitly30 handle these points. Is one view better than the other? Why?\n2. If ten shareholders each contribute $100,000 upon the formation of a\ncorporation so that the corporation\xe2\x80\x99s paid-in capital is $1M and two years later the\nfair market value (fmv)\nof the corporation\xe2\x80\x99s\nSubstance and Form: The argument of Justice Brandeis that\nassets has not changed\ntwo methods that accomplish the same thing should bear\nbut the corporation has\nthe same tax consequences \xe2\x80\x93 i.e., that substance should\naccumulated\nprevail over form \xe2\x80\x93 applies on many occasions in tax law.\nundistributed profits of\nHowever, tax law does not treat the two methods he\n$200,000, what would be\ndescribes in the first paragraph of his opinion by which a\nthe fmv of each\ncorporation can in effect distribute its accumulated profits\nwithout increasing its indebtedness as \xe2\x80\x9cequivalent.\xe2\x80\x9d\nshareholder\xe2\x80\x99s shares?\n\xc2\xa7\xc2\xa7 305(a), 305(b)(1).\n\xe2\x80\xa2Is it even\n\xe2\x80\xa2Moreover, the law of corporate tax does not treat equity\npossible to avoid\ninterests (stock) and creditor interests (debt) as equivalent\nmerging the\n\xe2\x80\x93 and so treats distributions of stock and debt differently.\ncapital and profits\naccounts of a\ncorporation when\nconsidering whether a shareholder has enjoyed an increment to his power\nto consume?\n\xe2\x80\xa2Should each shareholder pay income tax on a share\xe2\x80\x99s increased fmv if the\ncorporation does not distribute the profits?\n3. Does the concept of realization determine when taxpayer may spend an\nincrement to his consumption rights on consumption as he sees fit? If the\ncorporation will not pay out undistributed profits, why can\xe2\x80\x99t the shareholder simply\nborrow against his share of the undistributed profits? The interest taxpayer must\npay is simply the (nominal?) cost of spending money that he \xe2\x80\x9cowns\xe2\x80\x9d but is not\nentitled to receive.\n\xe2\x80\xa2Is a stock dividend an increment to taxpayer\xe2\x80\x99s store of rights of\n30\n\nThere was no SHS definition of \xe2\x80\x9cincome\xe2\x80\x9d in 1920.\n\n53\n\n\x0cconsumption? We tax all income once. When (and how) is a stock dividend\ntaxed?\n4. What exactly is the holding of the majority with respect to the meaning of\n\xe2\x80\x9cincome\xe2\x80\x9d under the Sixteenth Amendment? Which of the following are critical to\nthe case\xe2\x80\x99s outcome?\n\xe2\x80\xa2That shareholder did not \xe2\x80\x9crealize\xe2\x80\x9d any income and that without realization,\nthere is no \xe2\x80\x9cincome?\xe2\x80\x9d\n\xe2\x80\xa2That shareholder did not receive any property for his use and benefit and\nthat in the absence of such receipt, there is no \xe2\x80\x9cincome?\xe2\x80\x9d\n\xe2\x80\xa2That a corporation\xe2\x80\x99s undistributed accumulations do not constitute\n\xe2\x80\x9cincome\xe2\x80\x9d to a shareholder?\n\xe2\x80\xa2That if the corporation does not segregate particular assets for the\nshareholder, there is no \xe2\x80\x9cincome?\xe2\x80\x9d\n\xe2\x80\xa2That shareholder\xe2\x80\x99s receipt\nof shares did not alter his\nThe Corporation as Separate Entity: The most\nunderlying interest in the\nimportant point of any dissent is that it is a dissent.\ncorporation or make him\nNotice that Justice Brandeis would tax shareholders\nricher, so the receipt of\nin the same manner that partners in a partnership\nsuch shares is not \xe2\x80\x9cincome\xe2\x80\x9d\nare taxed on undistributed earnings. His view did not\nwithin\nthe\nSixteenth\nprevail. This fact firmly established the identity of a\ncorporation as separate from its shareholders \xe2\x80\x93\nAmendment?\nunlike a partnership and its partners.\n5. This case is often said to\nstand for the proposition\nthat \xe2\x80\x9cincome\xe2\x80\x9d within the Sixteenth Amendment must be \xe2\x80\x9crealized?\xe2\x80\x9d True?\n6. Justice Brandeis\xe2\x80\x99s parade of horribles has come to pass. We tax dividends\ndifferently depending on how they are distributed. \xc2\xa7 305. We tax partners on\nundistributed income but not corporate shareholders. Corporations do hold onto\nincome so that shareholders do not have to pay income tax. The Republic has\nsurvived.\n7. Income is taxed only once. \xe2\x80\x9cBasis\xe2\x80\x9d is money that will not again be subject to\nincome tax, usually because it has already been subject to tax. Thus, basis is the\nmeans by which we keep score with the government. Mrs. Macomber owned 2200\nshares of Standard Oil. Let\xe2\x80\x99s say that she paid $220,000 for these shares, i.e.,\n$100/share. After receiving the stock dividend, she owned 3300 shares.\n\xe2\x80\xa2What should be her basis in both the original 2200 shares and the 1100\n54\n\n\x0cdividend shares?\n\xe2\x80\xa2Suppose Justice Brandeis\xe2\x80\x99s view had prevailed. What should be her basis\nin the original 2200 shares and in the 1100 dividend shares?\n\xe2\x80\xa2Justice Brandeis acknowledged that he would tax corporate shareholders\nin the same manner as partners in a partnership are taxed.\n\xe2\x80\xa2How do you think partners are taxed on undistributed partnership\nprofits?\n\xe2\x80\xa2How should that change a partner\xe2\x80\x99s basis in his partnership interest?\n\xe2\x80\xa2What should happen to the partner\xe2\x80\x99s basis in his partnership interest\nif he later withdraws cash or property from the partnership?\nCommissioner v. Glenshaw Glass Co., 348 U.S. 426 (1955)\nMr. Chief Justice WARREN delivered the opinion of the Court.\nThis litigation involves two cases with independent factual backgrounds yet\npresenting the identical issue. \xe2\x80\xa6 The common question is whether money received\nas exemplary damages for fraud or as the punitive two-thirds portion of a trebledamage antitrust recovery must be reported by a taxpayer as gross income under\n[\xc2\xa7 61] of the Internal Revenue Code. [footnote omitted] In a single opinion, 211\nF.2d 928, the Court of Appeals [for the Third Circuit] affirmed the Tax Court\xe2\x80\x99s\nseparate rulings in favor of the taxpayers. [citation omitted] Because of the frequent\nrecurrence of the question and differing interpretations by the lower courts of this\nCourt\xe2\x80\x99s decisions bearing upon the problem, we granted the Commissioner of the\nInternal Revenue\xe2\x80\x99s ensuing petition for certiorari. [citation omitted]\nThe facts of the cases were largely stipulated and are not in dispute. So far as\npertinent they are as follows:\nCommissioner v. Glenshaw Glass Co. \xe2\x80\x93 The Glenshaw Glass Company, a\nPennsylvania corporation, manufactures glass bottles and containers. It was\nengaged in protracted litigation with the Hartford-Empire Company, which\nmanufactures machinery of a character used by Glenshaw. Among the claims\nadvanced by Glenshaw were demands for exemplary damages for fraud [footnote\nomitted] and treble damages for injury to its business by reason of Hartford\xe2\x80\x99s\nviolation of the federal antitrust laws. [footnote omitted] In December, 1947, the\nparties concluded a settlement of all pending litigation, by which Hartford paid\nGlenshaw approximately $800,000. Through a method of allocation which was\n55\n\n\x0capproved by the Tax Court, [citation omitted], and which is no longer in issue, it\nwas ultimately determined that, of the total settlement, $324,529.94 represented\npayment of punitive damages for fraud and antitrust violations. Glenshaw did not\nreport this portion of the settlement as income for the tax year involved. The\nCommissioner determined a deficiency claiming as taxable the entire sum less only\ndeductible legal fees. \xe2\x80\xa6\nCommissioner v. William Goldman Theatres, Inc. \xe2\x80\x93 William Goldman Theatres,\nInc., a Delaware corporation operating motion picture houses in Pennsylvania, sued\nLoew\xe2\x80\x99s, Inc., alleging a violation of the federal antitrust laws and seeking treble\ndamages. \xe2\x80\xa6 It was found that Goldman has suffered a loss of profits equal to\n$125,000 and was entitled to treble damages in the sum of $375,000. \xe2\x80\xa6 Goldman\nreported only $125,000 of the recovery as gross income and claimed that the\n$250,000 balance constituted punitive damages and as such was not taxable. \xe2\x80\xa6\nIt is conceded by the respondents that there is no constitutional barrier to the\nimposition of a tax on punitive damages. Our question is one of statutory\nconstruction: are these payments comprehended by \xc2\xa7 [61](a)?\nThe sweeping scope of the controverted statute is readily apparent: \xe2\x80\xa6\nThis Court has frequently stated that this language was used by Congress to exert\nin this field \xe2\x80\x98the full measure of its taxing power.\xe2\x80\x99 [citations omitted] Respondents\ncontend that punitive damages, characterized as \xe2\x80\x98windfalls\xe2\x80\x99 flowing from the\nculpable conduct of third parties, are not within the scope of the section. But\nCongress applied no limitations as to the source of taxable receipts, nor restrictive\nlabels as to their nature. And the Court has given a liberal construction to this broad\nphraseology in recognition of the intention of Congress to tax all gains except those\nspecifically exempted. [citations omitted] \xe2\x80\xa6 [Our] decisions demonstrate that we\ncannot but ascribe content to the catchall provision of [\xc2\xa7 61(a)], \xe2\x80\x98gains or profits\nand income derived from any source whatever.\xe2\x80\x99 The importance of that phrase has\nbeen too frequently recognized since its first appearance in the Revenue Act of\n1913 [footnote omitted] to say now that it adds nothing to the meaning of \xe2\x80\x98gross\nincome.\xe2\x80\x99\nNor can we accept respondents\xe2\x80\x99 contention that a narrower reading of [\xc2\xa7 61(a)] is\nrequired by the Court\xe2\x80\x99s characterization of income in Eisner v. Macomber, 252 U.S.\n189, 207, as \xe2\x80\x9cthe gain derived from capital, from labor, or from both combined.\xe2\x80\x9d\n[footnote omitted] \xe2\x80\xa6 In that context \xe2\x80\x93 distinguishing gain from capital \xe2\x80\x93 the\n56\n\n\x0cdefinition served a useful purpose. But it was not meant to provide a touchstone to\nall future gross income questions. [citations omitted]\nHere we have instances of undeniable accessions to wealth, clearly realized, and\nover which the taxpayers have complete dominion. The mere fact that the payments\nwere extracted from the wrongdoers as punishment for unlawful conduct cannot\ndetract from their character as taxable income to the recipients. Respondents\nconcede, as they must, that the recoveries are taxable to the extent they compensate\nfor damages actually incurred. It would be an anomaly that could not be justified in\nthe absence of clear congressional intent to say that a recovery for actual damages\nis taxable but not the additional amount extracted as punishment for the same\nconduct which caused the injury. And we find no such evidence of intent to exempt\nthese payments.\n\xe2\x80\xa6.\nReversed.\nMr. Justice DOUGLAS dissents. ...\nNotes and Questions:\n1. Taxpayers acknowledged that Congress could constitutionally impose a tax on\npunitive damages. Interestingly, the Supreme Court has indeed observed many\ntimes that Congress exercised all the power granted it by the Sixteenth Amendment.\nHow much room does this really leave for a taxpayer to argue that Congress could\ntax windfalls but had not? Taxpayer may still argue that it\xe2\x80\x99s not income, and there\nis no other tax on punitive damages.\n2. Memorize the elements of \xe2\x80\x9cgross income\xe2\x80\x9d stated in the first sentence of the last\nparagraph of the case. You\xe2\x80\x99ll have to do this eventually, so save some time and do\nit now.\n3. SHS holds that income includes all rights exercised in consumption plus changes\nin a taxpayer\xe2\x80\x99s wealth. Does the phrase \xe2\x80\x9caccessions to wealth\xe2\x80\x9d encompass more or\nless than that?\n4. Is the receipt of any accession to wealth, e.g., receiving exemplary damages, what\nmost people think of as \xe2\x80\x9cincome?\xe2\x80\x9d If not, what objectives does the Tax Code\n57\n\n\x0cimplicitly pursue by including all accessions to wealth in a taxpayer\xe2\x80\x99s taxable income?\n5. The following case provides a good primer (review) of Congress\xe2\x80\x99s constitutional\npower to tax. Read \xc2\xa7 104(a)(2), including the carryout paragraph at the end of\n\xc2\xa7 104(a).\n6. In Macomber, Standard Oil spent after-tax dollars (i.e., \xe2\x80\x9csurplus and undivided\nprofits\xe2\x80\x9d) to purchase capital assets with which it would presumably earn more\nprofits. If a negligent third person damaged some of those capital assets and paid\nmoney to Standard Oil so that it could restore them to their original condition, how\nshould Standard Oil be taxed on the money it received? See Clark v. Commissioner,\ninfra. How many times should Standard Oil pay income tax to have basis in a\nproductive asset?\nNow consider the assets with which a taxpayer earns income through work. What\nshould be a taxpayer\xe2\x80\x99s basis in his \xe2\x80\x9chuman capital?\xe2\x80\x9d How should this affect the\ntaxability of a restoration of such capital after it has been injured?\nMurphy v. Internal Revenue Service, 493 F.3d 170 (D.C. Cir. 2007), cert. denied,\n553 U.S. 1004 (2008).\nOn Rehearing\nGINSBURG, Chief Judge:\n....\nI. Background\n[After successfully complaining to the Department of Labor that her employer had\nblacklisted her in violation of various whistle-blower statutes, Murphy received an\naward of $45,000 for past and future emotional distress and $25,000 for damage to\nher vocational reputation. Murphy suffered both \xe2\x80\x9csomatic\xe2\x80\x9d and \xe2\x80\x9cemotional\xe2\x80\x9d\ninjuries along with other \xe2\x80\x9cphysical manifestations of stress,\xe2\x80\x9d i.e., anxiety attacks,\nshortness of breath and dizziness. She also suffered from bruxism (teeth grinding),\na condition often associated with stress that can cause permanent tooth damage.\nMurphy included the $70,000 in her gross income, but later filed an amended return\nclaiming that she was entitled to a refund because I.R.C. \xc2\xa7 104(a)(2) excluded the\n$70,000 from her gross income. The IRS rejected her claim for a refund because\nMurphy failed to prove that the compensatory damages were attributable to\n58\n\n\x0c\xe2\x80\x9cphysical injury\xe2\x80\x9d or \xe2\x80\x9cphysical sickness.\xe2\x80\x9d Hence \xc2\xa7 104(a)(2) did not exclude such\ndamages from her gross income. Murphy sued the IRS and the United States in\nfederal district court.\nMurphy argued: (1) I.R.C. \xc2\xa7 104(a)(2) excluded the compensatory damages from\nher gross income because the award was for \xe2\x80\x9cphysical personal injuries;\xe2\x80\x9d (2) taxing\nher award is unconstitutional because her damages were not \xe2\x80\x9cincome\xe2\x80\x9d within the\nmeaning of the Sixteenth Amendment. The district court rejected all of Murphy\xe2\x80\x99s\nclaims. Murphy appealed. On appeal, the court, 460 F.3d 79 (CADC 2006),\nreversed the district court\xe2\x80\x99s decision, concluding that \xc2\xa7 104(a)(2) did not exclude\nMurphy\xe2\x80\x99s award from her gross income, but that her award was not \xe2\x80\x9cincome\xe2\x80\x9d\nwithin the Sixteenth Amendment. The Government petitioned for a rehearing and\nargued that even if Murphy\xe2\x80\x99s award was not \xe2\x80\x9cincome\xe2\x80\x9d within the Sixteenth\nAmendment, there was no \xe2\x80\x9cconstitutional impediment\xe2\x80\x9d to taxing Murphy\xe2\x80\x99s award\nbecause a tax on such an award is not a direct tax and the tax is imposed uniformly.\nOn rehearing, the court held that Murphy could not sue the IRS but could sue the\nUnited States.]\n... In the present opinion, we affirm the judgment of the district court based upon\nthe newly argued ground that Murphy\xe2\x80\x99s award, even if it is not income within the\nmeaning of the Sixteenth Amendment, is within the reach of the congressional\npower to tax under Article I, Section 8 of the Constitution.\nII. Analysis\n....\nB. Section 104(a)(2) of the IRC\nSection 104(a) (\xe2\x80\x9cCompensation for injuries or sickness\xe2\x80\x9d) provides that \xe2\x80\x9cgross\nincome [under \xc2\xa7 61 of the IRC] does not include the amount of any damages (other\nthan punitive damages) received ... on account of personal physical injuries or\nphysical sickness.\xe2\x80\x9d 26 U.S.C. \xc2\xa7 104(a)(2). Since 1996 it has further provided that,\nfor purposes of this exclusion, \xe2\x80\x9cemotional distress shall not be treated as a physical\ninjury or physical sickness.\xe2\x80\x9d Id. \xc2\xa7 104(a). ...\n....\n\xe2\x80\xa6 In O\xe2\x80\x99Gilvie v. United States, 519 U.S. 79 (1996), the Supreme Court read [the\nphrase \xe2\x80\x9con account of\xe2\x80\x9d] to require a \xe2\x80\x9cstrong[ ] causal connection,\xe2\x80\x9d thereby making\n59\n\n\x0c\xc2\xa7 104(a)(2) \xe2\x80\x9capplicable only to those personal injury lawsuit damages that were\nawarded by reason of, or because of, the personal injuries.\xe2\x80\x9d The Court specifically\nrejected a \xe2\x80\x9cbut-for\xe2\x80\x9d formulation in favor of a \xe2\x80\x9cstronger causal connection.\xe2\x80\x9d \xe2\x80\xa6\n....\n\xe2\x80\xa6 Murphy no doubt suffered from certain physical manifestations of emotional\ndistress, but the record clearly indicates the Board awarded her compensation only\n\xe2\x80\x9cfor mental pain and anguish\xe2\x80\x9d and \xe2\x80\x9cfor injury to professional reputation.\xe2\x80\x9d ... [W]e\nconclude Murphy\xe2\x80\x99s damages were not \xe2\x80\x9cawarded by reason of, or because of, ...\n[physical] personal injuries,\xe2\x80\x9d O\xe2\x80\x99Gilvie, 519 U.S. at 83. Therefore, \xc2\xa7 104(a)(2) does\nnot permit Murphy to exclude her award from gross income.31\nC. Section 61 of the IRC\nMurphy and the Government agree that for Murphy\xe2\x80\x99s award to be taxable, it must\nbe part of her \xe2\x80\x9cgross income\xe2\x80\x9d as defined by \xc2\xa7 61(a) ..., which states in relevant part:\n\xe2\x80\x9cgross income means all income from whatever source derived.\xe2\x80\x9d The Supreme\nCourt has interpreted the section broadly to extend to \xe2\x80\x9call economic gains not\notherwise exempted.\xe2\x80\x9d Comm\xe2\x80\x99r v. Banks, 543 U.S. 426, 433 (2005); see also, e.g.,\n[citation omitted]; Comm\xe2\x80\x99r v. Glenshaw Glass Co., 348 U.S. 426, 430 (\xe2\x80\x9cthe Court\nhas given a liberal construction to [\xe2\x80\x9cgross income\xe2\x80\x9d] in recognition of the intention\nof Congress to tax all gains except those specifically exempted\xe2\x80\x9d). \xe2\x80\x9cGross income\xe2\x80\x9d\nin \xc2\xa7 61(a) is at least as broad as the meaning of \xe2\x80\x9cincomes\xe2\x80\x9d in the Sixteenth\nAmendment. [footnote omitted]. See Glenshaw Glass, 348 U.S. at 429, 432 n. 11\n\xe2\x80\xa6; [citation omitted].\nMurphy argues her award is not a gain or an accession to wealth and therefore not\npart of gross income. Noting the Supreme Court has long recognized \xe2\x80\x9cthe principle\nthat a restoration of capital [i]s not income; hence it [falls] outside the definition of\n\xe2\x80\x98income\xe2\x80\x99 upon which the law impose[s] a tax,\xe2\x80\x9d O\xe2\x80\x99Gilvie, 519 U.S. at 84; [citations\nomitted], Murphy contends a damage award for personal injuries \xe2\x80\x93 including\nnonphysical injuries \xe2\x80\x93 should be viewed as a return of a particular form of capital\n\xe2\x80\x93 \xe2\x80\x9chuman capital,\xe2\x80\x9d as it were. See GARY S. BECKER, HUMAN CAPITAL (1st ed.1964);\nGary S. Becker, The Economic Way of Looking at Life, Nobel Lecture (Dec. 9,\n1992), in NOBEL LECTURES IN ECONOMIC SCIENCES 1991-1995, at 43-45 (Torsten\n31 Insofar as compensation for nonphysical personal injuries appears to be excludable from gross\nincome under 26 C.F.R. \xc2\xa7 1.104-1, the regulation conflicts with the plain text of \xc2\xa7 104(a)(2); in these\ncircumstances the statute clearly controls. See Brown v. Gardner, 513 U.S. 115, 122 (1994) (finding \xe2\x80\x9cno\nantidote to [a regulation\xe2\x80\x99s] clear inconsistency with a statute\xe2\x80\x9d).\n\n60\n\n\x0cPersson ed., 1997). ...\n....\nFinally, Murphy argues her interpretation of \xc2\xa7 61 is reflected in the common law of\ntort and the provisions in various environmental statutes and Title VII of the Civil\nRights Act of 1964, all of which provide for \xe2\x80\x9cmake whole\xe2\x80\x9d relief. See, e.g., 42\nU.S.C. \xc2\xa7 1981a; 15 U.S.C. \xc2\xa7 2622. If a recovery of damages designed to \xe2\x80\x9cmake\nwhole\xe2\x80\x9d the plaintiff is taxable, she reasons, then one who receives the award has\nnot been made whole after tax. Section 61 should not be read to create a conflict\nbetween the tax code and the \xe2\x80\x9cmake whole\xe2\x80\x9d purpose of the various statutes.\nThe Government disputes Murphy\xe2\x80\x99s interpretation on all fronts. First, noting \xe2\x80\x9cthe\ndefinition [of gross income in the IRC] extends broadly to all economic gains,\xe2\x80\x9d\nBanks, 543 U.S. at 433, the Government asserts Murphy \xe2\x80\x9cundeniably had economic\ngain because she was better off financially after receiving the damages award than\nshe was prior to receiving it.\xe2\x80\x9d Second, the Government argues that the case law\nMurphy cites does not support the proposition that the Congress lacks the power to\ntax as income recoveries for personal injuries. \xe2\x80\xa6\n\xe2\x80\xa6.\nFinally, the Government argues that even if the concept of human capital is built\ninto \xc2\xa7 61, Murphy\xe2\x80\x99s award is nonetheless taxable because Murphy has no tax basis\nin her human capital. Under the IRC, a taxpayer\xe2\x80\x99s gain upon the disposition of\nproperty is the difference between the \xe2\x80\x9camount realized\xe2\x80\x9d from the disposition and\nhis basis in the property, 26 U.S.C. \xc2\xa7 1001, defined as \xe2\x80\x9cthe cost of such property,\xe2\x80\x9d\nid. \xc2\xa7 1012, adjusted \xe2\x80\x9cfor expenditures, receipts, losses, or other items, properly\nchargeable to [a] capital account,\xe2\x80\x9d id. \xc2\xa7 1016(a)(1). The Government asserts, \xe2\x80\x9cThe\nCode does not allow individuals to claim a basis in their human capital;\xe2\x80\x9d\naccordingly, Murphy\xe2\x80\x99s gain is the full value of the award. See Roemer v. Comm\xe2\x80\x99r,\n716 F.2d 693, 696 n. 2 (9th Cir.1983) (\xe2\x80\x9cSince there is no tax basis in a person\xe2\x80\x99s\nhealth and other personal interests, money received as compensation for an injury\nto those interests might be considered a realized accession to wealth\xe2\x80\x9d) (dictum).\n\n61\n\n\x0cAlthough\nMurphy\nand\nthe\nGovernment focus primarily upon\nwhether Murphy\xe2\x80\x99s award falls within\nthe definition of income first used in\nGlenshaw Glass [footnote omitted],\ncoming within that definition is not\nthe only way in which \xc2\xa7 61(a) could\nbe held to encompass her award.\nPrinciples of statutory interpretation\ncould\nshow\n\xc2\xa7 61(a)\nincludes\nMurphy\xe2\x80\x99s award in her gross income\nregardless whether it was an\n\xe2\x80\x9caccession to wealth,\xe2\x80\x9d as Glenshaw\nGlass requires. For example, if\n\xc2\xa7 61(a) were amended specifically to\ninclude in gross income \xe2\x80\x9c$100,000 in\naddition to all other gross income,\xe2\x80\x9d\nthen that additional sum would be a\npart of gross income under \xc2\xa7 61 even though no actual gain was associated with it.\nIn other words, although the \xe2\x80\x9cCongress cannot make a thing income which is not\nso in fact,\xe2\x80\x9d Burk-Waggoner Oil Ass\xe2\x80\x99n v. Hopkins, 269 U.S. 110, 114 (1925), it can\nlabel a thing income and tax it, so long as it acts within its constitutional authority,\nwhich includes not only the Sixteenth Amendment but also Article I, Sections 8\nand 9. See Penn Mut. Indem. Co. v. Comm\xe2\x80\x99r, 277 F.2d 16, 20 (3d Cir.1960)\n(\xe2\x80\x9cCongress has the power to impose taxes generally, and if the particular imposition\ndoes not run afoul of any constitutional restrictions then the tax is lawful, call it\nwhat you will\xe2\x80\x9d) (footnote omitted). Accordingly, rather than ask whether Murphy\xe2\x80\x99s\naward was an accession to her wealth, we go to the heart of the matter, which is\nwhether her award is properly included within the definition of gross income in\n\xc2\xa7 61(a), to wit, \xe2\x80\x9call income from whatever source derived.\xe2\x80\x9d\n\nDetermining gain or loss on disposition of\nproperty: Section 1001 establishes a\nformula for determining gain or loss on the\nsale or other disposition of property. To\ndetermine gain, subtract adjusted basis\nfrom the amount realized. \xc2\xa7 1001(a). We\nabbreviate this as AR \xe2\x88\x92 AB. To determine\nloss, subtract amount realized from\nadjusted basis. \xc2\xa7 1001(a). Section 1001\ndoes not impose any tax or determine any\nincome; it simply provides a means of\nmeasuring gain or loss. Section 1012\ndefines \xe2\x80\x9cbasis\xe2\x80\x9d to be the cost of property.\nSection 1011(a) defines \xe2\x80\x9cadjusted basis\xe2\x80\x9d\nto be \xe2\x80\x9cbasis\xe2\x80\x9d as \xe2\x80\x9cadjusted.\xe2\x80\x9d Section 1016\nnames occasions for adjusting basis.\n\nLooking at \xc2\xa7 61(a) by itself, one sees no indication that it covers Murphy\xe2\x80\x99s award\nunless the award is \xe2\x80\x9cincome\xe2\x80\x9d as defined by Glenshaw Glass and later cases.\nDamages received for emotional distress are not listed among the examples of\nincome in \xc2\xa7 61 and, as Murphy points out, an ambiguity in the meaning of a\nrevenue-raising statute should be resolved in favor of the taxpayer. See, e.g.,\nHassett v. Welch, 303 U.S. 303, 314 (1938); Gould v. Gould, 245 U.S. 151, 153\n(1917); [citations omitted]. A statute is to be read as a whole, however [citation\n62\n\n\x0comitted], and reading \xc2\xa7 61 in combination with \xc2\xa7 104(a)(2) \xe2\x80\xa6 presents a very\ndifferent picture \xe2\x80\x93 a picture so clear that we have no occasion to apply the canon\nfavoring the interpretation of ambiguous revenue-raising statutes in favor of the\ntaxpayer.\n... [I]n 1996 the Congress amended \xc2\xa7 104(a) to narrow the exclusion to amounts\nreceived on account of \xe2\x80\x9cpersonal physical injuries or physical sickness\xe2\x80\x9d from\n\xe2\x80\x9cpersonal injuries or sickness,\xe2\x80\x9d and explicitly to provide that \xe2\x80\x9cemotional distress\nshall not be treated as a physical injury or physical sickness,\xe2\x80\x9d thus making clear\nthat an award received on account of emotional distress is not excluded from gross\nincome under \xc2\xa7 104(a)(2). Small Business Job Protection Act of 1996, Pub.L. 104188, \xc2\xa7 1605, 110 Stat. 1755, 1838. As this amendment, which narrows the\nexclusion, would have no effect whatsoever if such damages were not included\nwithin the ambit of \xc2\xa7 61, and as we must presume that \xe2\x80\x9c[w]hen Congress acts to\namend a statute, ... it intends its amendment to have real and substantial effect,\xe2\x80\x9d\nStone v. INS, 514 U.S. 386, 397 (1995), the 1996 amendment of \xc2\xa7 104(a) strongly\nsuggests \xc2\xa7 61 should be read to include an award for damages from nonphysical\nharms. [footnote omitted]. ...\n....\n... For the 1996 amendment of \xc2\xa7 104(a) to \xe2\x80\x9cmake sense,\xe2\x80\x9d gross income in \xc2\xa7 61(a)\nmust, and we therefore hold it does, include an award for nonphysical damages\nsuch as Murphy received, regardless whether the award is an accession to wealth.\n[citation omitted].\nD. The Congress\xe2\x80\x99s Power to Tax\nThe taxing power of the Congress is established by Article I, Section 8 of the\nConstitution: \xe2\x80\x9cThe Congress shall have power to lay and collect taxes, duties,\nimposts and excises.\xe2\x80\x9d There are two limitations on this power. First, as the same\nsection goes on to provide, \xe2\x80\x9call duties, imposts and excises shall be uniform\nthroughout the United States.\xe2\x80\x9d Second, as provided in Section 9 of that same\nArticle, \xe2\x80\x9cNo capitation, or other direct, tax shall be laid, unless in proportion to the\ncensus or enumeration herein before directed to be taken.\xe2\x80\x9d See also U.S. Const.\nart. I, \xc2\xa7 2, cl. 3 (\xe2\x80\x9cdirect taxes shall be apportioned among the several states which\nmay be included within this union, according to their respective numbers\xe2\x80\x9d).32 We\nThough it is unclear whether an income tax is a direct tax, the Sixteenth Amendment definitively\nestablishes that a tax upon income is not required to be apportioned. [citation omitted].\n32\n\n63\n\n\x0cnow consider whether the tax laid upon Murphy\xe2\x80\x99s award violates either of these\ntwo constraints.\n1. A Direct Tax?\nOver the years, courts have considered numerous claims that one or another\nnonapportioned tax is a direct tax and therefore unconstitutional. Although these\ncases have not definitively marked the boundary between taxes that must be\napportioned and taxes that need not be, see Bromley v. McCaughn, 280 U.S. 124,\n136 (1929); Spreckels Sugar Ref. Co. v. McClain, 192 U.S. 397, 413 (1904)\n(dividing line between \xe2\x80\x9ctaxes that are direct and those which are to be regarded\nsimply as excises\xe2\x80\x9d is \xe2\x80\x9coften very difficult to be expressed in words\xe2\x80\x9d), some\ncharacteristics of each may be discerned.\nOnly three taxes are definitely known to be direct: (1) a capitation, U.S. Const. art.\nI, \xc2\xa7 9, (2) a tax upon real property, and (3) a tax upon personal property. See\nFernandez v. Wiener, 326 U.S. 340, 352 (1945) (\xe2\x80\x9cCongress may tax real estate or\nchattels if the tax is apportioned\xe2\x80\x9d); Pollock v. Farmers\xe2\x80\x99 Loan & Trust Co., 158 U.S.\n601, 637 (1895) (Pollock II).33 Such direct taxes are laid upon one\xe2\x80\x99s \xe2\x80\x9cgeneral\nownership of property,\xe2\x80\x9d Bromley, 280 U.S. at 136; see also Flint v. Stone Tracy\nCo., 220 U.S. 107, 149 (1911), as contrasted with excise taxes laid \xe2\x80\x9cupon a\nparticular use or enjoyment of property or the shifting from one to another of any\npower or privilege incidental to the ownership or enjoyment of property.\xe2\x80\x9d\nFernandez, 326 U.S. at 352; see also Thomas v. United States, 192 U.S. 363, 370\n(1904) (excises cover \xe2\x80\x9cduties imposed on importation, consumption, manufacture\nand sale of certain commodities, privileges, particular business transactions,\nvocations, occupations and the like\xe2\x80\x9d). More specifically, excise taxes include, in\naddition to taxes upon consumable items [citation omitted], taxes upon the sale of\ngrain on an exchange, Nicol v. Ames, 173 U.S. 509, 519 (1899), the sale of corporate\nstock, Thomas, 192 U.S. at 371, doing business in corporate form, Flint, 220 U.S.\nat 151, gross receipts from the \xe2\x80\x9cbusiness of refining sugar,\xe2\x80\x9d Spreckels, 192 U.S. at\n411, the transfer of property at death, Knowlton v. Moore, 178 U.S. 41, 81-82\n(1900), gifts, Bromley, 280 U.S. at 138, and income from employment, see Pollock\nv. Farmers\xe2\x80\x99 Loan & Trust Co., 157 U.S. 429, 579 (1895) (Pollock I) (citing\nSpringer v. United States, 102 U.S. 586 (1881)).\n\nPollock II also held that a tax upon the income of real or personal property is a direct tax. 158 U.S.\nat 637. Whether that portion of Pollock remains good law is unclear. See Graves v. New York ex rel.\nO\xe2\x80\x99Keefe, 306 U.S. 466, 480 (1939).\n33\n\n64\n\n\x0cMurphy and the amici supporting her argue the dividing line between direct and\nindirect taxes is based upon the ultimate incidence of the tax; if the tax cannot be\nshifted to someone else, as a capitation cannot, then it is a direct tax; but if the\nburden can be passed along through a higher price, as a sales tax upon a consumable\ngood can be, then the tax is indirect. This, she argues, was the distinction drawn\nwhen the Constitution was ratified. See Albert Gallatin, A Sketch of the Finances\nof the United States (1796), reprinted in 3 THE WRITINGS OF ALBERT GALLATIN 7475 (Henry Adams ed., Philadelphia, J.P. Lippincott & Co. 1879) (\xe2\x80\x9cThe most\ngenerally received opinion ... is, that by direct taxes ... those are meant which are\nraised on the capital or revenue of the people; by indirect, such as are raised on their\nexpense\xe2\x80\x9d); The Federalist No. 36, at 225 (Alexander Hamilton) (Jacob E. Cooke\ned., 1961) (\xe2\x80\x9cinternal taxes[ ] may be subdivided into those of the direct and those\nof the indirect kind ... by which must be understood duties and excises on articles\nof consumption\xe2\x80\x9d). But see Gallatin, supra, at 74 (\xe2\x80\x9c[Direct tax] is used, by different\nwriters, and even by the same writers, in different parts of their writings, in a variety\nof senses, according to that view of the subject they were taking\xe2\x80\x9d); EDWIN R.A.\nSELIGMAN, THE INCOME TAX 540 (photo. reprint 1970) (2d ed.1914) (\xe2\x80\x9cthere are\nalmost as many classifications of direct and indirect taxes are there are authors\xe2\x80\x9d).\nMoreover, the amici argue, this understanding of the distinction explains the\ndifferent restrictions imposed respectively upon the power of the Congress to tax\ndirectly (apportionment) and via excise (uniformity). Duties, imposts, and excise\ntaxes, which were expected to constitute the bulk of the new federal government\xe2\x80\x99s\nrevenue, see Erik M. Jensen, The Apportionment of \xe2\x80\x9cDirect Taxes\xe2\x80\x9d: Are\nConsumption Taxes Constitutional?, 97 COLUM. L. REV. 2334, 2382 (1997), have\na built-in safeguard against oppressively high rates: Higher taxes result in higher\nprices and therefore fewer sales and ultimately lower tax revenues. See The\nFederalist No. 21, supra, at 134-35 (Alexander Hamilton). Taxes that cannot be\nshifted, in contrast, lack this self-regulating feature, and were therefore constrained\nby the more stringent requirement of apportionment. See id. at 135 (\xe2\x80\x9cIn a branch\nof taxation where no limits to the discretion of the government are to be found in\nthe nature of things, the establishment of a fixed rule ... may be attended with fewer\ninconveniences than to leave that discretion altogether at large\xe2\x80\x9d); see also Jensen,\nsupra, at 2382-84.\n\xe2\x80\xa6 As it is clear that Murphy cannot shift her tax burden to anyone else, per Murphy\nand the amici, it must be a direct tax.\n\xe2\x80\xa6.\n65\n\n\x0cMurphy makes no attempt to reconcile her definition with the long line of cases\nidentifying various taxes as excise taxes, although several of them seem to refute\nher position directly. In particular, we do not see how a known excise, such as the\nestate tax, see, e.g., New York Trust Co. v. Eisner, 256 U.S. 345, 349 (1921);\nKnowlton, 178 U.S. at 81-83, or a tax upon income from employment, see Pollock\nII, 158 U.S. at 635; Pollock I, 157 U.S. at 579; cf. Steward Mach. Co. v. Davis, 301\nU.S. 548, 580-81 (1937) (tax upon employers based upon wages paid to employees\nis an excise), can be shifted to another person, absent which they seem to be in\nirreconcilable conflict with her position that a tax that cannot be shifted to someone\nelse is a direct tax. Though it could be argued that the incidence of an estate tax is\ninevitably shifted to the beneficiaries, we see at work none of the restraint upon\nexcessive taxation that Murphy claims such shifting is supposed to provide; the tax\nis triggered by an event, death, that cannot be shifted or avoided. In any event,\nKnowlton addressed the argument that Pollock I and II made ability to shift the\nhallmark of a direct tax, and rejected it. 178 U.S. at 81-82. Regardless what the\noriginal understanding may have been, therefore, we are bound to follow the\nSupreme Court, which has strongly intimated that Murphy\xe2\x80\x99s position is not the law.\n\xe2\x80\xa6.\nWe find it more appropriate to analyze this case based upon the precedents and\ntherefore to ask whether the tax laid upon Murphy\xe2\x80\x99s award is more akin, on the one\nhand, to a capitation or a tax upon one\xe2\x80\x99s ownership of property, or, on the other\nhand, more like a tax upon a use of property, a privilege, an activity, or a\ntransaction, see Thomas, 192 U.S. at 370. Even if we assume one\xe2\x80\x99s human capital\nshould be treated as personal property, it does not appear that this tax is upon\nownership; rather, as the Government points out, Murphy is taxed only after she\nreceives a compensatory award, which makes the tax seem to be laid upon a\ntransaction. See Tyler v. United States, 281 U.S. 497, 502 (1930) (\xe2\x80\x9cA tax laid upon\nthe happening of an event, as distinguished from its tangible fruits, is an indirect\ntax which Congress, in respect of some events ... undoubtedly may impose\xe2\x80\x9d);\nSimmons v. United States, 308 F.2d 160, 166 (4th Cir.1962) (tax upon receipt of\nmoney is not a direct tax); [citation omitted]. Murphy\xe2\x80\x99s situation seems akin to an\ninvoluntary conversion of assets; she was forced to surrender some part of her\nmental health and reputation in return for monetary damages. Cf. 26 U.S.C. \xc2\xa7 1033\n(property involuntarily converted into money is taxed to extent of gain recognized).\nAt oral argument Murphy resisted this formulation on the ground that the receipt of\nan award in lieu of lost mental health or reputation is not a transaction. This view\n66\n\n\x0cis tenable, however, only if one decouples Murphy\xe2\x80\x99s injury (emotional distress and\nlost reputation) from her monetary award, but that is not beneficial to Murphy\xe2\x80\x99s\ncause, for then Murphy has nothing to offset the obvious accession to her wealth,\nwhich is taxable as income. Murphy also suggested at oral argument that there was\nno transaction because she did not profit. Whether she profited is irrelevant,\nhowever, to whether a tax upon an award of damages is a direct tax requiring\napportionment; profit is relevant only to whether, if it is a direct tax, it nevertheless\nneed not be apportioned because the object of the tax is income within the meaning\nof the Sixteenth Amendment. Cf. Spreckels, 192 U.S. at 412-13 (tax upon gross\nreceipts associated with business of refining sugar not a direct tax); Penn Mut., 277\nF.2d at 20 (tax upon gross receipts deemed valid indirect tax despite taxpayer\xe2\x80\x99s net\nloss).\nSo we return to the question: Is a tax upon this particular kind of transaction\nequivalent to a tax upon a person or his property? [citation omitted]. Murphy did\nnot receive her damages pursuant to a business activity [citations omitted], and we\ntherefore do not view this tax as an excise under that theory. See Stratton\xe2\x80\x99s\nIndependence, Ltd. v. Howbert, 231 U.S. 399, 414-15 (1913) (\xe2\x80\x9cThe sale outright of\na mining property might be fairly described as a mere conversion of the capital from\nland into money\xe2\x80\x9d). On the other hand, as noted above, the Supreme Court several\ntimes has held a tax not related to business activity is nonetheless an excise. And\nthe tax at issue here is similar to those.\nBromley, in which a gift tax was deemed an excise, is particularly instructive: The\nCourt noted it was \xe2\x80\x9ca tax laid only upon the exercise of a single one of those powers\nincident to ownership,\xe2\x80\x9d 280 U.S. at 136, which distinguished it from \xe2\x80\x9ca tax which\nfalls upon the owner merely because he is owner, regardless of the use or\ndisposition made of his property,\xe2\x80\x9d id. at 137. A gift is the functional equivalent of\na below-market sale; it therefore stands to reason that if, as Bromley holds, a gift\ntax, or a tax upon a below-market sale, is a tax laid not upon ownership but upon\nthe exercise of a power \xe2\x80\x9cincident to ownership,\xe2\x80\x9d then a tax upon the sale of property\nat fair market value is similarly laid upon an incidental power and not upon\nownership, and hence is an excise. Therefore, even if we were to accept Murphy\xe2\x80\x99s\nargument that the human capital concept is reflected in the Sixteenth Amendment,\na tax upon the involuntary conversion of that capital would still be an excise and\nnot subject to the requirement of apportionment. But see Nicol, 173 U.S. at 521\n(indicating pre-Bromley that tax upon \xe2\x80\x9cevery sale made in any place ... is really and\npractically upon property\xe2\x80\x9d).\n67\n\n\x0cIn any event, even if a tax upon the sale of property is a direct tax upon the property\nitself, we do not believe Murphy\xe2\x80\x99s situation involves a tax \xe2\x80\x9cupon the sale itself,\nconsidered separate and apart from the place and the circumstances of the sale.\xe2\x80\x9d Id.\nat 520. Instead, as in Nicol, this tax is more akin to \xe2\x80\x9ca duty upon the facilities made\nuse of and actually employed in the transaction.\xe2\x80\x9d Id. at 519. To be sure, the facility\nused in Nicol was a commodities exchange whereas the facility used by Murphy\nwas the legal system, but that hardly seems a significant distinction. The tax may\nbe laid upon the proceeds received when one vindicates a statutory right, but the\nright is nonetheless a \xe2\x80\x9ccreature of law,\xe2\x80\x9d which Knowlton identifies as a \xe2\x80\x9cprivilege\xe2\x80\x9d\ntaxable by excise. 178 U.S. at 55 (right to take property by inheritance is granted\nby law and therefore taxable as upon a privilege);34 cf. Steward, 301 U.S. at 580-81\n(\xe2\x80\x9c[N]atural rights, so called, are as much subject to taxation as rights of less\nimportance. An excise is not limited to vocations or activities that may be\nprohibited altogether.... It extends to vocations or activities pursued as of common\nright.\xe2\x80\x9d) (footnote omitted).\n2. Uniformity\nThe Congress may not implement an excise tax that is not \xe2\x80\x9cuniform throughout the\nUnited States.\xe2\x80\x9d U.S. Const. art. I, \xc2\xa7 8, cl. 1. A \xe2\x80\x9ctax is uniform when it operates with\nthe same force and effect in every place where the subject of it is found.\xe2\x80\x9d United\nStates v. Ptasynski, 462 U.S. 74, 82 (1983) (internal quotation marks omitted); see\nalso Knowlton, 178 U.S. at 84-86, 106. The tax laid upon an award of damages for\na nonphysical personal injury operates with \xe2\x80\x9cthe same force and effect\xe2\x80\x9d throughout\nthe United States and therefore satisfies the requirement of uniformity.\nExclusions from Gross Income: Section 104(a)(2),\nwhich the court quoted, provides for an exclusion\nfrom gross income. Obviously $70,000 is money\nthat taxpayer could spend. If an exclusion had\napplied, taxpayer would not have to count it in her\ngross income even though she clearly received it.\n\nIII. Conclusion\n\nFor the foregoing reasons, we\nconclude\n(1)\nMurphy\xe2\x80\x99s\ncompensatory award was not\nreceived on account of\npersonal physical injuries,\nand therefore is not exempt\nfrom taxation pursuant to \xc2\xa7 104(a)(2) of the IRC; (2) the award is part of her \xe2\x80\x9cgross\nincome,\xe2\x80\x9d as defined by \xc2\xa7 61 of the IRC; and (3) the tax upon the award is an excise\nFor the same reason, we infer from Knowlton that a tax laid upon an amount received in settlement\nof a suit for a personal nonphysical injury would also be an excise. See 178 U.S. at 55.\n34\n\n68\n\n\x0cand not a direct tax subject to the apportionment requirement of Article I, Section\n9 of the Constitution. The tax is uniform throughout the United States and therefore\npasses constitutional muster. The judgment of the district court is accordingly\nAffirmed.\n\nBasis, Restoration of Capital, and MONEY:\nThe income tax is all about money, i.e., U.S.\ndollars. Basis is how we keep score with the\ngovernment. We keep score in terms of\ndollars \xe2\x80\x93 not in terms of emotional well-being\nor happiness. These latter concepts are real\nenough, but not capable of valuation in terms\nof money. While tort law may fashion an\nafter-the-fact exchange of money for\nemotional well-being, tax law does not\nrecognize the non-monetary aspects of the\nexchange \xe2\x80\x93 except as \xc2\xa7 104 otherwise\nprovides.\n\nNotes and Questions:\n1. Notice in the first footnote of the\ncase, the court acknowledged an\ninconsistency between a regulation and\nthe Code. Obviously, the Code\nprevails. See ch. 1, \xc2\xa7 VII supra.\n\n2. In the first paragraph of part IIC, the\ncourt states our second guiding\nprinciple (see chapter 1) of tax law:\n\xe2\x80\x9cThere are exceptions to [the principle\nthat we tax all of the income of a\nparticular taxpayer once], but we usually must find those exceptions in the Code\nitself.\xe2\x80\x9d\n\n3. What is a direct tax under the Constitution? What taxes do we know are direct\ntaxes? What is the constitutional limitation upon Congress\xe2\x80\x99s power to enact direct\ntaxes?\n\xe2\x80\xa2In National Federation of Independent Business v. Sebelius, 567 U.S. 519\n(2012), the Supreme Court held that\n[a] tax on going without health insurance does not fall within any\nrecognized category of direct tax. It is not a capitation. ... The whole\npoint of the shared responsibility payment is that it is triggered by\nspecific circumstances \xe2\x80\x93 earning a certain amount of income but not\nobtaining health insurance. The payment is also plainly not a tax on\nthe ownership of land or personal property. The shared\nresponsibility payment is thus not a direct tax that must be\napportioned among the several States.\nId. at 571.\n69\n\n\x0c4. What is an indirect tax under the Constitution? What taxes do we know are\nindirect taxes? What is the constitutional limitation upon Congress\xe2\x80\x99s power to enact\nindirect taxes?\n5. The court provides a good review of the power of Congress to impose taxes\naside from the income tax. The court acknowledged that a tax on tort damages for\nemotional distress might not be a tax on income in the constitutional sense (i.e.,\nSixteenth Amendment) of the word. How should this affect the fact that all items\nof gross income are added together and form the bases of other important elements\nof the income tax, e.g., AGI, tax brackets applicable to all income. Might a tax upon\nsuch damages therefore render the constitutionality of the income tax questionable\nwith respect to taxpayers such as Marrita Murphy?\n\xe2\x80\xa2Items subject to an indirect tax affect the amount of\nTort law and emotional\nitems subject to a direct tax.\ndistress: Tort law usually\nrequires a physical\n6. Do you think that taxpayer Murphy would place\nmanifestation of emotional\nmore value on her pre-event emotional tranquility\ndistress for plaintiff to\nand happiness or on her post-event emotional\nrecover damages. However,\ntranquility, happiness, and $70,000?\nthat physical manifestation is\n\xe2\x80\xa2Is it possible that we tax events that actually reduce\nnot itself a \xe2\x80\x9cpersonal physical\na taxpayer\xe2\x80\x99s overall wealth?\ninjury. H.R. REP. NO. 104-737\nat 301 n.56 (1996), reprinted\n7. The court cited the case of Penn Mut. Indem. Co.\nat 1996-3 C.B. 741, 1041.\nv. Comm\xe2\x80\x99r, 277 F.2d 16, 20 (3d Cir. 1960) with this\nparenthetical: \xe2\x80\x9cCongress has the power to impose\ntaxes generally, and if the particular imposition does not run afoul of any\nconstitutional restrictions then the tax is lawful, call it what you will.\xe2\x80\x9d\nIn National Federation of Independent Business v. Sebelius, 567 U.S. 519 (2012),\nthe Supreme Court \xe2\x80\x9cconfirmed\xe2\x80\x9d a \xe2\x80\x9cfunctional approach\xe2\x80\x9d to whether an assessment\n\n70\n\n\x0cis a tax. 567 U.S. at 563-66\n(\xe2\x80\x9cshared responsibility payment\xe2\x80\x9d\nTaxing Only the Creation of Value? [reprise from\nactually a \xe2\x80\x9ctax,\xe2\x80\x9d even though\nchapter 1] Voluntary exchanges are often\ncalled a \xe2\x80\x9cpenalty\xe2\x80\x9d).\nessential to the creation of the income that the\n\xe2\x80\xa2In Eisner v. Macomber,\nInternal Revenue Code subjects to income tax.\nthe Supreme Court said:\nArguably, the Code should not subject to tax\n\xe2\x80\x9cCongress cannot by any\n\xe2\x80\x9cincome\xe2\x80\x9d derived from involuntary exchanges\ndefinition [of \xe2\x80\x9cincome\xe2\x80\x9d] it\nthat everyone understands (probably) reduce a\ntaxpayer\xe2\x80\x99s wealth. This is not the case. Courtmay adopt conclude the\nordered damages that a plaintiff deems\nmatter, since it cannot by\ninadequate to compensate for the loss of an\nlegislation alter the\nunpurchased intangible (e.g., emotional\nConstitution, from which\ntranquility) may nevertheless be subject to\nalone it derives its power\nincome tax. See \xc2\xa7 104(a).\nto legislate, and within\nwhose limitations alone\nthat power can be\nlawfully exercised.\xe2\x80\x9d\n\xe2\x80\xa2Are these positions inconsistent?\n\xe2\x80\xa2Does this imply that Congress can enact a tax \xe2\x80\x93 assuming that the\nlegislative proposal originates in the House of Representatives \xe2\x80\x93 and later\nsearch for its constitutional underpinning?\n\nII. The Constitutional and Statutory Definitions of \xe2\x80\x9cGross\nIncome:\xe2\x80\x9d Accessions to Wealth\nA. Some Recurring Themes\nConsider now the many forms that an \xe2\x80\x9caccession to wealth\xe2\x80\x9d can take. Section 61(a)\nof the Code provides a non-exclusive list of fourteen items. Obviously, \xe2\x80\x9cgross\nincome\xe2\x80\x9d includes compensation for services. \xc2\xa7 61(a)(1). We should not be\nespecially surprised that \xe2\x80\x9cgross income\xe2\x80\x9d includes the other items on the list.\nHowever, the first sentence of \xc2\xa7 61(a) does not limit \xe2\x80\x9cgross income\xe2\x80\x9d to the items\non this list. This point has required courts to consider whether various benefits\nconstituted an \xe2\x80\x9caccession to wealth.\xe2\x80\x9d The following cases, some of which pre-date\nGlenshaw Glass, present some examples.\n71\n\n\x0cOld Colony Trust Co. v. Commissioner, 279 U.S. 716 (1929)\nMR. CHIEF JUSTICE TAFT delivered the opinion of the Court.\n....\nWilliam M. Wood was president of the American Woolen Company during the\nyears 1918, 1919, and 1920. In 1918 he received as salary and commissions from\nthe company $978,725, which he included in his federal income tax return for 1918.\nIn 1919, he received as salary and commissions from the company $548,132.87,\nwhich he included in his return for 1919.\nAugust 3, 1916, the American Woolen Company had adopted the following\nresolution, which was in effect in 1919 and 1920:\n\xe2\x80\x9cVoted: That this company pay any and all income taxes, state and Federal,\nthat may hereafter become due and payable upon the salaries of all the\nofficers of the company, including the president, William M. Wood[,] ... to\nthe end that said persons and officers shall receive their salaries or other\ncompensation in full without deduction on account of income taxes, state or\nfederal, which taxes are to be paid out of the treasury of this corporation.\xe2\x80\x9d\n....\n... [T]he American Woolen Company paid to the collector of internal revenue Mr.\nWood\xe2\x80\x99s federal income and surtaxes due to salary and commissions paid him by\nthe company, as follows:\nTaxes for 1918 paid in 1919 . . . . $681,169 88\nTaxes for 1919 paid in 1920 . . . . $351,179 27\nThe decision of the Board of Tax Appeals here sought to be reviewed was that the\nincome taxes of $681,169.88 and $351,179.27 paid by the American Woolen\nCompany for Mr. Wood were additional income to him for the years 1919 and\n1920.\nThe question certified by the circuit court of appeals for answer by this Court is:\n\xe2\x80\x9cDid the payment by the employer of the income taxes assessable against\n72\n\n\x0cthe employee constitute additional taxable income to such employee?\xe2\x80\x9d\n....\n... Coming now to the merits of this case, we think the question presented is whether\na taxpayer, having induced a third person to pay his income tax or having\nacquiesced in such payment as made in discharge of an obligation to him, may\navoid the making of a return thereof and the payment of a corresponding tax. We\nthink he may not do so. The payment of the tax by the employers was in\nconsideration of the services rendered by the employee, and was again derived by\nthe employee from his labor. The form of the payment is expressly declared to make\nno difference. Section 213, Revenue Act of 1918, c. 18, 40 Stat. 1065 [\xc2\xa7 61]. It is\ntherefore immaterial that the taxes were directly paid over to the government. The\ndischarge by a third person of an obligation to him is equivalent to receipt by the\nperson taxed. The certificate shows that the taxes were imposed upon the employee,\nthat the taxes were actually paid by the employer, and that the employee entered\nupon his duties in the years in question under the express agreement that his income\ntaxes would be paid by his employer. ... The taxes were paid upon a valuable\nconsideration \xe2\x80\x93 namely, the services rendered by the employee and as part of the\ncompensation therefor. We think, therefore, that the payment constituted income to\nthe employee.\n....\nNor can it be argued that the payment of the tax ... was a gift. The payment for\nservices, even though entirely voluntary, was nevertheless compensation within the\nstatute. ...\nIt is next argued against the payment of this tax that, if these payments by the\nemployer constitute income to the employee, the employee will be called upon to\npay the tax imposed upon this additional income, and that the payment of the\nadditional tax will create further income which will in turn be subject to tax, with\nthe result that there would be a tax upon a tax. This, it is urged, is the result of the\ngovernment\xe2\x80\x99s theory, when carried to its logical conclusion, and results in an\nabsurdity which Congress could not have contemplated.\nIn the first place, no attempt has been made by the Treasury to collect further taxes\nupon the theory that the payment of the additional taxes creates further income, and\nthe question of a tax upon a tax was not before the circuit court of appeals, and has\nnot been certified to this Court. We can settle questions of that sort when an attempt\n73\n\n\x0cto impose a tax upon a tax is undertaken, but not now. [citations omitted]. It is not,\ntherefore, necessary to answer the argument based upon an algebraic formula to\nreach the amount of taxes due. The question in this case is, \xe2\x80\x9cDid the payment by\nthe employer of the income taxes assessable against the employee constitute\nadditional taxable income to such employee?\xe2\x80\x9d The answer must be \xe2\x80\x9cYes.\xe2\x80\x9d\nSeparate opinion of MR. JUSTICE McREYNOLDS [omitted].\nNotes and Questions:\n1. Taxpayers pay their federal income taxes from after-tax income. This was not\nalways true. Act of Oct. 3, 1913, entitled \xe2\x80\x9cAn act to reduce tariff duties and to\nprovide revenue for the Government and for other purposes,\xe2\x80\x9d part IIB, granted a\ndeduction for national taxes paid. After Congress repealed this deduction, the\nAmerican Woolen Company began paying William Wood\xe2\x80\x99s federal income taxes.\nWithout a deduction, taxpayer pays income taxes from after-tax income.\n2. The Court seems to say both that taxpayer received additional compensation\n(taxable) and that taxpayer benefitted from third-party satisfaction of an obligation\n(also taxable).\nA Little Algebra: Is the argument that the\nCommissioner creates a never-ending\nupward spiral of taxes upon taxes true?\n\xe2\x80\xa2No.\n\xe2\x80\xa2If taxpayer is to have $X remaining after\npayment of taxes and the tax rate is \xce\xbb , then\ntaxable income equal to $X/(1 \xe2\x88\x92 \xce\xbb ) will\nproduce $X of after-tax income. Obviously,\ngraduated tax rates would require some\nincremental computations.\n\xe2\x80\xa2We call a computation of the amount of\nincome necessary to produce a desired aftertax amount \xe2\x80\x9cgrossing up.\xe2\x80\x9d\n\n3. A taxpayer\xe2\x80\x99s wealth increases\nwhen someone else pays one of\ntaxpayer\xe2\x80\x99s obligations. We treat this\nas an accession to wealth. You will\nencounter this principle may times\nthroughout this course. Thus, when\ntaxpayer\xe2\x80\x99s employer pays taxpayer\xe2\x80\x99s\nfederal income taxes, taxpayer\nshould include the amount of taxes in\nhis gross income. The principle is\napplicable in many contexts.\n\n4. A key consideration is whether a\nthird party makes a payment to\nsatisfy an actual \xe2\x80\x9cobligation\xe2\x80\x9d of the\ntaxpayer, or merely to \xe2\x80\x9crestore\xe2\x80\x9d to taxpayer \xe2\x80\x9ccapital\xe2\x80\x9d wrongfully or erroneously\ntaken from him. See Clark infra.\n74\n\n\x0cClark v. Commissioner, 40 B.T.A. 333 (1939)\nOpinion. LEECH.\nThis is a proceeding to redetermine a deficiency in income tax for the calendar year\n1934 in the amount of $10,618.87. The question presented is whether petitioner\nderived income by the payment to him of an amount of $19,941.10, by his tax\ncounsel, to compensate him for a loss suffered on account of erroneous advice given\nhim by the latter. The facts were stipulated and ... so far as material, follow[]:\n3. The petitioner during the calendar year 1932, and for a considerable period prior\nthereto, was married and living with his wife. He was required by the Revenue Act\nof 1932 to file a Federal Income Tax Return of his income for the year 1932. For\nsuch year petitioner and his wife could have filed a joint return or separate returns.\n4. Prior to the time that the 1932 Federal Income Tax return or returns of petitioner\nand/or his wife were due to be filed, petitioner retained experienced counsel to\nprepare the necessary return or returns for him and/or his wife. Such tax counsel\nprepared a joint return for petitioner and his wife and advised petitioner to file it\ninstead of two separate returns. In due course it was filed with the Collector of\nInternal Revenue for the First District of California. ...\n....\n6. [Tax counsel had improperly deducted more than the allowable amount of capital\nlosses.]\n7. The error referred to in paragraph six above was called to the attention of the tax\ncounsel who prepared the joint return of petitioner and his wife for the year 1932.\nRecomputations were then made which disclosed that if petitioner and his wife had\nfiled separate returns for the year 1932 their combined tax liability would have been\n$19,941.10 less than that which was finally assessed against and paid by petitioner.\n8. Thereafter, tax counsel admitted that if he had not erred in computing the tax\nliability shown on the joint return filed by the petitioner, he would have advised\npetitioner to file separate returns for himself and his wife, and accordingly tax\ncounsel tendered to petitioner the sum of $19,941.10, which was the difference\nbetween what petitioner and his wife would have paid on their 1932 returns if\nseparate returns had been filed and the amount which petitioner was actually\n75\n\n\x0crequired to pay on the joint return as filed. Petitioner accepted the $19,941.10.\n9. In his final determination of petitioner\xe2\x80\x99s 1934 tax liability, the respondent\nincluded the aforesaid $19,941.10 in income.\n10. Petitioner\xe2\x80\x99s books of account are kept on the cash receipts and disbursements\nbasis and his tax returns are made on such basis under the community property laws\nof the State of California.\nThe theory on which the respondent included the above sum of $19,941.10 in\npetitioner\xe2\x80\x99s gross income for 1934, is that this amount constituted taxes paid for\npetitioner by a third party and that, consequently, petitioner was in receipt of\nincome to that extent. ... Petitioner, on the contrary, contends that this payment\nconstituted compensation for damages or loss caused by the error of tax counsel,\nand that he therefore realized no income from its receipt in 1934.\nWe agree with the petitioner. ... Petitioner\xe2\x80\x99s taxes were not paid for him by any\nperson \xe2\x80\x93 as rental, compensation for services rendered, or otherwise. He paid his\nown taxes.\nWhen the joint return was filed, petitioner became obligated to and did pay the taxes\ncomputed on that basis. [citation omitted] In paying that obligation, he sustained a\nloss which was caused by the negligence of his tax counsel. The $19,941.10 was\npaid to petitioner, not qua taxes [citation omitted], but as compensation to petitioner\nfor his loss. The measure of that loss, and the compensation therefor, was the sum\nof money which petitioner became legally obligated to and did pay because of that\nnegligence. The fact that such obligation was for taxes is of no moment here.\n....\n... And the fact that the payment of the compensation for such loss was voluntary,\nas here, does not change its exempt status. [citation omitted] It was, in fact,\ncompensation for a loss which impaired petitioner\xe2\x80\x99s capital.\n\n76\n\n\x0cMoreover, so long as petitioner neither could nor did take a deduction in a prior\nyear of this loss in such a way as to offset income for the prior year, the amount\nreceived by him in the taxable year, by way of recompense, is not then includable\nin his gross income. Central Loan & Investment Co., 39 B.T.A. 981.\nDecision will be entered for the petitioner.\nNotes and Questions:\n\nA return of capital is not gross income.\nAfter all, the capital that is returned has\nalready been subject to income tax.\n\n1. Does the Commissioner\xe2\x80\x99s position\nfollow from the Supreme Court\xe2\x80\x99s holding\nin Old Colony Trust?\n2. Is this holding consistent with SHS? What do you know from reading the case\nabout what taxpayer\xe2\x80\x99s after-tax wealth should have been? In fact, is that not what\nthe court was referencing when it described the payment as \xe2\x80\x9ccompensation for a\nloss which impaired [taxpayer\xe2\x80\x99s] capital?\n3. In Murphy, supra, taxpayer made a \xe2\x80\x9creturn-of-capital\xe2\x80\x9d argument. Why did\ntaxpayer in Murphy lose but the taxpayer in Clark win?\nGotcher v. United States, 401 F.2d 118 (5th Cir. 1968)\nTHORNBERRY, Circuit Judge.\nIn 1960, Mr. and Mrs. Gotcher took a twelve-day expense-paid trip to Germany to\ntour the Volkswagon facilities there. The trip cost $1372.30. His employer,\nEconomy Motors, paid $348.73, and Volkswagon of Germany and Volkswagon of\nAmerica shared the remaining $1023.53. Upon returning, Mr. Gotcher bought a\ntwenty-five percent interest in Economy Motors, the Sherman, Texas Volkswagon\ndealership, that had been offered to him before he left. Today he is President of\nEconomy Motors in Sherman and owns fifty percent of the dealership. Mr. and\nMrs. Gotcher did not include any part of the $1372.30 in their 1960 income. The\nCommissioner determined that the taxpayers had realized income to the extent of\nthe $1372.30 for the expense-paid trip and asserted a tax deficiency of $356.79,\nplus interest. Taxpayers paid the deficiency, plus $82.29 in interest, and thereafter\ntimely filed suit for a refund. The district court, sitting without a jury, held that the\ncost of the trip was not income or, in the alternative, was income and deductible as\n77\n\n\x0can ordinary and necessary business expense. [citation omitted] We affirm the\ndistrict court\xe2\x80\x99s determination that the cost of the trip was not income to Mr. Gotcher\n($686.15); however, Mrs. Gotcher\xe2\x80\x99s expenses ($686.15) constituted income and\nwere not deductible.\n... The court below reasoned that the cost of the trip to the Gotchers was not income\nbecause an economic or financial benefit does not constitute income under \xc2\xa7 61\nunless it is conferred as compensation for services rendered. This conception of\ngross income is too restrictive since it is [well]-settled that \xc2\xa7 61 should be broadly\ninterpreted and that many items, including compensatory gains, constitute gross\nincome. [footnote omitted]\nSections 101-[139G] specifically exclude certain items from gross income.\nAppellant argues that the cost of the trip should be included in income since it is\nnot specifically excluded by \xc2\xa7\xc2\xa7 101-[139G], reasoning that \xc2\xa7 61 was drafted\nbroadly to subject all economic gains to tax and any exclusions should be narrowly\nlimited to the specific exclusions. [footnote omitted] This analysis is too restrictive\nsince it has been generally held that exclusions from gross income are not limited\nto the enumerated exceptions. [footnote omitted] ...\nIn determining whether the expense-paid trip was income within \xc2\xa7 61, we must look\nto the tests that have been developed under this section. The concept of economic\ngain to the taxpayer is key to \xc2\xa7 61. H. SIMONS, PERSONAL INCOME TAXATION 51\n(1938); J. SNEED, THE CONFIGURATIONS OF GROSS INCOME 8 (1967). This concept\ncontains two distinct requirements: There must be an economic gain, and this gain\nmust primarily benefit the taxpayer personally. In some cases, as in the case of an\nexpense-paid trip, there is no direct economic gain, but there is indirect economic\ngain inasmuch as a benefit has been received without a corresponding diminution\nof wealth. Yet even if expense-paid items, as meals and lodging, are received by\nthe taxpayer, the value of these items will not be gross income, even though the\nemployee receives some incidental benefit, if the meals and lodging are primarily\nfor the convenience of the employer. See Int. Rev. Code of 1954, \xc2\xa7 119.\n\xe2\x80\xa6 [T]here is no evidence in the record to indicate that the trip was an award for\npast services since Mr. Gotcher was not an employee of VW of Germany and he\ndid nothing to earn that part of the trip paid by Economy Motors.\nThe trip was made in 1959 when VW was attempting to expand its local dealerships\nin the United States. The \xe2\x80\x98buy American\xe2\x80\x99 campaign and the fact that the VW people\n78\n\n\x0cfelt they had a \xe2\x80\x98very ugly product\xe2\x80\x99 prompted them to offer these tours of Germany\nto prospective dealers. ... VW operations were at first so speculative that cars had\nto be consigned with a repurchase guarantee. In 1959, when VW began to push for\nits share of the American market, its officials determined that the best way to\nremove the apprehension about this foreign product was to take the dealer to\nGermany and have him see his investment first-hand. It was believed that once the\ndealer saw the manufacturing facilities and the stability of the \xe2\x80\x98new Germany\xe2\x80\x99 he\nwould be convinced that VW was for him. [footnote omitted] Furthermore, VW\nconsidered the expenditure justified because the dealer was being asked to make a\nsubstantial investment of his time and money in a comparatively new product.\nIndeed, after taking the trip, VW required him to acquire first-class facilities. ...\nVW could not have asked that this upgrading be done unless it convinced the dealer\nthat VW was here to stay. Apparently these trips have paid off since VW\xe2\x80\x99s sales\nhave skyrocketed and the dealers have made their facilities top-rate operations\nunder the VW requirements for a standard dealership.\nThe activities in Germany support the conclusion that the trip was oriented to\nbusiness. The Government makes much of the fact that the travel brochure allocated\nonly two of the twelve days to the touring of VW factories. This argument ignores\nthe uncontradicted evidence that not all of the planned activities were in the\nbrochure. There is ample support for the trial judge\xe2\x80\x99s finding that a substantial\namount of time was spent touring VW facilities and visiting local dealerships. VW\nhad set up these tours with local dealers so that the travelers could discuss how the\nfacilities were operated in Germany. Mr. Gotcher took full advantage of this\nopportunity and even used some of his \xe2\x80\x98free time\xe2\x80\x99 to visit various local dealerships.\nMoreover, at almost all of the evening meals VW officials gave talks about the\norganization and passed out literature and brochures on the VW story.\nSome of the days were not related to touring VW facilities, but that fact alone\ncannot be decisive. The dominant purpose of the trip is the critical inquiry and some\npleasurable features will not negate the finding of an overall business purpose.\n[citation omitted] Since we are convinced that the agenda related primarily to\nbusiness and that Mr. Gotcher\xe2\x80\x99s attendance was prompted by business\nconsiderations, the so-called sightseeing complained of by the Government is\ninconsequential. [citation omitted] \xe2\x80\xa6 [E]ven this touring of the countryside had an\nindirect relation to the business since the tours were not typical sightseeing\nexcursions but were connected to the desire of VW that the dealers be persuaded\nthat the German economy was stable enough to justify investment in a German\nproduct. \xe2\x80\xa6 It is the business reality of the total situation, not the colorful\n79\n\n\x0cexpressions in the literature, that controls. Considering the record, the\ncircumstances prompting the trip, and the objective achieved, we conclude that the\nprimary purpose of the trip was to induce Mr. Gotcher to take out a VW dealership\ninterest.\nThe question, therefore, is what tax consequences should follow from an expensepaid trip that primarily benefits the party paying for the trip. In several analogous\nsituations the value of items received by employees has been excluded from gross\nincome when these items were primarily for the benefit of the employer. Section\n119 excludes from gross income of an employee the value of meals and lodging\nfurnished to him for the convenience of the employer. Even before these items were\nexcluded by the 1954 Code, the Treasury and the courts recognized that they should\nbe excluded from gross income. [footnote omitted] Thus it appears that the value\nof any trip that is paid by the employer or by a businessman primarily for his own\nbenefit should be excluded from gross income of the payee on similar reasoning.\n[citations omitted]\nIn the recent case of Allen J. McDonnell, 26 T.C.M. 115, Tax Ct. Mem. 1967-68, a\nsales supervisor and his wife were chosen by lot to accompany a group of contest\nwinners on an expense-paid trip to Hawaii. In holding that the taxpayer had\nreceived no income, the Tax Court noted that he was required by his employer to\ngo and that he was serving a legitimate business purpose though he enjoyed the trip.\nThe decision suggests that in analyzing the tax consequences of an expense-paid\ntrip one important factor is whether the traveler had any choice but to go. Here,\nalthough the taxpayer was not forced to go, there is no doubt that in the reality of\nthe business world he had no real choice. The trial judge reached the same\nconclusion. He found that the invitation did not specifically order the dealers to go,\nbut that as a practical matter it was an order or directive that if a person was going\nto be a VW dealer, sound business judgment necessitated his accepting the offer of\ncorporate hospitality. So far as Economy Motors was concerned, Mr. Gotcher knew\nthat if he was going to be a part-owner of the dealership, he had better do all that\nwas required to foster good business relations with VW. Besides having no choice\nbut to go, he had no control over the schedule or the money spent. VW did all the\nplanning. In cases involving noncompensatory economic gains, courts have\nemphasized that the taxpayer still had complete dominion and control over the\nmoney to use it as he wished to satisfy personal desires or needs. Indeed, the\nSupreme Court has defined income as accessions of wealth over which the taxpayer\nhas complete control. Commissioner of Internal Revenue v. Glenshaw Glass Co.,\nsupra. Clearly, the lack of control works in the taxpayer\xe2\x80\x99s favor here.\n80\n\n\x0cMcDonnell also suggests that one does not realize taxable income when he is\nserving a legitimate business purpose of the party paying the expenses. The cases\ninvolving corporate officials who have traveled or entertained clients at the\ncompany\xe2\x80\x99s expense are apposite. \xe2\x80\xa6 [W]hen it has been shown that the expenses\nwere paid to effectuate a legitimate corporate end and not to benefit the officer\npersonally, the officer has not been taxed though he enjoyed and benefited from the\nactivity. [footnote omitted] Thus, the rule is that the economic benefit will be\ntaxable to the recipient only when the payment of expenses serves no legitimate\ncorporate purposes. [citation omitted] The decisions also indicate that the tax\nconsequences are to be determined by looking to the primary purpose of the\nexpenses and that the first consideration is the intention of the payor. The\nGovernment in argument before the district court agreed that whether the expenses\nwere income to taxpayers is mainly a question of the motives of the people giving\nthe trip. Since this is a matter of proof, the resolution of the tax question really\ndepends on whether Gotcher showed that his presence served a legitimate corporate\npurpose and that no appreciable amount of time was spent for his personal benefit\nand enjoyment. [citation omitted]\nExamination of the record convinces us that the personal benefit to Gotcher was\nclearly subordinate to the concrete benefits to VW. The purpose of the trip was to\npush VW in America and to get dealers to invest more money and time in their\ndealerships. Thus, although Gotcher got some ideas that helped him become a better\ndealer, there is no evidence that this was the primary purpose of the trip. Put another\nway, this trip was not given as a pleasurable excursion through Germany or as a\nmeans of teaching taxpayer the skills of selling. The personal benefits and pleasure\nwere incidental to the dominant purpose of improving VW\xe2\x80\x99s position on the\nAmerican market and getting people to invest money.\nThe corporate-executive decisions indicate that some economic gains, though not\nspecifically excluded from \xc2\xa7 61, may nevertheless escape taxation. They may be\nexcluded even though the entertainment and travel unquestionably give enjoyment\nto the taxpayer and produce indirect economic gains. When this indirect economic\ngain is subordinate to an overall business purpose, the recipient is not taxed. We\nare convinced that the personal benefit to Mr. Gotcher from the trip was merely\nincidental to VW\xe2\x80\x99s sales campaign.\nAs for Mrs. Gotcher, the trip was primarily vacation. She did not make the tours\nwith her husband to see the local dealers or attend discussions about the VW\norganization. This being so, the primary benefit of the expense-paid trip for the wife\n81\n\n\x0cwent to Mr. Gotcher in that he was relieved of her expenses. He should therefore\nbe taxed on the expenses attributable to his wife. [citation omitted] Nor are the\nexpenses deductible since the wife\xe2\x80\x99s presence served no bona fide business purpose\nfor her husband. Only when the wife\xe2\x80\x99s presence is necessary to the conduct of the\nhusband\xe2\x80\x99s business are her expenses deductible under \xc2\xa7 162. [citation omitted]\nAlso, it must be shown that the wife made the trip only to assist her husband in his\nbusiness. ...\nAffirmed in part; reversed in part.\nJOHN R. BROWN, Chief Judge (concurring): [omitted].\nNotes and Questions:\n1. Is Gotcher a case where taxpayer did not receive any \xe2\x80\x9cgross income\xe2\x80\x9d or a case\nwhere taxpayer did receive \xe2\x80\x9cgross income\xe2\x80\x9d that the Code or another authority\nexcluded? It might make a difference.\n\xe2\x80\xa2What happened to our second principle (see chapter 1) \xe2\x80\x93 that all income is\ntaxed once unless an exception is specifically found in the Code?\n2. What tests does the court state to determine whether the trip was \xe2\x80\x9cgross income?\xe2\x80\x9d\n3. If the procurement of a benefit \xe2\x80\x9cprimarily benefits\xe2\x80\x9d the payor rather than the\nrecipient, has the recipient really realized an \xe2\x80\x9caccession to wealth\xe2\x80\x9d whose value\nshould be measured by its cost?\n\n82\n\n\x0c4. How important should the absence of control over how money is spent be in\ndetermining whether taxpayer has realized an accession to wealth on which he\nshould pay income tax? What factors are\nimportant in determining whether a nonTaxability of a Price Reduction: What\ncompensatory benefit is an \xe2\x80\x9caccession to\nhappens when taxpayer can purchase a\nwealth?\xe2\x80\x9d\ncomputer that \xe2\x80\x9cnormally\xe2\x80\x9d retails for $1000\nfor $800 during a \xe2\x80\x9ccomputer blowout sale?\xe2\x80\x9d\n5. Review: what is value? Do you think\nDoes our taxpayer enjoy a $200 accession\nthat taxpayer valued his trip as much as\nto wealth? Answer: No.\nVW valued it? \xe2\x80\x93 as much as it cost VW?\nWhat about the cost of his wife\xe2\x80\x99s trip?\nA \xe2\x80\x9cmere reduction in price\xe2\x80\x9d is not taxable\nincome. A contrary rule would raise\n6. This case involved a prospective\ninsurmountable\nproblems\nof\nvalue\ninvestor. The recipient may also be a\ndetermination. Recall the alternative\nprospective employee or a prospective\ndefinitions of \xe2\x80\x9cvalue\xe2\x80\x9d in chapter 1. Perhaps\nan insufficient number of persons were\ncustomer.\nwilling to pay $1000 for the computer worth\n$800 in the first place.\n7. Back to windfalls, plus some dumb\nluck.\nCesarini v. United States, 296 F. Supp. 3 (N.D. Ohio 1969)\nYOUNG, District Judge.\n\xe2\x80\xa6.\n\xe2\x80\xa6 Plaintiffs are husband and wife, and live within the jurisdiction of the United\nStates District Court for the Northern District of Ohio. In 1957, the plaintiffs\npurchased a used piano at an auction sale for approximately $15.00, and the piano\nwas used by their daughter for piano lessons. In 1964, while cleaning the piano,\nplaintiffs discovered the sum of $4,467.00 in old currency, and since have retained\nthe piano instead of discarding it as previously planned. Being unable to ascertain\nwho put the money there, plaintiffs exchanged the old currency for new at a bank,\nand reported a sum of $4,467.00 on their 1964 joint income tax return as ordinary\nincome from other sources. On October 18, 1965, plaintiffs filed an amended return\n\xe2\x80\xa6, this second return eliminating the sum of $4,467.00 from the gross income\ncomputation, and requesting a refund in the amount of $836.51, the amount\nallegedly overpaid as a result of the former inclusion of $4,467.00 in the original\n83\n\n\x0creturn for the calendar year of 1964. \xe2\x80\xa6 [T]he Commissioner of Internal Revenue\nrejected taxpayers\xe2\x80\x99 refund claim in its entirety, and plaintiffs filed the instant action\nin March of 1967.\nPlaintiffs make three alternative contentions in support of their claim that the sum\nof $836.51 should be refunded to them. First, that the $4,467.00 found in the piano\nis not includable in gross income under \xc2\xa7 61 of the Internal Revenue Code. (26\nU.S.C. \xc2\xa7 61) Secondly, even if the retention of the cash constitutes a realization of\nordinary income under \xc2\xa7 61, it was due and owing in the year the piano was\npurchased, 1957, and by 1964, the statute of limitations provided by 26 U.S.C.\n\xc2\xa7 6501 had elapsed. And thirdly, that if the treasure trove money is gross income\nfor the year 1964, it was entitled to capital gains treatment under \xc2\xa7 1221 of Title\n26. The Government, by its answer and its trial brief, asserts that the amount found\nin the piano is includable in gross income under \xc2\xa7 61(a) of Title 26, U.S.C., that the\nmoney is taxable in the year it was actually found, 1964, and that the sum is properly\ntaxable at ordinary income rates, not being entitled to capital gains treatment under\n26 U.S.C. \xc2\xa7\xc2\xa7 2201 et seq.\n... [T]his Court has concluded that the taxpayers are not entitled to a refund of the\namount requested, nor are they entitled to capital gains treatment on the income\nitem at issue.\nThe starting point in determining whether an item is to be included in gross income\nis, of course, \xc2\xa7 61(a) ..., and that section provides in part: \xe2\x80\x9cExcept as otherwise\nprovided in this subtitle, gross income means all income from whatever source\nderived, including (but not limited to) the following items:\xe2\x80\x9d * * *\xe2\x80\x99\nSubsections (1) through (15) of \xc2\xa7 61(a) then go on to list fifteen items specifically\nincluded in the computation of the taxpayers\xe2\x80\x99 gross income, and Part II of\nSubchapter B of the 1954 Code (\xc2\xa7\xc2\xa7 71 et seq.) deals with other items expressly\nincluded in gross income. While neither of these listings expressly includes the\ntype of income which is at issue in the case at bar, Part III of Subchapter B (\xc2\xa7\xc2\xa7 101\net seq.) deals with items specifically excluded from gross income, and found money\nis not listed in those sections either. This absence of express mention in any code\nsections necessitates a return to the \xe2\x80\x98all income from whatever source\xe2\x80\x99 language of\n\xc2\xa7 61(a) of the code, and the express statement there that gross income is \xe2\x80\x98not limited\nto\xe2\x80\x99 the following fifteen examples. \xe2\x80\xa6\nThe decisions of the United States Supreme Court have frequently stated that this\n84\n\n\x0cbroad all-inclusive language was used by Congress to exert the full measure of its\ntaxing power under the Sixteenth Amendment to the United States Constitution.\n[citations omitted]\nIn addition, the Government in the instant case cites and relies upon an I.R.S.\nRevenue Ruling which is undeniably on point:\n\xe2\x80\x98The finder of treasure-trove is in receipt of taxable income, for Federal\nincome tax purposes, to the extent of its value in United States Currency,\nfor the taxable year in which it is reduced to undisputed possession.\xe2\x80\x99 Rev.\nRul. 61, 1953-1, Cum. Bull. 17.\n\xe2\x80\xa6.\n\xe2\x80\xa6 While it is generally true that revenue rulings may be disregarded by the courts\nif in conflict with the code and the regulations, or with other judicial decisions,\nplaintiffs in the instant case have been unable to point to any inconsistency between\nthe gross income sections of the code, the interpretation of them by the regulations\nand the Courts, and the revenue ruling which they herein attack as inapplicable. On\nthe other hand, the United States has shown consistency in the letter and spirit\nbetween the ruling and the code, regulations, and court decisions.\nAlthough not cited by either party, and noticeably absent from the Government\xe2\x80\x99s\nbrief, the following Treasury Regulation appears in the 1964 Regulations, the year\nof the return in dispute:\n\xe2\x80\x98\xc2\xa7 1.61-14 Miscellaneous items of gross income.\n\xe2\x80\x98(a) In general. In addition to the items enumerated in section 61(a), there\nare many other kinds of gross income * * *. Treasure trove, to the extent\nof its value in United States currency, constitutes gross income for the\ntaxable year in which it is reduced to undisputed possession.\xe2\x80\x99\n\xe2\x80\xa6 This Court is of the opinion that Treas. Reg. \xc2\xa7 1.61-14(a) is dispositive of the\nmajor issue in this case if the $4,467.00 found in the piano was \xe2\x80\x98reduced to\nundisputed possession\xe2\x80\x99 in the year petitioners reported it, for this Regulation was\napplicable to returns filed in the calendar year of 1964.\nThis brings the Court to the second contention of the plaintiffs: that if any tax was\ndue, it was in 1957 when the piano was purchased, and by 1964 the Government\n85\n\n\x0cwas blocked from collecting it by reason of the statute of limitations. Without\nreaching the question of whether the voluntary payment in 1964 constituted a\nwaiver on the part of the taxpayers, this Court finds that the $4,467.00 sum was\nproperly included in gross income for the calendar year of 1964. Problems of when\ntitle vests, or when possession is complete in the field of federal taxation, in the\nabsence of definitive federal legislation on the subject, are ordinarily determined\nby reference to the law of the state in which the taxpayer resides, or where the\nproperty around which the dispute centers in located. Since both the taxpayers and\nthe property in question are found within the State of Ohio, Ohio law must govern\nas to when the found money was \xe2\x80\x98reduced to undisputed possession\xe2\x80\x99 within the\nmeaning of Treas. Reg. 1.61-14 and Rev. Rul. 61-53-1, Cum. Bull. 17.\nIn Ohio, there is no statute specifically dealing with the rights of owners and finders\nof treasure trove, and in the absence of such a statute the common-law rule of\nEngland applies, so that \xe2\x80\x98title belongs to the finder as against all the world except\nthe true owner.\xe2\x80\x99 Niederlehner v. Weatherly, 78 Ohio App. 263, 29 N.E.2d 787\n(1946), appeal dismissed, 146 Ohio St. 697, 67 N.E.2d 713 (1946). The\nNiederlehner case held, inter alia, that the owner of real estate upon which money\nis found does not have title against the finder. Therefore, in the instant case if\nplaintiffs had resold the piano in 1958, not knowing of the money within it, they\nlater would not be able to succeed in an action against the purchaser who did\ndiscover it. Under Ohio law, the plaintiffs must have actually found the money to\nhave superior title over all but the true owner, and they did not discover the old\ncurrency until 1964. Unless there is present a specific state statute to the contrary,\n[footnote omitted] the majority of jurisdictions are in accord with the Ohio rule.\n[footnote omitted] Therefore, this Court finds that the $4,467.00 in old currency\nwas not \xe2\x80\x98reduced to undisputed possession\xe2\x80\x99 until its actual discovery in 1964, and\nthus the United States was not barred by the statute of limitations from collecting\nthe $836.51 in tax during that year.\nFinally, plaintiffs\xe2\x80\x99 contention that they are entitled to capital gains treatment upon\nthe discovered money must be rejected. [Taxpayers\xe2\x80\x99 gain did not result from the\nsale or exchange of a capital asset.] \xe2\x80\xa6\nNotes and Questions:\n1. How did the court treat Rev. Rul. 1953-1? What does this tell you about the legal\nstatus of a revenue ruling?\n86\n\n\x0c2. What role did state law play in the resolution of this case? Why was it necessary\nto invoke it?\n3. What tax norms would the court have violated if it had held in favor of the\nCesarinis?\nB. Section 61(a)(3): Gains Derived from Dealings in Property\nSection 61(a)(3) includes in a taxpayer\xe2\x80\x99s \xe2\x80\x9cgross income\xe2\x80\x9d \xe2\x80\x9cgains derived from\ndealings in property.\xe2\x80\x9d This provision does not tell us how to determine what those\ngains might be. For that, we turn to \xc2\xa7\xc2\xa7 1001(a and b). Read it. (The word \xe2\x80\x9cover\xe2\x80\x9d\nfrequently appears in the Code as a directive to subtract whatever is described.)\nSection 1001(a) directs you to \xc2\xa7 1011.\nRead it. Section 1011 directs you to\nFluctuations in Value: The fair market value\n\xc2\xa7\xc2\xa7 1012 and 1016. Read \xc2\xa7 1012(a) and\nof property may fluctuate over the time\n1016(a).\ntaxpayer owns it. If its value increases,\ntaxpayer must recognize taxable gain upon\nThe effect of subtracting \xe2\x80\x9cadjusted\nits sale. If its value decreases, \xc2\xa7 165(a) might\nbasis\xe2\x80\x9d is to exclude that amount from\npermit taxpayer to reduce his gross income\ntaxpayer\xe2\x80\x99s \xe2\x80\x9cgross income\xe2\x80\x9d and so from\nby the amount of the loss upon its sale. If its\nhis income tax burden. That money of\nvalue increases and taxpayer could have\ncourse had already been subject to\nsold it but does not \xe2\x80\x93 does taxpayer realize\nincome tax at the time the taxpayer put\na tax loss when he later sells it for more than\nit into his \xe2\x80\x9cstore of property rights\xe2\x80\x9d and\nhis basis but less than the fmv it once had?\nso should not be subject to tax again.\nWe begin with a case dealing with a loss from a dealing in property.\nHort v. CIR, 313 U.S. 28 (1941)\nMR. JUSTICE MURPHY delivered the opinion of the Court.\n....\nPetitioner acquired the property, a lot and ten-story office building, by devise from\nhis father \xe2\x80\xa6 [T]he Irving Trust Co. and petitioner\xe2\x80\x99s father executed a contract in\nwhich the latter agreed to lease the main floor and basement to the former for a term\n87\n\n\x0cof fifteen years at an annual rental of $25,000, the term to commence [in 1932.\nShortly after agreeing to let such premises to Irving Trust Co., petitioner\xe2\x80\x99s father\ndied.]\nIn 1933, the Irving Trust Co. found it unprofitable to\nmaintain a branch in petitioner\xe2\x80\x99s building. After\nTaxpayer argued that his\nsome negotiations, petitioner and the Trust Co.\ndamages should be computed\nthus: ((present value of future\nagreed to cancel the lease in consideration of a\nrent payments) MINUS (fair\npayment to petitioner of $140,000. Petitioner did not\nrental value of property))\ninclude this amount in gross income in his income\nMINUS (amount realized)\ntax return for 1933. On the contrary, he reported a\nEQUALS (deductible loss).\nloss of $21,494.75 on the theory that the amount he\nreceived as consideration for the cancellation was\n$21,494.75 less than the difference between the present value of the unmatured\nrental payments and the fair rental value of the main floor and basement for the\nunexpired term of the lease. ...\nThe Commissioner included the entire $140,000 in gross income, disallowed the\nasserted loss, ... and assessed a deficiency. The Board of Tax Appeals affirmed.\nThe Circuit Court of Appeals affirmed per curiam ... [W]e granted certiorari limited\nto the question whether, \xe2\x80\x9cin computing net gain or loss for income tax purposes, a\ntaxpayer [can] offset the value of the lease canceled against the consideration\nreceived by him for the cancellation.\xe2\x80\x9d\n....\nThe amount received by petitioner for cancellation of the lease must be included in\nhis gross income in its entirety. Section [61] [footnote omitted] ... expressly defines\ngross income to include \xe2\x80\x9cgains, profits, and income derived from ... rent, ... or gains\nor profits and income from any source whatever.\xe2\x80\x9d Plainly this definition reached\nthe rent paid prior to cancellation, just as it would have embraced subsequent\npayments if the lease had never been canceled. It would have included a\nprepayment of the discounted value of unmatured rental payments whether received\nat the inception of the lease or at any time thereafter. Similarly, it would have\nextended to the proceeds of a suit to recover damages had the Irving Trust Co.\nbreached the lease instead of concluding a settlement. [citations omitted] That the\namount petitioner received resulted from negotiations ending in cancellation of the\nlease, rather than from a suit to enforce it, cannot alter the fact that basically the\npayment was merely a substitute for the rent reserved in the lease. So far as the\n88\n\n\x0capplication of [\xc2\xa7 61(a)] is concerned, it is immaterial that petitioner chose to accept\nan amount less than the strict present value of the unmatured rental payments, rather\nthan to engage in litigation, possibly uncertain and expensive.\nThe consideration received for cancellation of the lease was not a return of capital.\nWe assume that the lease was \xe2\x80\x9cproperty,\xe2\x80\x9d whatever that signifies abstractly. ...\nSimply because the lease was \xe2\x80\x9cproperty,\xe2\x80\x9d the amount received for its cancellation\nwas not a return of capital, quite apart from the fact that \xe2\x80\x9cproperty\xe2\x80\x9d and \xe2\x80\x9ccapital\xe2\x80\x9d\nare not necessarily synonymous in the Revenue Act of 1932 or in common usage.\nWhere, as in this case, the disputed amount was essentially a substitute for rental\npayments which [\xc2\xa7 61(a)] expressly characterizes as gross income, it must be\nregarded as ordinary income, and it is immaterial that, for some purposes, the\ncontract creating the right to such payments may be treated as \xe2\x80\x9cproperty\xe2\x80\x9d or\n\xe2\x80\x9ccapital.\xe2\x80\x9d\n....\nWe conclude that petitioner must report as gross income the entire amount received\nfor cancellation of the lease, without regard to the claimed disparity between that\namount and the difference between the present value of the unmatured rental\npayments and the fair rental value of the property for the unexpired period of the\nlease. The cancellation of the lease involved nothing more than relinquishment of\nthe right to future rental payments in return for a present substitute payment and\npossession of the leased premises. Undoubtedly it diminished the amount of gross\nincome petitioner expected to realize, but, to that extent, he was relieved of the duty\nto pay income tax. Nothing in [\xc2\xa7 165] [footnote omitted] indicates that Congress\nintended to allow petitioner to reduce ordinary income actually received and\nreported by the amount of income he failed to realize. [citations omitted] We may\nassume that petitioner was injured insofar as the cancellation of the lease affected\nthe value of the realty. But that would become a deductible loss only when its extent\nhad been fixed by a closed transaction. [citations omitted]\nThe judgment of the Circuit Court of Appeals is affirmed.\nNotes and Questions:\n1. Taxpayer measured his gain/loss with the benefit of the bargain as his reference\npoint. An economist would not value the buyout of the lease differently. If a lessor\xe2\x80\x99s\n89\n\n\x0cinterest has a certain value and the lessor sells it for less than that value, why can\xe2\x80\x99t\nthe lessor recognize a tax loss? Cf. \xc2\xa7 165 (deductibility of losses). The Court did\nnot accept taxpayer\xe2\x80\x99s return-of-capital argument. Why was it correct in doing so?\n2. The Tax Code taxes all income once unless specifically provided otherwise.\nBasis is the tool by which a taxpayer keeps score with the government concerning\nwhat accessions to wealth have already been subject to tax.\n\xe2\x80\xa2How does the Court\xe2\x80\x99s opinion implement these principles?\n\xe2\x80\xa2How did taxpayer\xe2\x80\x99s contentions fail to implement these principles?\n\xe2\x80\xa2What exactly was taxpayer\xe2\x80\x99s basis in his lessor\xe2\x80\x99s interest in the stream of\npayments to be recognized under the lease? Where would his basis come\nfrom?\n3. Sections 61(a) lists several forms that gross income may take. One such form is\nincome from discharge of\nindebtedness. \xc2\xa7 61(a)(11). The\nLump sum payments: On occasion, taxpayer may\nCode does not treat all forms of\naccept a lump sum payment in lieu of receiving\ngross income the same.\nperiodic payments. The tax law characterizes the\nDifferent rates of tax may apply\nlump sum in the same manner as it would have\nto different forms of gross\ncharacterized the periodic payments. We saw\nincome. Or, the Code might not\nthe Court apply this principle in Glenshaw Glass\nwhen it treated a lump sum payment in lieu of\ntax some forms of gross income\nprofits as if it were profit.\nat all. This was a key point in\nMurphy v. IRS, supra, which\nturned on the construction of\n\xc2\xa7 104. In the following case, the court distinguishes between a gain that taxpayer\nderived from dealings in property and gains that taxpayer derived from a discharge\nof his debt. Determine what was at issue in Gehl, what the parties argued, and why\nit mattered.\n\n90\n\n\x0cUnited States v. Gehl, 50 F.3d 12 (unpublished), 1995 WL 115589 (8th Cir.), cert.\ndenied, 516 U.S. 899 (1995)\nNOTICE: THIS IS AN UNPUBLISHED OPINION.\n....\nBOGUE, Senior District Judge.\nTaxpayers James and Laura Gehl (taxpayers) appeal from an adverse decision in\nthe United States Tax Court finding deficiencies in their income taxes for 1988 and\n1989. For the reasons stated below, we affirm.\nBACKGROUND\nPrior to the events in issue, the taxpayers borrowed money from the Production\nCredit Association of the Midlands (PCA). Mortgages on a 218 acre family farm\nwere given to the PCA to secure the recourse loan. As of December 30, 1988, the\ntaxpayers were insolvent and unable to make the payments on the loan, which had\nan outstanding balance of $152,260. The transactions resolving the situation\nbetween the PCA and the taxpayers form the basis of the current dispute.\nPursuant to a restructuring agreement, taxpayers, by deed in lieu of foreclosure,\nconveyed 60 acres of the farm land to the PCA on December 30, 1988, in partial\nsatisfaction of the debt. The taxpayers basis in the 60 acres was $14,384 and they\nwere credited with $39,000 towards their loan, the fair market value of the land.\nOn January 4, 1989, taxpayers conveyed, also by deed in lieu of foreclosure, an\nadditional 141 acres of the mortgaged farm land to the PCA in partial satisfaction\nof the debt. Taxpayers basis in the 141 acres was $32,000 and the land had a fair\nmarket value of $77,725. Taxpayers also paid $6,123 in cash to the PCA to be\napplied to their loan. The PCA thereupon forgave the remaining balance of the\ntaxpayers\xe2\x80\x99 loan, $29,412. Taxpayers were not debtors under the Bankruptcy Code\nduring 1988 or 1989, but were insolvent both before and after the transfers and\ndischarge of indebtedness.\nAfter an audit, the Commissioner of Revenue (Commissioner) determined tax\ndeficiencies of $6,887 for 1988 and $13,643 for 1989 on the theory that the\ntaxpayers had realized a gain on the disposition of their farmland in the amount by\nwhich the fair market value of the land exceeded their basis in the same at the time\nof the transfer (gains of $24,616 on the 60 acre conveyance and $45,645 on the\n91\n\n\x0cconveyance of the 141 acre conveyance). The taxpayers petitioned the Tax Court\nfor redetermination of their tax liability for the years in question contending that\nany gain they realized upon the transfer of their property should not be treated as\nincome because they remained insolvent after the transactions.\nThe Tax Court found in favor of the Commissioner. In doing so, the court\n\xe2\x80\x9cbifurcated\xe2\x80\x9d its analysis of the transactions, considering the transfers of land and\nthe discharge of the remaining debt separately. The taxpayers argued that the entire\nset of transactions should be considered together and treated as income from the\ndischarge of indebtedness. As such, any income derived would be excluded as the\ntaxpayers remained insolvent throughout the process. 26 U.S.C. \xc2\xa7 108(a)(1). As to\nthe discharge of indebtedness, the court determined that because the taxpayers\nremained insolvent after their debt was discharged, no income would be attributable\nto that portion of the restructuring agreement.\nOn the other hand, the court found the taxpayers to have received a gain includable\nas gross income from the transfers of the farm land (determined by the excess of\nthe respective fair market values over the respective basis). This gain was found to\nexist despite the continued insolvency in that the gain from the sale or disposition\nof land is not income from the discharge of indebtedness. The taxpayers appealed.\nDISCUSSION\nWe review the Tax Court\xe2\x80\x99s interpretation of law de novo. [citation omitted]\nDiscussion of this case properly begins with an examination of I.R.C. \xc2\xa7 61 which\ndefines gross income under the Code. In order to satisfy their obligation to the\nPCA, the taxpayers agreed to participate in an arrangement which could potentially\ngive rise to gross income in two distinct ways.35 I.R.C. \xc2\xa7 61(a)(3) provides that for\ntax purposes, gross income includes \xe2\x80\x9cgains derived from dealings in property.\xe2\x80\x9d\nLikewise, income is realized pursuant to I.R.C. \xc2\xa7 61(a)(12) [now \xc2\xa7 61(a)(11)] for\n\xe2\x80\x9cincome from discharge of indebtedness.\xe2\x80\x9d\nThere can be little dispute with respect to Tax Court\xe2\x80\x99s treatment of the $29,412\nportion of the debt forgiven subsequent to the transfers of land and cash. The\n\nAside from being part of the restructuring agreement, the taxpayer\xe2\x80\x99s transfer of $6,123 cash to the\nPCA has little significance for the purposes of the present appeal.\n35\n\n92\n\n\x0cCommissioner stipulated that under I.R.C. \xc2\xa7 108(a)(1)(B),36 the so-called\n\xe2\x80\x9cinsolvency exception,\xe2\x80\x9d the taxpayers did not have to include as income any part\nof the indebtedness that the PCA forgave. The $29,412 represented the amount by\nwhich the land and cash transfers fell short of satisfying the outstanding debt. The\nTax Court properly found this amount to be excluded.\nFurther, the Tax Court\xe2\x80\x99s treatment of the land transfers, irrespective of other\nportions of the restructuring agreement, cannot be criticized. Section 1001 governs\nthe determination of gains and losses on the sale or exchange of property. Section\n1001(a) provides that \xe2\x80\x9c[t]he gain from the sale or other disposition of property shall\nbe the excess of the amount realized therefrom over the adjusted basis ...\xe2\x80\x9d The\ntaxpayers contend that because the disposition of their land was compulsory and\nthat they had no discretion with respect to the proceeds, the deeds in lieu of\nforeclosure are not \xe2\x80\x9csales\xe2\x80\x9d for the purposes of \xc2\xa7 1001. We disagree. A transfer of\nproperty by deed in lieu of foreclosure constitutes a \xe2\x80\x9csale or exchange\xe2\x80\x9d for federal\nincome tax purposes. Allan v. Commissioner of Revenue, 86 F.C. 655, 659-60,\naff\xe2\x80\x99d. 856 F.2d 1169, 1172 (8th Cir. 1988) (citations omitted). The taxpayers\xe2\x80\x99\ntransfers by deeds in lieu of foreclosure of their land to the PCA in partial\nsatisfaction of the recourse debt were properly considered sales or exchanges for\npurposes of \xc2\xa7 1001.\nTaxpayers also appear to contend that under their circumstances, there was no\n\xe2\x80\x9camount realized\xe2\x80\x9d under I.R.C. \xc2\xa7\xc2\xa7 1001(a-b) and thus, no \xe2\x80\x9cgain\xe2\x80\x9d from the land\ntransfers as the term is used in I.R.C. \xc2\xa7 61(a)(3). Again, we must disagree. The\namount realized from a sale or other disposition of property includes the amount of\nliabilities from which the transferor is discharged as a result of the sale or\ndisposition. Treas. Reg. \xc2\xa7 1.1001-2(a)(1). Simply because the taxpayers did not\nactually receive any cash proceeds from the land transfers does not mean there was\nno amount realized. Via the land transfers, they were given credit toward an\noutstanding recourse loan to the extent of the land\xe2\x80\x99s fair market value. This loan\nhad to be paid back. It is clear that the transfers of land employed to satisfy that end\nmust be treated the same as receiving money from a sale. In this case the land\ntransfers were properly considered \xe2\x80\x9cgains derived from dealings in property\xe2\x80\x9d to the\nextent the fair market value in the land exceeded the taxpayers\xe2\x80\x99 basis in said land.\nI.R.C. \xc2\xa7\xc2\xa7 61(a)(3), 1001(a).\nI.R.C. \xc2\xa7 108(a)(1)(B) provides that \xe2\x80\x9cgross income does not include any amount which (but for this\nsubsection) would be includable in gross income by reason of the discharge (in whole or in part) of\nindebtedness of the taxpayer if ... the discharge occurs when the taxpayer is insolvent.\xe2\x80\x9d ...\n36\n\n93\n\n\x0cThe taxpayers\xe2\x80\x99 primary and fundamental argument in this case is the Tax Court\xe2\x80\x99s\nrefusal to treat the entire settlement of their loan, including the land transfers, as\ncoming within the scope of I.R.C. \xc2\xa7 108. As previously stated, \xc2\xa7 108 and attending\nTreasury Regulations act to exclude income from the discharge of indebtedness\nwhere the taxpayer thereafter remains insolvent. The taxpayers take issue with the\nbifurcated analysis conducted by the Tax Court and contend that, because of their\ncontinued insolvency, \xc2\xa7 108 acts to exclude any income derived from the various\ntransactions absolving their debt to the PCA.\nAs an initial consideration, the taxpayers read the insolvency exception of \xc2\xa7 108\ntoo broadly. I.R.C. \xc2\xa7 61 provides an [sic] non-exclusive list of fifteen [fourteen]\nitems which give rise to income for tax purposes, including income from discharge\nof indebtedness. Of the numerous potential sources of income, \xc2\xa7 108 grants an\nexclusion to insolvent taxpayers only as to income from the discharge of\nindebtedness. It does not preclude the realization of income from other activities or\nsources.\nWhile \xc2\xa7 108 clearly applied to a portion of the taxpayers\xe2\x80\x99 loan restructuring\nagreement, the land transfers were outside the section\xe2\x80\x99s scope and were properly\ntreated independently. [citation omitted]\nThere is ample authority to support Tax Court\xe2\x80\x99s bifurcated analysis and substantive\ndecision rendered with respect to the present land transfers. The Commissioner\nrelies heavily on Treas. Reg. \xc2\xa7 1.1001-2 and example 8 contained therein, which\nprovides:\n(a) Inclusion in amount realized. - (1) * * *\nGiving property as payment: The\nexchange of appreciated (or\ndepreciated) property to pay for\nsomething is a recognition event on\nthe property exchanged. Why?\nThis is a very important principle.\nLearn it.\n\n(2) Discharge of indebtedness. The amount\nrealized on a sale or other disposition of\nproperty that secures a recourse liability does\nnot include amounts that are (or would be if\nrealized and recognized) income from the\ndischarge of indebtedness under section\n[61(a)(11)]. * * *\n(c) Examples * * *\n94\n\n\x0cExample (8). In 1980, F transfers to a creditor an asset with a fair market\nvalue of $6,000 and the creditor discharges $7,500 of indebtedness for\nwhich F is personally liable. The amount realized on the disposition of the\nasset is its fair market value ($6,000). In addition, F has income from the\ndischarge of indebtedness of $1,500 ($7,500 \xe2\x88\x92 $6,000).\nWe believe the regulation is controlling and serves ... to provide support for the\ndecision rendered by the Tax Court.37\nCONCLUSION\nFor the reasons stated, we affirm the decision of the Tax Court.\nNotes and Questions:\n1. Section 61(a) presents a comprehensive definition of \xe2\x80\x9cgross income.\xe2\x80\x9d However,\nnot all the fourteen enumerated types or sources of income are subject to the same\nrate of tax, and other provisions may exclude certain types of gross income from\nincome subject to tax altogether. Naturally, taxpayers would prefer to characterize\ntheir income as of a type or from a source not subject to income tax. Under certain\ncircumstances, \xc2\xa7 108 excludes discharge of indebtedness income from income tax.\nSee chapter 3 infra. For these reasons, the type or source of income can matter\ngreatly.\n2. Taxpayer may transfer a piece of appreciated (or depreciated) property to\nanother to satisfy an obligation or make a payment. Taxpayer might alternatively\nhave sold the property for its fmv. The gain derived from the sale would be subject\nto income tax. Taxpayer could then pay the cash he realized to the obligee or payee.\nThe result should be no different if taxpayer simply transfers the property directly\nto the obligee or payee. The court recognized this when it stated:\nIt is clear that the transfers of land employed to satisfy [an obligation or\nmake a payment] must be treated the same as receiving money from a sale.\nIn this case the land transfers were properly considered \xe2\x80\x9cgains derived from\ndealings in property\xe2\x80\x9d to the extent the fair market value in the land exceeded\nDespite the technical accuracy of the decision, one wonders about the propriety of the government\xe2\x80\x99s\nexhaustive pursuit of this matter in view of the taxpayers\xe2\x80\x99 dire financial situation and continued\ninsolvency.\n37\n\n95\n\n\x0cthe taxpayers\xe2\x80\x99 basis in said land. I.R.C. \xc2\xa7\xc2\xa7 61(a)(3), 1001(a).\n3. Notice that if taxpayers\xe2\x80\x99 views in Gehl had prevailed, they would have realized\nthe benefit of the appreciation in the value of their property (i.e., an accession to\nwealth) without that accession ever being subject to tax \xe2\x80\x93 contrary to the first of the\nthree principles stated chapter 1 that you should know by now.\n4. Why is relief from a liability included in amount realized when applying the\nformula of \xc2\xa7 1001?\nC. Barter\nNow suppose that instead of accepting money in exchange for property or services,\ntaxpayer accepts services for services, property for property, property for services,\nor services for property.\nRev. Rul. 79-24, 1979-1 C.B. 60\nGROSS INCOME; BARTER TRANSACTIONS\n....\nFACTS\nSituation 1. In return for personal legal services performed by a lawyer for a\nhousepainter, the housepainter painted the lawyer\xe2\x80\x99s personal residence. Both the\nlawyer and the housepainter are members of a barter club, an organization that\nannually furnishes its members a directory of members and the services they\nprovide. All the members of the club are professionals or trades persons. Members\ncontact other members directly and negotiate the value of the services to be\nperformed.\nSituation 2. An individual who owned an apartment building received a work of\nart created by a professional artist in return for the rent-free use of an apartment for\nsix months by the artist.\nLAW\nThe applicable sections of the Internal Revenue Code of 1954 and the Income Tax\nRegulations thereunder are 61(a) and 1.61-2, relating to compensation for services.\n96\n\n\x0cSection 1.61-2(d)(1) of the regulations provides that if services are paid for other\nthan in money, the fair market value of the property or services taken in payment\nmust be included in income. If the services were rendered at a stipulated price,\nsuch price will be presumed to be the fair market value of the compensation\nreceived in the absence of evidence to the contrary.\nHOLDINGS\nSituation 1. The fair market value of the services received by the lawyer and the\nhousepainter are includible in their gross incomes under \xc2\xa7 61 of the Code.\nSituation 2. The fair market value of the work of art and the six months fair rental\nvalue of the apartment are includible in the gross incomes of the apartment-owner\nand the artist under \xc2\xa7 61 of the Code.\nNotes and Questions:\n1. Each party to a barter transaction gave up something and received something.\nIrrespective of the fmv of what a party gives up, it is the value of what taxpayer\nreceives that matters. Read the Law and Holdings carefully. Section 1001(a) also\nrequires this. This implies that two parties to a transaction may realize different\namounts.\n\xe2\x80\xa2Why would it be wrong to measure the amount realized by what taxpayer\ngave up in a barter transaction? Consider \xe2\x80\x93\n2. (continuing note 1): In situation 2, let\xe2\x80\x99s say that the fmv of the painting was\n$6000. The fmv of the rent was $7000. We say that we tax income once \xe2\x80\x93 but we\ndon\xe2\x80\x99t tax it more than once. In the following questions, keep track of what the\ntaxpayer has and on how much income he has paid income tax.\n\xe2\x80\xa2What should be the apartment-owner\xe2\x80\x99s taxable gain (or loss) from\nexchanging rent for the painting?\n\xe2\x80\xa2What should be the apartment-owner\xe2\x80\x99s basis in the painting he received?\n\xe2\x80\xa2What is the apartment-owner\xe2\x80\x99s taxable gain if he sells the painting\nimmediately upon receipt for its fmv?\n3. Read Reg. \xc2\xa7 1.61-2(d)(1 and 2(i)).\n\xe2\x80\xa2Taxpayer performed accounting services over the course of one year for\nBaxter Realty. The fmv of these services was $15,000. Taxpayer billed\nBaxter Realty for $15,000. Unfortunately, Baxter Realty was short on cash\nand long on inventory, which included a tract of land known as Blackacre.\n97\n\n\x0cThe fmv of Blackacre was $20,000. Its cost to Baxter Realty was $11,000.\nTaxpayer agreed to accept Blackacre as full payment for the bill. Six months\nlater, Taxpayer sold Blackacre to an unrelated third person for $22,000.\n1. How much must Taxpayer report as gross income from the\nreceipt of Blackacre as payment for his services?\n2. How much must Taxpayer report as gross income derived from\nthe sale of Blackacre?\n3. How much must Baxter Realty report as gross income derived\nfrom its dealings in Blackacre?\nD. Improvements to Leaseholds and the Time Value of Money\nHelvering v. Bruun, 309 U.S. 461 (1940)\nMR. JUSTICE ROBERTS delivered the opinion of the Court.\n....\n... [O]n July 1, 1915, the respondent, as owner, leased a lot of land and the building\nthereon for a term of ninety-nine years.\nThe lease provided that the lessee might at any time, upon giving bond to secure\nrentals accruing in the two ensuing years, remove or tear down any building on the\nland, provided that no building should be removed or torn down after the lease\nbecame forfeited, or during the last three and one-half years of the term. The lessee\nwas to surrender the land, upon termination of the lease, with all buildings and\nimprovements thereon.\nIn 1929, the tenant demolished and removed the existing building and constructed\na new one which had a useful life of not more than fifty years. July 1, 1933, the\nlease was cancelled for default in payment of rent and taxes, and the respondent\nregained possession of the land and building.\n\xe2\x80\x9cUnamortized cost\xe2\x80\x9d equals\n\xe2\x80\x9cadjusted basis.\xe2\x80\x9d\n....\n\xe2\x80\x9c... [At] said date, July 1, 1933, the building which had been erected upon said\npremises by the lessee had a fair market value of $64,245.68, and ... the\nunamortized cost of the old building, which was removed from the premises in 1929\n98\n\n\x0cto make way for the new building, was $12,811.43, thus leaving a net fair market\nvalue as at July 1, 1933, of $51,434.25, for the aforesaid new building erected upon\nthe premises by the lessee.\xe2\x80\x9d\nOn the basis of these facts, the petitioner determined that, in 1933, the respondent\nrealized a net gain of $51,434.25. The Board overruled his determination, and the\nCircuit Court of Appeals affirmed the Board\xe2\x80\x99s decision.\nThe course of administrative practice and judicial decision in respect of the question\npresented has not been uniform. In 1917, the Treasury ruled that the adjusted value\nof improvements installed upon leased premises is income to the lessor upon the\ntermination of the lease. [footnote omitted] The ruling was incorporated in two\nsucceeding editions of the Treasury Regulations. [footnote omitted] In 1919, the\nCircuit Court of Appeals for the Ninth Circuit held, in Miller v. Gearin, 258 F.2d\n5, that the regulation was invalid, as the gain, if taxable at all, must be taxed as of\nthe year when the improvements were completed. [footnote omitted]\nThe regulations were accordingly amended to impose a tax upon the gain in the\nyear of completion of the improvements, measured by their anticipated value at the\ntermination of the lease and discounted for the duration of the lease. Subsequently,\nthe regulations permitted the lessor to spread the depreciated value of the\nimprovements over the remaining life of the lease, reporting an aliquot part each\nyear, with provision that, upon premature termination, a tax should be imposed\nupon the excess of the then value of the improvements over the amount theretofore\nreturned. [footnote omitted]\nIn 1935, the Circuit Court of Appeals for the Second Circuit decided, in Hewitt\nRealty Co. v. Commissioner, 76 F.2d 880, that a landlord received no taxable\nincome in a year, during the term of the lease, in which his tenant erected a building\non the leased land. The court, while recognizing that the lessor need not receive\nmoney to be taxable, based its decision that no taxable gain was realized in that\ncase on the fact that the improvement was not portable or detachable from the land,\nand, if removed, would be worthless except as bricks, iron, and mortar. It said, 76\nF.2d 884: \xe2\x80\x9cThe question, as we view it, is whether the value received is embodied\nin something separately disposable, or whether it is so merged in the land as to\nbecome financially a part of it, something which, though it increases its value, has\nno value of its own when torn away.\xe2\x80\x9d This decision invalidated the regulations then\nin force. [footnote omitted]\n99\n\n\x0cIn 1938, this court decided M.E. Blatt Co. v. United States, 305 U. S. 267. There,\nin connection with the execution of a lease, landlord and tenant mutually agreed\nthat each should make certain improvements to the demised premises and that those\nmade by the tenant should become and remain the property of the landlord. The\nCommissioner valued the improvements as of the date they were made, allowed\ndepreciation thereon to the termination of the leasehold, divided the depreciated\nvalue by the number of years the lease had to run, and found the landlord taxable\nfor each year\xe2\x80\x99s aliquot portion thereof. His action was sustained by the Court of\nClaims. The judgment was reversed on the ground that the added value could not\nbe considered rental accruing over the period of the lease; that the facts found by\nthe Court of Claims did not support the conclusion of the Commissioner as to the\nvalue to be attributed to the improvements after a use throughout the term of the\nlease, and that, in the circumstances disclosed, any enhancement in the value of the\nrealty in the tax year was not income realized by the lessor within the Revenue Act.\nThe circumstances of the instant case differentiate it from the Blatt and Hewitt\ncases, but the petitioner\xe2\x80\x99s contention that gain was realized when the respondent,\nthrough forfeiture of the lease, obtained untrammeled title, possession, and control\nof the premises, with the added increment of value added by the new building, runs\ncounter to the decision in the Miller case and to the reasoning in the Hewitt case.\nThe respondent insists that the realty \xe2\x80\x93 a capital asset at the date of the execution\nof the lease \xe2\x80\x93 remained such throughout the term and after its expiration; that\nimprovements affixed to the soil became part of the realty indistinguishably\nblended in the capital asset; that such improvements cannot be separately valued or\ntreated as received in exchange for the improvements which were on the land at the\ndate of the execution of the lease; that they are therefore in the same category as\nimprovements added by the respondent to his land, or accruals of value due to\nextraneous and adventitious circumstances. Such added value, it is argued, can be\nconsidered capital gain only upon the owner\xe2\x80\x99s disposition of the asset. The position\nis that the economic gain consequent upon the enhanced value of the recaptured\nasset is not gain derived from capital or realized within the meaning of the Sixteenth\nAmendment, and may not therefore be taxed without apportionment.\nWe hold that the petitioner was right in assessing the gain as realized in 1933.\n....\nThe respondent cannot successfully contend that the definition of gross income in\n100\n\n\x0c[\xc2\xa7 61(a)] [footnote omitted] is not broad enough to embrace the gain in question.\n... He emphasizes the necessity that the gain be separate from the capital and\nseparately disposable. \xe2\x80\xa6\nWhile it is true that economic gain is not always taxable as income, it is settled that\nthe realization of gain need not be in cash derived from the sale of an asset. Gain\nmay occur as a result of exchange of property, payment of the taxpayer\'s\nindebtedness, relief from a liability, or other profit realized from the completion of\na transaction. [footnote omitted] The fact that the gain is a portion of the value of\nproperty received by the taxpayer in the transaction does not negative its realization.\nHere, as a result of a business transaction, the respondent received back his land\nwith a new building on it, which added an ascertainable amount to its value. It is\nnot necessary to recognition of taxable gain that he should be able to sever the\nimprovement begetting the gain from his original capital. If that were necessary, no\nincome could arise from the exchange of property, whereas such gain has always\nbeen recognized as realized taxable gain.\nJudgment reversed.\n....\nNotes and Questions:\n1. Aliquot: a fractional part that is contained a precise number of times in the whole.\n2. Bruun of course undercuts the language of Eisner v. Macomber concerning the\nneed to sever the improvement (increase in value) from the whole. You can see in\ntaxpayer\xe2\x80\x99s (respondent\xe2\x80\x99s) contentions the elements of the Macomber Court\xe2\x80\x99s\ndefinition of \xe2\x80\x9cincome\xe2\x80\x9d (i.e., this was not gain derived from capital). And of course,\n\xe2\x80\x9crealization\xe2\x80\x9d does not require receipt of cash.\n3. Why did everyone who had anything to do with this case subtract the\nunamortized cost of the old building from the fmv of the new building in\ndetermining taxpayer\xe2\x80\x99s taxable income? After all, taxpayer does not own a building\nthat no longer physically exists.\n4. Sections 109/1019 reverse the holding of Bruun. Section 109 provides that a\nlessor of real taxpayer does not realize taxable gross income attributable to\nimprovements that the lessee made to the real property upon termination of the\n101\n\n\x0clease. Section 1019 provides that taxpayer may not increase or decrease his\nadjusted basis in property because he received gross income that \xc2\xa7 109 excludes.\n\xe2\x80\xa2Is \xc2\xa7 1019 necessary?\n\xe2\x80\xa2What is conceptually wrong with \xc2\xa7\xc2\xa7 109 and 1019? Isn\xe2\x80\x99t there\nsome untaxed additions to taxpayer\xe2\x80\x99s storehouse of property rights? Where?\n5. Section 109 does not apply to improvements that the lessee makes which the\nparties intend as rent. Reg. \xc2\xa7 1.61-8(c) (\xe2\x80\x9cIf a lessee places improvements on real\nestate which constitute, in whole or in part, a substitute for rent, such improvements\nconstitute rental income to the lessor.\xe2\x80\x9d)\n\xe2\x80\xa2Suppose that a retailer leases space for a period of one year in\ntaxpayer/lessor\xe2\x80\x99s shopping mall. As part of the rental, lessee agrees to install\nvarious fixtures and to leave them to the lessor at the termination of the\nlease. The value of the fixtures is $20,000.\n\xe2\x80\xa2What is lessor\xe2\x80\x99s basis in the fixtures?\n\xe2\x80\xa2Exactly what does the payment of rent purchase?\n\xe2\x80\xa2Exactly what does a lessor \xe2\x80\x9csell\xe2\x80\x9d by accepting a rent payment?\n6. Consider each of the rules the Court considered \xe2\x80\x93 as well as the rule that\nCongress created in \xc2\xa7\xc2\xa7 109/1019. Identify each rule and consider this question:\nwhat difference does it make which rule is applied?\n\xe2\x80\xa2Let\xe2\x80\x99s assume that the lessee did not remove a building, but simply erected a new\nbuilding on vacant premises. Let\xe2\x80\x99s also put some numbers and dates into the\nproblem for illustrative purposes. Assume that the fmv of the building in 2000 upon\ncompletion is $400,000. The building will last 40 years. The building will lose\n$10,000 of value every year, and this is the amount that taxpayer may claim as a\ndepreciation/cost recovery deduction. Taxpayer must reduce his basis in the\nproperty (\xc2\xa7 1016) for depreciation deductions. The adjusted basis of the property\nequals its fmv. The lease upon completion of the building will run another 20 years\nuntil 2020. The lessee did not default thereby causing early termination of the lease.\nImmediately upon termination of the lease, taxpayer sells the property, and the\nportion of the selling price attributable to the building is $200,000. Taxpayer\xe2\x80\x99s\nmarginal tax bracket is 30%.\n(1) CIR\xe2\x80\x99s view, the rule of the 1917 regulations, and the Supreme Court\xe2\x80\x99s\nholding in Helvering v. Bruun: taxpayer derives taxable income at the\ntermination of the lease equal to fmv \xe2\x88\x92 (ab in old building)\n\xe2\x80\xa2How much gross income must taxpayer recognize for receiving the\n102\n\n\x0cbuilding and when?\n\xe2\x80\xa2How much is the income tax on this item of taxpayer\xe2\x80\x99s gross\nincome?\n\xe2\x80\xa2How much gain will taxpayer realize from the sale of the building?\n\xe2\x80\xa2How much income tax must taxpayer pay for having sold the\nbuilding?\n\xe2\x80\xa2What is taxpayer\xe2\x80\x99s total tax bill?\n(2) Miller v. Gearin:\ntaxpayer must\nThe cost of deriving income and depreciation: Taxpayer\nrecognize taxable\nshould not be subject to tax on the costs that he incurs to\nincome equal to the\nearn income. The costs of supplies, e.g., fuel to operate a\nfmv of that\nproductive machine, represent consumption from which\nimprovement in the\ntaxpayer derives income. The Code taxes only \xe2\x80\x9cnet\xe2\x80\x9d\nincome. It accomplishes this by granting taxpayer a\nyear of completion.\ndeduction for such consumption. \xc2\xa7 162. Suppose that\n\xe2\x80\xa2How much gross\ntaxpayer incurs a cost to purchase an asset that will\nincome must taxpayer\nproduce income for many years, e.g., a building.\nrecognize for\nTaxpayer\xe2\x80\x99s taxable income would be subject to\nreceiving the building\n(enormous) distortion if he reduced his gross income by the\nand when?\ncost of such an asset in the year he purchased it. The Code\n\xe2\x80\xa2How much is the\ntreats such a purchase as an investment \xe2\x80\x93 a mere\nincome tax on this\nconversion in the form in which taxpayer holds his wealth,\nitem of taxpayer\xe2\x80\x99s\nnot an accession to it. A taxpayer\xe2\x80\x99s mere conversion of the\ngross income?\nform in which he holds wealth is not a taxable event.\n\xe2\x80\xa2What will taxpayer\xe2\x80\x99s\nTaxpayer will have a cost basis in the asset. Taxpayer will\nbasis in the building\nthen consume a portion of the asset year after year.\nbe?\nTaxpayer may deduct such incremental consumption of a\n\xe2\x80\xa2What will taxpayer\xe2\x80\x99s\nproductive asset year after year. This deduction is for\nannual\n\xe2\x80\x9cdepreciation\xe2\x80\x9d \xe2\x80\x93 whose name is now \xe2\x80\x9ccost recovery.\xe2\x80\x9d\ndepreciation/cost\n\xc2\xa7 168. To the extent of the depreciation deduction,\nrecovery allowance be\ntaxpayer has converted investment into consumption.\nfor each of the next\nHence, taxpayer must reduce his basis in the asset for such\ndeductions. \xc2\xa7 1016. This represents \xe2\x80\x9cde-investment\xe2\x80\x9d in the\ntwenty years?\nasset.\n\xe2\x80\xa2How much will the\nannual\ndepreciation/cost\nrecovery allowance reduce taxpayer\xe2\x80\x99s income tax liability\nfor each of the remaining years of the lease?\n\xe2\x80\xa2What will be the total reduction in taxpayer\xe2\x80\x99s income tax\n103\n\n\x0cliability resulting from depreciation/cost recovery\nallowances?\n\xe2\x80\xa2What should happen to taxpayer\xe2\x80\x99s basis in the\nbuilding for each year that he claims a\ndepreciation/cost recovery deduction?\n\xe2\x80\xa2What will be taxpayer\xe2\x80\x99s net income tax liability for having\nreceived the building?\n\xe2\x80\xa2How much gain will taxpayer realize from the sale of the building?\n\xe2\x80\xa2How much income tax must taxpayer pay for having sold the\nbuilding?\n\xe2\x80\xa2What is taxpayer\xe2\x80\x99s total tax bill?\n(3) New regulations that the Court referenced in Bruun that Treasury\npromulgated after Miller: taxpayer includes the discounted present value\n(PV) of the improvement\xe2\x80\x99s fmv at the termination of lease in his taxable\nincome at the time of completion of the building.\n\xe2\x80\xa2How much gross income must taxpayer recognize for receiving the\nbuilding and when?\n\xe2\x80\xa2How much is the income tax on this item of taxpayer\xe2\x80\x99s gross\nincome?\n\xe2\x80\xa2How much gain will taxpayer realize from the sale of the building?\n\xe2\x80\xa2How much income tax must taxpayer pay for having sold the\nbuilding?\n\xe2\x80\xa2What is taxpayer\xe2\x80\x99s total tax bill?\n(4) Even newer regulations and the rule of the Court of Claims\xe2\x80\x99s holding\nin M.E. Blatt Co. v. U.S.: taxpayer/lessor must determine what the fmv of\nthe improvement will be at the termination of the lease and report as taxable\nincome for each remaining year of the lease an aliquot share of that amount.\nIn the event of premature termination, taxpayer/lessor must report as taxable\nincome or may claim as a reduction to his taxable income an amount equal\nto (fmv at time of termination) \xe2\x88\x92 (amount of income previously taxed).\n\xe2\x80\xa2How much gross income must taxpayer recognize for receiving the\nbuilding and when?\n\xe2\x80\xa2How much is the income tax on this item of taxpayer\xe2\x80\x99s gross\nincome?\n\xe2\x80\xa2How much gain will taxpayer realize from the sale of the building?\n\xe2\x80\xa2How much income tax must taxpayer pay for having sold the\nbuilding?\n104\n\n\x0c\xe2\x80\xa2What is taxpayer\xe2\x80\x99s total tax bill?\n(5) \xc2\xa7\xc2\xa7 109/1019, Hewitt Realty Co. v. CIR, and Supreme Court holding in\nM.E. Blatt Co. v. U.S.\n\xe2\x80\xa2How much gross income must taxpayer recognize for receiving the\nbuilding and when?\n\xe2\x80\xa2How much is the income tax on this item of taxpayer\xe2\x80\x99s gross\nincome?\n\xe2\x80\xa2How much gain will taxpayer realize from the sale of the building?\n\xe2\x80\xa2How much income tax must taxpayer pay for having sold the\nbuilding?\n\xe2\x80\xa2What is taxpayer\xe2\x80\x99s total tax bill?\nCompare the tax liability of taxpayer in (1), (2), (3), (4), and (5). Did the choice of\nthe applicable rule affect the net income tax liability of taxpayer?\n7. It is very expensive to litigate a case to a federal circuit court of appeals or all\nthe way to the United States Supreme Court. If taxpayer\xe2\x80\x99s total net tax liability\nunder any of the five approaches that the Court identified in Bruun is the same, why\nwould parties spend serious money litigating a choice of rule question to the\nSupreme Court? For that matter, why would the Treasury Department use up so\nmuch ink promulgating and then changing regulations?\n8. The answer (of course) lies in the fact that the right to have $1 today is worth\nmore than the right to have $1 at some future time. The number of dollars involved\nin any of these transactions may not change, but their value certainly does. Yet\ncalculations of taxable income and income tax liability do not (often) change\nmerely because $1 today is worth more than $1 tomorrow. Taxpayers understand\nthat principle very well and seek to reduce the present value of their tax liability as\nmuch as possible. They can do this by accelerating recognition of deductions and\ndeferring recognition of income.\n\xe2\x80\xa2We now consider exactly how taxpayers and the CIR would value the same\ntax liability that taxpayers must pay (and the U.S. Treasury would receive)\nsooner rather than later.\n9. There are formulas that incorporate the variables of time and discount rate that\nenable us to determine either the future value (FV) of $1 or the present value (PV)\nof $1 in the future. We can use the formulas to generate easy-to-use tables that\nenable us to make future value and present value determinations.\n105\n\n\x0c\xe2\x80\xa2You can Google \xe2\x80\x9cpresent value tables\xe2\x80\x9d to find a variety of such tables.\n\xe2\x80\xa2Some tables appear in the pages immediately following this one. Do not\nforget that these tables are here. You may wish to use them from time to\ntime.\n\xe2\x80\xa2Table 1 shows what $1 today will be worth at given interest rates (across\nthe top of the table) after a given number of years (down the left-hand side\nof the table).\n\xe2\x80\xa2Table 2 shows what $1 at some given future date is worth today.\n\xe2\x80\xa2Table 3 shows the present value of receiving $1 at the end of every year\nfor a given number of years, as is the case with an annuity. This table is\nuseful in determining the PV of any stream of payments that does not vary\nin amount, e.g., straight-line depreciation deductions.\n\xe2\x80\xa2A useful approximation that you can verify by referring to table 1 is the socalled rule of 72. Simply divide 72 by the interest rate expressed as a whole\nnumber, e.g., 6 rather than 6%. The quotient is very close to the length of\ntime it takes money to double in value at that interest rate.\nTable 1: Future value of $1 at various interest rates, compounded annually:\nFV = 1(1 + r)t\nFV = future value; r = interest rate expressed as decimal; t = time, i.e., # of years.\nIn the left hand column is the number of years. In the top row is the interest rate.\n1\n2\n3\n4\n\n1%\n1.01\n1.0201\n1.0303\n1.0406\n\n2%\n1.02\n1.0404\n1.0612\n1.0824\n\n3%\n1.03\n1.0609\n1.0927\n1.1255\n\n4%\n1.04\n1.0816\n1.1249\n1.1699\n\n5%\n1.05\n1.1025\n1.1576\n1.2155\n\n6%\n1.06\n1.1236\n1.191\n1.2625\n\n7%\n1.07\n1.1449\n1.225\n1.3108\n\n8%\n1.08\n1.1664\n1.2597\n1.3605\n\n9%\n10%\n1.09 1.1\n1.1881 1.21\n1.295 1.331\n1.4116 1.4641\n\n5\n6\n7\n8\n\n1.051\n1.0615\n1.0721\n1.0829\n\n1.1041\n1.1262\n1.1487\n1.1717\n\n1.1593\n1.1941\n1.2299\n1.2668\n\n1.2167\n1.2653\n1.3159\n1.3686\n\n1.2763\n1.3401\n1.4071\n1.4775\n\n1.3382\n1.4185\n1.5036\n1.5938\n\n1.4026\n1.5007\n1.6058\n1.7182\n\n1.4693\n1.5869\n1.7138\n1.8509\n\n1.5386 1.6105\n1.6771 1.7716\n1.828 1.9487\n1.9926 2.1436\n\n9\n10\n20\n30\n\n1.0937\n1.1046\n1.2202\n1.3478\n\n1.1951\n1.219\n1.4859\n1.8114\n\n1.3048\n1.3439\n1.8061\n2.4273\n\n1.4233\n1.4802\n2.1911\n3.2434\n\n1.5513\n1.6289\n2.6533\n4.3219\n\n1.6895\n1.7908\n3.2071\n5.7435\n\n1.8385\n1.9672\n3.8697\n7.6123\n\n1.999\n2.1589\n4.661\n10.063\n\n2.1719 2.3579\n2.3674 2.5937\n5.6044 6.7275\n13.268 17.449\n\n106\n\n\x0cTable 2: Present Value of $1 at a future date at a given interest rate\ncompounded annually: PV = 1/(1 + r)t\n1\n2\n3\n4\n\n1%\n0.9901\n0.9803\n0.9706\n0.961\n\n2%\n0.9804\n0.9612\n0.9423\n0.9238\n\n3%\n0.9709\n0.9426\n0.9151\n0.8885\n\n4%\n0.9615\n0.9246\n0.889\n0.8548\n\n5%\n0.9524\n0.907\n0.8638\n0.8227\n\n6%\n0.9434\n0.89\n0.8396\n0.7921\n\n7%\n0.9346\n0.8734\n0.8163\n0.7629\n\n8%\n0.9259\n0.8573\n0.7938\n0.735\n\n9%\n0.9174\n0.8417\n0.7722\n0.7084\n\n10%\n0.9091\n0.8264\n0.7513\n0.683\n\n5\n6\n7\n8\n\n0.9515\n0.942\n0.9327\n0.9235\n\n0.9057\n0.888\n0.8706\n0.8535\n\n0.8626\n0.8375\n0.8131\n0.7894\n\n0.8219\n0.7903\n0.7599\n0.7307\n\n0.7835\n0.7462\n0.7107\n0.6768\n\n0.7473\n0.705\n0.6651\n0.6274\n\n0.713\n0.6663\n0.6227\n0.582\n\n0.6806\n0.6302\n0.5835\n0.5403\n\n0.6499\n0.5963\n0.547\n0.5019\n\n0.6209\n0.5645\n0.5132\n0.4665\n\n9\n10\n20\n30\n\n0.9143\n0.9053\n0.8195\n0.7419\n\n0.8368\n0.8203\n0.673\n0.5521\n\n0.7664\n0.7441\n0.5537\n0.412\n\n0.7026\n0.6756\n0.4564\n0.3083\n\n0.6446\n0.6139\n0.3769\n0.2314\n\n0.5919\n0.5584\n0.3118\n0.1741\n\n0.5439\n0.5083\n0.2584\n0.1314\n\n0.5002\n0.4632\n0.2145\n0.0994\n\n0.4604\n0.4224\n0.1784\n0.0754\n\n0.4241\n0.3855\n0.1486\n0.0573\n\nTable 3: Present Value of a $1 Annuity Discounted by a Given Interest rate\nfor a Certain Number of Annual Payments: PV = (\xe2\x88\x920.1)*(1\xe2\x88\x921/(1 + i)\xe2\x88\x92t))/i\n1\n2\n3\n4\n\n1%\n0.9901\n1.9704\n2.941\n3.902\n\n2%\n0.9804\n1.9416\n2.8839\n3.8077\n\n3%\n0.9709\n1.9135\n2.8286\n3.7171\n\n4%\n0.9615\n1.8861\n2.7751\n3.6299\n\n5%\n0.9524\n1.8594\n2.7232\n3.546\n\n6%\n0.9434\n1.8334\n2.673\n3.4651\n\n7%\n0.9346\n1.808\n2.6243\n3.3872\n\n8%\n0.9259\n1.7833\n2.5771\n3.3121\n\n9%\n10%\n0.9174 0.9091\n1.7591 1.7355\n2.5313 2.4869\n3.2397 3.1699\n\n5\n6\n7\n8\n\n4.8534\n5.7955\n6.7282\n7.6517\n\n4.7135\n5.6014\n6.472\n7.3255\n\n4.5797\n5.4172\n6.2303\n7.0197\n\n4.4518\n5.2421\n6.0021\n6.7327\n\n4.3295\n5.0757\n5.7864\n6.4632\n\n4.2124\n4.9173\n5.5824\n6.2098\n\n4.1002\n4.7665\n5.3893\n5.9713\n\n3.9927\n4.6229\n5.2064\n5.7466\n\n3.8897 3.7908\n4.4859 4.3553\n5.033 4.8684\n5.5348 5.3349\n\n9\n10\n20\n30\n\n8.566\n9.4713\n18.046\n25.808\n\n8.1622\n8.9826\n16.351\n22.396\n\n7.7861\n8.5302\n14.877\n19.6\n\n7.4353\n8.1109\n13.59\n17.292\n\n7.1078\n7.7217\n12.462\n15.372\n\n6.8017\n7.3601\n11.47\n13.765\n\n6.5152\n7.0236\n10.594\n12.409\n\n6.2469\n6.7101\n9.8181\n11.258\n\n5.9952 5.759\n6.4177 6.1446\n9.1285 8.5136\n10.274 9.4269\n\n107\n\n\x0c10. Now: let\xe2\x80\x99s assume that the discount rate in our problems above is 8% and\nrework the answers. Compare the present value of taxpayer\xe2\x80\x99s $60,000 tax liability\non the very same transactions in 2000 under each of the five rules:\n(1) CIR\xe2\x80\x99s view, of the 1917 regulations, and the Supreme Court\xe2\x80\x99s holding\nin Bruun: taxpayer derives taxable income at the termination of the lease\nequal to fmv \xe2\x88\x92 (ab in old building).\n\xe2\x80\xa2In 2000, what is the present value of taxpayer\xe2\x80\x99s net tax liability?\n(2) Miller v. Gearin: taxpayer must recognize taxable income equal to the\nfmv of that improvement in the year of completion.\n\xe2\x80\xa2In 2000, what is the present value of taxpayer\xe2\x80\x99s net tax liability?\n(3) New regulations that the Court referenced in Bruun that Treasury\npromulgated after Miller: the discounted PV of improvement\xe2\x80\x99s fmv at the\ntermination of lease is included in taxpayer\xe2\x80\x99s taxable income at the time of\ncompletion of the building.\n\xe2\x80\xa2In 2000, what is the present value of taxpayer\xe2\x80\x99s net tax liability?\n(4) Even newer regulations and the rule of the Court of Claims\xe2\x80\x99s holding\nin M.E. Blatt Co. v. U.S.: taxpayer/lessor must determine what the fmv of\nthe improvement will be at the termination of the lease and report as taxable\nincome for each remaining year of the lease an aliquot share of that\ndepreciated amount. In the event of premature termination, taxpayer/lessor\nmust report as taxable income or may claim as a reduction to his/her taxable\nincome an amount equal to (fmv at time of termination) \xe2\x88\x92 (amount of\nincome previously taxed).\n\xe2\x80\xa2In 2000, what is the present value of taxpayer\xe2\x80\x99s net tax liability?\n(5) \xc2\xa7\xc2\xa7 109/1019, Hewitt Realty Co. v. CIR, and Supreme Court holding in\nM.E. Blatt Co. v. U.S.\n\xe2\x80\xa2In 2000, what is the present value of taxpayer\xe2\x80\x99s net tax liability?\n11. The time value of money is one place where taxpayers and the Commissioner\nnow play the tax game. Look for the ways in which it affects the contentions of\nparties, especially in chapter 9, infra. The higher the discount rate, the more\ntaxpayer benefits from deferring payment of a tax and/or accelerating a deduction.\n12. Congress can itself exploit the time value of money to pursue certain policy\nobjectives that require taxpayers to save money for specified forms of consumption.\n108\n\n\x0cFor example, Congress may wish for taxpayers to save money throughout their\nworking lives that they can spend in retirement. Sections 219/62(a)(7) permit\ntaxpayers to reduce their adjusted gross income (AGI) by amounts that they save in\nan Individual Retirement Account (IRA). So also, Congress may wish for taxpayers\nto save money that they can spend on medical expenses at some future date.\nSections 223/62(a)(19) permit taxpayers to reduce their (AGI) by amounts that they\nsave in a Health Savings Account. The money that taxpayers deposit in these\naccounts at a young age can grow significantly, as the tables above attest.\nE. Imputed Income\nImputed income is the value a person derives by performing services for himself or\nby making use of property that he owns.\nConsider the following:\nMary and John are attorneys who both are in the 25% marginal tax bracket. They\nare equally productive and efficient in their work as attorneys. They both own\nhouses that need a paint job. The cost of hiring a painter to paint their homes is\n$9000.\n\xe2\x80\xa2John hires a painter to paint his house. To pay the painter, John must work\nsix extra weekends in order to earn another $12,000. After paying $3000 in\ntaxes, John can pay the painter $9000. For having worked to earn an\nadditional $12,000 and paid $3000 more in income tax, John will have a\nhouse with a $9000 paint job \xe2\x80\x93 which he will commence \xe2\x80\x9cconsuming.\xe2\x80\x9d John\nhad to pay $3000 in income taxes to consume $9000.\n\xe2\x80\xa2Mary decides to do the job herself on five successive weekends. The fmv\nof these services is $9000. When she has completed the job, Mary will have\na house with a $9000 paint job \xe2\x80\x93 which she will commence \xe2\x80\x9cconsuming.\xe2\x80\x9d\nMary paid nothing in income taxes to consume $9000.\nNotice: John earned $2000 per weekend. Mary \xe2\x80\x9cearned\xe2\x80\x9d $1800 per weekend. Mary\nis not as productive or as efficient a painter as she is an attorney. Nevertheless,\nMary expended fewer resources to acquire a painted house than John did. How?\n\xe2\x80\xa2The answer lies in the fact that John had to pay income tax on his\n\xe2\x80\x9cconsumption,\xe2\x80\x9d and Mary did not.\n\xe2\x80\xa2Services that one performs for oneself give rise to \xe2\x80\x9cimputed income.\xe2\x80\x9d\n\xe2\x80\xa2As a matter of administrative practice and convenience, we do not tax\nimputed income.\n109\n\n\x0c\xe2\x80\xa2As the facts of this hypothetical illustrate, not taxing imputed income\ncauses inefficiency. Mary would create more value by practicing law on the\nweekends than by painting.\n\xe2\x80\xa2Not taxing imputed income also causes distortions because from Mary\xe2\x80\x99s\npoint of view, not taxing her imputed income encourages her to perform\nmore services for herself \xe2\x80\x93 so long as the cost of her inefficiency is less than\nthe income taxes that she saves.\n\xe2\x80\xa2In addition to these inefficiencies and distortions, not taxing imputed\nincome derived from performing services for oneself costs the U.S.\nTreasury money. Obviously, we should not be concerned about de minimis\namounts, e.g., mowing our own lawns. But one major source of lost revenue\nis the non-taxation of imputed income derived by the stay-at-home parent.\nEileen and Robert are both in the 25% tax bracket. Assume that the annual rental\nrate for a home is 10% of the home\xe2\x80\x99s fmv. Both Robert and Eileen have\naccumulated $250,000. The income necessary to accumulate this money has\nalready been subject to income tax. Prevailing interest rates are 8%.\n\xe2\x80\xa2Robert elects to take the $20,000 return on his investments to pay the rent\non a house valued at $150,000. After paying $5000 in income taxes, he will\nhave $15,000 with which to pay rent. His investment will not grow because\nhe uses his entire return on investment to pay income tax plus rent.\n\xe2\x80\xa2Eileen elects to change the form in which she holds some of her investment\nand to use $150,000 to purchase a house. She will still have $100,000\ninvested. Eileen can live in her house rent-free and will earn a 6% (i.e., 8%\n\xe2\x88\x92 (25% of 8%)) after-tax return on her investment, compounded annually.\nSee table 1 in the discussion of Bruun, supra. In less than 16 years, Eileen\nwill have $250,000 PLUS she will own a $150,000 home (assuming that it\ndoes not lose value; its value might even increase).\nNotice: Obviously Eileen came out ahead of Robert. Both Eileen and Robert started\nwith the same wealth and lived in the same type of house. How did Eileen do so\nmuch better than Robert?\n\xe2\x80\xa2Again, Robert had to pay income tax on his consumption while Eileen did\nnot.\n\xe2\x80\xa2The fair rental value of property that a taxpayer owns is also imputed\nincome, and it is not subject to income tax.\n\xe2\x80\xa2As the facts of this hypothetical illustrate, not taxing imputed income\ncauses inefficiency because it encourages taxpayers to invest in assets that\nthey can use in preference to other investments.\n110\n\n\x0c\xe2\x80\xa2A house is something that a consumer can and wants to consume.\n\xe2\x80\xa2Not taxing imputed income derived from ownership of property increases\na taxpayer\xe2\x80\x99s return on investing in such property. Eileen received $15,000\nworth of rent annually on her $150,000 investment \xe2\x80\x93 a tax-free return of\n10%. A net after-tax return of 10% subject to 25% income tax would require\na before-tax return of 13.33%.\n\xe2\x80\xa2A major source of lost revenue to the Treasury through the non-taxation of\nthe fair rental value of property that taxpayer owns results from Americans\xe2\x80\x99\nwidespread ownership of homes \xe2\x80\x93 and the ownership of homes that are more\nexpensive than what many taxpayers would otherwise purchase.\n\xe2\x80\xa2Perhaps the risk-adjusted return on Turkish apricot futures is greater than\nthe 10% return Eileen so easily earned on her investment in a house, but\nEileen will not choose to maximize her investment return in this manner\nunless the return on such an investment is greater than 13.33%. The Tax\nCode assures that many taxpayers will prefer to purchase assets such as\nhomes rather than make investments with higher before-tax returns.\n\xe2\x80\xa2If excluding the fair rental value of a home from its owner\xe2\x80\x99s gross\nincome is not sufficient motivation to buy a home \xe2\x80\x93\n\xe2\x80\xa2\xc2\xa7 163(h) permits taxpayers who file married filing jointly to\ndeduct mortgage interest on up to $750,000 of indebtedness\nincurred to purchase a home.38\n\xe2\x80\xa2\xc2\xa7 121 permits exclusion from gross income of up to\n$250,000 of gain from the sale or exchange of a taxpayer\xe2\x80\x99s\nprincipal residence under prescribed circumstances.\n\xe2\x80\xa2\xc2\xa7 164(a)(1) permits a deduction for state and local real\nproperty taxes.39\n\xe2\x80\xa2Of course, these rules greatly increase demand for houses.40\nWithout question, the Tax Code has distorted the market for houses\nand increased their prices.\n\nThis is the limit for 2018 to 2025. Then the limit will again be $1,000,000. Moreover, \xc2\xa7 163(h) will\nagain allow a deduction for interest that taxpayer pays on $100,000 of home equity indebtedness.\n38\n\nFor 2018 to 2025, taxpayer may deduct a total of $10,000 for state and local property taxes, state and\nlocal personal property taxes, and state, local, and foreign income taxes. Foreign property taxes are not\ndeductible. Beginning in 2026, all these taxes will be deductible without limit.\n39\n\n40\n\nThe Tax Code makes a substantial contribution to urban sprawl.\n\n111\n\n\x0cIII. The Constitutional and Statutory Definitions of \xe2\x80\x9cGross\nIncome:\xe2\x80\x9d Realization\nCan a taxpayer realize income if he never receives it, but someone else does?\nHelvering v. Horst, 311 U.S. 112 (1940)\nMR. JUSTICE STONE delivered the opinion of the Court.\nThe sole question for decision is whether the gift, during the donor\xe2\x80\x99s taxable year,\nof interest coupons detached from the bonds, delivered to the donee and later in the\nyear paid at maturity, is the realization of income taxable to the donor.\nIn 1934 and 1935, respondent, the owner of negotiable bonds, detached from them\nnegotiable interest coupons shortly before their due date and delivered them as a\ngift to his son, who, in the same year, collected them at maturity. The\nCommissioner ruled that, under ... [\xc2\xa7 61], the interest payments were taxable, in the\nyears when paid, to the respondent donor, who reported his income on the cash\nreceipts basis. The circuit court of appeals reversed the order of the Board of Tax\nAppeals sustaining the tax. We granted certiorari because of the importance of the\nquestion in the administration of the revenue laws and because of an asserted\nconflict in principle of the decision below with that of Lucas v. Earl, 281 U.S. 111,\nand with that of decisions by other circuit courts of appeals. See Bishop v.\nCommissioner, 54 F.2d 298; Dickey v. Burnet, 56 F.2d 917, 921; Van Meter v.\nCommissioner, 61 F.2d 817.\nThe court below thought that, as the consideration for the coupons had passed to\nthe obligor, the donor had, by the gift, parted with all control over them and their\npayment, and for that reason the case was distinguishable from Lucas v. Earl, supra,\nand Burnet v. Leininger, 285 U.S. 136, where the assignment of compensation for\nservices had preceded the rendition of the services, and where the income was held\ntaxable to the donor.\nThe holder of a coupon bond is the owner of two independent and separable kinds\nof right. One is the right to demand and receive at maturity the principal amount\nof the bond representing capital investment. The other is the right to demand and\nreceive interim payments of interest on the investment in the amounts and on the\ndates specified by the coupons. Together, they are an obligation to pay principal\n112\n\n\x0cand interest given in exchange for money or property which was presumably the\nconsideration for the obligation of the bond. Here respondent, as owner of the\nbonds, had acquired the legal right to demand payment at maturity of the interest\nspecified by the coupons and the power to command its payment to others which\nconstituted an economic gain to him.\nAdmittedly not all economic gain of the taxpayer is taxable income. From the\nbeginning, the revenue laws have been interpreted as defining \xe2\x80\x9crealization\xe2\x80\x9d of\nincome as the taxable event, rather than the acquisition of the right to receive it.\nAnd \xe2\x80\x9crealization\xe2\x80\x9d is not deemed to occur until the income is paid. But the decisions\nand regulations have consistently recognized that receipt in cash or property is not\nthe only characteristic of realization of income to a taxpayer on the cash receipts\nbasis. Where the taxpayer does not receive payment of income in money or\nproperty, realization may occur when the last step is taken by which he obtains the\nfruition of the economic gain which has already accrued to him. Old Colony Trust\nCo. v. Commissioner, 279 U.S. 716; Corliss v. Bowers, 281 U.S. 376, 378. Cf.\nBurnet v. Wells, 289 U.S. 670.\nIn the ordinary case the taxpayer who acquires the right to receive income is taxed\nwhen he receives it, regardless of the time when his right to receive payment\naccrued. But the rule that income is not taxable until realized has never been taken\nto mean that the taxpayer, even on the cash receipts basis, who has fully enjoyed\nthe benefit of the economic gain represented by his right to receive income can\nescape taxation because he has not himself received payment of it from his obligor.\nThe rule, founded on administrative convenience, is only one of postponement of\nthe tax to the final event of enjoyment of the income, usually the receipt of it by the\ntaxpayer, and not one of exemption from taxation where the enjoyment is\nconsummated by some event other than the taxpayer\xe2\x80\x99s personal receipt of money\nor property. [citation omitted] This may occur when he has made such use or\ndisposition of his power to receive or control the income as to procure in its place\nother satisfactions which are of economic worth. The question here is whether,\nbecause one who in fact receives payment for services or interest payments is\ntaxable only on his receipt of the payments, he can escape all tax by giving away\nhis right to income in advance of payment. If the taxpayer procures payment\ndirectly to his creditors of the items of interest or earnings due him, see Old Colony\nTrust Co. v. Commissioner, supra; [citations omitted], or if he sets up a revocable\ntrust with income payable to the objects of his bounty, [citation omitted], [citations\nomitted], he does not escape taxation because he did not actually receive the money.\n[citations omitted]\n113\n\n\x0cUnderlying the reasoning in these cases is the thought that income is \xe2\x80\x9crealized\xe2\x80\x9d by\nthe assignor because he, who owns or controls the source of the income, also\ncontrols the disposition of that which he could have received himself and diverts\nthe payment from himself to others as the means of procuring the satisfaction of his\nwants. The taxpayer has equally enjoyed the fruits of his labor or investment and\nobtained the satisfaction of his desires whether he collects and uses the income to\nprocure those satisfactions or whether he disposes of his right to collect it as the\nmeans of procuring them. [citation omitted]\nAlthough the donor here, by the transfer of the coupons, has precluded any\npossibility of his collecting them himself, he has nevertheless, by his act, procured\npayment of the interest, as a valuable gift to a member of his family. Such a use of\nhis economic gain, the right to receive income, to procure a satisfaction which can\nbe obtained only by the expenditure of money or property would seem to be the\nenjoyment of the income whether the satisfaction is the purchase of goods at the\ncorner grocery, the payment of his debt there, or such nonmaterial satisfactions as\nmay result from the payment of a campaign or community chest contribution, or a\ngift to his favorite son. Even though he never receives the money, he derives\nmoney\xe2\x80\x99s worth from the disposition of the coupons which he has used as money or\nmoney\xe2\x80\x99s worth in the procuring of a satisfaction which is procurable only by the\nexpenditure of money or money\xe2\x80\x99s worth. The enjoyment of the economic benefit\naccruing to him by virtue of his acquisition of the coupons is realized as completely\nas it would have been if he had collected the interest in dollars and expended them\nfor any of the purposes named. [citation omitted]\nIn a real sense, he has enjoyed compensation for money loaned or services rendered,\nand not any the less so because it is his only reward for them. To say that one who\nhas made a gift thus derived from interest or earnings paid to his donee has never\nenjoyed or realized the fruits of his investment or labor because he has assigned\nthem instead of collecting them himself and then paying them over to the donee is\nto affront common understanding and to deny the facts of common experience.\nCommon understanding and experience are the touchstones for the interpretation\nof the revenue laws.\nThe power to dispose of income is the equivalent of ownership of it. The exercise\nof that power to procure the payment of income to another is the enjoyment, and\nhence the realization, of the income by him who exercises it. We have had no\ndifficulty in applying that proposition where the assignment preceded the rendition\n114\n\n\x0cof the services, Lucas v. Earl, supra; Burnet v. Leininger, supra, for it was\nrecognized in the Leininger case that, in such a case, the rendition of the service by\nthe assignor was the means by which the income was controlled by the donor, and\nof making his assignment effective. But it is the assignment by which the\ndisposition of income is controlled when the service precedes the assignment, and,\nin both cases, it is the exercise of the power of disposition of the interest or\ncompensation, with the resulting payment to the donee, which is the enjoyment by\nthe donor of income derived from them.\n....\nThe dominant purpose of the revenue laws is the taxation of income to those who\nearn or otherwise create the right to receive it and enjoy the benefit of it when paid.\nSee Corliss v. Bowers, supra, 281 U.S. 376, 378; Burnet v. Guggenheim, 288 U.S.\n280, 283. The tax laid by the 1934 Revenue Act upon income \xe2\x80\x9cderived from ...\nwages, or compensation for personal service, of whatever kind and in whatever\nform paid ... ; also from interest ...\xe2\x80\x9d therefore cannot fairly be interpreted as not\napplying to income derived from interest or compensation when he who is entitled\nto receive it makes use of his power to dispose of it in procuring satisfactions which\nhe would otherwise procure only by the use of the money when received.\nIt is the statute which taxes the income to the donor although paid to his donee.\nLucas v. Earl, supra; Burnet v. Leininger, supra. \xe2\x80\xa6\n\xe2\x80\xa6 When, by the gift of the coupons, he has separated his right to interest payments\nfrom his investment and procured the payment of the interest to his donee, he has\nenjoyed the economic benefits of the income in the same manner and to the same\nextent as though the transfer were of earnings, and, in both cases, the import of the\nstatute is that the fruit is not to be attributed to a different tree from that on which\nit grew. See Lucas v. Earl, supra, 281 U.S. at 115.\nReversed.\nThe separate opinion of MR. JUSTICE McREYNOLDS.\n....\nThe unmatured coupons given to the son were independent negotiable instruments,\ncomplete in themselves. Through the gift, they became at once the absolute\n115\n\n\x0cproperty of the donee, free from the donor\xe2\x80\x99s control and in no way dependent upon\nownership of the bonds. No question of actual fraud or purpose to defraud the\nrevenue is presented.\n....\n... The challenged judgment should be affirmed.\nTHE CHIEF JUSTICE and MR. JUSTICE ROBERTS concur in this opinion.\nNotes and Questions:\n1. Under the rules of \xc2\xa7 102, donors make gifts with after-tax income, and the donee\nmay exclude the value of the gift from his gross income. Taxpayer Horst of course\ntried to reverse this.\n2. No doubt, taxpayer\xe2\x80\x99s son was in a lower tax bracket than taxpayer was. Hence,\nthe bond interest would have been subject to a lower rate of tax if taxpayer had\nprevailed.\n3. Consumption can take the form of directing income to another.\n4. The Internal Revenue Code taxes \xe2\x80\x9ctaxable income,\xe2\x80\x9d \xc2\xa7\xc2\xa7 1(a-e). [Section 1(j)\nrather than \xc2\xa7\xc2\xa7 1(a-e) govern for 2018 to 2025.] The computation of \xe2\x80\x9ctaxable\nincome\xe2\x80\x9d begins with a summing up of all items of \xe2\x80\x9cgross income.\xe2\x80\x9d The concept of\n\xe2\x80\x9cgross income\xe2\x80\x9d does not inherently embody a netting of gains and losses. A\ntaxpayer may deduct losses only to the extent that the Code permits.41 Sections\n165(a and c) allow taxpayers to deduct trade or business losses and investment\nlosses. A realization requirement applies to losses, just as it does to gross income.\nTo be deductible, taxpayer must have \xe2\x80\x9crealized\xe2\x80\x9d the losses. Now read Cottage\nSavings Association.\n\nMany gamblers have learned the hard way that there is a limit to what they can deduct from their\ngambling winnings. \xc2\xa7 165(d) (wagering losses deductible only to extent of gain from wagering\ntransactions; until 2026, wagering \xe2\x80\x9closses\xe2\x80\x9d include deductions otherwise allowable).\n41\n\n116\n\n\x0cCottage Savings Ass\xe2\x80\x99n v. CIR, 499 U.S. 554 (1991)\nJUSTICE MARSHALL delivered the opinion of the Court.\nThe issue in this case is whether a financial institution realizes tax-deductible losses\nwhen it exchanges its interests in one group of residential mortgage loans for\nanother lender\xe2\x80\x99s interests in a different group of residential mortgage loans. We\nhold that such a transaction does give rise to realized losses.\nI\nPetitioner Cottage Savings Association (Cottage Savings) is a savings and loan\nassociation (S & L) formerly regulated by the Federal Home Loan Bank Board\n(FHLBB). [footnote omitted] Like many S & L\xe2\x80\x99s, Cottage Savings held numerous\nlong-term, low-interest mortgages that declined in value when interest rates surged\nin the late 1970\'s. These institutions would have benefited from selling their\ndevalued mortgages in order to realize tax-deductible losses. However, they were\ndeterred from doing so by FHLBB accounting regulations, which required them to\nrecord the losses on their books. Reporting these losses consistent with the theneffective FHLBB accounting regulations would have placed many S & L\xe2\x80\x99s at risk\nof closure by the FHLBB.\nThe FHLBB responded to this situation by relaxing its requirements for the\nreporting of losses. In a regulatory directive known as \xe2\x80\x9cMemorandum R-49,\xe2\x80\x9d dated\nJune 27, 1980, the FHLBB determined that S & L\xe2\x80\x99s need not report losses\nassociated with mortgages that are exchanged for \xe2\x80\x9csubstantially identical\xe2\x80\x9d\nmortgages held by other lenders. [footnote omitted]. The FHLBB\xe2\x80\x99s acknowledged\npurpose for Memorandum R-49 was to facilitate transactions that would generate\ntax losses but that would not substantially affect the economic position of the\ntransacting S & L\xe2\x80\x99s.\nThis case involves a typical Memorandum R-49 transaction. On December 31,\n1980, Cottage Savings sold \xe2\x80\x9c90% participation\xe2\x80\x9d in 252 mortgages to four S & L\xe2\x80\x99s.\nIt simultaneously purchased \xe2\x80\x9c90% participation interests\xe2\x80\x9d in 305 mortgages held\nby these S & L\xe2\x80\x99s.42 All of the loans involved in the transaction were secured by\nBy exchanging merely participation interests, rather than the loans themselves, each party retained\nits relationship with the individual obligors. Consequently, each S & L continued to service the loans\non which it had transferred the participation interests and made monthly payments to the participationinterest holders.\n42\n\n117\n\n\x0csingle-family homes, most in the Cincinnati area. The fair market value of the\npackage of participation interests exchanged by each side was approximately $4.5\nmillion. The face value of the participation interests Cottage Savings relinquished\nin the transaction was approximately $6.9 million.\nOn its 1980 federal income tax return, Cottage Savings claimed a deduction for\n$2,447,091, which represented the adjusted difference between the face value of\nthe participation interests that it traded and the fair market value of the participation\ninterests that it received. As permitted by Memorandum R-49, Cottage Savings did\nnot report these losses to the FHLBB. After the Commissioner of Internal Revenue\ndisallowed Cottage Savings\xe2\x80\x99 claimed deduction, Cottage Savings sought a\nredetermination in the Tax Court. The Tax Court held that the deduction was\npermissible.\nOn appeal by the Commissioner, the Court of Appeals reversed. The Court of\nAppeals agreed with the Tax Court\xe2\x80\x99s determination that Cottage Savings had\nrealized its losses through the transaction. \xe2\x80\xa6\nBecause of the importance of this issue to the S & L industry and the conflict among\nthe Circuits over whether Memorandum R-49 exchanges produce deductible tax\nlosses, [footnote omitted] we granted certiorari. We now reverse.\nII\nRather than assessing tax liability on the basis of annual fluctuations in the value\nof a taxpayer\xe2\x80\x99s property, the Internal Revenue Code defers the tax consequences of\na gain or loss in property value until the taxpayer \xe2\x80\x9crealizes\xe2\x80\x9d the gain or loss. The\nrealization requirement is implicit in \xc2\xa7 1001(a) of the Code, 26 U.S.C. \xc2\xa7 1001(a),\nwhich defines \xe2\x80\x9c[t]he gain [or loss] from the sale or other disposition of property\xe2\x80\x9d\nas the difference between \xe2\x80\x9cthe amount realized\xe2\x80\x9d from the sale or disposition of the\nproperty and its \xe2\x80\x9cadjusted basis.\xe2\x80\x9d As this Court has recognized, the concept of\nrealization is \xe2\x80\x9cfounded on administrative convenience.\xe2\x80\x9d Helvering v. Horst, 311\nU.S. 112, 116 (1940). Under an appreciation-based system of taxation, taxpayers\nand the Commissioner would have to undertake the \xe2\x80\x9ccumbersome, abrasive, and\nunpredictable administrative task\xe2\x80\x9d of valuing assets on an annual basis to determine\nwhether the assets had appreciated or depreciated in value. [citation omitted]. In\ncontrast, \xe2\x80\x9c[a] change in the form or extent of an investment is easily detected by a\ntaxpayer or an administrative officer.\xe2\x80\x9d R. MAGILL, TAXABLE INCOME 79 (rev.\ned.1945).\n118\n\n\x0cSection 1001(a)\xe2\x80\x99s language\nprovides a straightforward test\nfor realization: to realize a gain\nor loss in the value of property,\nthe taxpayer must engage in a\n\xe2\x80\x9csale or other disposition of\n[the] property.\xe2\x80\x9d The parties\nagree that the exchange of\nparticipation interests in this\ncase cannot be characterized as\na \xe2\x80\x9csale\xe2\x80\x9d under \xc2\xa7 1001(a); the\nissue before us is whether the\ntransaction\nconstitutes\na\n\xe2\x80\x9cdisposition of property.\xe2\x80\x9d The\nCommissioner argues that an\nexchange of property can be treated as a \xe2\x80\x9cdisposition\xe2\x80\x9d under \xc2\xa7 1001(a) only if the\nproperties exchanged are materially different. The Commissioner further submits\nthat, because the underlying mortgages were essentially economic substitutes, the\nparticipation interests exchanged by Cottage Savings were not materially different\nfrom those received from the other S & L\xe2\x80\x99s. Cottage Savings, on the other hand,\nmaintains that any exchange of property is a \xe2\x80\x9cdisposition of property\xe2\x80\x9d under\n\xc2\xa7 1001(a), regardless of whether the property exchanged is materially different.\nAlternatively, Cottage Savings contends that the participation interests exchanged\nwere materially different because the underlying loans were secured by different\nproperties.\n\nConsistency between tax and financial accounting:\nThe FHLBB obviously intended Memorandum R-49\nto enable savings and loan associations to reduce\ntheir income tax liability and thereby come closer\nto solvency. This tax savings came at the expense\nof all other taxpayers who must \xe2\x80\x9cpick up the slack.\xe2\x80\x9d\n\xe2\x80\xa2Income tax rules often require taxpayers to\nmaintain consistent positions in their financial\naccounting and tax accounting. On the authority of\nthe FHLBB \xe2\x80\x93 not Congress or the IRS \xe2\x80\x93 the savings\nand loan associations could treat dud loans\ncompletely differently for financial accounting and\ntax accounting purposes.\n\nWe must therefore determine whether the realization principle in \xc2\xa7 1001(a)\nincorporates a \xe2\x80\x9cmaterial difference\xe2\x80\x9d requirement. If it does, we must further decide\nwhat that requirement amounts to and how it applies in this case. We consider these\nquestions in turn.\nA\nNeither the language nor the history of the Code indicates whether and to what\nextent property exchanged must differ to count as a \xe2\x80\x9cdisposition of property\xe2\x80\x9d under\n\xc2\xa7 1001(a). Nonetheless, we readily agree with the Commissioner that an exchange\nof property gives rise to a realization event under \xc2\xa7 1001(a) only if the properties\nexchanged are \xe2\x80\x9cmaterially different.\xe2\x80\x9d The Commissioner himself has, by\nregulation, construed \xc2\xa7 1001(a) to embody a material difference requirement:\n119\n\n\x0c\xe2\x80\x9cExcept as otherwise provided ... the gain or loss realized from the\nconversion of property into cash, or from the exchange of property for other\nproperty differing materially either in kind or in extent, is treated as income\nor as loss sustained.\xe2\x80\x9d Treas. Reg. \xc2\xa7 1.1001-1, 26 CFR \xc2\xa7 1.1001-1 (1990)\n(emphasis added).\nBecause Congress has delegated to the Commissioner the power to promulgate \xe2\x80\x9call\nneedful rules and regulations for the enforcement of [the Internal Revenue Code],\xe2\x80\x9d\n26 U.S.C. \xc2\xa7 7805(a), we must defer to his regulatory interpretations of the Code so\nlong as they are reasonable, see National Muffler Dealers Assn., Inc. v. United\nStates, 440 U.S. 472, 476-477 (1979).\nWe conclude that Treasury Regulation \xc2\xa7 1.1001-1 is a reasonable interpretation of\n\xc2\xa7 1001(a). Congress first employed the language that now comprises \xc2\xa7 1001(a) of\nthe Code in \xc2\xa7 202(a) of the Revenue Act of 1924, ch. 234, 43 Stat. 253; that\nlanguage has remained essentially unchanged through various reenactments.\n[footnote omitted] And since 1934, the Commissioner has construed the statutory\nterm \xe2\x80\x9cdisposition of property\xe2\x80\x9d to include a \xe2\x80\x9cmaterial difference\xe2\x80\x9d requirement.\n[footnote omitted] As we have recognized, \xe2\x80\x9c\xe2\x80\x98Treasury regulations and\ninterpretations long continued without substantial change, applying to unamended\nor substantially reenacted statutes, are deemed to have received congressional\napproval and have the effect of law.\xe2\x80\x99\xe2\x80\x9d United States v. Correll, 389 U.S. 299, 305306 (1967), quoting Helvering v. Winmill, 305 U.S. 79, 83 (1938).\nTreasury Regulation \xc2\xa7 1.1001-1 is also consistent with our landmark precedents on\nrealization. In a series of early decisions involving the tax effects of property\nexchanges, this Court made clear that a taxpayer realizes taxable income only if the\nproperties exchanged are \xe2\x80\x9cmaterially\xe2\x80\x9d or \xe2\x80\x9cessentially\xe2\x80\x9d different. See United States\nv. Phellis, 257 U.S. 156, 173 (1921); Weiss v. Stearn, 265 U.S. 242, 253-254\n(1924); Marr v. United States, 268 U.S. 536, 540-542 (1925); see also Eisner v.\nMacomber, 252 U.S. 189, 207-212 (1920) (recognizing realization requirement).\nBecause these decisions were part of the \xe2\x80\x9ccontemporary legal context\xe2\x80\x9d in which\nCongress enacted \xc2\xa7 202(a) of the 1924 Act, [citation omitted], and because\nCongress has left undisturbed through subsequent reenactments of the Code the\nprinciples of realization established in these cases, we may presume that Congress\nintended to codify these principles in \xc2\xa7 1001(a) [citations omitted]. The\nCommissioner\xe2\x80\x99s construction of the statutory language to incorporate these\nprinciples certainly was reasonable.\n120\n\n\x0cB\nPrecisely what constitutes a \xe2\x80\x9cmaterial difference\xe2\x80\x9d for purposes of \xc2\xa7 1001(a) of the\nCode is a more complicated question. The Commissioner argues that properties are\n\xe2\x80\x9cmaterially different\xe2\x80\x9d only if they differ in economic substance. To determine\nwhether the participation interests exchanged in this case were \xe2\x80\x9cmaterially\ndifferent\xe2\x80\x9d in this sense, the Commissioner argues, we should look to the attitudes\nof the parties, the evaluation of the interests by the secondary mortgage market, and\nthe views of the FHLBB. We conclude that \xc2\xa7 1001(a) embodies a much less\ndemanding and less complex test.\nUnlike the question whether \xc2\xa7 1001(a) contains a material difference requirement,\nthe question of what constitutes a material difference is not one on which we can\ndefer to the Commissioner. For the Commissioner has not issued an authoritative,\nprelitigation interpretation of what property exchanges satisfy this requirement.\n[footnote omitted] Thus, to give meaning to the material difference test, we must\nlook to the case law from which the test derives and which we believe Congress\nintended to codify in enacting and reenacting the language that now comprises\n\xc2\xa7 1001(a). [citation omitted].\nWe start with the classic treatment of realization in Eisner v. Macomber, supra. In\nMacomber, a taxpayer who owned 2,200 shares of stock in a company received\nanother 1,100 shares from the company as part of a pro rata stock dividend meant\nto reflect the company\xe2\x80\x99s growth in value. At issue was whether the stock dividend\nconstituted taxable income. We held that it did not, because no gain was realized.\nWe reasoned that the stock dividend merely reflected the increased worth of the\ntaxpayer\xe2\x80\x99s stock, and that a taxpayer realizes increased worth of property only by\nreceiving \xe2\x80\x9csomething of exchangeable value proceeding from the property,\xe2\x80\x9d see\n252 U.S. at 207.\nIn three subsequent decisions \xe2\x80\x93 United States v. Phellis, supra; Weiss v. Stearn,\nsupra; and Marr v. United States, supra \xe2\x80\x93 we refined Macomber\xe2\x80\x99s conception of\nrealization in the context of property exchanges. In each case, the taxpayer owned\nstock that had appreciated in value since its acquisition. And in each case, the\ncorporation in which the taxpayer held stock had reorganized into a new\ncorporation, with the new corporation assuming the business of the old corporation.\nWhile the corporations in Phellis and Marr both changed from New Jersey to\nDelaware corporations, the original and successor corporations in Weiss both were\nincorporated in Ohio. In each case, following the reorganization, the stockholders\n121\n\n\x0cof the old corporation received shares in the new corporation equal to their\nproportional interest in the old corporation.\nThe question in these cases was whether the taxpayers realized the accumulated\ngain in their shares in the old corporation when they received in return for those\nshares stock representing an equivalent proportional interest in the new\ncorporations. In Phellis and Marr, we held that the transactions were realization\nevents. We reasoned that, because a company incorporated in one State has\n\xe2\x80\x9cdifferent rights and powers\xe2\x80\x9d from one incorporated in a different State, the\ntaxpayers in Phellis and Marr acquired through the transactions property that was\n\xe2\x80\x9cmaterially different\xe2\x80\x9d from what they previously had. United States v. Phellis, 257\nU.S. at 169-173; see Marr v. United States, supra, 268 U.S. at 540-542 (using\nphrase \xe2\x80\x9cessentially different\xe2\x80\x9d). In contrast, we held that no realization occurred in\nWeiss. By exchanging stock in the predecessor corporation for stock in the newly\nreorganized corporation, the taxpayer did not receive \xe2\x80\x9ca thing really different from\nwhat he theretofore had.\xe2\x80\x9d Weiss v. Stearn, supra. As we explained in Marr, our\ndetermination that the reorganized company in Weiss was not \xe2\x80\x9creally different\xe2\x80\x9d\nfrom its predecessor turned on the fact that both companies were incorporated in\nthe same State. See Marr v. United States, supra, 268 U.S. at 540-542 (outlining\ndistinction between these cases).\nObviously, the distinction in Phellis and Marr that made the stock in the successor\ncorporations materially different from the stock in the predecessors was minimal.\nTaken together, Phellis, Marr, and Weiss stand for the principle that properties are\n\xe2\x80\x9cdifferent\xe2\x80\x9d in the sense that is \xe2\x80\x9cmaterial\xe2\x80\x9d to the Internal Revenue Code so long as\ntheir respective possessors enjoy legal entitlements that are different in kind or\nextent. Thus, separate groups of stock are not materially different if they confer\n\xe2\x80\x9cthe same proportional interest of the same character in the same corporation.\xe2\x80\x9d\nMarr v. United States, 268 U.S. at 540. However, they are materially different if\nthey are issued by different corporations, id. at 541; United States v. Phellis, supra,\n257 U.S. at 173, or if they confer \xe2\x80\x9cdifferen[t] rights and powers\xe2\x80\x9d in the same\ncorporation, Marr v. United States, supra, 268 U.S. at 541. No more demanding a\nstandard than this is necessary in order to satisfy the administrative purposes\nunderlying the realization requirement in \xc2\xa7 1001(a). See Helvering v. Horst, 311\nU.S. at 116. For, as long as the property entitlements are not identical, their\nexchange will allow both the Commissioner and the transacting taxpayer easily to\nfix the appreciated or depreciated values of the property relative to their tax bases.\nIn contrast, we find no support for the Commissioner\xe2\x80\x99s \xe2\x80\x9ceconomic substitute\xe2\x80\x9d\n122\n\n\x0cconception of material difference. According to the Commissioner, differences\nbetween properties are material for purposes of the Code only when it can be said\nthat the parties, the relevant market (in this case the secondary mortgage market),\nand the relevant regulatory body (in this case the FHLBB) would consider them\nmaterial. Nothing in Phellis, Weiss, and Marr suggests that exchanges of properties\nmust satisfy such a subjective test to trigger realization of a gain or loss.\nMoreover, the complexity of the Commissioner\xe2\x80\x99s approach ill-serves the goal of\nadministrative convenience that underlies the realization requirement. In order to\napply the Commissioner\xe2\x80\x99s test in a principled fashion, the Commissioner and the\ntaxpayer must identify the relevant market, establish whether there is a regulatory\nagency whose views should be taken into account, and then assess how the relevant\nmarket participants and the agency would view the transaction. The\nCommissioner\xe2\x80\x99s failure to explain how these inquiries should be conducted further\ncalls into question the workability of his test.\nFinally, the Commissioner\xe2\x80\x99s test is incompatible with the structure of the Code.\nSection 1001(c) ... provides that a gain or loss realized under \xc2\xa7 1001(a) \xe2\x80\x9cshall be\nrecognized\xe2\x80\x9d unless one of the Code\xe2\x80\x99s nonrecognition provisions applies. One such\nnonrecognition provision withholds recognition of a gain or loss realized from an\nexchange of properties that would appear to be economic substitutes under the\nCommissioner\xe2\x80\x99s material difference test. This provision, commonly known as the\n\xe2\x80\x9clike kind\xe2\x80\x9d exception, withholds recognition of a gain or loss realized\n\xe2\x80\x9con the exchange of property held for productive use in a trade or business\nor for investment ... for property of like kind which is to be held either for\nproductive use in a trade or business or for investment.\xe2\x80\x9d 26 U.S.C.\n\xc2\xa7 1031(a)(1).\nIf Congress had expected that exchanges of similar properties would not count as\nrealization events under \xc2\xa7 1001(a), it would have had no reason to bar recognition\nof a gain or loss realized from these transactions.\nC\nUnder our interpretation of \xc2\xa7 1001(a), an exchange of property gives rise to a\nrealization event so long as the exchanged properties are \xe2\x80\x9cmaterially different\xe2\x80\x9d \xe2\x80\x93\nthat is, so long as they embody legally distinct entitlements. Cottage Savings\xe2\x80\x99\ntransactions at issue here easily satisfy this test. Because the participation interests\nexchanged by Cottage Savings and the other S & L\xe2\x80\x99s derived from loans that were\n123\n\n\x0cmade to different obligors and secured by different homes, the exchanged interests\ndid embody legally distinct entitlements. Consequently, we conclude that Cottage\nSavings realized its losses at the point of the exchange.\nThe Commissioner contends that it is anomalous to treat mortgages deemed to be\n\xe2\x80\x9csubstantially identical\xe2\x80\x9d by the FHLBB as \xe2\x80\x9cmaterially different.\xe2\x80\x9d The anomaly,\nhowever, is merely semantic; mortgages can be substantially identical for\nMemorandum R-49 purposes and still exhibit \xe2\x80\x9cdifferences\xe2\x80\x9d that are \xe2\x80\x9cmaterial\xe2\x80\x9d for\npurposes of the Internal Revenue Code. Because Cottage Savings received\nentitlements different from those it gave up, the exchange put both Cottage Savings\nand the Commissioner in a position to determine the change in the value of Cottage\nSavings\xe2\x80\x99 mortgages relative to their tax bases. Thus, there is no reason not to treat\nthe exchange of these interests as a realization event, regardless of the status of the\nmortgages under the criteria of Memorandum R-49.\nIII\n\xe2\x80\xa6.\nIV\n\xe2\x80\xa6 [The decision of the Tax Court is affirmed.]\nSo ordered.\nJUSTICE BLACKMUN, with whom JUSTICE WHITE joins, concurring in part\nand dissenting in part \xe2\x80\x93 omitted.\nNotes and Questions:\n1. As a practical matter, what was wrong with the Commissioner\xe2\x80\x99s arguments?\n2. What is the test of \xe2\x80\x9crealization\xe2\x80\x9d upon an exchange that the Court derived from\nPhellis/Weiss/Marr?\n3. In considering its earlier constructions of the \xe2\x80\x9crealization\xe2\x80\x9d requirement (part IIB\nof the opinion) in Macomber/Phellis/Weiss/Marr, the Court never mentioned the\nSixteenth Amendment. Moreover, the Court stated in part IIB that administrative\npurposes underlie the \xe2\x80\x9crealization requirement.\xe2\x80\x9d By this time \xe2\x80\x93 if not earlier \xe2\x80\x93 the\nCourt had de-constitutionalized the \xe2\x80\x9crealization\xe2\x80\x9d requirement \xe2\x80\x93 a matter that is\n124\n\n\x0ccritical to the Subpart F rules governing U.S. taxation of foreign source income.\n4. The Court\xe2\x80\x99s application of the realization requirement gives taxpayers\nconsiderable control over the timing of tax gains and losses.\n5. As the Court indicated in part IIB of its opinion, \xc2\xa7 1001(c) provides that\n\xe2\x80\x9c[e]xcept as otherwise provided, the amount of the gain or loss, determined under\nthis section, on the sale or exchange of property shall be recognized.\xe2\x80\x9d In \xc2\xa7\xc2\xa7 1031\nto 1045 (among others), Congress \xe2\x80\x9cotherwise provided.\xe2\x80\x9d We briefly consider here\n\xc2\xa7 1031 and \xc2\xa7 1033.\n\xe2\x80\xa2\xc2\xa7 1031 (like-kind exchanges): \xc2\xa7 1031(a) provides that \xe2\x80\x9c[no gain or loss shall be\nrecognized on the exchange of real property held for productive use in a trade or\nbusiness or for investment if such property is exchanged solely for property of like\nkind which is to be held either for productive use in a trade or business or for\ninvestment.\xe2\x80\x9d Tax-deferred exchange treatment does not apply to property that the\ntaxpayer holds \xe2\x80\x9cprimarily\xe2\x80\x9d for resale. \xc2\xa7 1032(a)(2).\nTax Cuts and Jobs Act: Before\n2018, \xc2\xa7 1031\xe2\x80\x99s non-recognition\ntreatment extended to like-kind\nexchanges of any property \xe2\x80\x9cheld\nfor productive use in a trade or\nbusiness or for investment[.]\xe2\x80\x9d The\nTax Cuts and Jobs Act now restricts\nsuch treatment to exchanges of\nreal property. The Act denies taxdeferred treatment exchanges of\nreal property held primarily for\nsale. \xc2\xa7 1031(a)(2). The Act also\ndenies tax-deferred treatment of\nexchanges of real property\nlocated outside of the United\nStates. \xc2\xa7 1031(h). The Act made\nobsolete many of \xc2\xa7 1031\xe2\x80\x99s\nregulations.\n\nThe phrase \xe2\x80\x9clike kind\xe2\x80\x9d refers to the nature or\ncharacter of the property, not its grade or quality.\nFor example, improved and unimproved lands are\nof \xe2\x80\x9clike kind.\xe2\x80\x9d Reg. \xc2\xa7 1.1031(a)-1(b).\nThe transfers in a \xc2\xa7 1031 transaction need not be\nsimultaneous. Moreover, more than two parties\nmay be involved. It would be rare that A and B\nown properties that they wish to exchange with\neach other.43 More likely, B wishes to procure real\nproperty from A. A wishes to exchange his real\nproperty for other real property. B can then\nprocure real property that A will accept and then\nexchange it for the property that A owns.\nSince it would be rare for the properties involved\nin an exchange to be worth the same amount, one\nor more parties may throw in something \xe2\x80\x9cto boot.\xe2\x80\x9d\n\nMulti-party transfers of multiple pieces of real property will be (already are?) the domain of real estate\nspecialists \xe2\x80\x93 and beyond the scope of this introduction to tax-deferral through basis transfers.\n43\n\n125\n\n\x0cIn such a case, the word \xe2\x80\x9csolely\xe2\x80\x9d in \xc2\xa7 1031(a) does not require that the entire\nexchange be disqualified from \xc2\xa7 1031 \xe2\x80\x93 only the assets that are not \xe2\x80\x9clike kind.\xe2\x80\x9d In\nthe exchange, taxpayer realizes gain/loss. When there is boot, taxpayer must\nrecognize gain or boot received, whichever is less. \xc2\xa7 1031(b). The assumption of a\nliability is treated as the payment of boot. Reg. \xc2\xa7 1.1031-2.\nTo implement the principle that we tax all income once, the tax on gain is deferred\nthrough the transfer of basis. Section 1031(d) provides that the transferor\xe2\x80\x99s basis in\nthe property he received is the same as the basis he had in the property that he\ntransferred, decreased by the amount of boot received, and increased by the amount\nof boot subject to immediate recognition or decreased by the amount of loss\nrecognized. Such transfer of basis from one property to another has the effect of\ndeferring, not excluding, eventual recognition of gain. Tax deferral under \xc2\xa7 1031 is\nnot optional but mandatory, a point that works against a taxpayer who wishes to\nrecognize loss in a completed transaction as the taxpayer in Cottage Saving & Loan\ndid.\nProblems:\n\xe2\x80\xa21. A, who is not a dealer in real estate, in 2010 exchanges real estate held\nfor investment, which he purchased in 1995 for $50,000, for other real estate\n(to be held for productive use in trade or business) which has a fair market\nvalue of $60,000, and $20,000 in cash.\n\xe2\x80\xa2How much gain did A derive from this dealing in property?\n\xe2\x80\xa2How much gain must A recognize from this dealing in property?\n\xe2\x80\xa2What is A\xe2\x80\x99s adjusted basis in the property that he acquired in this\ntransaction?\nSee Reg. \xc2\xa7 1.1031(b)-1(b), Example 1.\n\xe2\x80\xa21A. Suppose A exchanged the real property for other real estate which has\na fmv of $40,000 and $40,000 of cash. How would your answers change?\n\xe2\x80\xa22. B, an individual, owns an apartment house which has an adjusted basis\nin his hands of $500,000, but which is subject to a mortgage of $150,000.\nOn September 1, 1954, he transfers the apartment house to C, receiving in\nexchange therefor $50,000 in cash and another apartment house with a fair\nmarket value on that date of $600,000. The transfer to C is made subject to\nthe $150,000 mortgage.\n\xe2\x80\xa2How much gain did B derive from this dealing in property?\n126\n\n\x0c\xe2\x80\xa2How much gain must B recognize from this dealing in property?\n\xe2\x80\xa2What is B\xe2\x80\x99s adjusted basis in the property that he acquired in this\ntransaction?\nSee Reg. \xc2\xa7 1.1031(d)-2, Example 1.\n\xe2\x80\xa2\xc2\xa7 1033 (involuntary exchanges): A taxpayer whose property is destroyed, stolen,\nseized, requisitioned, or condemned may receive money for the property. The\nreceipt of money would require taxpayer to treat such an \xe2\x80\x9cinvoluntary conversion\xe2\x80\x9d\nof property into money as a recognition event. If taxpayer uses the proceeds of the\ninvoluntary conversion to procure property \xe2\x80\x9csimilar or related in service or use to\nthe property so converted,\xe2\x80\x9d taxpayer does not have to recognize gain except to the\nextent the amount of money received exceeds the cost of the replacement property.\n\xc2\xa7 1031(a)(2)(A). Again, the deferral of recognition is handled through a transfer of\nbasis from the converted property to the replacement property, decreased by the\nmoney that taxpayer did not spend on the replacement property and increased by\nthe amount of gain taxpayer recognized on the conversion (or decreased by the\namount of loss taxpayer recognized on the conversion). \xc2\xa7 1033(b)(1). In the case of\nan involuntary conversion, tax deferral is elective. \xc2\xa7 1033(a)(2)(A).\nProblem:\n\xe2\x80\xa2A\xe2\x80\x99s vessel which has an adjusted basis of $100,000 is destroyed in 2015,\nand receives in 2016 an insurance payment of $210,000. A invests $150,000\nof the insurance proceeds in a new vessel. A makes the election under\n\xc2\xa7 1033(a)(2)(A).\n\xe2\x80\xa2How much gain does A derive from this dealing in property?\n\xe2\x80\xa2How much gain must A recognize from this dealing in property?\n\xe2\x80\xa2What is A\xe2\x80\x99s basis in the replacement vessel?\nSee Reg. \xc2\xa7 1.1033(b)-1, Example.\n\nIV. The Constitutional and Statutory Definitions of \xe2\x80\x9cGross\nIncome:\xe2\x80\x9d Dominion and Control\nGenerally, taxpayer has dominion and control over a monetary accession to wealth\nif, as a practical matter, he may spend it without interference from others. The socalled \xe2\x80\x9cclaim of right\xe2\x80\x9d doctrine \xe2\x80\x93 which the Court first announced in North\n127\n\n\x0cAmerican Oil Consolidated v. Burnet, 286 U.S. 417 (1932) \xe2\x80\x93 implements this\nprinciple.\nGilbert v. Commissioner, 552 F.2d 478 (2nd Cir. 1977)\nLUMBARD, Circuit Judge:\nThe taxpayer Edward M. Gilbert appeals from a determination by the tax court that\nhe realized taxable income on certain unauthorized withdrawals of corporate funds\nmade by him in 1962. We reverse.\nUntil June 12, 1962, Gilbert was\nClaim of Right doctrine: Taxpayer must include in\npresident, principal stockholder,\nhis gross income an item when he has a \xe2\x80\x9cclaim of\nand a director of the E.L. Bruce\nright\xe2\x80\x9d to it. In North American Oil Consolidated v.\nCompany, Inc., a New York\nBurnet, 286 U.S. 417, 424 (1932), the Supreme\ncorporation which was engaged\nCourt stated the doctrine thus:\nin the lumber supply business.\nIf a taxpayer receives earnings under a\nclaim of right and without restriction as to\nIn 1961 and early 1962 Gilbert\nits disposition, he has received income\nacquired on margin substantial\nwhich he is required to return, even though\npersonal\nand\nbeneficial\nit may still be claimed that he is not entitled\nownership of stock in another\nto retain the money, and even though he\nlumber supply company, the\nmay still be adjudged liable to restore its\nCelotex Corporation, intending\nequivalent.\nultimately to bring about a\nmerger of Celotex into Bruce.\nTo this end, he persuaded\nassociates of his to purchase Celotex stock, guaranteeing them against loss, and\nalso induced Bruce itself to purchase a substantial number of Celotex shares. In\naddition, on March 5, 1962, Gilbert granted Bruce an option to purchase his Celotex\nshares from him at cost. By the end of May 1962, 56% of Celotex was thus\ncontrolled by Gilbert and Bruce, and negotiations for the merger were proceeding;\nagreement had been reached that three of the directors of Bruce would be placed on\nthe board of Celotex. It is undisputed that this merger would have been in Bruce\xe2\x80\x99s\ninterest.44\nThe stock market declined on May 28, 1962, however, and Gilbert was called upon\nAccording to undisputed testimony in the tax court, it was the consensus of the Bruce board that the\nCelotex assets were selling at a bargain price and also that the dovetailing of the two companies\xe2\x80\x99 sales\noperations would result in substantial economies.\n44\n\n128\n\n\x0cto furnish additional margin for the Celotex shares purchased by him and his\nassociates. Lacking sufficient cash of his own to meet this margin call, Gilbert\ninstructed the secretary of Bruce to use corporate funds to supply the necessary\nmargin. Between May 28 and June 6 a series of checks totalling $1,958,000 were\nwithdrawn from Bruce\xe2\x80\x99s accounts and used to meet the margin call. $5,000 was\nrepayed to Bruce on June 5. According to his testimony in the tax court, Gilbert\nfrom the outset intended to repay all the money and at all times thought he was\nacting in the corporation\xe2\x80\x99s best interests as well as his own.45 He promptly informed\nseveral other Bruce officers and directors of the withdrawals; however, some were\nnot notified until June 11 or 12.\nOn about June 1, Gilbert returned to New York from Nevada, where he had been\nattending to a personal matter. Shortly thereafter he consulted with Shearman,\nSterling & Wright, who were outside counsel to Bruce at the time, regarding the\nwithdrawals. They, he, and another Bruce director initiated negotiations to sell\nmany of the Celotex shares to Ruberoid Company as a way of recouping most of\nBruce\xe2\x80\x99s outlay.\nOn June 8, Gilbert went to the law offices of Shearman, Sterling & Wright and\nexecuted interest-bearing promissory notes to Bruce for $1,953,000 secured by an\nassignment of most of his property. [(footnote omitted)]. The notes were callable\nby Bruce on demand, with presentment and notice of demand waived by Gilbert.\nThe tax court found that up through June 12 the net value of the assets assigned for\nsecurity by Gilbert substantially exceeded the amount owed. [(footnote omitted)].\nAfter Gilbert informed other members of the Bruce board of directors of his actions,\na meeting of the board was scheduled for the morning of June 12. At the meeting\nthe board accepted the note and assignment but refused to ratify Gilbert\xe2\x80\x99s\nunauthorized withdrawals. During the meeting, word came that the board of\ndirectors of the Ruberoid Company had rejected the price offered for sale of the\nCelotex stock. Thereupon, the Bruce board demanded and received Gilbert\xe2\x80\x99s\nresignation and decided to issue a public announcement the next day regarding his\nunauthorized withdrawals. All further attempts on June 12 to arrange a sale of the\nCelotex stock fell through and in the evening Gilbert flew to Brazil, where he stayed\nfor several months. On June 13 the market price of Bruce and Celotex stock\nTwo years previously, Gilbert accomplished a merger with Bruce of another corporation controlled\nby him, Empire National Corporation, and in the process he had made some unauthorized withdrawals\nof Empire funds, all of which he paid back.\n45\n\n129\n\n\x0cplummeted, and trading in those shares was suspended by the Securities and\nExchanges Commission.\nOn June 22 the Internal Revenue Service filed tax liens against Gilbert based on a\njeopardy assessment for $3,340,000, of which $1,620,000 was for 1958-1960 and\n$1,720,000 was for 1962. [(footnote omitted)]. Bruce, having failed to file the\nassignment from Gilbert because of the real estate filing fee involved,46 now found\nitself subordinate in priority to the IRS and, impeded by the tax lien, has never since\nbeen able to recover much of its $1,953,000 from the assigned assets. [footnote\nomitted]. For the fiscal year ending June 30, 1962, Bruce claimed a loss deduction\non the $1,953,000 withdrawn by Gilbert. Several years later Gilbert pled guilty to\nfederal and state charges of having unlawfully withdrawn the funds from Bruce.\nOn these facts, the tax court determined that Gilbert realized income when he made\nthe unauthorized withdrawals of funds from Bruce, and that his efforts at restitution\ndid not entitle him to any offset against this income.\nThe starting point for analysis of this case is James v. United States, 366 U.S. 213\n(1961), which established that embezzled funds can constitute taxable income to\nthe embezzler.\nWhen a taxpayer acquires earnings, lawfully or unlawfully, without the\nconsensual recognition, express or implied, of an obligation to repay and\nwithout restriction as to their disposition, \xe2\x80\x9che has received income which he\nis required to return, even though it may still be claimed that he is not\nentitled to the money, and even though he may still be adjudged liable to\nrestore its equivalent.\xe2\x80\x9d Id. at 219 [(quoting North American Oil\nConsolidated v. Burnet, 286 U.S. 417, 424 (1932)].\nThe Commissioner contends that there can never be \xe2\x80\x9cconsensual recognition ... of\nan obligation to repay\xe2\x80\x9d in an embezzlement case. He reasons that because the\ncorporation as represented by a majority of the board of directors was unaware of\nthe withdrawals, there cannot have been consensual recognition of the obligation\nto repay at the time the taxpayer Gilbert acquired the funds. Since the withdrawals\nwere not authorized and the directors refused to treat them as a loan to Gilbert, the\nWhen attempting to file in the New York County Clerk\xe2\x80\x99s office on June 13 or 14, Bruce was told\nthat it would have to pay a mortgage tax of at least $10,000 because the assignment included real\nproperty. ...\n46\n\n130\n\n\x0cCommissioner concludes that Gilbert should be taxed like a thief rather than a\nborrower.\nIn a typical embezzlement, the embezzler intends at the outset to abscond with the\nfunds. If he repays the money during the same taxable year, he will not be taxed.\nSee James v. Commissioner, supra at 220; Quinn v. Commissioner, 524 F.2d 617,\n624-25 (7th Cir. 1975); Rev. Rul. 65-254, 1965 2 Cum. Bul. 50. As we held in Buff\nv. Commissioner, 496 F.2d 847 (2d Cir. 1974), if he spends the loot instead of\nrepaying, he cannot avoid tax on his embezzlement income simply by signing\npromissory notes later in the same year. See also id. at 849-50 (Oakes, J.,\nconcurring).\nThis is not a typical embezzlement case, however, and we do not interpret James\nas requiring income realization in every case of unlawful withdrawals by a\ntaxpayer. There are a number of facts that differentiate this case from Buff and\nJames. When Gilbert withdrew the corporate funds, he recognized his obligation to\nrepay and intended to do so. [(footnote omitted)]. The funds were to be used not\nonly for his benefit but also for the benefit of the corporation; meeting the margin\ncalls was necessary to maintain the possibility of the highly favorable merger.\nAlthough Gilbert undoubtedly realized that he lacked the necessary authorization,\nhe thought he was serving the best interests of the corporation and he expected his\ndecision to be ratified shortly thereafter. That Gilbert at no time intended to retain\nthe corporation\xe2\x80\x99s funds is clear from his actions.47 He immediately informed several\nof the corporation\xe2\x80\x99s officers and directors, and he made a complete accounting to\nall of them within two weeks. He also disclosed his actions to the corporation\xe2\x80\x99s\noutside counsel, a reputable law firm, and followed its instructions regarding\nrepayment. In signing immediately payable promissory notes secured by most of\nhis assets, Gilbert\xe2\x80\x99s clear intent was to ensure that Bruce would obtain full\nrestitution. In addition, he attempted to sell his shares of Celotex stock in order to\nraise cash to pay Bruce back immediately.\nWhen Gilbert executed the assignment to Bruce of his assets on June 8 and when\nthis assignment for security was accepted by the Bruce board on June 12, the net\nmarket value of these assets was substantially more than the amount owed. The\nBruce board did not release Gilbert from his underlying obligation to repay, but the\nIf Gilbert had been intending to abscond with the $1,953,000, it is difficult to see how he could have\nhoped to avoid detection in the long run. Since his equity in the corporation itself was worth well over\n$1,953,000, it would have been absurd for him to attempt such a theft.\n47\n\n131\n\n\x0cassignment was nonetheless valid and Bruce\xe2\x80\x99s failure to make an appropriate filing\nto protect itself against the claims of third parties, such as the IRS, did not relieve\nGilbert of the binding effect of the assignment. Since the assignment secured an\nimmediate payable note, Gilbert had as of June 12 granted Bruce full discretion to\nliquidate any of his assets in order to recoup on the $1,953,000 withdrawal. Thus,\nGilbert\xe2\x80\x99s net accretion in real wealth on the overall transaction was zero: he had for\nhis own use withdrawn $1,953,000 in corporate funds but he had now granted the\ncorporation control over at least $1,953,000 worth of his assets.\nWe conclude that where a taxpayer withdraws funds from a corporation which he\nfully intends to repay and which he expects with reasonable certainty he will be\nable to repay, where he believes that his withdrawals will be approved by the\ncorporation, and where he makes a prompt assignment of assets sufficient to secure\nthe amount owed, he does not realize income on the withdrawals under the James\ntest. When Gilbert acquired the money, there was an express consensual recognition\nof his obligation to repay: the secretary of the corporation, who signed the checks,\nthe officers and directors to whom Gilbert gave contemporaneous notification, and\nGilbert himself were all aware that the transaction was in the nature of a loan.\nMoreover, the funds were certainly not received by Gilbert \xe2\x80\x9cwithout restriction as\nto their disposition\xe2\x80\x9d as is required for taxability under James; the money was to be\nused solely for the temporary purpose of meeting certain margin calls and it was so\nused. For these reasons, we reverse the decision of the tax court.\nNotes and Questions:\n1. James v. United States, 366 U.S. 213 (1961) was an embezzlement case. The\nSupreme Court had held in Commissioner v. Wilcox, 327 U.S. 404 (1946) that an\nembezzler did not realize gross income because he was subject to an obligation to\nrepay the embezzled funds. Taxpayer had no bona fide claim of right to the funds.\nId. at 408. In Rutkin v. United States, 343 U.S. 130, 139 (1952), the Supreme Court\nheld that taxpayer must include money that he obtained by extortion in his gross\nincome. James shifted the focus of such cases from the bona fides of a claim of\nright to consensual recognition of an obligation to repay. Gilbert turned on whether\nthere was a consensual recognition of an obligation to repay.\n2. When must that consensual recognition of an obligation to repay exist? Does\nthe following excerpt from Gilbert answer the question?\nAs we held in Buff v. Commissioner, 496 F.2d 847 (2d Cir. 1974), if he\n132\n\n\x0cspends the loot instead of repaying, he cannot avoid tax on his\nembezzlement income simply by signing promissory notes later in the same\nyear. See also id. at 849-50 (Oakes, J., concurring).\n3. The withdrawals from the E.L. Bruce Company were \xe2\x80\x9cunauthorized.\xe2\x80\x9d Does that\nmean that there could not have been a \xe2\x80\x9cconsensual recognition of an obligation to\nrepay?\xe2\x80\x9d\n\xe2\x80\xa2The last paragraph of the opinion gives some idea of how little is required\nto show \xe2\x80\x9cconsensual recognition of [an] obligation to repay.\n4. If taxpayer has acquired funds without restriction as to their disposition, he has\nthe power to spend them on consumption \xe2\x80\x93 one of the elements of the SHS\ndefinition of income. Did taxpayer Gilbert ever feel free to spend the money as he\npleased?\n\n133\n\n\x0c5.\nIt seems that\ntaxpayer was willing\nto \xe2\x80\x9cbet the company\xe2\x80\x9d\nand had done so\nbefore. E.L. Bruce\nCompany evidently\nwillingly reaped the\nrewards of a good bet\nand only fired Gilbert\nwhen he made a bad\none. Cf. second\nfootnote of Gilbert. Is\nthat relevant to the\nincome tax question\nthat the facts of\nGilbert raise?\n6.\nWhy are loan\nproceeds not included\nin taxpayer\xe2\x80\x99s gross\nincome? After all,\ntaxpayer may act\nwithout restriction as\nto their disposition?\n\nOther statutory items of gross income: Recall from chapter 1\nthat the Code specifically names some items of gross income\nin \xc2\xa7\xc2\xa7 72-91. You should at least skim the table of contents to\nyour Code to get an idea of what Congress has deemed\nworthy of specific inclusion. These Code sections often define\nthe precise extent to which an item is (so implicitly is not)\ngross income.\nPrizes and Awards: Read \xc2\xa7 74(a). With only the exceptions\nnoted in \xc2\xa7\xc2\xa7 74(b and c), gross income includes amounts\nreceived as prizes and awards. A recurring question in the\ncase of non-cash prizes is their valuation. For reasons you\ncan readily identify, valuation must be an objective matter.\nHowever, this does not imply that the fmv of a prize to the\nrecipient is the price paid by the giver. For example, most\npersons would agree that merely driving a new automobile\nfrom the dealer\xe2\x80\x99s lot substantially reduces its value. The\nwinner of an automobile should be given at least some credit\nfor this fact. See McCoy v. CIR, 38 T.C. 841 (1962) (prize of\nautomobile). Taxpayer might convincingly demonstrate the\nvalue that he places on the prize by trading it as soon as\npossible after receiving it for something he values more \xe2\x80\x93 in\neconomic terms, a \xe2\x80\x9crevealed preference.\xe2\x80\x9d See McCoy, supra\n(taxpayer traded automobile for $1000 cash plus a\ndifferent new automobile); Turner v. CIR, T.C. Memo. 195438 (taxpayer exchanged two first-class steamship tickets for\nfour tourist class tickets).\n\n7.\nSecurity and\ndamage deposits: An\nelectric utility company (IPL) requires customers with suspect credit to make a\nsecurity deposit to assure prompt payment of utility bills. Customers are entitled to\na refund of their deposit upon establishing good credit or making a sufficient\nnumber of timely payments. The electric company treated the deposits as a current\nliability. So long as the company refunded the deposits when customers were\nentitled to them, the company could spend the money as it chose. Should the utility\ninclude the deposits in its gross income? The answer to this question turns on\nwhether the company had \xe2\x80\x9ccomplete dominion\xe2\x80\x9d over the funds.\nIPL hardly enjoyed \xe2\x80\x98complete dominion\xe2\x80\x99 over the customer deposits\nentrusted to it. Rather, these deposits were acquired subject to an express\n134\n\n\x0c\xe2\x80\x98obligation to repay,\xe2\x80\x99 either at the time service was terminated or at the time\na customer established good credit. So long as the customer fulfills his legal\nobligation to make timely payments, his deposit ultimately is to be\nrefunded, and both the timing and method of that refund are largely within\nthe control of the customer.\n... In determining whether a taxpayer enjoys \xe2\x80\x98complete dominion\xe2\x80\x99 over a\ngiven sum, the crucial point is not whether his use of the funds is\nunconstrained during some interim period. The key is whether the taxpayer\nhas some guarantee that he will be allowed to keep the money. IPL\xe2\x80\x99s receipt\nof these deposits was accompanied by no such guarantee.\nCIR v. Indianapolis Power & Light Co., 493 U.S. 203, 209-10 (1990). What facts\ndo you think are relevant to whether a payment is a security or damage deposit?\nConsider what terms you would include in a lease that you drafted for a landlord.\n\nDo the CALI lesson, Basic Income Taxation: Gross Income: Realization Concepts\nin Gross Income.\nDo the CALI lesson, Basic Income Taxation: Gross Income: Indirect Transfers for\nServices.\n\nWrap-up Questions for Chapter 2\n1. What policies does a broad definition of \xe2\x80\x9cgross income\xe2\x80\x9d implement and how?\n2. What is the tax treatment of a return of capital? How does this treatment\nimplement the principle that we tax income once?\n3. In determining whether a taxpayer should include certain forms of consumption\nin his gross income, why should it matter that taxpayer has no discretion in what it\nis he must consume (for example, a trip to Germany to view Volkswagen facilities)?\n4. The exchange of appreciated property to pay for something is a recognition\nevent. How does this rule implement the principal that we tax all income once?\n135\n\n\x0c5. What economic distortions result from the Code\xe2\x80\x99s failure to tax imputed income?\n\nWhat have you learned?\nCan you explain or define \xe2\x80\x93\n\xe2\x80\xa2Eisner v. Macomber; definition of \xe2\x80\x9cgross income,\xe2\x80\x9d the significance of\n\xe2\x80\x9crealization\xe2\x80\x9d\n\xe2\x80\xa2When and how a shareholder\xe2\x80\x99s share of undistributed corporate income is taxed\n\xe2\x80\xa2This definitional characteristic of \xe2\x80\x9cbasis:\xe2\x80\x9d money that will not be subject to tax\n(again)\n\xe2\x80\xa2Basis as the way taxpayer keeps score with the government\n\xe2\x80\xa2Glenshaw Glass; definition of \xe2\x80\x9cgross income\xe2\x80\x9d\n\xe2\x80\xa2Realization of income without actual receipt but through control of its disposition\n\xe2\x80\xa2Constitutional importance of direct vs. indirect taxes\n\xe2\x80\xa2Income tax treatment of \xe2\x80\x93\n\xe2\x80\xa2receiving a windfall\n\xe2\x80\xa2receiving punitive damages\n\xe2\x80\xa2receiving compensatory damages\n\xe2\x80\xa2someone else paying taxpayer\xe2\x80\x99s obligation\n\xe2\x80\xa2receiving a benefit over which taxpayer has no discretion to control\n\xe2\x80\xa2receiving a return of capital\n\xe2\x80\xa2receiving barter income\n\xe2\x80\xa2using appreciated (depreciated property) to pay for something\n\xe2\x80\xa2receiving imputed income from performing services\n\xe2\x80\xa2receiving imputed income from owning property\n\xe2\x80\xa2benefitting from a discharge (forgiveness) of indebtedness\n\xe2\x80\xa2stealing money\n\xe2\x80\xa2\xc2\xa7 1001 formula for determining gain or loss; why is relief from a liability included\nin \xe2\x80\x9camount realized\xe2\x80\x9d\n\xe2\x80\xa2Time value of money; present value; future value\n\xe2\x80\xa2Realization upon exchange of legal entitlements different in kind or extent\n\xe2\x80\xa2Exchange of \xe2\x80\x9cmaterially different\xe2\x80\x9d properties that are \xe2\x80\x9clike-kind\xe2\x80\x9d\n\xe2\x80\xa2Dominion and control\n\xe2\x80\xa2Claim of right doctrine; test of James v. United States\n\xe2\x80\xa2Difference in fact between a loan and stealing money\n\xe2\x80\xa2Tax treatment of security deposits\n\xe2\x80\xa2Tax treatment of like-kind exchanges and involuntary conversions\n\xe2\x80\xa2How does Congress defer recognizing gain without forgiving it?\n136\n\n\x0cChapter 3: Exclusions from Gross Income\nIn this chapter, we take up exclusions from gross income. Congress has chosen \xe2\x80\x93\nfor various reasons \xe2\x80\x93 to permit taxpayers\nnot to \xe2\x80\x9ccount\xe2\x80\x9d certain accessions to\nThe Tax Formula:\nwealth in their gross income. An\nexclusion is not the same as a deduction.\n\xe2\x9e\x94(gross income)\nA deduction is a reduction (subtraction)\nMINUS deductions named in \xc2\xa7 62\nfrom what would otherwise be \xe2\x80\x9ctaxable\nEQUALS (adjusted gross income (AGI))\nincome.\xe2\x80\x9d An exclusion does not even\nMINUS (standard deduction or itemized\ndeductions)\ncount as \xe2\x80\x9cgross income,\xe2\x80\x9d and so cannot\nMINUS (deduction for \xe2\x80\x9cqualified business\nbecome \xe2\x80\x9ctaxable income\xe2\x80\x9d \xe2\x80\x93 even though\nincome\xe2\x80\x9d)\nit usually is quite clearly an \xe2\x80\x9caccession\nto wealth.\xe2\x80\x9d We are still focusing on the\nEQUALS (taxable income)\nfirst line of the \xe2\x80\x9ctax formula\xe2\x80\x9d \xe2\x80\x93 only now\nwe are examining accessions to wealth\nCompute income tax liability from tables\nthat are not included in gross income as\nin \xc2\xa7 1(j) (indexed for inflation)\nopposed to those that are. Deductions\nMINUS (credits against tax)\ncome later.\nThe availability of exclusions has\nseveral consequences:\n\xe2\x80\xa2Taxpayers will seek wealth in forms that the Code excludes from their\ngross income. This point becomes more important as Congress curtails\nother means of reducing taxable income by suspending or repealing\ndeductions.\n\xe2\x80\xa2The fact that a taxpayer may acquire a form of wealth without bearing any\ntax burden will encourage other to \xe2\x80\x9ccapture\xe2\x80\x9d some of the benefit.\n\xe2\x80\xa2The fact that many taxpayers find a benefit to be attractive affects the\nmarket for that benefit, e.g., health care. Taxpayers acting as consumers will\nbid up the price of the benefit and so must spend more to acquire such forms\nof wealth (benefits) than they would if all taxpayers had to purchase the\nbenefit with after-tax dollars. The price of acquiring the tax-favored benefit\nwill increase. Entrepreneurs will enter businesses in which customers can\npurchase goods and services with untaxed dollars. Such entrepreneurs might\nhave created more net after-tax societal value by selling other goods and\nservices.\n\xe2\x80\xa2The Treasury obviously must forego tax revenues simply because these\naccessions to wealth are not subject to income tax.\n137\n\n\x0cYou should consider the net effectiveness of exclusions from gross income as a\nmeans of congressional pursuit of policy. Consider also whether there are better\nways to accomplish these objectives. We will consider the parameters of some\nexclusions and note others. This text groups excluded benefits very roughly into\nthree overlapping categories: those that encourage the development of the society\nand government that we want, those that encourage the creation of social benefits\n\xe2\x80\x93 perhaps of a sort that the government might otherwise feel obliged to provide,\nand those that are employment-based.\n\nI. The Society and Government that We Want\nThe Code excludes from a taxpayer\xe2\x80\x99s gross income certain benefits that (seem to)\nencourage taxpayers to make certain decisions that foster development of a certain\ntype of society and government. You might see in such provisions as \xc2\xa7\xc2\xa7 102, 103,\n107, and 121 the policies of generosity, federalism, spiritual growth, and home\nownership. Consider:\n\xe2\x80\xa2Whether these are policies that the government should pursue;\n\xe2\x80\xa2Whether tax benefits are the appropriate means of pursuing these policies.\nAfter all, those who choose to avail themselves of the benefits of these tax\nbenefits do so at the expense of taxpayers who do not;\n\xe2\x80\xa2Whether providing tax benefits to those who can avail themselves of those\nbenefits is fair to those who lack the wherewithal to make the same choice?\nDoes the exclusion perpetuate undesirable inequalities in our society?\n\xe2\x80\xa2Whether the tax provisions by which Congress pursues these policies lead\nto unintended consequences and/or capture by those other than those\nCongress intended to benefit.\nA. Gifts and Inheritances, \xc2\xa7 102, and Related Basis Rules, \xc2\xa7\xc2\xa7 1014, 1015\nRead \xc2\xa7 102. The Code has always provided an exclusion for gifts and inheritances\nfrom the federal income tax base. Perhaps Congress has always felt that it would\nbe inappropriate to assess a tax on the generosity and/or affection of relatives who\ngive birthday and Christmas gifts \xe2\x80\x93 sometimes very expensive ones. But:\n\xe2\x80\xa2Is it possible that the exclusion may lead to a culture of gift-giving in\ncontexts other than the family \xe2\x80\x93 whose effects may not reflect generosity or\naffection?\n138\n\n\x0c\xe2\x80\xa2If so, is it possible that the costs of such gifts will escalate, and is it not\ncertain that the donor will (at least try to) deduct the escalating costs of such\ngifts from her taxable income?\nCommissioner v. Duberstein, 363 U.S. 278 (1960).\nMR. JUSTICE BRENNAN delivered the opinion of the Court.\nThese two cases concern the provision of the Internal Revenue Code which\nexcludes from the gross income of an income taxpayer \xe2\x80\x9cthe value of property\nacquired by gift.\xe2\x80\x9d [footnote omitted] ... The importance to decision of the facts of\nthe cases requires that we state them in some detail.\nNo. 376, Commissioner v. Duberstein. The taxpayer, Duberstein, [footnote\nomitted] was president of the Duberstein Iron & Metal Company, a corporation\nwith headquarters in Dayton, Ohio. For some years, the taxpayer\xe2\x80\x99s company had\ndone business with Mohawk Metal Corporation, whose headquarters were in New\nYork City. The president of Mohawk was one Berman. The taxpayer and Berman\nhad generally used the telephone to transact their companies\xe2\x80\x99 business with each\nother, which consisted of buying and selling metals. The taxpayer testified, without\nelaboration, that he knew Berman \xe2\x80\x9cpersonally,\xe2\x80\x9d and had known him for about seven\nyears. From time to time in their telephone conversations, Berman would ask\nDuberstein whether the latter knew of potential customers for some of Mohawk\xe2\x80\x99s\nproducts in which Duberstein\xe2\x80\x99s company itself was not interested. Duberstein\nprovided the names of potential customers for these items.\nOne day in 1951, Berman telephoned Duberstein and said that the information\nDuberstein had given him had proved so helpful that he wanted to give the latter a\npresent. Duberstein stated that Berman owed him nothing. Berman said that he had\na Cadillac as a gift for Duberstein, and that the latter should send to New York for\nit; Berman insisted that Duberstein accept the car, and the latter finally did so,\nprotesting, however, that he had not intended to be compensated for the\ninformation. At the time, Duberstein already had a Cadillac and an Oldsmobile, and\nfelt that he did not need another car. Duberstein testified that he did not think\nBerman would have sent him the Cadillac if he had not furnished him with\ninformation about the customers. It appeared that Mohawk later deducted the value\nof the Cadillac as a business expense on its corporate income tax return.\n139\n\n\x0cDuberstein did not include the value of the Cadillac in gross income for 1951,\ndeeming it a gift. The Commissioner asserted a deficiency for the car\xe2\x80\x99s value\nagainst him ... [T]he Tax Court affirmed the Commissioner\xe2\x80\x99s determination. It said\nthat \xe2\x80\x9cThe record is significantly barren of evidence revealing any intention on the\npart of the payor to make a gift. ... The only justifiable inference is that the\nautomobile was intended by the payor to be remuneration for services rendered to\nit by Duberstein.\xe2\x80\x9d The Court of Appeals for the Sixth Circuit reversed.\nNo. 546, Stanton v. United States. The taxpayer, Stanton, had been for\napproximately 10 years in the employ of Trinity Church in New York City. He was\ncomptroller of the Church corporation, and president of a corporation, Trinity\nOperating Company, the church set up as a fully owned subsidiary to manage its\nreal estate holdings, which were more extensive than simply the church property.\nHis salary by the end of his employment there in 1942 amounted to $22,500 a year.\nEffective November 30, 1942, he resigned from both positions to go into business\nfor himself. The Operating Company\xe2\x80\x99s directors, who seem to have included the\nrector and vestrymen of the church, passed the following resolution upon his\nresignation:\n\xe2\x80\x9cBe it resolved that, in appreciation of the services rendered by Mr. Stanton\n..., a gratuity is hereby awarded to him of Twenty Thousand Dollars,\npayable to him in equal instalments of Two Thousand Dollars at the end of\neach and every month commencing with the month of December, 1942;\nprovided that, with the discontinuance of his services, the Corporation of\nTrinity Church is released from all rights and claims to pension and\nretirement benefits not already accrued up to November 30, 1942.\xe2\x80\x9d\nThe Operating Company\xe2\x80\x99s action was later explained by one of its directors as\nbased on the fact that\n\xe2\x80\x9cMr. Stanton was liked by all of the Vestry personally. He had a pleasing\npersonality. He had come in when Trinity\xe2\x80\x99s affairs were in a difficult\nsituation. He did a splendid piece of work, we felt. Besides that ... , he was\nliked by all of the members of the Vestry personally.\xe2\x80\x9d\nAnd by another:\n\xe2\x80\x9c[W]e were all unanimous in wishing to make Mr. Stanton a gift. Mr.\nStanton had loyally and faithfully served Trinity in a very difficult time.\n140\n\n\x0cWe thought of him in the highest regard. We understood that he was going\nin business for himself. We felt that he was entitled to that evidence of good\nwill.\xe2\x80\x9d\nOn the other hand, there was a suggestion of some ill feeling between Stanton and\nthe directors, arising out of the recent termination of the services of one Watkins,\nthe Operating Company\xe2\x80\x99s treasurer, whose departure was evidently attended by\nsome acrimony. At a special board meeting on October 28, 1942, Stanton had\nintervened on Watkins\xe2\x80\x99 side and asked reconsideration of the matter. The minutes\nreflect that\n\xe2\x80\x9cresentment was expressed as to the \xe2\x80\x98presumptuous\xe2\x80\x99 suggestion that the\naction of the Board, taken after long deliberation, should be changed.\xe2\x80\x9d\nThe Board adhered to its determination that Watkins be separated from employment\n... [T]he Board voted the payment of six months\xe2\x80\x99 salary to Watkins in a resolution\nsimilar to that quoted in regard to Stanton, but which did not use the term \xe2\x80\x9cgratuity.\xe2\x80\x9d\nAt the meeting, Stanton announced that, in order to avoid any ... embarrassment or\nquestion at any time as to his willingness to resign if the Board desired, he was\ntendering his resignation ..., which ... was [eventually] accepted.\n... There was undisputed testimony that there were in fact no enforceable rights or\nclaims to pension and retirement benefits which had not accrued at the time of the\ntaxpayer\xe2\x80\x99s resignation, and that the last proviso of the resolution was inserted\nsimply out of an abundance of caution. The taxpayer received in cash a refund of\nhis contributions to the retirement plans, and there is no suggestion that he was\nentitled to more. He was required to perform no further services for Trinity after\nhis resignation.\nThe Commissioner asserted a deficiency against the taxpayer after the latter had\nfailed to include the payments in question in gross income. After payment of the\ndeficiency and administrative rejection of a refund claim, the taxpayer sued the\nUnited States for a refund in the District Court for the Eastern District of New York.\nThe trial judge, sitting without a jury, made the simple finding that the payments\nwere a \xe2\x80\x9cgift,\xe2\x80\x9d [footnote omitted] and judgment was entered for the taxpayer. The\nCourt of Appeals for the Second Circuit reversed.\nThe Government, urging that clarification of the problem typified by these two\ncases was necessary, and that the approaches taken by the Courts of Appeals for\n141\n\n\x0cthe Second and the Sixth Circuits were in conflict, petitioned for certiorari in No.\n376, and acquiesced in the taxpayer\xe2\x80\x99s petition in No. 546. On this basis, and because\nof the importance of the question in the administration of the income tax laws, we\ngranted certiorari in both cases.\nThe exclusion of property acquired by gift from gross income under the federal\nincome tax laws was made in the first income tax statute [footnote omitted] passed\nunder the authority of the Sixteenth Amendment, and has been a feature of the\nincome tax statutes ever since. The meaning of the term \xe2\x80\x9cgift\xe2\x80\x9d as applied to\nparticular transfers has always been a matter of contention. [footnote omitted]\nSpecific and illuminating legislative history on the point does not appear to exist.\nAnalogies and inferences drawn from other revenue provisions, such as the estate\nand gift taxes, are dubious. [citation omitted]. The meaning of the statutory term\nhas been shaped largely by the decisional law. With this, we turn to the contentions\nmade by the Government in these cases.\nFirst. The Government suggests that we promulgate a new \xe2\x80\x9ctest\xe2\x80\x9d in this area to\nserve as a standard to be applied by the lower courts and by the Tax Court in dealing\nwith the numerous cases that arise. [footnote omitted] We reject this invitation. We\nare of opinion that the governing principles are necessarily general, and have\nalready been spelled out in the opinions of this Court, and that the problem is one\nwhich, under the present statutory framework, does not lend itself to any more\ndefinitive statement that would produce a talisman for the solution of concrete\ncases. The cases at bar are fair examples of the settings in which the problem usually\narises. They present situations in which payments have been made in a context with\nbusiness overtones \xe2\x80\x93 an employer making a payment to a retiring employee; a\nbusinessman giving something of value to another businessman who has been of\nadvantage to him in his business. In this context, we review the law as established\nby the prior cases here.\nThe course of decision here makes it plain that the statute does not use the term\n\xe2\x80\x9cgift\xe2\x80\x9d in the common law sense, but in a more colloquial sense. This Court has\nindicated that a voluntarily executed transfer of his property by one to another,\nwithout any consideration or compensation therefor, though a common law gift, is\nnot necessarily a \xe2\x80\x9cgift\xe2\x80\x9d within the meaning of the statute. For the Court has shown\nthat the mere absence of a legal or moral obligation to make such a payment does\nnot establish that it is a gift. Old Colony Trust Co. v. Commissioner, 279 U.S. 716,\n730. And, importantly, if the payment proceeds primarily from \xe2\x80\x9cthe constraining\nforce of any moral or legal duty,\xe2\x80\x9d or from \xe2\x80\x9cthe incentive of anticipated benefit\xe2\x80\x9d of\n142\n\n\x0can economic nature, Bogardus v. Commissioner, 302 U.S. 34, 41, it is not a gift.\nAnd, conversely, \xe2\x80\x9c[w]here the payment is in return for services rendered, it is\nirrelevant that the donor derives no economic benefit from it.\xe2\x80\x9d Robertson v. United\nStates, 343 U.S. 711, 714.48 A gift in the statutory sense, on the other hand,\nproceeds from a \xe2\x80\x9cdetached and disinterested generosity,\xe2\x80\x9d Commissioner v. LoBue,\n351 U.S. 243, 246; \xe2\x80\x9cout of affection, respect, admiration, charity or like impulses.\xe2\x80\x9d\nRobertson v. United States, supra, at 343 U.S. 714. And, in this regard, the most\ncritical consideration, as the Court was agreed in the leading case here, is the\ntransferor\xe2\x80\x99s \xe2\x80\x9cintention.\xe2\x80\x9d Bogardus v. Commissioner, 302 U.S. 34, 43. \xe2\x80\x9cWhat\ncontrols is the intention with which payment, however voluntary, has been made.\xe2\x80\x9d\nId. at 302 U.S. 45 (dissenting opinion). [footnote omitted]\nThe Government says that this \xe2\x80\x9cintention\xe2\x80\x9d of the transferor cannot mean what the\ncases on the common law concept of gift call \xe2\x80\x9cdonative intent.\xe2\x80\x9d With that we are in\nagreement, for our decisions fully support this. Moreover, the Bogardus case itself\nmakes it plain that the donor\xe2\x80\x99s characterization of his action is not determinative \xe2\x80\x93\nthat there must be an objective inquiry as to whether what is called a gift amounts\nto it in reality. 302 U.S. at 40. It scarcely needs adding that the parties\xe2\x80\x99 expectations\nor hopes as to the tax treatment of their conduct, in themselves, have nothing to do\nwith the matter.\nIt is suggested that the Bogardus criterion would be more apt if rephrased in terms\nof \xe2\x80\x9cmotive,\xe2\x80\x9d rather than \xe2\x80\x9cintention.\xe2\x80\x9d We must confess to some skepticism as to\nwhether such a verbal mutation would be of any practical consequence. We take it\nthat the proper criterion, established by decision here, is one that inquires what the\nbasic reason for his conduct was in fact \xe2\x80\x93 the dominant reason that explains his\naction in making the transfer. Further than that we do not think it profitable to go.\nSecond. The Government\xe2\x80\x99s proposed \xe2\x80\x9ctest,\xe2\x80\x9d while apparently simple and precise\nin its formulation, depends frankly on a set of \xe2\x80\x9cprinciples\xe2\x80\x9d or \xe2\x80\x9cpresumptions\xe2\x80\x9d\nderived from the decided cases, and concededly subject to various exceptions; and\nit involves various corollaries, which add to its detail. Were we to promulgate this\ntest as a matter of law, and accept with it its various presuppositions and stated\nconsequences, we would be passing far beyond the requirements of the cases before\nus, and would be painting on a large canvas with indeed a broad brush. The\nGovernment derives its test from such propositions as the following: that payments\nThe cases including \xe2\x80\x9ctips\xe2\x80\x9d in gross income are classic examples of this. See, e.g., Roberts v.\nCommissioner, 176 F.2d 221.\n48\n\n143\n\n\x0cby an employer to an employee, even though voluntary, ought, by and large, to be\ntaxable; that the concept of a gift is inconsistent with a payment\xe2\x80\x99s being a deductible\nbusiness expense; that a gift involves \xe2\x80\x9cpersonal\xe2\x80\x9d elements; that a business\ncorporation cannot properly make a gift of its assets. The Government admits that\nthere are exceptions and qualifications to these propositions. We think, to the extent\nthey are correct, that these propositions are not principles of law, but rather maxims\nof experience that the tribunals which have tried the facts of cases in this area have\nenunciated in explaining their factual determinations. Some of them simply\nrepresent truisms: it doubtless is, statistically speaking, the exceptional payment by\nan employer to an employee that amounts to a gift. Others are overstatements of\npossible evidentiary inferences relevant to a factual determination on the totality of\ncircumstances in the case: it is doubtless relevant to the over-all inference that the\ntransferor treats a payment as a business deduction, or that the transferor is a\ncorporate entity. But these inferences cannot be stated in absolute terms. Neither\nfactor is a shibboleth. The taxing statute does not make nondeductibility by the\ntransferor a condition on the \xe2\x80\x9cgift\xe2\x80\x9d exclusion; nor does it draw any distinction, in\nterms, between transfers by corporations and individuals, as to the availability of\nthe \xe2\x80\x9cgift\xe2\x80\x9d exclusion to the transferee. The conclusion whether a transfer amounts to\na \xe2\x80\x9cgift\xe2\x80\x9d is one that must be reached on consideration of all the factors.\nSpecifically, the trier of fact must be careful not to allow trial of the issue whether\nthe receipt of a specific payment is a gift to turn into a trial of the tax liability, or of\nthe propriety, as a matter of fiduciary or corporate law, attaching to the conduct of\nsomeone else. The major corollary to the Government\xe2\x80\x99s suggested \xe2\x80\x9ctest\xe2\x80\x9d is that, as\nan ordinary matter, a payment by a corporation cannot be a gift, and, more\nspecifically, there can be no such thing as a \xe2\x80\x9cgift\xe2\x80\x9d made by a corporation which\nwould allow it to take a deduction for an ordinary and necessary business expense.\nAs we have said, we find no basis for such a conclusion in the statute; and if it were\napplied as a determinative rule of \xe2\x80\x9claw,\xe2\x80\x9d it would force the tribunals trying tax cases\ninvolving the donee\xe2\x80\x99s liability into elaborate inquiries into the local law of\ncorporations or into the peripheral deductibility of payments as business expenses.\nThe former issue might make the tax tribunals the most frequent investigators of an\nimportant and difficult issue of the laws of the several States, and the latter inquiry\nwould summon one difficult and delicate problem of federal tax law as an aid to\nthe solution of another. [footnote omitted] Or perhaps there would be required a\ntrial of the vexed issue whether there was a \xe2\x80\x9cconstructive\xe2\x80\x9d distribution of corporate\nproperty, for income tax purposes, to the corporate agents who had sponsored the\ntransfer. [footnote omitted] These considerations, also, reinforce us in our\nconclusion that, while the principles urged by the Government may, in nonabsolute\n144\n\n\x0cform as crystallizations of experience, prove persuasive to the trier of facts in a\nparticular case, neither they nor any more detailed statement than has been made\ncan be laid down as a matter of law.\nThird. Decision of the issue presented in these cases must be based ultimately on\nthe application of the factfinding tribunal\xe2\x80\x99s experience with the mainsprings of\nhuman conduct to the totality of the facts of each case. The nontechnical nature of\nthe statutory standard, the close relationship of it to the date of practical human\nexperience, and the multiplicity of relevant factual elements, with their various\ncombinations, creating the necessity of ascribing the proper force to each, confirm\nus in our conclusion that primary weight in this area must be given to the\nconclusions of the trier of fact. Baker v. Texas & Pacific R. Co., 359 U.S. 227;\nCommissioner v. Heininger, 320 U.S. 467, 475; United States v. Yellow Cab Co.,\n338 U.S. 338, 341; Bogardus v. Commissioner, supra, at 302 U.S. at 45 (dissenting\nopinion). [footnote omitted]\nThis conclusion may not satisfy an academic desire for tidiness, symmetry, and\nprecision in this area, any more than a system based on the determinations of\nvarious factfinders ordinarily does. But we see it as implicit in the present statutory\ntreatment of the exclusion for gifts, and in the variety of forums in which federal\nincome tax cases can be tried. If there is fear of undue uncertainty or overmuch\nlitigation, Congress may make more precise its treatment of the matter by singling\nout certain factors and making them determinative of the matters, as it has done in\none field of the \xe2\x80\x9cgift\xe2\x80\x9d exclusion\xe2\x80\x99s former application, that of prizes and awards.\n[footnote omitted] Doubtless diversity of result will tend to be lessened somewhat,\nsince federal income tax decisions, even those in tribunals of first instance turning\non issues of fact, tend to be reported, and since there may be a natural tendency of\nprofessional triers of fact to follow one another\xe2\x80\x99s determinations, even as to factual\nmatters. But the question here remains basically one of fact, for determination on\na case-by-case basis.\nOne consequence of this is that appellate review of determinations in this field must\nbe quite restricted. Where a jury has tried the matter upon correct instructions, the\nonly inquiry is whether it cannot be said that reasonable men could reach differing\nconclusions on the issue. [citation omitted]. Where the trial has been by a judge\nwithout a jury, the judge\xe2\x80\x99s findings must stand unless \xe2\x80\x9cclearly erroneous.\xe2\x80\x9d Fed.\nRules Civ. Proc. 52(a). ... The rule itself applies also to factual inferences from\nundisputed basic facts citation omitted], as will on many occasions be presented in\nthis area. [citation omitted]. And Congress has, in the most explicit terms, attached\n145\n\n\x0cthe identical weight to the findings of the Tax Court. I.R.C. \xc2\xa7 7482(a). [footnote\nomitted]\nFourth. A majority of the Court is in accord with the principles just outlined. And,\napplying them to the Duberstein case, we are in agreement, on the evidence we\nhave set forth, that it cannot be said that the conclusion of the Tax Court was\n\xe2\x80\x9cclearly erroneous.\xe2\x80\x9d It seems to us plain that, as trier of the facts, it was warranted\nin concluding that, despite the characterization of the transfer of the Cadillac by the\nparties, and the absence of any obligation, even of a moral nature, to make it, it was,\nat bottom, a recompense for Duberstein\xe2\x80\x99s past services, or an inducement for him\nto be of further service in the future. We cannot say with the Court of Appeals that\nsuch a conclusion was \xe2\x80\x9cmere suspicion\xe2\x80\x9d on the Tax Court\xe2\x80\x99s part. To us, it appears\nbased in the sort of informed experience with human affairs that factfinding\ntribunals should bring to this task.\nAs to Stanton, we are in disagreement. To four of us, it is critical here that the\nDistrict Court as trier of fact made only the simple and unelaborated finding that\nthe transfer in question was a \xe2\x80\x9cgift.\xe2\x80\x9d [footnote omitted] To be sure, conciseness is\nto be strived for, and prolixity avoided, in findings; but, to the four of us, there\ncomes a point where findings become so sparse and conclusory as to give no\nrevelation of what the District Court\xe2\x80\x99s concept of the determining facts and legal\nstandard may be. [citation omitted]. Such conclusory, general findings do not\nconstitute compliance with Rule 52\'s direction to \xe2\x80\x9cfind the facts specially and state\nseparately ... conclusions of law thereon.\xe2\x80\x9d While the standard of law in this area is\nnot a complex one, we four think the unelaborated finding of ultimate fact here\ncannot stand as a fulfillment of these requirements. It affords the reviewing court\nnot the semblance of an indication of the legal standard with which the trier of fact\nhas approached his task. For all that appears, the District Court may have viewed\nthe form of the resolution or the simple absence of legal consideration as\nconclusive. While the judgment of the Court of Appeals cannot stand, the four of\nus think there must be further proceedings in the District Court looking toward new\nand adequate findings of fact. In this, we are joined by MR. JUSTICE\nWHITTAKER, who agrees that the findings were inadequate, although he does not\nconcur generally in this opinion.\nAccordingly, in No. 376, the judgment of this Court is that the judgment of the\nCourt of Appeals is reversed, and in No. 546, that the judgment of the Court of\nAppeals is vacated, and the case is remanded to the District Court for further\nproceedings not inconsistent with this opinion.\n146\n\n\x0cIt is so ordered.\nMR. JUSTICE HARLAN concurs in the result in No. 376. In No. 546, he would\naffirm the judgment of the Court of Appeals for the reasons stated by MR. JUSTICE\nFRANKFURTER.\nMR. JUSTICE WHITTAKER, ... concurs only in the result of this opinion.\nMR. JUSTICE DOUGLAS dissents, since he is of the view that, in each of these\ntwo cases, there was a gift ...\nMR. JUSTICE BLACK, concurring and dissenting.\nI agree with the Court that it was not clearly erroneous for the Tax Court to find as\nit did in No. 376 that the automobile transfer to Duberstein was not a gift, and so I\nagree with the Court\xe2\x80\x99s opinion and judgment reversing the judgment of the Court\nof Appeals in that case.\nI dissent in No. 546, Stanton v. United States. ... [T]he Court of Appeals was ...\nwrong in reversing the District Court\xe2\x80\x99s judgment.\nMR. JUSTICE FRANKFURTER, concurring in the judgment in No. 376 and\ndissenting in No. 546.\n....\n... While I agree that experience has shown the futility of attempting to define, by\nlanguage so circumscribing as to make it easily applicable, what constitutes a gift\nfor every situation where the problem may arise, I do think that greater explicitness\nis possible in isolating and emphasizing factors which militate against a gift in\nparticular situations.\n... While we should normally suppose that a payment from father to son was a gift\nunless the contrary is shown, in the two situations now before us, the business\nimplications are so forceful that I would apply a presumptive rule placing the\nburden upon the beneficiary to prove the payment wholly unrelated to his services\nto the enterprise. The Court, however, has declined so to analyze the problem, and\nhas concluded\n147\n\n\x0c\xe2\x80\x9cthat the governing principles are necessarily general, and [...] that the\nproblem is one which, under the present statutory framework, does not lend\nitself to any more definitive statement that would produce a talisman for the\nsolution of concrete cases.\xe2\x80\x9d\n....\n... What the Court now does sets factfinding bodies to sail on an illimitable ocean\nof individual beliefs and experiences. This can hardly fail to invite, if indeed not\nencourage, too individualized diversities in the administration of the income tax\nlaw. I am afraid that, by these new phrasings, the practicalities of tax administration,\nwhich should be as uniform as is possible in so vast a country as ours, will be\nembarrassed. ... I agree with the Court in reversing the judgment in Commissioner\nv. Duberstein.\nBut I would affirm the decision of the Court of Appeals for the Second Circuit in\nStanton v. United States. ... The business nature of the payment is confirmed by the\nwords of the resolution, explaining the \xe2\x80\x9cgratuity\xe2\x80\x9d as\n\xe2\x80\x9cin appreciation of the services rendered by Mr. Stanton as Manager of the\nEstate and Comptroller of the Corporation of Trinity Church throughout\nnearly ten years, and as President of Trinity Operating Company, Inc.\xe2\x80\x9d\n\xe2\x80\xa6\nNotes and Questions:\n1. On remand of the Stanton case, the federal district court reexamined the evidence\nand determined that the Vestry was motivated by gratitude to a friend, good will,\nesteem, and kindliness. Hence the payment was a gift. Stanton v. U.S., 186 F. Supp.\n393, 396-97 (E.D.N.Y. 1963). The court of appeals affirmed because the\ndetermination of the federal district court was not clearly erroneous. U.S. v. Stanton,\n287 F.2d 876, 877 (2d Cir. 1961).\n2. The Supreme Court stated:\nA gift in the statutory sense ... proceeds from a \xe2\x80\x9cdetached and disinterested\ngenerosity\xe2\x80\x9d [citation omitted], \xe2\x80\x9cout of affection, respect, admiration, charity\nor like impulses.\xe2\x80\x9d [citation omitted]. And in this regard, the most critical\n148\n\n\x0cconsideration ... is the transferor\xe2\x80\x99s \xe2\x80\x9cintention.\xe2\x80\x9d [citation omitted].\nDo people give gifts because they are detached and disinterested \xe2\x80\x93 or very attached\nand intensely interested?\n3. The donee is the one who will invoke \xc2\xa7 102. How is the donee to prove the\ndonor\xe2\x80\x99s intent? Consider:\n\xe2\x80\xa2Taxpayer first joined a bakery workers\xe2\x80\x99 union in 1922 and gradually rose\nthrough the ranks. In 1947, he was elected international vice president. He\nwas an effective leader and instrumental in the merger of several locals into\none large local. Other officials of the local decided to give him and his wife\na testimonial dinner at which the local would present him with sufficient\nfunds to purchase a home. Taxpayer had nothing to do with planning the\ndinner and objected to it. The local raised money by selling insertions in a\nspecial souvenir journal. More than 1300 persons attended the dinner. There\nwere six groups who contributed journal insertions:\n\xe2\x80\xa2Employers of bakery workers who wanted to stay on good terms\nwith the local made deductible payments from their business\naccounts. Many employers had known taxpayer for many years and\nwere on good terms with him. Most of this group\xe2\x80\x99s journal insertions\nincluded a greeting such as \xe2\x80\x9ccongratulations\xe2\x80\x9d and \xe2\x80\x9cbest wishes.\xe2\x80\x9d\n\xe2\x80\xa2Employer trade associations made payments from assessments on\nemployers, who in turn deducted payments that they made from\ntheir business accounts.\n\xe2\x80\xa2Businesses who sold supplies to the baking industry and treated\npayments for journal insertions as deductible advertising expenses.\n\xe2\x80\xa2Other union locals who made payments from funds accumulated\nfrom dues that they collected from members.\n\xe2\x80\xa2Lawyers and doctors who knew taxpayer personally and were in\nsome manner associated with union activity in the baking industry.\nSome of these persons deducted their expenditure.\n\xe2\x80\xa2Employees and other individuals, many of whom purchased dinner\ntickets but only a few of whom purchased journal insertions. Many\nin this group felt friendship, admiration, affection, and respect for\ntaxpayer.\nTaxpayers (husband and wife) received nearly $61,000 from these\ncontributions in 1956 and claimed that the amount was excludable as a gift.\n\xe2\x80\xa2What issues do these facts raise after Duberstein? Doesn\xe2\x80\x99t the\nopinion of Duberstein create some quite predictable problems?\n149\n\n\x0c\xe2\x80\xa2If you represented taxpayer or the IRS, how would you undertake\nto address them? See Kralstein v. Commissioner, 38 T.C. 810\n(1962), acq. 1963-2 C.B. 3 (1963).\n4. A recurring fact pattern raises the question of whether \xe2\x80\x9cgifts\xe2\x80\x9d that a pastor\nreceives from congregants are indeed gifts. Congregations\xe2\x80\x99 governing bodies may\ndevelop the capacity to track donors\xe2\x80\x99 desire (and/or mere willingness) to make nondeductible gifts to their pastor. e.g., special envelopes for contributions intended to\nbe gifts. This is not equivalent to objective evidence of an intent to make a gift. The\nTax Court has recently developed a 4-factor test for such cases: \xe2\x80\x9c[1] whether the\ndonations are objectively provided in exchange for services; [2] whether the cleric\n(or other church authorities) requested personal donations; [3] whether the\ndonations were part of a routinized, highly structured program, and given by\nindividual church members or the congregation as a whole; and [4] whether the\ncleric receives a separate salary from the church and the amount of that salary in\ncomparison to the personal donations.\xe2\x80\x9d Felton v. Commissioner, T.C. Memo. 2018168, 116 T.C.M. (CCH) 365 (2018) (factors weighed in favor of salary rather than\ngifts); see Brown v. Commissioner, T.C. Memo. 2019-69, 117 T.C.M. (CCH) 1339\n(2019) (same).\n5. Does Justice Frankfurter have a point when he said:\nWhat the Court now does sets fact-finding bodies to sail on an illimitable\nocean of individual beliefs and experiences. This can hardly fail to invite, if\nindeed not encourage, too individualized diversities in the administration of\nthe income tax law.\nThe Court combined two cases. How many possible outcomes for the two taxpayers\nwere there? How many of them were espoused by at least one judge?\n\xe2\x80\xa2No justice voted for Duberstein to win and Stanton to lose.\n\xe2\x80\xa2Isn\xe2\x80\x99t the disparity of views pretty good evidence that Justice Frankfurter\nwas absolutely right?\n6. A business culture developed until the 1950s of giving very substantial business\ngifts in settings such as these. When the marginal tax bracket of the donor is very\nhigh, e.g., 70% and maybe higher, the cost of making a very substantial gift is quite\nlow if its donor may deduct its cost. For example, if the donor\xe2\x80\x99s marginal tax\nbracket is 70%, the actual cost to the donor of making a deductible gift is only 30%\nof its price. Is it possible that Berman felt that if his gift was not sufficiently\n150\n\n\x0cgenerous, Duberstein might pitch some of that business to others?\n7. Subsequent to Duberstein, Congress added \xc2\xa7 102(c)(1) and \xc2\xa7 274(b)(1) to the\nCode. Read these sections.\n\xe2\x80\xa2Would \xc2\xa7 102(c)(1) change the result of either Duberstein or Stanton?\n\xe2\x80\xa2Would \xc2\xa7 274(b)(1) change the result of either Duberstein or Stanton?\n8. Notice: \xc2\xa7\xc2\xa7 261 to 280H do not themselves establish deduction rules, but rather\nlimit deductions that other Code sections might provide when the expenditure is for\ncertain items or purposes.\n\xe2\x80\xa2In the case of gifts, \xc2\xa7 274(b) limits the deductibility of a gift(s) given to\none individual to a total of $25 if its cost is deducted under \xc2\xa7 162 (trade or\nbusiness expenses) or \xc2\xa7 212 (expenses of producing or collecting profit or\nmanaging property held to produce income).\n\xe2\x80\xa2In Duberstein, \xc2\xa7 274(b) would have limited Mohawk Corporation\xe2\x80\x99s \xc2\xa7 162\ndeduction to $25. If Mohawk had nevertheless purchased a Cadillac for\nDuberstein, Mohawk would have paid income tax on the cost of the gift (less\n$25). Mohawk would essentially have been a surrogate taxpayer for\nDuberstein\xe2\x80\x99s accession to wealth.\n\xe2\x80\xa2Do you think that this cuts back on the number of Cadillacs given\nas business gifts?\n\xe2\x80\xa2No matter what the merits of cases, isn\xe2\x80\x99t litigation of business gift\nissues likely to be much less frequent because of \xc2\xa7 274(b)(1)?\n\xe2\x80\xa2Is the congressional reaction to Duberstein better than the position\nthat the Commissioner argued for in the case? Of course, the\ncongressional solution was not one that the Commissioner would be\nin a position to advocate.\n\xe2\x80\xa2The congressional solution leaves the remainder of the Duberstein\nanalysis intact.\n9. Section 102\'s exclusion also extends to bequests. Section 102(b)(2) provides that\nincome from gifted property is not excluded from a taxpayer\xe2\x80\x99s gross income. In\nIrwin v. Gavit, 268 U.S. 161 (1925), the Supreme Court held that the gift exclusion\nextended to the gift of the corpus of a trust, but not to the income from it. Id. at 167.\nAn income beneficiary for life must pay income tax on that income; the\nremainderman does not pay income tax on the property.\n\xe2\x80\xa2Notice that the value of a remainderman\xe2\x80\x99s interest is less than the fmv of\nthe property itself because she will not acquire it until the income\nbeneficiary dies.\n151\n\n\x0c\xe2\x80\xa2If the donor had simply given the corpus outright without subjecting it to a\nlife estate, the value of the exclusion would have been more. Where did this\nloss in value disappear to? Shouldn\xe2\x80\x99t someone benefit from it?\n\xe2\x80\xa2Might these points ever be important in matters of estate planning? How\nso?\n10. Taxpayer was an attorney who entered into a contract with a client whereby he\nagreed to provide whatever legal services she should require for the remainder of\nher life without billing her. The client agreed to bequeath to taxpayer certain stock.\nEventually the client died, and taxpayer received the stock. Taxpayer argued that\nthe fmv of the stock should be excluded from his gross income under \xc2\xa7 102(a).\n\xe2\x80\xa2Do you agree? See Wolder v. Commissioner, 493 F.2d 608 (2d Cir.), cert.\ndenied, 419 U.S. 828 (1974).\n11. Read \xc2\xa7\xc2\xa7 74 and 274(j) carefully. Notice how the scope of the rule of \xc2\xa7 74(a) is\ndelineated by \xe2\x80\x9cexceptions\xe2\x80\x9d stated in \xc2\xa7 74 (b, c, and d). The \xe2\x80\x9cexception\xe2\x80\x9d of \xc2\xa7 74(c)\nis further refined by examining limitations and definitions of terms applicable to\nemployer deductions in \xc2\xa7 274(j).\n\xe2\x80\xa2Congress frequently articulates precise tax rules through the statement of a\nbroad rule followed by specific exceptions and definitions.\n\xe2\x80\xa2When you see the word \xe2\x80\x9cqualified\xe2\x80\x9d in a Code section, e.g., \xe2\x80\x9cqualified plan\naward,\xe2\x80\x9d look for a definition of the phrase.\nDo the CALI Lesson, Basic Income Taxation: Gross Income: Gifts, Bequests,\nPrizes, and Donative Cancellations of Indebtedness.\n12. Recall from chapter 1: The Essence of Basis: Adjusted basis represents money\nthat will not again be subject to income tax, usually because it is what remains after\ntaxpayer already paid income tax on a greater sum of money. More pithily: basis is\n\xe2\x80\x9cmoney that has already been taxed\xe2\x80\x9d (and so can\xe2\x80\x99t be taxed again).\n\xe2\x80\xa2Section 1015 states a special rule governing a donee\xe2\x80\x99s basis in property\nthat she acquired by gift. Read the first sentence of \xc2\xa7 1015(a). What rule(s)\ndoes it state?\n13. Consider this hypothetical posed by the Supreme Court in Taft v. Bowers, 278\nU.S. 470 (1929), where the Court held that the Code\xe2\x80\x99s adjusted basis rules\napplicable to gifts are constitutional:\n152\n\n\x0c\xe2\x80\x9cIn 1916, A purchased 100 shares of stock for $1000, which he held until 1923,\nwhen their fair market value had become $2000. He then gave them to B, who sold\nthem during the year 1923 for $5000.\xe2\x80\x9d\n\xe2\x80\xa2(i) On how much gain must B pay income tax in 1923? See \xc2\xa7 1015(a).\n\xe2\x80\xa2(ii) Suppose that A had purchased the shares for $5000 and gave them to B in 1923\nwhen their fmv was $2000. B sold the shares later in 1923 for $1000. How much\nloss may B claim on her income tax return for 1923?\n\xe2\x80\xa2(iii) Suppose that A had purchased the shares for $2000 and gave them to B when\ntheir fmv was $1000. B sold the shares in 1923 for $1500. How much gain or loss\nmust B claim on her income tax return?\n\xe2\x80\xa2(iv) Suppose that A had purchased the shares for $2000 and gave them to B when\ntheir fmv was $1000. B sold them in\n1923 for $5000. On how much gain\nMixing taxes to increase basis: When we say\nmust B pay income tax in 1923?\nthat \xe2\x80\x9cbasis is money that has already been\ntaxed (and so can\xe2\x80\x99t be taxed again),\xe2\x80\x9d we\n\xe2\x80\xa2(v) Suppose that A had purchased\nare referring to the federal income tax. The\nthe shares for $2000 and gave them\nfederal estate and gift taxes are not in pari\nto B when their fmv was $3000. B\nmateria with the federal income tax. Hence,\nsold them in 1923 for $1000. How\npayment of federal estate or gift tax does\nmuch loss may B claim on her\nnot affect liability for federal income tax,\nincome tax return?\nand vice versa. It follows that payment of\nfederal estate or gift taxes should not affect\n14. The federal estate and gift taxes\na taxpayer\xe2\x80\x99s income tax basis in her\nare in pari materia with each other.\nproperty. However, \xc2\xa7 1015(d) makes an\nThe federal income tax is not in pari\nexception to this (quite logical) rule. Read\nmateria with the federal estate and\n\xc2\xa7 1015(d)(1 and 6). What rule(s) does this\ngift taxes.\nprovision state?\n\xe2\x80\xa2What does this mean?\n15. Now consider the effect of \xc2\xa7 1015(d)(1 and 6). Assume that the gift tax on any\ngift is 20% of the fmv of the gift. Assume also that the gift was made in 2021. How\ndoes this change your answers to the first question immediately above?\n\n153\n\n\x0c16. What should be the basis rules when property is acquired partly by gift and\npartly by sale, i.e., when donee pays less than the property\xe2\x80\x99s fmv? See Reg.\n\xc2\xa7 1.1015-4.\n17. What should be the basis rules when property is acquired from a decedent?\nRead \xc2\xa7 1014. Identify the major\nTax Cuts and Jobs Act: The Tax Cuts and Jobs loophole that the statute creates.\nAct limited the debt for which home \xe2\x80\xa2What problem does \xc2\xa7 1014(e)\nmortgage interest is deductible for 2018 to address?\n2025. These limits are lower than they had \xe2\x80\xa2When taxpayer\xe2\x80\x99s basis in property\nbeen. In 2026, the limit on the mortgage is determined under \xc2\xa7 1014, she is\ninterest deduction will again be interest on presumed to have held the property\nup\nto\n$1,000,000\nof\nacquisition for more than one year, \xc2\xa7 1223(9), a\nindebtedness and interest on up to $100,000 matter important to the computation\nof home equity indebtedness.\nof taxpayer\xe2\x80\x99s tax liability. See\nchapter 10, infra.\nThe Tax Cuts and Jobs Act provides for a\nsimilar seven-year suspension of unlimited\ndeductibility of property taxes plus state\nDo the CALI Lesson, Basic Federal\nand local income taxes or sales and local\nTaxation:\nProperty\nsales taxes. There is an overall limit of Income\n$10,000 on the aggregate of all these Transactions: Computation of Gain\ntaxes. \xc2\xa7 164(b)(6)(B). Foreign real property and Loss Realized.\ntaxes are not deductible during the same \xe2\x80\xa2This exercise brings together\nseveral principles you should have\nseven-year period. \xc2\xa7 164(b)(6)(A).\nlearned.\nThe Tax Cuts and Jobs Act doubled the\namount of the standard deduction. Doubling\nthe standard deduction and limiting B. Exclusion of Gain from Sale of\ndeductions for some of the more significant Principal Residence: \xc2\xa7 121\ndeductions for homeowners will inhibit pursuit\nof the goal of an \xe2\x80\x9cownership society.\xe2\x80\x9d\nPresident George Bush II\nannounced early in his presidency\nIn a politically-charged environment, it was that he wanted America to be an\nnot lost on politicians that coastal \xe2\x80\x9cblue\xe2\x80\x9d \xe2\x80\x9cownership society.\xe2\x80\x9d How would\nstates are typically home to high-cost houses (does) widespread taxpayer\nand high state and local taxes. Are the ownership of private homes make\nTCJA\xe2\x80\x99s limits on deductions simply a matter of\nAmerica a better place? We have\n\xe2\x80\x9cpolitics?\xe2\x80\x9d\nalready examined imputed income\nderived from ownership of\n154\n\n\x0cproperty \xe2\x80\x93 a significant matter when it comes to a taxpayer\xe2\x80\x99s principal residence.\n\xe2\x80\xa2Read \xc2\xa7 121.\n\xe2\x80\xa2What is the rule of \xc2\xa7 121(a)?\n\xe2\x80\xa2Does \xc2\xa7 121 promote an \xe2\x80\x9cownership society\xe2\x80\x9d \xe2\x80\x93 or something else?\nDon\xe2\x80\x99t forget that \xe2\x80\x93\n\xe2\x80\xa2\xc2\xa7 163(h) permits deduction of mortgage interest on up to\n$750,000.\n\xe2\x80\xa2\xc2\xa7 164(a)(1) permits a deduction for state and local real\nproperty taxes. The deduction for these taxes plus state and\nlocal income or sales taxes is subject to an aggregate limit of\n$10,000.\n\xe2\x80\xa2Notice that \xc2\xa7 121(b)(5) and \xc2\xa7 121(c) employ pro-rating ratios so that at\nleast some taxpayers who fail to meet all the requirements of \xc2\xa7 121(a) and\n\xc2\xa7 121(b)(3) can derive some benefit from home ownership. Are the ratios\nwhat you expect them to be?\nDo the CALI Lesson, Basic Federal Income Taxation: Property Transactions:\nExclusion of Gain on the Sale of a Principal Residence.\n\xe2\x80\xa2Notice: \xe2\x80\x9cownership\xe2\x80\x9d and \xe2\x80\x9cuse\xe2\x80\x9d are different concepts.\nC. Interest on State and Local Bonds: \xc2\xa7 103\nRead \xc2\xa7\xc2\xa7 103 and 141.\nInterest derived from a state or local bond is excluded from a taxpayer\xe2\x80\x99s gross\nincome. \xc2\xa7 103(a). This exclusion does not extend to interest derived from some\n\xe2\x80\x9cprivate activity bonds,\xe2\x80\x9d \xc2\xa7 103(b)(1), \xe2\x80\x9carbitrage bonds,\xe2\x80\x9d \xc2\xa7 103(b)(2), or bonds not\nin registered form, \xc2\xa7 103(b)(3). This provision has always been a part of the Code\nbecause it was not always clear that Congress has the constitutional power to tax\nsuch income.\nIt might appear that \xc2\xa7 103 would encourage investors to choose to purchase the\nbonds of state and local governments. After all, the interest income that such bonds\ngenerate is not subject to tax, whereas other investment income is subject to federal\n155\n\n\x0cincome tax. The investor should be able to keep more of her income. However, both\nborrowers (state and local governments) and investors know that the interest on\nsuch bonds is not subject to federal income tax. Hence, state and local governments\ncan borrow money at less than prevailing interest rates, i.e., the rate that any other\nborrower would have to pay. If the market \xe2\x80\x9cbids down\xe2\x80\x9d the interest rate to the point\nthat taxpayers in the highest tax bracket (37% until 2026, 39.6% after 2025) are no\nbetter off than they would be if they had purchased a corporate bond carrying\nequivalent risk and paid the income tax on the interest that they receive, the\nexclusion would function \xe2\x80\x9conly\xe2\x80\x9d as a means by which the U.S. Treasury transfers\nthe tax revenue that it must forego to state and local governments. There are some\n(potential) economic distortions that this exclusion causes:\n\xe2\x80\xa2If there are enough taxpayers in the highest tax bracket to \xe2\x80\x9cclear the\nmarket\xe2\x80\x9d for state and local bonds, the interest rate on such bonds should\ngravitate to (1 \xe2\x88\x92 \xce\xbb)*(prevailing interest on corporate bonds), where \xce\xbb\ndenotes the highest marginal tax rate. If this is the case, all the tax that the\nU.S. Treasury foregoes is transferred to state and local governments.\n\xe2\x80\xa2But if there are not enough taxpayers in the highest tax bracket to \xe2\x80\x9cclear the\nmarket\xe2\x80\x9d for state and local bonds, state and local governments must offer\nan interest rate higher than (1 \xe2\x88\x92 \xce\xbb)*(prevailing interest on corporate bonds).\nPerhaps it will be necessary to entice some taxpayers in the second-tohighest or even third-to-highest bracket to purchase such bonds. The effect\nof this is to give taxpayers in the highest tax bracket a windfall, i.e., an aftertax return on state and local bonds that is higher than the after-tax return on\ncorporate bonds. In this case, not all the foregone tax revenue is transferred\nfrom the U.S. Treasury to state and local governments; some of it is\ntransferred to taxpayers in the highest tax bracket.\n\xe2\x80\xa2How will this affect the market for corporate bonds?\n\xe2\x80\xa2In effect, those who invest in state and local bonds have the power to \xe2\x80\x9cvote\xe2\x80\x9d\nto have some of their tax dollars go to state and local governments rather\nthan to the federal government. Most of the (rational) voters will have high\nincomes.\n\xe2\x80\xa2There is no limit to the amount of interest that a taxpayer may exclude\nunder this provision.49 Hence state and local governments may be\nencouraged to borrow more than they otherwise would. The laws of some\nHowever, such interest might be a \xe2\x80\x9ctax preference\xe2\x80\x9d item, \xc2\xa7 57(a)(5) (private activity bonds), and so\nsubject to the AMT. \xc2\xa7 55(b)(2)(B).\n49\n\n156\n\n\x0cstates limit the amount that they can borrow.\n\xe2\x80\xa2State and local governments may elect to finance \xe2\x80\x9ctoo many\xe2\x80\x9d capital\nprojects \xe2\x80\x93 e.g., highways, schools, government buildings \xe2\x80\x93 by issuing\nbonds, as opposed either to foregoing such expenditures or procuring\nnecessary funds in another manner, e.g., raising taxes.\nD. Scholarships: \xc2\xa7 117\nRead \xc2\xa7 117.\nWhat justification do you see for the exclusion(s) provided by \xc2\xa7 117? Some of you\nreceive scholarship assistance on which you pay no federal income tax. Others do\nnot receive such assistance and must work to be here. The wages that such students\nearn are subject to federal income tax.\nProblem:\nMoldaur is the son of a professor at the Mega State University. Moldaur has\nenrolled at Mega State University. Tuition is $20,000 at Mega State University.\nMoldaur is entitled to a 50% reduction in his tuition because he is the son of a\nprofessor. In addition, Moldaur qualified for a Hoffnung Scholarship under the\nstate\xe2\x80\x99s lottery-to-education scholarship program. The state collects lottery revenues\nand divides them equally among those who qualify for scholarships. This year, each\nscholarship recipient was credited with $14,000 towards tuition. The result for\nMoldaur is that he had a $4000 account surplus, which the university refunded to\nhim.\n\xe2\x80\xa2Tax consequences to Moldaur? Read \xc2\xa7 117(b)(1) and Prop. Reg. \xc2\xa7 1.1176(c)(1) carefully.\n\xe2\x80\xa2Tax consequences to Moldaur\xe2\x80\x99s father? Read \xc2\xa7 117(d) carefully.\nDo the CALI Lesson, Basic Federal Income Taxation: Gross Income: Scholarships.\nE. Rental Value of Parsonages: \xc2\xa7 107\nRead \xc2\xa7\xc2\xa7 107 and 265.\nA \xe2\x80\x9cminister of the gospel\xe2\x80\x9d may exclude the housing allowance that a congregation\n157\n\n\x0cpays to her. Such a taxpayer may spend some of this allowance on home mortgage\ninterest (deductible under \xc2\xa7 163(h)) or real estate taxes (deductible under\n\xc2\xa7 164(a)(1)). Explain how this is a double dip. How might a congregation, as payor\nof this allowance, capture some or all the benefit of the exclusion? The United\nStates Court of Appeals for the Seventh Circuit recently held that \xc2\xa7 107 does not\nviolate the Establishment Clause of the First Amendment. See Gaylor v. Mnuchin,\n919 F.3d 420, 437 (7th Cir. 2019).\n\nII. Social Benefits\nThe Code excludes from gross income payments for various benefits or the fmv of\nbenefits taxpayer receives in kind. Who should administer government benefit\nprograms, e.g., benefits for workplace injury? Who administers benefit \xe2\x80\x9cprograms\xe2\x80\x9d\nwhen they are the product of exclusions from gross income?\nA. Life Insurance Death Benefits, \xc2\xa7 101, and Annuities, \xc2\xa7 72\nSection 101(a)(1) excludes\nA bit about insurance. The basic idea of insurance, of\nfrom\ngross\nincome\ncourse, is that individual persons purchase a policy\n\xe2\x80\x9camounts received (whether\nthat promises payment upon materialization of a\nin a single sum or\nspecified risk. The policy is effective for a certain\notherwise) under a life\nperiod, e.g., one year. The insurance company pools\ninsurance contract, if such\nthe premiums, and pays those for whom the risk\namounts are paid by reason\nmaterializes. Notice that policy-holders pay their\nof the death of the insured.\xe2\x80\x9d\npremiums from after-tax money. Cf. \xc2\xa7 264(a)(1) (no\nThis provision has always\ndeduction for taxpayer-beneficiary for payment of\nbeen a part of the Code, and\npremiums). We could treat the \xe2\x80\x9cwinner\xe2\x80\x9d as if she has\nthe desire to avoid taxing\nsimply received a gift from those who contributed to\nheirs has made repeal\nthe pool of money. Under such a rationale, the\ndifficult. Many people\nproceeds would be excluded from gross income by\npurchase life insurance so\n\xc2\xa7 102.\nthat family members will\nreceive money at a time\nwhen they no longer have the income of the deceased insured. It could be unseemly\nto tax a grieving family under such circumstances. However:\n\xe2\x80\xa2\xe2\x80\x9cIf any amount excluded from gross income ... is held under an agreement\nto pay interest thereon, the interest payments shall be included in gross\n158\n\n\x0cincome.\xe2\x80\x9d \xc2\xa7 101(c).\n\xe2\x80\xa2If life insurance proceeds are paid otherwise than as a lump sum, a portion\nof each payment is allocated pro rata to the amount excluded and the\nremaining return on investment is subject to income tax. \xc2\xa7 101(d)(1).\nConsider: H purchased a life insurance policy on his life with a face amount of\n$200,000 and named W as the beneficiary. H died. W and the insurance company\nentered an agreement whereby the insurance company would hold $200,000 and\npay her $250,000 in five years; W would have no claim of right to the funds during\nthat time. At that time, instead of paying W $250,000, the insurance company will\npay W $28,000 per year at a time when her life expectancy will be ten years.\n\xe2\x80\xa2How would the payments to\nW be taxed during the first\nA note about life insurance. Life insurance comes in\nfive years after H\xe2\x80\x99s death,\nvarious forms, and tax benefits can extend well beyond\nassuming W had no claim of\nexcluding death benefits from gross income. \xe2\x80\x9cLife\nright during that time?\ninsurance contract\xe2\x80\x9d is defined in \xc2\xa7 7702 so as to\n\xe2\x80\xa2How would the payments to\npreclude an investment from being a \xe2\x80\x9clife insurance\nW during the succeeding ten\ncontract.\xe2\x80\x9d To be insurance, there must be a shifting of\nyears be taxed?\nrisk from the insured to the insurer.\n\xe2\x80\xa2See \xc2\xa7\xc2\xa7 101(c and d); Reg.\n\xe2\x80\xa2Term insurance is insurance that promises only for the\n\xc2\xa7 1.101-3(a); Reg. \xc2\xa7 1.101term for which it is purchased to pay upon the\n4(c); Reg. \xc2\xa7 1.101-4(a)(1)(i);\noccurrence of death. Upon expiration of the term, the\nReg. \xc2\xa7 1.101-4(g) (Examples\npolicyholder has nothing.\n1 and 3 (first two sentences\n\xe2\x80\xa2Permanent life insurance is life insurance that the\nonly)50).\ninsured maintains by paying a premium periodically.\n\xe2\x80\xa2The last provision might not\nPremiums for permanent life insurance are higher than\nbe in your edition of the\nthey are for term insurance; the insurance company\nRegulations. Go to Westlaw\ninvests the excess on behalf of the insured. The policy\nbuilds up cash value (\xe2\x80\x9cinside buildup\xe2\x80\x9d) \xe2\x80\x93 tax-free. Inside\nor Lexis to find it.\nbuildup can reduce premiums in future years, notably\nas premiums would otherwise increase because the\nSection 101(a)(2) provides\ninsured is older and the risk of her death higher.\nthat in the case of a transfer\n\xe2\x80\xa2Non-taxation of inside buildup permits permanent life\nof a life insurance contract\ninsurance to function as a tax shelter.\nfor valuable consideration,\nthe exclusion is lost. The\nbeneficiary in such a case\nSection 101(d)(1)(B) (repealed) provided a $1000 exclusion from gross income for a surviving spouse\nbeneficiary in addition to the exclusion provided by pro-rating a payment between recovery of basis\nand taxable income. This $1000 additional exclusion has been repealed, but the regulations still\nincorporate it.\n50\n\n159\n\n\x0cmay exclude only the amount she paid for the policy plus any subsequent premiums\nthat she paid.\n\xe2\x80\xa2An exception to this exception is made when the transferee takes for her\nbasis the basis of the transferor. \xc2\xa7 101(a)(2)(A).\n\xe2\x80\xa2When might a transferee take for her basis the basis of the transferor?\n\xe2\x80\xa2Another exception to the exception is made when the transfer is to the\ninsured, a partner of the insured, a partnership in which the insured is a\npartner, or a corporation in which the insured is a shareholder or officer.\n\xc2\xa7 101(a)(2)(B).\n\xe2\x80\xa2When (why) would transfers such as those described in \xc2\xa7 101(a)(2)(B)\noccur?\nH purchased a permanent life insurance policy on his life with a face amount of\n$300,000. He named W as the beneficiary. When H was 63 years old, and H and\nW\xe2\x80\x99s children no longer depended on them for support, W died. H saw no need to\ncontinue making premium payments so he sold the policy to his employer for\n$100,000.\n\xe2\x80\xa2How would you compute H\xe2\x80\x99s gross income from this sale?\n\xe2\x80\xa2How would you compute H\xe2\x80\x99s gross income if instead H surrendered the\npolicy to the insurance company for its cash value of $100,000?\n\xe2\x80\xa2Are there additional facts that you would need to know?\n\xe2\x80\xa2Read on.\nIn Rev. Rul. 2009-13, 2009-21 I.R.B. 1029, the IRS took the position that a policy\nholder who surrendered a life insurance policy (Situation 1) should recognize as\nordinary income gain equal to the cash surrender value received less the total of all\npremiums previously paid. The cash surrender value reflected cost-of-insurance\ncharges. In contrast, a policy holder who sold a life insurance policy to an unrelated\nperson (Situation 2) should reduce his basis by the cost-of-insurance and compute\ngain accordingly. Gain equal to inside buildup was subject to income tax as\nordinary income; gain in excess of inside buildup was taxed as capital gain.\n\xe2\x80\xa2In the case of surrender of a life insurance policy, inside buildup that had\npaid at least some of the premiums was not subject to tax. In the case of a\nsale of an insurance policy, inside buildup had paid at least some of the\npremiums was subject to tax.51\nApplication of the rules for the commercial sale of a life insurance policy require access to\ninformation not always readily available. The Tax Cuts and Jobs Act added \xc2\xa7 101(a)(3). Section\n101(a)(3) defines a \xe2\x80\x9creportable policy sale\xe2\x80\x9d to be an acquisition of an interest in a life insurance policy\nwhen the acquirer has no family, business, or financial interest with the insured other than an interest\n51\n\n160\n\n\x0c\xe2\x80\xa2The Tax Cuts and Jobs Act (2017) amended \xc2\xa7 1016 to provide that no\nadjustment to the basis of an annuity or life insurance contract is to be made\n\xe2\x80\x9cfor mortality, expense, or other reasonable charges incurred[.]\xe2\x80\x9d\n1016(a)(1)(B).\n\xe2\x80\xa2How does this amendment of \xc2\xa7 1016 change the outcomes of Situations 1\nand 2 of Rev. Rul. 2009-13?\nNotes and Questions:\n1. In Situation 2, assume that the face amount of the policy was $400,000. B paid\n$80,000 for the policy plus another $500 per month in premiums for another six\nyears. A died. B received $400,000 from the life insurance company. How much\nmust B include in her gross income?\n2. Section 72 provides another opportunity to read a Code section replete with\nrules, exceptions, and definitions. The following paragraphs explain these rules,\nexceptions, and definitions. You must learn to read Code provisions for yourself.\n3. Section 72 governs the tax treatment of payouts from an annuity contract.\nSection 72(a)(1) provides that gross income includes \xe2\x80\x9cany amount received as an\nannuity ... under an annuity, endowment, or life insurance contract.\xe2\x80\x9d\n\xe2\x80\xa2Thus, annuity treatment can only apply to payments made under the named\ntype of contracts.\n\xe2\x80\xa2A taxpayer may invest after-tax dollars in an annuity contract. As with life\ninsurance contracts, the inside buildup of an annuity contract is not subject\nto income tax. At a certain point in time, the taxpayer begins to receive a\nstream of payments from the investment and the income that the annuity has\naccumulated.\n\xe2\x80\xa2You should see immediately that taxpayer will be receiving some of her\nown after-tax money and some not-yet-taxed investment income.\n\xe2\x80\xa2There may be a fixed number of payments or the stream of payments may\nterminate only on the death of the taxpayer. Section 72 allocates a portion\nin the life insurance policy. Every person who acquires such an interest in a life insurance policy must\nreport it to the IRS and to all persons, including the issuer, named in such notice. \xc2\xa7 6050Y(a). The\nissuer of the policy is to notify the IRS and the seller(s) of the amount of investment in the insurance\ncontract. \xc2\xa7 6050Y(b). Payment of death benefits triggers a reporting requirement on the part of the\npayor of the gross amount of payments and an estimate of the buyer\xe2\x80\x99s investment in the contract. \xc2\xa7\n6050Y(c).\n\n161\n\n\x0cof each payment to taxpayer\xe2\x80\x99s recovery of basis and a portion to not-yettaxed inside buildup.\n\xe2\x80\xa2Section 72(c)(1) defines taxpayer\xe2\x80\x99s \xe2\x80\x9cinvestment in the contract.\xe2\x80\x9d\n\xe2\x80\xa2Section 72(c)(4) defines \xe2\x80\x9cannuity starting date\xe2\x80\x9d as \xe2\x80\x9cthe first day of the first\nperiod for which an amount is received as an annuity under the contract[.]\xe2\x80\x9d\n\xe2\x80\xa2Section 72(a)(1) provides that taxpayer must include in gross income \xe2\x80\x9cany\namount received as an annuity[.]\xe2\x80\x9d\n\xe2\x80\xa2Section 72(b)(1) excepts from \xe2\x80\x9camounts received as an annuity\xe2\x80\x9d a prorated amount of taxpayer\xe2\x80\x99s basis in the contract. This requires a\ndetermination of taxpayer\xe2\x80\x99s \xe2\x80\x9cexpected return under the contract.\xe2\x80\x9d\n\xe2\x80\xa2If the \xe2\x80\x9cexpected return\xe2\x80\x9d depends on the life expectancy of one or more\nindividuals, taxpayer determines the \xe2\x80\x9cexpected return\xe2\x80\x9d in accordance with\nactuarial tables that the Secretary of the Treasury has prescribed. These\ntables are in the regulations, see Reg. \xc2\xa7 1.72-9.\n\xe2\x80\xa2Simply multiply the number of payments taxpayer can expect based\non these actuarial tables by the amount of each payment. This\nproduct is the \xe2\x80\x9cexpected return.\xe2\x80\x9d\n\xe2\x80\xa2Divide the taxpayer\xe2\x80\x99s investment in the contract by the \xe2\x80\x9cexpected\nreturn.\xe2\x80\x9d \xc2\xa7 72(b)(1). Taxpayer multiplies this quotient by \xe2\x80\x9cany\namount received as an annuity\xe2\x80\x9d to determine the amount that she\nexcludes from gross income. Id.\n\xe2\x80\xa2If taxpayer outlives what the actuaries predicted ...: Once taxpayer has\nexcluded her investment in the annuity contract from her gross income,\ntaxpayer may no longer exclude any \xe2\x80\x9camount received as an annuity\xe2\x80\x9d from\nher gross income. \xc2\xa7 72(b)(2).\n\xe2\x80\xa2After all, receipt of such a payment would be an accession to\nwealth, i.e., income, which must be subject to income tax once.\n\xe2\x80\xa2If taxpayer dies before the actuaries predicted she would ...: On the other\nhand, should payments cease because taxpayer died prior to recovery of\ntaxpayer\xe2\x80\x99s investment in the contract, taxpayer may deduct the amount of\nthe unrecovered investment for her last taxable year. \xc2\xa7 72(b)(3)(A).\n4. Section 72(e) states rules applicable to amounts received under an annuity,\nendowment, or life insurance contract that are not received as an annuity \xe2\x80\x93 if no\nother provision of this subtitle is applicable. \xc2\xa7 72(e)(1).\n\xe2\x80\xa2Section 1001 is a provision of \xe2\x80\x9cthis subtitle\xe2\x80\x9d and applies when a life\ninsurance policy is sold \xe2\x80\x93 and now without reduction of basis for mortality\ncharges.\n162\n\n\x0c5. Section 101(g): Amounts that a \xe2\x80\x9cterminally ill\xe2\x80\x9d or \xe2\x80\x9cchronically ill\xe2\x80\x9d person\nreceives under a life insurance contract may qualify for exclusion under\n\xc2\xa7 101(a)(1). The same is true of the \xe2\x80\x9camount realized\xe2\x80\x9d on the sale of a life insurance\npolicy to a \xe2\x80\x9cviatical settlement provider.\xe2\x80\x9d \xc2\xa7 101(g)(2).\n\xe2\x80\xa2A \xe2\x80\x9cterminally ill\xe2\x80\x9d taxpayer is one who is certified by a physician as having\n\xe2\x80\x9can illness or physical condition which can reasonably be expected to result\nin death in 24 months or less after the date of the certification.\xe2\x80\x9d\n\xc2\xa7 101(g)(4)(A).\n\xe2\x80\xa2A \xe2\x80\x9cchronically ill\xe2\x80\x9d taxpayer is one who is not \xe2\x80\x9cterminally ill\xe2\x80\x9d and is unable\nto perform at least two activities of daily living (i.e., eating, toileting,\ntransferring, bathing, dressing, and continence) or requires substantial\nsupervision to protect herself \xe2\x80\x9cfrom threats to health and safety due to\nsevere cognitive impairment.\xe2\x80\x9d \xc2\xa7 101(g)(4)(B), referencing \xc2\xa7 7702B(c)(2).\n\xe2\x80\xa2A \xe2\x80\x9cchronically ill\xe2\x80\x9d taxpayer must use the payment for unreimbursed costs\nof long-term care. \xc2\xa7 101(g)(3)(A).\nSection 101(g) enables an insured taxpayer to get money out of a life insurance\npolicy at a time when she has a substantial need for cash and the risk of death has\nnearly materialized.\nDo the CALI Lesson, Basic Federal Income Taxation: Gross Income: Annuities\nand Life Insurance Proceeds. You may have to read some portions of the Code to\nanswer all the questions. That would be a good thing. In a tax-deferred corporate\nreorganization, the basis of the transferee is determined by reference to the basis of\nthe contract in the hands of the transferor.\nB. Compensation for Injuries or Sickness: \xc2\xa7\xc2\xa7 104, 105, 106\nRead \xc2\xa7 104. Injured persons stand in need of compensation. Consider the precise\nextent to which the subsections of \xc2\xa7 104 exclude compensation for injury from\ngross income.\n\xe2\x80\xa2\xc2\xa7 104(a)(2): Section 104(a)(2) seems to encourage taxpayers to search for a\nphysical injury, much as a tort claim for negligent infliction of emotional distress\nimpels a plaintiff to search for a physical manifestation. Review part IIB of\nCADC\xe2\x80\x99s opinion in Murphy v. Internal Revenue Service, 493 F.3d 170 (CADC\n2007), supra, chapter 2. The Government was correct in its reading of the \xe2\x80\x9con\n163\n\n\x0caccount of\xe2\x80\x9d language in the statute. There must be a strong causal connection\nbetween the physical injury and the emotional distress \xe2\x80\x93 not the other way around\n\xe2\x80\x93 in order for \xc2\xa7 104(a)(2) to exclude it from gross income by \xc2\xa7 104(a)(2).\n\xe2\x80\xa2\xc2\xa7 104(a)(3): What does \xc2\xa7 104(a)(3) mean? What health or accident insurance\npayments does \xc2\xa7 104(a)(3) reference?\n\xe2\x80\xa2\xe2\x80\x9cHealth and accident\xe2\x80\x9d insurance includes wage continuation policies. This\nis important for employees whose employers provide health insurance but\nnot disability insurance.\n\xe2\x80\xa2The exclusion applies to multiple payments from more than one selfpurchased policy, even though the amount received exceeds the expense\nagainst which taxpayer procured the insurance.\n\xe2\x80\xa2Read \xc2\xa7 105. Notice the layout of \xc2\xa7 105. Section 105(a) establishes a broad rule of\ninclusion in gross income. But use of the \xe2\x80\x9cexcept as otherwise provided in this\nsection\xe2\x80\x9d language enables Congress to define the precise scope of an exclusion.\nWhat rule emerges from \xc2\xa7\xc2\xa7 105(a and b)?\n\xe2\x80\xa2The following two problems are derived from and answered by Rev. Rul. 69-154,\n1969-1 C.B. 46. What is your intuition about how they should be solved? Feel free\nto look up that revenue ruling.\n\xe2\x80\xa2C is covered by his employer\xe2\x80\x99s health insurance policy. C\xe2\x80\x99s employer pays\nthe annual premium of $10,000. This amount is excluded from C\xe2\x80\x99s gross\nincome. See \xc2\xa7 106(a). In addition, C paid the entire premium of $5000 for a\npersonal health insurance policy.\n\xe2\x80\xa2During the year, C had only one illness and incurred and paid total\nmedical expenses, as defined in \xc2\xa7 213 of the Code, of $2700. In the\nsame year, C was indemnified $2100 by his employer\xe2\x80\x99s insurance\npolicy and $1500 by his personal insurance policy.\n\xe2\x80\xa2What is C\xe2\x80\x99s gross income from the insurance companies\xe2\x80\x99\nreimbursements?\n\xe2\x80\xa2D is covered by a health insurance policy. The annual premium is $10,000.\nD\xe2\x80\x99s employer pays $4000; D excludes this amount from his gross income.\nD\xe2\x80\x99s employer deducts the other $6000 from D\xe2\x80\x99s taxable wages. In addition,\nD paid the entire premium of $5000 for a personal health insurance policy.\n\xe2\x80\xa2During the year, D had only one illness and paid total medical\nexpenses, as defined in \xc2\xa7 213 of the Code, of $2700. In the same\nyear, D was indemnified $2100 by his employer\xe2\x80\x99s insurance policy\n164\n\n\x0cand $1500 by his personal insurance policy.\n\xe2\x80\xa2What is D\xe2\x80\x99s gross income from these reimbursements?\n\xe2\x80\xa2Read \xc2\xa7 106(a).\nDo the CALI Lesson, Basic Federal Income Taxation: Gross Income: Damages\nand Related Receipts.\nC. Payments to Wrongfully Incarcerated Individual: \xc2\xa7 139F\nSection 139F provides: \xe2\x80\x9cIn the case of any wrongfully incarcerated individual,\ngross income shall not include any civil damages, restitution, or other monetary\naward (including compensatory or statutory damages and restitution imposed in a\ncriminal matter) relating to the incarceration of such individual for the \xe2\x80\xa6 offense\nfor which such individual was convicted.\xe2\x80\x9d\nD. Social Security: \xc2\xa7 86\nRead \xc2\xa7 86. It is not an easy read. Section 86 is among the Code provisions that\nrequire inclusion of certain items in gross income. Section 86 limits the amount of\nsocial security benefits that a taxpayer must include in gross income. Taxpayer\nexcludes the remainder.\n\n165\n\n\x0cExclusion by discretion:\nOn\noccasion, the IRS may choose not\nto require taxpayers to include\nsome benefit in their gross\nincome. You may surmise the\nreasons why the IRS might take\nsuch a position. Examples of such\ndiscretionary exclusions include\nfrequent flyer miles \xe2\x80\x9cearned\xe2\x80\x9d for\nbusiness or official travel, see\nAnnouncement 2002-18 (so long\nas not converted to cash) and\nidentity\nprotection\nservices\nprovided to data breach victims,\nsee Announcement 2015-35.\n\n\xe2\x80\xa2Section 86 establishes three levels of taxable\nsocial security income that are subject to\ndifferent rules of inclusion. We begin with an\namount of income that \xc2\xa7 86(b)(1)(A) defines.\n\xe2\x80\xa2The amount of a taxpayer\xe2\x80\x99s income determined\nunder \xc2\xa7 86(b)(1)(A) will either be \xe2\x80\x93\n\xe2\x80\xa2below the statutory \xe2\x80\x9cbase amount.\xe2\x80\x9d\n\xe2\x80\xa2above the statutory \xe2\x80\x9cbase amount\xe2\x80\x9d but below\nthe statutory \xe2\x80\x9cadjusted base amount.\xe2\x80\x9d OR\n\xe2\x80\xa2above the statutory \xe2\x80\x9cadjusted base amount.\xe2\x80\x9d\n\nAgain, notice that the Code uses definitions to\ndelimit its rules. As you read the text that\nfollows, examine the Code sections cited. Rather\nthan try to state the computation rules, we will\napply the rules through three problems involving\nthe taxpayer \xe2\x80\x9cJoe the Pensioner.\xe2\x80\x9d He is single and receives social security benefits.\nConsider:\n\xe2\x80\xa2Joe the Pensioner received $20,000 of social security benefits payments last year.\nIn addition, he received $1000 in municipal bond interest that \xc2\xa7 103 exempts from\nhis gross income. Joe also did some work for his old employer for which he received\n$6000. What is Joe\xe2\x80\x99s gross income?\n\xe2\x80\xa2Section 86(a) with deceptive simplicity sets forth rules governing taxpayer\ninclusion in gross income of social security benefits. Section 86(a) requires\ncomputations of various amounts and then comparing them. Hopefully, we can\nreduce this to a few straight-forward \xe2\x80\x9cif ... then\xe2\x80\x9d rules. It is best52 to begin with\n\xc2\xa7 86(b) \xe2\x80\x93 the provision that defines the \xe2\x80\x9cTaxpayers to Whom Subsection (a)\napplies.\xe2\x80\x9d\n\xe2\x80\xa2Section 86(b)(1)(A)(i) requires that we determine what Joe\xe2\x80\x99s \xe2\x80\x9cmodified\nagi\xe2\x80\x9d is. That phrase is defined in \xc2\xa7 86(b)(2). Joe\xe2\x80\x99s AGI at the moment, not\ncounting his social security benefits or tax-exempt interest, is $6000. To\nobtain Joe\xe2\x80\x99s \xe2\x80\x9cmodified agi,\xe2\x80\x9d we do not add his benefits (\xc2\xa7 86(b)(2)(A)\n(\xe2\x80\x9cdetermined without regard to this section\xe2\x80\x9d)) but we do add certain items,\nincluding his tax-exempt interest income, \xc2\xa7 86(b)(2)(B), i.e., $1000. Joe\xe2\x80\x99s\nmodified adjusted gross income is $7000.\n\xe2\x80\xa2Section 86(b)(1)(A) requires us to add Joe\xe2\x80\x99s modified adjusted gross\n52\n\n... in my view.\n\n166\n\n\x0cincome plus one-half of his social security benefits. $7000 + $10,000 =\n$17,000. We will refer to this as the \xe2\x80\x9c(b)(1)(A) amount.\xe2\x80\x9d\n\xe2\x80\xa2Subtract the \xe2\x80\x9cbase amount\xe2\x80\x9d from $17,000. \xc2\xa7 86(b)(1)(A and B).\n\xe2\x80\xa2\xe2\x80\x9cBase amount\xe2\x80\x9d is defined for Joe in \xc2\xa7 86(c)(1)(A) as $25,000.\n\xe2\x80\xa2According to \xc2\xa7 86(a)(1), Joe must include in his gross income the\nlesser of one-half of the social security benefits that he received or\none-half of the amount by which his \xe2\x80\x9c(b)(1)(A) amount\xe2\x80\x9d exceeds his\n\xe2\x80\x9cbase amount.\xe2\x80\x9d\n\xe2\x80\xa2Joe\xe2\x80\x99s \xe2\x80\x9cmodified agi\xe2\x80\x9d does not exceed his \xe2\x80\x9cbase amount,\xe2\x80\x9d so onehalf of the excess described in \xc2\xa7 86(b)(1) in our case will of course\nbe $0.\n\xe2\x80\xa2\xc2\xa7 86(a)(1) requires a comparison: $0 < $10,000.\n\xe2\x80\xa2Joe must include the lesser of these figures, i.e., $0, of his Social\nSecurity benefits in his gross income.\nNotice that if the base amount exceeds taxpayer\xe2\x80\x99s \xe2\x80\x9cmodified agi\xe2\x80\x9d plus one-half of\nher social security benefits, then there will be no \xe2\x80\x9cexcess\xe2\x80\x9d \xe2\x80\x93 a term that appears in\n\xc2\xa7 86(a)(1)(B). We can state the following straight-forward rule.\n1. If taxpayer\xe2\x80\x99s \xe2\x80\x9cmodified agi\xe2\x80\x9d plus one-half of her social security\nbenefits is less than the statutory \xe2\x80\x9cbase amount,\xe2\x80\x9d none of taxpayer\xe2\x80\x99s\nsocial security benefits will be subject to federal income tax.\nNow suppose that Joe the Pensioner received $20,000 of social security benefit\npayments, $1000 in tax exempt interest, and $18,000 of payments for work he did\nfor his old employer.\n\xe2\x80\xa2Joe\xe2\x80\x99s \xe2\x80\x9cmodified agi\xe2\x80\x9d plus one-half of his social security benefits (i.e.,\n\xe2\x80\x9c(b)(1)(A)\xe2\x80\x9d amount) is $29,000. This is $4000 more than the statutory \xe2\x80\x9cbase\namount,\xe2\x80\x9d i.e., $25,000, \xc2\xa7 86(c)(1)(A).\n\xe2\x80\xa2Section 86(a)(2) describes a taxpayer whose \xe2\x80\x9c(b)(1)(A) amount\xe2\x80\x9d is\nmore than an \xe2\x80\x9cadjusted base amount.\xe2\x80\x9d For Joe, the \xe2\x80\x9cadjusted base\namount\xe2\x80\x9d is $34,000. \xc2\xa7 86(c)(2)(A). Joe\xe2\x80\x99s \xe2\x80\x9c(b)(1)(A) amount\xe2\x80\x9d does\nnot exceed his \xe2\x80\x9cadjusted base amount,\xe2\x80\x9d so \xc2\xa7 86(a)(1) applies to him.\n\xe2\x80\xa2According to \xc2\xa7 86(a)(1), Joe must include in his gross income the lesser of\none-half of the social security benefits that he received or one-half of the\namount by which his \xe2\x80\x9c(b)(1)(A)\xe2\x80\x9d amount exceeds his \xe2\x80\x9cbase amount.\xe2\x80\x9d\n\xe2\x80\xa2The first amount is $10,000. The second amount is $2000.\n\xe2\x80\xa2Joe must include $2000 of social security benefits in his gross\nincome.\n167\n\n\x0cWe can now state the second of our straight-forward rules.\n2. If taxpayer\xe2\x80\x99s \xe2\x80\x9cmodified agi\xe2\x80\x9d plus one-half of her social security\nbenefits is more than the statutory \xe2\x80\x9cbase amount\xe2\x80\x9d but less than the\n\xe2\x80\x9cadjusted base amount,\xe2\x80\x9d taxpayer must include in her gross income the\nlesser of one-half of her social security benefits or one-half of the\namount by which her \xe2\x80\x9cmodified agi\xe2\x80\x9d exceeds the statutory base\namount.\nNow suppose that Joe the Pensioner received $20,000 of social security benefit\npayments, $1000 in tax exempt interest, and $30,000 of payments for work he did\nfor his old employer.\n\xe2\x80\xa2Joe\xe2\x80\x99s \xe2\x80\x9c(b)(1)(A)\xe2\x80\x9d amount is now $41,000. This is $7000 more than his\n\xe2\x80\x9cadjusted base amount,\xe2\x80\x9d i.e., $34,000, \xc2\xa7 86(c)(2)(A). This means that\n\xc2\xa7 86(a)(2) applies rather than \xc2\xa7 86(a)(1).\n\xe2\x80\xa2Section 86(a)(2) requires us to determine two different amounts and to\ninclude the lesser in Joe\xe2\x80\x99s gross income.\n\xe2\x80\xa2The first amount (\xc2\xa7 86(a)(2)(A)) is \xe2\x80\x93\n\xe2\x80\xa285% of the \xe2\x80\x9cexcess,\xe2\x80\x9d i.e., 85% of $7000, i.e., $5950, PLUS\n\xe2\x80\xa2the lesser of\n\xe2\x80\xa2the amount that would be included in Joe\xe2\x80\x99s gross\nincome if our second rule (i.e., \xc2\xa7 86(a)(1)) did apply.\nThe lesser of one-half of Joe\xe2\x80\x99s social security\nbenefits (i.e., $10,000) or one-half of the excess of\nJoe\xe2\x80\x99s \xe2\x80\x9c(b)(1)(A)\xe2\x80\x9d amount over his \xe2\x80\x9cbase amount\xe2\x80\x9d\n(i.e., \xc2\xbd of ($41,000 \xe2\x88\x92 $25,000) = $8000) is $8000.\n\xe2\x80\xa2or\n\xe2\x80\xa2one-half of the difference between Joe\xe2\x80\x99s \xe2\x80\x9cbase\namount\xe2\x80\x9d and \xe2\x80\x9cadjusted base amount.\xe2\x80\x9d The difference\nbetween Joe\xe2\x80\x99s \xe2\x80\x9cbase amount\xe2\x80\x9d and his \xe2\x80\x9cmodified base\namount\xe2\x80\x9d is $34,000 \xe2\x88\x92 $25,000. One-half of that\namount is $4500.\n\xe2\x80\xa2$4500 < $8000.\n\xe2\x80\xa2$5950 + $4500 EQUALS $10,450.\n\xe2\x80\xa2The second amount (\xc2\xa7 86(a)(2)(B)) is \xe2\x80\x93\n\xe2\x80\xa285% of Joe\xe2\x80\x99s social security benefit, i.e., 85% of $20,000 =\n$17,000.\n168\n\n\x0c\xe2\x80\xa2$10,450 < $17,000. Joe must include $10,450 in his gross income.\nWe state the third of our straight-forward rules.\n3. If taxpayer\xe2\x80\x99s \xe2\x80\x9cmodified agi\xe2\x80\x9d plus one-half of her social security\nbenefits is more than the statutory \xe2\x80\x9cadjusted base amount,\xe2\x80\x9d taxpayer\nmust include in her gross income the lesser of two amounts computed\naccording to two more rules.\nD. Unemployment Benefits: \xc2\xa7 85\nA taxpayer must include in her gross income unemployment compensation. \xc2\xa7 85.\n\nIII. Employment-Based Exclusions from Gross Income\nThe employment relationship is the seat of several exclusions from gross income.\nSections 79, 106, 119, 127, 129, 132, and 137 exclude certain named benefits from\nthe gross income of \xe2\x80\x9can employee.\xe2\x80\x9d Employment-based exclusions from gross\nincome can have a powerful influence in shaping employment relationships. Be\nalert to the possibility that the employer may capture the benefit of the exclusion\nsimply by providing a benefit and then paying employees less than it otherwise\nwould have. We should expect employees to deem employers who pay substandard\nwages in exchange for benefits that employees don\xe2\x80\x99t really want to be not\nparticularly desirable. The converse is true also: employees should seek out\nemployers who provide benefits that they particularly value.\nThere is overlap between benefits provided in the employment setting that the Code\nexcludes from gross income and social benefits that the Code excludes from gross\nincome. An implicit message is that the employment setting is where employees\nshould seek and employers should provide certain social benefits. See whether you\nagree.\nA. Group Term Life Insurance: \xc2\xa7 79\nRead \xc2\xa7 79. What is the effect of restricting the exclusion to the purchase of groupterm life insurance and not allowing discrimination in favor of a key employee?\n169\n\n\x0cWhy should there be a $50,000 ceiling on the amount of group-term life insurance\nwhose purchase is excluded from an employee\xe2\x80\x99s gross income?\nThe cost of group term life insurance with a death benefit that exceeds $50,000 is\ngross income to the employee to the extent that such cost exceeds the cost of\n$50,000 of group term life insurance plus the amount that the employee paid for\nsuch insurance. \xc2\xa7 79(a). The regulations prescribe the monthly premium for such\nexcess insurance. Reg. \xc2\xa7 1.79-3(d).\nCARES Act, \xc2\xa7 2206: added \xc2\xa7\n127(c)(1)(B) to provide that\n\xe2\x80\x9ceducational\nassistance\xe2\x80\x9d\nincludes payments of an\nemployee\xe2\x80\x99s education loan.\nThe provision was to sunset on\nDecember 31, 2020, but has\nbeen extended to the end of\n2025 by the Taxpayer\nCertainty and Disaster Tax\nRelief Act of 2020, tit. I, subtit.\nB, \xc2\xa7 120.\n\nB. Educational Assistance Programs: \xc2\xa7 127\nRead \xc2\xa7 127. Why might a relatively low-cost\nprivate school charge more tuition per credit hour\nin its night or weekend MBA programs than it does\nfor its full-time day program?\nC. Dependent Care Assistance Programs: \xc2\xa7 129\n\nRead \xc2\xa7 129. Why\nmight a highly-paid employee prefer a dependent care\nassistance program to a 20% credit against income tax\nliability? What is the maximum available exclusion if\ntaxpayer has one child? Compare this figure with that\nof \xc2\xa7 21.\n\nARPA, \xc2\xa7 9632 amended \xc2\xa7\n129 to provide that in 2021,\ntaxpayers could exclude\n$10,500 (or half that amount\nfor taxpayers married filing\nseparately) for employerprovided dependent care\nassistance. This of course is\nmore than twice the previous\nlimit.\n\n\xe2\x80\xa2Consider: Taxpayers (married filing jointly) have three\nchildren, none of whom has reached the age of 13. They\nboth work and earn substantial incomes. They are in the\n35% income tax bracket, and their credit under \xc2\xa7 21 is\n20% of their dependent care expenses. They incur $6000 of dependent care\nexpenses during the year. Should they prefer an exclusion under \xc2\xa7 129 or a tax\ncredit under \xc2\xa7 21?\n\n170\n\n\x0cD. Employer Contributions to Accident and Health Plans: \xc2\xa7 106\nRead \xc2\xa7\xc2\xa7 106 and 223.\nARPA, \xc2\xa7 9631 amended \xc2\xa7 21\nto provide that in 2021,\ntaxpayers could claim a\ncredit for much more of their\ndependent care expenses.\nFirst, the credit is made\nrefundable.\nSecond, the\ndollar limit of employmentrelated\nexpenses\nwas\nincreased to $8000 for one\nqualifying individual, and\n$16,000 for two or more\nqualifying individuals. Third,\nthe \xe2\x80\x9capplicable percentage\xe2\x80\x9d\nis 50%, subject to the same\nphasedown rules. Fourth, the\n\xe2\x80\x9capplicable percentage\xe2\x80\x9d is\nreduced only as taxpayer\xe2\x80\x99s\nagi exceeds $125,000.\nHence,\n20%\nis\nthe\n\xe2\x80\x9capplicable percentage\xe2\x80\x9d only\nfor taxpayers whose agi\nexceeds $185,000. Sixth, for\ntaxpayers whose agi exceeds\n$400,000 the \xe2\x80\x9capplicable\npercentage\xe2\x80\x9d phases out by 1\npercentage point for each\n$2000 (or fraction thereof)\nby which taxpayer\xe2\x80\x99s agi\nexceeds $400,000.\n\nDuring World War II, the nation lived under wage\nand price controls. Employers could circumvent\nwage controls by providing employees with certain\nbenefits, notably pensions and health insurance. In\n1954, Congress codified the employee exclusion of\nemployer payments for accident or health plans in\n\xc2\xa7 106(a). Recall that \xc2\xa7 105(b) excludes the payments\nthat such plans provide for care from gross income.\nEmployers of course deduct whatever payments they\nmake as employee compensation, \xc2\xa7 162(a)(1). Most\nof the money that employees spend or employers\nspend on their behalf for health care is not subject to\nincome tax at either the employer or employee level.\nIn the United States health care is now a significant\naspect of any employment relationship. Health care\ncosts have spiraled upward. Payments for health\nplans have become the biggest expenditure that\nemployers make for employee benefits. Highly\ndistorted markets for health care services now\nprevail. See William P. Kratzke, Tax Subsidies,\nThird-Party Payments, and Cross-Subsidization:\nAmerica\xe2\x80\x99s Distorted Health Care Markets, 40 U.\nMEM. L. REV. 279 (2009).\n\nHealth Savings Accounts (HSA) are savings accounts\nestablished for the benefit of an individual who has a\nhigh-deductible health plan. See \xc2\xa7 223. An employee\ntaxpayer may deduct the contributions she makes to\nsuch an account. \xc2\xa7 223(a). An employee taxpayer\nmay exclude employer contributions to such an account. \xc2\xa7 106(d). Unspent funds\nin an HSA grow tax-free. \xc2\xa7 223(e)(1). There is a monthly limit to the amount that\ntaxpayer may save in such accounts. The savings in the account can be withdrawn\nwithout income tax to pay for medical expenses, presumably for the deductible\nportion that the health plan does not pay for. \xc2\xa7 213(f)(1). Employer contributions\nto an HSA are not subject to employment taxes, \xc2\xa7 106(d)(1), but employee\n171\n\n\x0ccontributions are subject to employment taxes.\nE. Meals or Lodging Furnished for the Convenience of the Employer: \xc2\xa7 119\nRead \xc2\xa7 119.\nCommissioner v. Kowalski, 434 U.S. 77 (1977)\nMR. JUSTICE BRENNAN delivered the opinion of the Court.\nThis case presents the question whether cash payments to state police troopers,\ndesignated as meal allowances, are included in gross income under \xc2\xa7 61(a) of the\nInternal Revenue Code ..., 26 U.S.C. \xc2\xa7 61(a), [footnote omitted] and, if so, are\notherwise excludable under \xc2\xa7 119 of the Code, 26 U.S.C. \xc2\xa7 119. [footnote omitted]\nI\n... Respondent [footnote omitted] is a state police trooper employed by the Division\nof State Police of the Department of Law and Public Safety of the State of New\nJersey. During 1970, the tax year in question, he received a base salary of\n$8,739.38, and an additional $1,697.54 [footnote omitted] designated as an\nallowance for meals.\n... Under [the State\xe2\x80\x99s cash allowance] system, troopers remain on call in their\nassigned patrol areas during their midshift break. Otherwise, troopers are not\nrestricted in any way with respect to where they may eat in the patrol area and,\nindeed, may eat at home if it is located within that area. Troopers may also bring\ntheir midshift meal to the job and eat it in or near their patrol cars.\nThe meal allowance is paid biweekly in advance and is included, although\nseparately stated, with the trooper\xe2\x80\x99s salary. The meal allowance money is also\nseparately accounted for in the State\xe2\x80\x99s accounting system. Funds are never\ncommingled between the salary and meal allowance accounts. Because of these\ncharacteristics of the meal allowance system, the Tax Court concluded that the\n\xe2\x80\x9cmeal allowance was not intended to represent additional compensation.\xe2\x80\x9d\nNotwithstanding this conclusion, it is not disputed that the meal allowance has\n172\n\n\x0cmany features inconsistent with its characterization as a simple reimbursement for\nmeals that would otherwise have been taken at a meal station. For example,\ntroopers are not required to spend their meal allowances on their midshift meals,\nnor are they required to account for the manner in which the money is spent. ... [N]o\nreduction in the meal allowance is made for periods when a trooper is not on patrol\nbecause, for example, he is assigned to a headquarters building or is away from\nactive duty on vacation, leave, or sick leave. In addition, the cash allowance for\nmeals is described on a state police recruitment brochure as an item of salary to be\nreceived in addition to an officer\xe2\x80\x99s base salary and the amount of the meal\nallowance is a subject of negotiations between the State and the police troopers\xe2\x80\x99\nunion. Finally, the amount of an officer\xe2\x80\x99s cash meal allowance varies with his rank,\nand is included in his gross pay for purposes of calculating pension benefits.\nOn his 1970 income tax return, respondent reported $9066 in wages. That amount\nincluded his salary plus $326.45 which represented cash meal allowances reported\nby the State on respondent\xe2\x80\x99s Wage and Tax Statement (Form W-2). [footnote\nomitted]. The remaining amount of meal allowance, $1,371.09, was not reported.\nOn audit, the Commissioner determined that this amount should have been included\nin respondent\xe2\x80\x99s 1970 income, and assessed a deficiency.\nRespondent sought review in the United States Tax Court, arguing that the cash\nmeal allowance was not compensatory, but was furnished for the convenience of\nthe employer, and hence was not \xe2\x80\x9cincome\xe2\x80\x9d within the meaning of \xc2\xa7 61(a), and that,\nin any case, the allowance could be excluded under \xc2\xa7 119. ... [T]he Tax Court, with\nsix dissents, [footnote omitted] held that the cash meal payments were income\nwithin the meaning of \xc2\xa7 61 and, further, that such payments were not excludable\nunder \xc2\xa7 119. [footnote omitted]. The Court of Appeals for the Third Circuit, in a\nper curiam opinion, held that its earlier decision in Saunders v. Commissioner, 215\nF.2d 768 (1954), which determined that cash payments under the New Jersey meal\nallowance program were not taxable, required reversal. We granted certiorari to\nresolve a conflict among the Courts of Appeals on the question. [footnote omitted].\nWe reverse.\nII\nA\nThe starting point in the determination of the scope of \xe2\x80\x9cgross income\xe2\x80\x9d is the\ncardinal principle that Congress in creating the income tax intended \xe2\x80\x9cto use the full\nmeasure of its taxing power.\xe2\x80\x9d [citations omitted]. ... In the absence of a specific\nexemption, therefore, respondent\xe2\x80\x99s meal allowance payments are income within the\n173\n\n\x0cmeaning of \xc2\xa7 61 since, like the payments involved in Glenshaw Glass Co., the\npayments are \xe2\x80\x9cundeniabl[y] accessions to wealth, clearly realized, and over which\nthe [respondent has] complete dominion.\xe2\x80\x9d Commissioner v. Glenshaw Glass Co.,\n[348 U.S. 426, 431 (1955)]. [citations omitted].\nRespondent contends, however, that \xc2\xa7 119 can be construed to be a specific\nexemption covering the meal allowance payments to New Jersey troopers.\nAlternatively, respondent argues that notwithstanding \xc2\xa7 119, a specific exemption\nmay be found in a line of lower court cases and administrative rulings which\nrecognize that benefits conferred by an employer on an employee \xe2\x80\x9cfor the\nconvenience of the employer\xe2\x80\x9d \xe2\x80\x93 at least when such benefits are not \xe2\x80\x9ccompensatory\xe2\x80\x9d\n\xe2\x80\x93 are not income within the meaning of the Internal Revenue Code. In responding\nto these contentions, we turn first to \xc2\xa7 119. Since we hold that \xc2\xa7 119 does not cover\ncash payments of any kind, we then trace the development over several decades of\nthe \xe2\x80\x9cconvenience of the employer\xe2\x80\x9d doctrine as a determinant of the tax status of\nmeals and lodging, turning finally to the question whether the doctrine as applied\nto meals and lodging survives the enactment of the Internal Revenue Code of 1954.\nB\nSection 119 provides that an employee may exclude from income \xe2\x80\x9cthe value of any\nmeals ... furnished to him by his employer for the convenience of the employer, but\nonly if ... the meals are furnished on the business premises of the employer ...\xe2\x80\x9d By\nits terms, \xc2\xa7 119 covers meals furnished by the employer, and not cash\nreimbursements for meals. This is not a mere oversight. As we shall explain at\ngreater length below, the form of \xc2\xa7 119 which Congress enacted originated in the\nSenate and the Report accompanying the Senate bill is very clear: \xe2\x80\x9cSection 119\napplies only to meals or lodging furnished in kind.\xe2\x80\x9d S. Rep. No. 1622, 83d Cong.,\n2d Sess., 190 (1954). See also Treas. Reg. \xc2\xa7 1.119-1(c)(2) ... Accordingly,\nrespondent\xe2\x80\x99s meal allowance payments are not subject to exclusion under \xc2\xa7 119.\nC\n[The Court reviewed some early administrative determinations concerning the\n\xe2\x80\x9cconvenience of the employer\xe2\x80\x9d doctrine. The phrase first appeared in O.D. 265.\nO.D. 514 provided that the \xe2\x80\x9cconvenience of the employer\xe2\x80\x9d turned on the employer\xe2\x80\x99s\ncharacterization of a (noncash, T.D. 2992) benefit as noncompensatory. Mim. 5023\nprovided that the \xe2\x80\x9cconvenience of the employer\xe2\x80\x9d turned on the necessity of\nproviding a benefit to the proper functioning of the employer\xe2\x80\x99s business. Mim.\n6472 provided that the doctrine was inapplicable whenever an employee\xe2\x80\x99s receipt\nof a benefit represents compensation for services.]\n174\n\n\x0cCoexisting with the regulations and administrative determinations of the Treasury,\nbut independent of them, is a body of case law also applying the \xe2\x80\x9cconvenience of\nthe employer\xe2\x80\x9d test to exclude from an employee\xe2\x80\x99s statutory income benefits\nconferred by his employer.\nAn early case is Jones v. United States, 60 Ct. Cl. 552 (1925). There, the Court of\nClaims ruled that neither the value of quarters provided an Army officer for nine\nmonths of a tax year nor payments in commutation of quarters paid the officer for\nthe remainder of the year were includable in income. The decision appears to rest\nboth on a conclusion that public quarters, by tradition and law, were not\n\xe2\x80\x9ccompensation received as such\xe2\x80\x9d within the meaning of \xc2\xa7 213 of the Revenue Act\nof 1921, 42 Stat. 237, and also on the proposition that \xe2\x80\x9cpublic quarters for the\nhousing of ... officers is as much a military necessity as the procurement of\nimplements of warfare or the training of troops.\xe2\x80\x9d 60 Ct. Cl. at 569; 565-568. ...\nSubsequent judicial development of the \xe2\x80\x9cconvenience of the employer\xe2\x80\x9d doctrine\ncentered primarily in the Tax Court. In two reviewed cases decided more than a\ndecade apart, Benaglia v. Commissioner, 36 B.T.A. 838 (1937), and Van Rosen v.\nCommissioner, 17 T.C. 834 (1951), that court settled on the business necessity\nrationale for excluding food and lodging from an employee\xe2\x80\x99s income.53 Van\nRosen\xe2\x80\x99s unanimous decision is of particular interest in interpreting the legislative\nhistory of the 1954 recodification of the Internal Revenue Code, since it predates\nthat recodification by only three years. There, the Tax Court expressly rejected any\nreading of Jones, supra, that would make tax consequences turn on the intent of the\nemployer, even though the employer in Van Rosen, as in Jones, was the United\nStates, and, also as in Jones, the subsistence payments involved in the litigation\nwere provided by military regulation. [footnote omitted]. In addition, Van Rosen\nrefused to follow the Jones holding with respect to cash allowances, apparently on\n\xe2\x80\x9cThe better and more accurate statement of the reason for the exclusion from the employee\xe2\x80\x99s income\nof the value of subsistence and quarters furnished in kind is found, we think, in Arthur Benaglia, 36\nB.T.A. 838, where it was pointed out that, on the facts, the subsistence and quarters were not supplied\nby the employer and received by the employee \xe2\x80\x98for his personal convenience[,] comfort or pleasure, but\nsolely because he could not otherwise perform the services required of him.\xe2\x80\x99 In other words, though\nthere was an element of gain to the employee, in that he received subsistence and quarters which\notherwise he would have had to supply for himself, he had nothing he could take, appropriate, use and\nexpend according to his own dictates, but, rather, the ends of the employer\xe2\x80\x99s business dominated and\ncontrolled, just as in the furnishing of a place to work and in the supplying of the tools and machinery\nwith which to work. The fact that certain personal wants and needs of the employee were satisfied was\nplainly secondary and incidental to the employment.\xe2\x80\x9d\n53\n\nVan Rosen v. Commissioner, 17 T.C. at 838.\n\n175\n\n\x0cthe theory that a civilian who receives cash allowances for expenses otherwise\nnondeductible has funds he can \xe2\x80\x9ctake, appropriate, use and expend,\xe2\x80\x9d 17 T.C. at 838,\nin substantially the same manner as \xe2\x80\x9cany other civilian employee whose\nemployment is such as to permit him to live at home while performing the duties\nof his employment.\xe2\x80\x9d Id. at 836, 839-840. It is not clear from the opinion whether\nthe last conclusion is based on notions of equity among taxpayers or is simply an\nevidentiary conclusion that, since Van Rosen was allowed to live at home while\nperforming his duties, there was no business purpose for the furnishing of food and\nlodging.\nTwo years later, the Tax Court, in an unreviewed decision in Doran v.\nCommissioner, 21 T.C. 374 (1953), returned in part to the \xe2\x80\x9cemployer\xe2\x80\x99s\ncharacterization\xe2\x80\x9d rationale rejected by Van Rosen. In Doran, the taxpayer was\nfurnished lodging in kind by a state school. State law required the value of the\nlodging to be included in the employee\xe2\x80\x99s compensation. Although the court\nconcluded that the lodging was furnished to allow the taxpayer to be on 24-hour\ncall, a reason normally sufficient to justify a \xe2\x80\x9cconvenience of the employer\xe2\x80\x9d\nexclusion, [footnote omitted] it required the value of the lodging to be included in\nincome on the basis of the characterization of the lodging as compensation under\nstate law. The approach taken in Doran is the same as that in Mim. 6472, supra.\n[footnote omitted] However, the Court of Appeals for the Second Circuit, in\nDiamond v. Sturr, 221 F.2d 264 (1955), on facts indistinguishable from Doran,\nreviewed the law prior to 1954 and held that the business necessity view of the\n\xe2\x80\x9cconvenience of the employer\xe2\x80\x9d\xe2\x80\x99 test, \xe2\x80\x9chaving persisted through the interpretations\nof the Treasury and the Tax Court throughout years of reenactment of the Internal\nRevenue Code,\xe2\x80\x9d was the sole test to be applied. 221 F.2d at 268.\nD\nEven if we assume that respondent\xe2\x80\x99s meal allowance payments could have been\nexcluded from income under the 1939 Code pursuant to the doctrine we have just\nsketched, we must nonetheless inquire whether such an implied exclusion survives\nthe 1954 recodification of the Internal Revenue Code. [citation omitted]. Two\nprovisions of the 1954 Code are relevant to this inquiry: \xc2\xa7 119 and \xc2\xa7 120 [footnote\nomitted], now repealed [footnote omitted], which allowed police officers to exclude\nfrom income subsistence allowances of up to $5 per day.\nIn enacting \xc2\xa7 119, the Congress was determined to \xe2\x80\x9cend the confusion as to the tax\nstatus of meals and lodging furnished an employee by his employer.\xe2\x80\x9d H.R. Rep.\nNo. 1337, 83d Cong., 2d Sess., 18 (1954); S. Rep. No. 1622, 83d Cong., 2d Sess.,\n176\n\n\x0c19 (1954). However, the House and Senate initially differed on the significance that\nshould be given the \xe2\x80\x9cconvenience of the employer\xe2\x80\x9d doctrine for the purposes of\n\xc2\xa7 119. As explained in its Report, the House proposed to exclude meals from gross\nincome \xe2\x80\x9cif they [were] furnished at the place of employment and the employee\n[was] required to accept them at the place of employment as a condition of his\nemployment.\xe2\x80\x9d H.R. Rep. No. 1337, supra, at 18; see H.R. 8300, 83d Cong., 2d\nSess., \xc2\xa7 119 (1954). Since no reference whatsoever was made to the concept, the\nHouse view apparently was that a statute \xe2\x80\x9cdesigned to end the confusion as to the\ntax status of meals and lodging furnished an employee by his employer\xe2\x80\x9d required\ncomplete disregard of the \xe2\x80\x9cconvenience of the employer\xe2\x80\x9d doctrine.\nThe Senate, however, was of the view that the doctrine had at least a limited role to\nplay. After noting the existence of the doctrine and the Tax Court\xe2\x80\x99s reliance on state\nlaw to refuse to apply it in Doran v. Commissioner, supra, the Senate Report states:\n\xe2\x80\x9cYour committee believes that the House provision is ambiguous in\nproviding that meals or lodging furnished on the employer\xe2\x80\x99s premises,\nwhich the employee is required to accept as a condition of his employment,\nare excludable from income whether or not furnished as compensation.\nYour committee has provided that the basic test of exclusion is to be\nwhether the meals or lodging are furnished primarily for the convenience of\nthe employer (and thus excludable), or whether they were primarily for the\nconvenience of the employee (and therefore taxable). However, in deciding\nwhether they were furnished for the convenience of the employer, the fact\nthat a State statute or an employment contract fixing the terms of the\nemployment indicate the meals or lodging are intended as compensation is\nnot to be determinative. This means that employees of State institutions who\nare required to live and eat on the premises will not be taxed on the value\nof the meals and lodging even though the State statute indicates the meals\nand lodging are part of the employee\xe2\x80\x99s compensation.\xe2\x80\x9d S. Rep. No. 1622,\nsupra, at 19.\nIn a technical appendix, the Senate Report further elaborated:\n\xe2\x80\x9cSection 119 applies only to meals or lodging furnished in kind. Therefore,\nany cash allowances for meals or lodging received by an employee will\ncontinue to be includible in gross income to the extent that such allowances\nconstitute compensation.\xe2\x80\x9d Id. at 190-91.\n177\n\n\x0cAfter conference, the House acquiesced in the Senate\xe2\x80\x99s version of \xc2\xa7 119. Because\nof this, respondent urges that \xc2\xa7 119, as passed, did not discard the \xe2\x80\x9cconvenience of\nthe employer\xe2\x80\x9d doctrine, but indeed endorsed the doctrine shorn of the confusion\ncreated by Mim. 6472 and cases like Doran. Respondent further argues that, by\nnegative implication, the technical appendix to the Senate Report creates a class of\nnoncompensatory cash meal payments that are to be excluded from income. We\ndisagree.\nThe Senate unquestionably intended to overrule Doran and rulings like Mim. 6472.\nEqually clearly, the Senate refused completely to abandon the \xe2\x80\x9cconvenience of the\nemployer\xe2\x80\x9d doctrine as the House wished to do. On the other hand, the Senate did\nnot propose to leave undisturbed the convenience of the employer doctrine as it had\nevolved prior to the promulgation of Mim. 6472. The language of \xc2\xa7 11954 quite\nplainly rejects the reasoning behind rulings \xe2\x80\xa6 which rest on the employer\xe2\x80\x99s\ncharacterization of the nature of a payment. [footnote omitted]. This conclusion is\nbuttressed by the Senate\xe2\x80\x99s choice of a term of art, \xe2\x80\x9cconvenience of the employer,\xe2\x80\x9d\nin describing one of the conditions for exclusion under \xc2\xa7 119. In so choosing, the\nSenate obviously intended to adopt the meaning of that term as it had developed\nover time, except, of course, to the extent \xc2\xa7 119 overrules decisions like Doran. As\nwe have noted above, Van Rosen v. Commissioner, 17 T.C. 834 (1951), provided\nthe controlling court definition at the time of the 1954 recodification, and it\nexpressly rejected the Jones theory of \xe2\x80\x9cconvenience of the employer\xe2\x80\x9d \xe2\x80\x93 \xe2\x80\xa6 and\nadopted as the exclusive rationale the business necessity theory. See 17 T.C. at\n838-840. The business necessity theory was also the controlling administrative\ninterpretation of \xe2\x80\x9cconvenience of the employer\xe2\x80\x9d prior to Mim. 6472. See supra at\n434 U.S. 85-86, and n 19. Finally, although the Senate Report did not expressly\ndefine \xe2\x80\x9cconvenience of the employer,\xe2\x80\x9d it did describe those situations in which it\nwished to reverse the courts and create an exclusion as those where \xe2\x80\x9can employee\nmust accept ... meals or lodging in order properly to perform his duties.\xe2\x80\x9d S. Rep.\nNo. 1622, supra, at 190.\nAs the last step in its restructuring of prior law, the Senate adopted an additional\nrestriction, created by the House and not theretofore a part of the law, which\nrequired that meals subject to exclusion had to be taken on the business premises\nof the employer. Thus, \xc2\xa7 119 comprehensively modified the prior law, both\nexpanding and contracting the exclusion for meals and lodging previously\n\xe2\x80\x9c[T]he provisions of an employment contract ... shall not be determinative of whether ... meals ... are\nintended as compensation.\xe2\x80\x9d\n54\n\n178\n\n\x0cprovided, and it must therefore be construed as its draftsmen obviously intended it\nto be \xe2\x80\x93 as a replacement for the prior law, designed to \xe2\x80\x9cend [its] confusion.\xe2\x80\x9d\nBecause \xc2\xa7 119 replaces prior law, respondent\xe2\x80\x99s further argument \xe2\x80\x93 that the technical\nappendix in the Senate Report recognized the existence under \xc2\xa7 61 of an exclusion\nfor a class of noncompensatory cash payments \xe2\x80\x93 is without merit. If cash meal\nallowances could be excluded on the mere showing that such payments served the\nconvenience of the employer, as respondent suggests, then cash would be more\nwidely excluded from income than meals in kind, an extraordinary result given the\npresumptively compensatory nature of cash payments and the obvious intent of\n\xc2\xa7 119 to narrow the circumstances in which meals could be excluded. Moreover,\nthere is no reason to suppose that Congress would have wanted to recognize a class\nof excludable cash meal payments. The \xe2\x80\xa6 precedents [supporting] exclusion of\ncash \xe2\x80\xa6 rest on the proposition that the convenience of the employer can be inferred\nfrom the characterization given the cash payments by the employer, and the heart\nof this proposition is undercut by both the language of \xc2\xa7 119 and the Senate Report.\nFinally, as petitioner suggests, it is much more reasonable to assume that the cryptic\nstatement in the technical appendix \xe2\x80\x93 \xe2\x80\x9ccash allowances ... will continue to be\nincludable in gross income to the extent that such allowances constitute\ncompensation\xe2\x80\x9d \xe2\x80\x93 was meant to indicate only that meal payments otherwise\ndeductible under \xc2\xa7 162(a)(2) of the 1954 Code [footnote omitted] were not affected\nby \xc2\xa7 119.\nMoreover, even if we were to assume with respondent that cash meal payments\nmade for the convenience of the employer could qualify for an exclusion\nnotwithstanding the express limitations upon the doctrine embodied in \xc2\xa7 119, there\nwould still be no reason to allow the meal allowance here to be excluded. Under\nthe pre-1954 \xe2\x80\x9cconvenience of the employer\xe2\x80\x9d doctrine, respondent\xe2\x80\x99s allowance is\nindistinguishable from that in Van Rosen v. Commissioner, supra, and hence it is\nincome. ... In any case, to avoid the completely unwarranted result of creating a\nlarger exclusion for cash than kind, the meal allowances here would have to be\ndemonstrated to be necessary to allow respondent \xe2\x80\x9cproperly to perform his duties.\xe2\x80\x9d\nThere is not even a suggestion on this record of any such necessity.\n\xe2\x80\xa6.\nReversed.\n\n179\n\n\x0cMR. JUSTICE BLACKMUN, with whom THE CHIEF JUSTICE joins, dissenting.\n....\nI fear that state troopers the country over, not handsomely paid to begin with, will\nnever understand today\xe2\x80\x99s decision. And I doubt that their reading of the Court\xe2\x80\x99s\nopinion \xe2\x80\x93 if, indeed, a layman can be expected to understand its technical wording\n\xe2\x80\x93 will convince them that the situation is as clear as the Court purports to find it.\nNotes and Questions:\n1. In the first sentence of its opinion, the Court set forth the issues it undertook to\nresolve. How did it resolve those issues?\n2. Whether meal money falls within an exclusion and whether it is gross income\nare separate questions. With respect to the second question, let\xe2\x80\x99s review: What facts\nwere particularly bad for Officer Kowalski and why? What strings were attached\nto the meal money that were different than the strings attached to any worker\xe2\x80\x99s\nwages?\n3. Why would an employer provide in a contract that lodging is intended to be\ncompensatory?\n4. How important should the employer\xe2\x80\x99s treatment of meal money \xe2\x80\x93 separate\naccounting, no commingling of funds \xe2\x80\x93 be in resolution of the question of whether\ncash-for-meals should be included in an employee\xe2\x80\x99s gross income? Isn\xe2\x80\x99t that a red\nherring in determining whether taxpayer Kowalski has enjoyed an accession to\nwealth? The Tax Court concluded that the meal money was not intended to be\nadditional compensation, but was nevertheless includable in taxpayer\xe2\x80\x99s gross income.\n5. In the first footnote of the case, the Court quoted a case that quoted Benaglia.\nTaxpayer Benaglia\xe2\x80\x99s employer provided him accommodations at the Royal\nHawaiian Hotel and meals in the hotel dining room because otherwise taxpayer\ncould not perform the services required of him as manager of that and other hotels.\nMoreover, Benaglia was denied the discretion to spend this accession to wealth in\nany manner that he saw fit.\n\xe2\x80\xa2Have we seen the \xe2\x80\x9cdeprivation of discretion\xe2\x80\x9d theme before?\n\xe2\x80\xa2What conclusion do these holdings suggest?\n180\n\n\x0c\xe2\x80\xa2See Reg. \xc2\xa7 1.119-1(a)(3)(i).\n6. Surely even a taxpayer denied a choice in her purchase of meals or lodging and\nwhose employment requires that any meal that she does eat be taken where and\nwhen the employer orders derives some consumption benefit that she would have\npaid something for if the employer had not provided it. Does it have to be all-ornothing?\n\xe2\x80\xa2Section 274(n)(1) limits deductions (not exclusions) for food or beverages\nto 50% of the amount spent. The Code implicitly treats the other 50% as a\npersonal expenditure and so subject to federal income tax \xe2\x80\x93 but it is the one\nwho pays for the meal who must pay the income tax, not (necessarily) the\none who consumes it.\n\xe2\x80\xa2How important is administrative ease in this? How important is accuracy?\nIf 50% isn\xe2\x80\x99t the right figure (and neither is another figure), should we revert\nto all-or-nothing? Perhaps 50% is simply a \xe2\x80\x9cleast-bad\xe2\x80\x9d figure.\n7 Should \xe2\x80\x9cunderpayment\xe2\x80\x9d of a class of workers provide any support whatsoever\nfor a conclusion that \xc2\xa7 119 encompasses the cash payments in this case \xe2\x80\x93 as Justice\nBlackmun suggests? How many people do not feel that they are \xe2\x80\x9cunderpaid?\xe2\x80\x9d\n\xe2\x80\xa2Were the view of Justice Blackmun to have prevailed, the consequences\nwould have been highly unfortunate. How so and why? What economic\ndistortions would have resulted?\n8. What interest should the State of New Jersey, Officer Kowalski\xe2\x80\x99s employer,\nhave in the outcome of this case? If Officer Kowalski must pay income tax on his\nmeal money, the State of New Jersey may find that it must increase the wages of\nits state troopers. It is entirely possible that the State of New Jersey captured all the\ntax savings that Justice Blackmun feels all state troopers deserve.\n9. Using the figures that the Court provided, Officer Kowalski received 13%\n($1371 out of $10,437) tax-free. Naturally, this affects the amount of income tax\nthat others must pay if the Government is to raise a certain amount of revenue.\nMoreover, other workers who might pay income tax on $9066 \xe2\x80\x93 the amount on\nwhich Officer Kowalski did pay income tax \xe2\x80\x93 who do not receive meal money that\nthey may spend any way they wish probably would understand very well the\nsystem\xe2\x80\x99s discriminatory treatment of two different taxpayers\xe2\x80\x99 unequal accessions\nto wealth \xe2\x80\x93 contrary to Justice Blackmun\xe2\x80\x99s inferential suggestion that this decision\nis difficult for lay people to understand.\n181\n\n\x0c10. In a sense, the Kowalski case presents the tip of an iceberg. Notice the topics\nof \xc2\xa7\xc2\xa7 105, 106, 107, 125, 127, 129, 132, 137. These code sections name benefits\nthat an employer can provide employees that are not subject to income tax to either\nthe employer or the employee. These provisions assure that like taxpayers who\nwork for different employers are not taxed alike.\n11. Presumably, the accessions to wealth that employers offer employees that\nemployees may in turn exclude from their gross income empower employers to\ncustomize the type of workforce they want. Maybe that is good. Airlines can pay\nless-than-market wages to persons who like to travel. Retailers can give employee\ndiscounts to persons who would (enthusiastically) shop at their establishments\nanyway. And so on.\n\xe2\x80\xa2Consider this proposition: instead of aspiring to horizontal equality, aspire\nto horizontal equity by permitting a fixed ceiling on the value of excludable\nbenefits that employers may provide employees. See William P. Kratzke,\nThe (Im)Balance of Externalities in Employment-Based Exclusions from\nGross Income, 60 TAX LAW. 1, 3-8 (2006) (effective rate of federal income\nand employment taxes would be more progressive).\n12. Read Reg. \xc2\xa7 1.119-1(a)(2)(ii)(d).\n\xe2\x80\xa2Do you think that someone lobbied to have this provision included in the\nregulations? Who?\n13. Consider:\n13a. Fishing Expeditions, Inc. flies fishing parties to remote cabins that it owns in\nAlaska. Its employees are small-airplane pilots, guides, and cooks. Obviously while\nservicing a fishing party, the employees must reside at a remote cabin and take\nmeals there also. The employees must pay Fishing Expeditions, Inc. $200 per week,\nwhich Fishing Expeditions collects by deducting this amount from their paychecks.\nThe employees must include the $200 in their gross income.\n\xe2\x80\xa2True or false? See \xc2\xa7 119(b)(3); Reg. \xc2\xa7 1.119-1(a)(3)(ii).\n\n182\n\n\x0cDeadweight Loss: Deadweight loss is someone\xe2\x80\x99s loss and no one\xe2\x80\x99s gain. The value of\na good or service to a person is what the person is willing to pay for it. Everyone\nseeks to maximize value to herself through purchasing choices within the limits of her\nafter-tax income. Do exclusions from gross income cause deadweight loss? Yes.\nConsider: Taxpayer pays income taxes at a marginal rate of 25%. Taxpayer is\nwilling to pay $90 for a benefit and no more. Taxpayer would have to earn $120\nto pay tax on the income necessary to purchase the benefit for $90. Naturally,\ntaxpayer would be willing to pay less. The market price of the benefit is $100.\nTaxpayer will not purchase this benefit, but will spend her after-tax income in ways\nthat maximize her own consumer surplus. Producers in turn strive to provide taxpayer\ngoods and services at a cost to them that is less than the price taxpayer (and others)\nare willing to pay. All producers make a profit, so the markets are \xe2\x80\x9csustainable.\xe2\x80\x9d The\neconomy works with allocative efficiency.\nNow suppose that the Code excludes the benefit from taxpayer\xe2\x80\x99s gross income if her\nemployer provides it. Taxpayer\xe2\x80\x99s employer offers to provide the benefit to taxpayer\nif taxpayer will accept a $100 reduction in pay. Should taxpayer accept the offer?\nFrom taxpayer\xe2\x80\x99s perspective, she can choose to keep the $100 in wages; this nets\ntaxpayer $75 after taxes. But because of the exclusion, taxpayer can rationally\nchoose to accept the benefit. That is because taxpayer essentially \xe2\x80\x9cpays\xe2\x80\x9d $75 for\nsomething she values at $90. That\xe2\x80\x99s $15 of consumer surplus.\nUnfortunately, the producers of the things taxpayer would have bought with her $75\nof after-tax income lose the sales. The surplus value that they and taxpayer would\nhave created by entering value-increasing bargains is lost \xe2\x80\x93 and replaced by a\ntransaction that most assuredly does not increase after-tax value. No one captures\nthe net loss in surplus value. It is deadweight loss.\nAll exclusions from gross income imply some deadweight loss. Assume that you had\naccess to any information you wanted. How would you determine whether the\nnation should absorb such deadweight losses?\n13b. Cicely is an employee of the Hanford Nuclear Works. The HNR is located 60\nmiles from the nearest structure and 70 miles from the nearest town. HNR maintains\nsome barracks-style housing onsite that it provides various workers, who are\ntypically in their 20s and single for free. The value of this housing is $500 per\n183\n\n\x0cmonth. To be fair to the other workers, HNR pays a housing stipend of $500 per\nmonth to employees who elect to live in the nearest town and commute to the\njobsite.\n\xe2\x80\xa2Tax consequences to the workers who live onsite?\n\xe2\x80\xa2Tax consequences to the workers who live in town?\nF. Employee Fringe Benefits: \xc2\xa7 132\nPrior to 1984 \xe2\x80\x93 and as taxpayer Kowalski argued \xe2\x80\x93 there evolved an uneven\npatchwork of \xe2\x80\x9cfringe benefits\xe2\x80\x9d that employers and employees alike assumed were\nnot subject to income tax. This cost the Treasury revenue and resulted in horizontal\ninequities. Congress addressed the problem, and in 1984, \xe2\x80\x9cdrew a line in the sand.\xe2\x80\x9d\nThe following is an explanation of what Congress did and why.\nH. Rep. No. 98-432 (II), 98th Cong., 2d Sess. 1984, at 412, 1984 U.S.C.C.A.N.\n697, 1215, 1984 WL 37400, to accompany H.R. 4170.\n....\nIn providing statutory rules for exclusion of certain fringe benefits for income and\npayroll tax purposes, the committee has attempted to strike a balance between two\ncompeting objectives.\nFirst, the committee is aware that in many industries, employees may receive, either\nfree or at a discount, goods and services which the employer sells to the general\npublic. In many cases, these practices are long established, and have been treated\nby employers, employees, and the IRS as not giving rise to taxable income.\nAlthough employees may receive an economic benefit from the availability of these\nfree or discounted goods or services, employers often have valid business reasons,\nother than simply providing compensation, for encouraging employees to avail\nthemselves of the products which they sell to the public. For example, a retail\nclothing business will want its salespersons to wear, when they deal with customers,\nthe clothing which it seeks to sell to the public. In addition, the fact that the selection\nof goods and services usually available from a particular employer usually is\nrestricted makes it appropriate to provide a limited exclusion, when such discounts\nare generally made available to employees, for the income employees realize from\nobtaining free or reduced-cost goods or services. The committee believes,\n184\n\n\x0ctherefore, that many present practices under which employers may provide to a\nbroad group of employees, either free or at a discount, the products and services\nwhich the employer sells or provides to the public do not serve merely to replace\ncash compensation. These reasons support the committee\xe2\x80\x99s decision to codify the\nability of employers to continue these practices without imposition of income or\npayroll taxes.\nThe second objective of the committee\xe2\x80\x99s bill is to set forth clear boundaries for the\nprovision of tax-free benefits. ... [A]dministrators of the tax law have not had clear\nguidelines in this area, and hence taxpayers in identical situations have been treated\ndifferently. The inequities, confusion, and administrative difficulties for\nbusinesses, employees, and the IRS ... have increased substantially in recent years.\nThe committee believes that it is unacceptable to allow these conditions ... to\ncontinue any longer.\nIn addition, the committee is concerned that without any well-defined limits on the\nability of employers to compensate their employees tax-free by using a medium\nother than cash, new practices will emerge that could shrink the income tax base\nsignificantly, and further shift a disproportionate tax burden to those individuals\nwhose compensation is in the form of cash. A shrinkage of the base of the social\nsecurity payroll tax could also pose a threat to the viability of the social security\nsystem above \xe2\x80\xa6 Finally, an unrestrained expansion of noncash compensation\nwould increase inequities among employees in different types of businesses, and\namong employers as well.\nThe nondiscrimination rule is an important common thread among the types of\nfringe benefits which are excluded under the bill from income and employment\ntaxes. Under the bill, most fringe benefits may be made available tax-free to\nofficers, owners, or highly compensated employees only if the benefits are also\nprovided on substantially equal terms to other employees. The committee believes\nthat it would be fundamentally unfair to provide tax-free treatment for economic\nbenefits that are furnished only to highly paid executives. Further, where benefits\nare limited to the highly paid, it is more likely that the benefit is being provided so\nthat those who control the business can receive compensation in a nontaxable form;\nin that situation, the reasons stated above for allowing tax-free treatment would not\nbe applicable. Also, if highly paid executives could receive free from taxation\neconomic benefits that are denied to lower-paid employees, while the latter are\ncompensated only in fully taxable cash, the committee is concerned that this\nsituation would exacerbate problems of noncompliance among taxpayers. In this\n185\n\n\x0cregard, some commentators argue that the current situation \xe2\x80\x93 in which the lack of\nclear rules for the tax treatment of nonstatutory fringe benefits encourages the\nnonreporting of many types of compensatory benefits \xe2\x80\x93 has led to nonreporting of\ntypes of cash income which are clearly taxable under present-law rules, such as\ninterest and dividends.\nIn summary, the committee believes that by providing\nrules which essentially codify many present practices\nunder which employers provide their own products\nand services tax-free to a broad group of employees ...\nthe bill substantially improves the equity and\nadministration of the tax system.\nC. Explanation of Provisions\n1. Overview\n\nSection 83: Read \xc2\xa7 83(a) and\nskim \xc2\xa7 83(b, c, d, f, h). For\nnow, \xc2\xa7 83(a) establishes that\nreceipt of property in\nexchange for services is gross\nincome to the one performing\nthe services. That is hardly\nprofound. The larger concern\nof \xc2\xa7 83 is with the timing of\nrecognition of that income\nand associated deductions,\nmatters we consider in\nchapter 9.\n\nUnder the bill, certain fringe benefits provided by an\nemployer are excluded from the recipient employee\xe2\x80\x99s\ngross income for federal income tax purposes and from the wage base (and, if\napplicable, the benefit base) for purposes of income tax withholding, FICA, FUTA,\nand RRTA.\n....\nAny fringe benefit that does not qualify for exclusion under the bill (for example,\nfree or discounted goods or services which are limited to corporate officers) and\nthat is not excluded under another statutory fringe benefit provision of the code is\ntaxable to the recipient under ... \xc2\xa7\xc2\xa7 61 and 83, and is includible in wages for\nemployment tax purposes, at the excess of its fair market value over any amount\npaid by the employee for the benefit.\nNotes and Questions:\n\n1. As the Report implies, the notion that fringe benefits were nontaxable had gotten\nout of hand. The approach of Congress was to define fringe benefits that are\nexcludible from gross income and to draw a line in the sand: \xe2\x80\x9cthis far and no\nfarther.\xe2\x80\x9d The Court in Kowalski explained and applied this principle.\n186\n\n\x0c2. Read \xc2\xa7 132. Originally, \xc2\xa7 132 named only four exclusions. Congress has added\nother carefully defined \xe2\x80\x9cqualified\xe2\x80\x9d fringe benefits that are excluded from an\nemployee\xe2\x80\x99s gross income. Consider these problems:\n1. Phillip works for Sports World, a mega-sporting goods store. Phillip enjoys\nbeing outdoors and so would probably spend a lot of time shopping at Sports World,\neven if he didn\xe2\x80\x99t work there. Last year, Sports World sold $10M worth of sporting\ngoods. The cost of its merchandise was $7M; its overhead was $2M. Sports World\noffers its employees a 25% employee discount on items that employees purchase.\nPhillip purchased a fishing boat that retails for $1000. Phillip paid $750.\n\xe2\x80\xa2Tax consequences to Phillip?\n1a. One week later, Phillip sold the fishing boat to his brother for $1050.\n\xe2\x80\xa2Tax consequences to Phillip?\n\xe2\x80\xa2See \xc2\xa7 132(a)(2) and \xc2\xa7 132(c).\n1b. Sports World is situated in a large, oddly-shaped building that had stood empty\nfor several years. Service merchants in the area (restaurants, dry cleaners, dentists,\noptometrists, etc.) were anxious that Sports World would occupy the building and\nreadily entered into reciprocal arrangements whereby employees of Sports World\nwere entitled to a 20% discount off the retail prices of these merchants\xe2\x80\x99 services.\nSports World agreed to give only a 10% discount for the employees of these service\nmerchants. Last week, Phillip paid $80 for dental services that normally cost $100.\nA nearby optometrist purchased a tent from Sports World that normally retails for\n$100 for only $90.\n\xe2\x80\xa2Tax consequences to Phillip?\n\xe2\x80\xa2Tax consequences to the optometrist?\n\xe2\x80\xa2See \xc2\xa7 132(i); Reg. \xc2\xa7 1.132-3(a)(3).\n2. Mesquite Airlines is a commercial airline. It offers its employees free standby\nair travel. Moreover, Mesquite Airlines has entered into a reciprocal agreement with\nseveral other airlines whereby employees of Mesquite may fly standby for free on\nother airlines, and employees of the other airlines may fly free on Mesquite\nAirlines. Megan is a retired airline pilot who flew airplanes for Mesquite Airlines\nfor 35 years. Megan flew standby on a Mesquite Airlines flight; the normal fare\nwas $400.\n\xe2\x80\xa2Tax consequences to Megan? See \xc2\xa7 132(h).\n187\n\n\x0c2a. Megan flew standby on another airline. The normal fare was $400.\n\xe2\x80\xa2Tax consequences to Megan?\n2b. Without charging her, Mesquite Airlines permitted Megan to reserve her seat\nfor two weeks from now. The normal fare was $400.\n\xe2\x80\xa2Tax consequences to Megan?\n3. When the University of Memphis Law School moved into its home in downtown\nMemphis, faculty members chose their offices pursuant to a system\nthat incorporated consideration of rank and seniority. Staff offices have a rental\nvalue of $3600 per year. Professor K now has a corner office with a nice view of\nthe Mississippi River. The rental value of the \xe2\x80\x9cworst\xe2\x80\x9d faculty office is $4800 per\nyear. The rental value of Professor K\xe2\x80\x99s office is $14,400 per year.\n\xe2\x80\xa2Tax consequences to Professor K? See \xc2\xa7 132(a)(3) and \xc2\xa7 132(d).\nCode and Regulations: By now you should have\ngained some facility flipping between the\nprovisions of the Code and the Regulations.\nWithin that context, this reminder might be\nappropriate. The Code is the text that Congress\nenacted. It is law so long as it is consistent with\nthe Constitution. The Regulations are text that\nthe Treasury Department adopted to construe\nthe Code. It also is law, so long as it is consistent\nwith the Code and with the Constitution. You\nhave already seen implementation of this\nhierarchy in cases that you have read.\n\n3a. Same facts. The Law School\npurchased for Professor K and one\nother professor (but no one else)\nonline access to the CCH FEDERAL\nTAX REPORTER. The retail cost of\nthis access is $2500 per year.\n\xe2\x80\xa2Tax consequences to Professor K?\n\xe2\x80\xa2Is there any other information you\nneed to answer this question?\n\n4. Joe the Plumber, Inc. sells\nplumbing services to customers. It\nhas a policy of offering employees\na 25% discount on plumbing\nservices that they purchase from Joe the Plumber, Inc. However, Joe the Plumber,\nInc. offers a 40% discount to its \xe2\x80\x9chighly-compensated\xe2\x80\x9d employees. An employee\npurchased plumbing services that normally cost $200 for $150. One of Joe the\nPlumber\xe2\x80\x99s highly-compensated employees purchased the same services for $120.\n\xe2\x80\xa2Tax consequences to the employee?\n\xe2\x80\xa2Tax consequences to the highly-compensated employee?\n\xe2\x80\xa2See \xc2\xa7 132(j)(1).\n5. Lotsa Refunds, Inc. is a tax return preparer that does a volume business among\nunbanked, low-income persons. The corporation has ten employees. At the end of\n188\n\n\x0ca very hectic tax season, Lotsa Refunds presented each of its employees with a $50\nprepaid Mastercard cash card, in addition to her normal wages. This was because\nof the gratitude Lotsa Refunds felt for its employees having worked long hours\nagainst tight deadlines. Lotsa Refunds\xe2\x80\x99 highly-compensated employees did not\nreceive such a card.\n\xe2\x80\xa2Tax consequences to the employees?\n5a. The employees of Lotsa Refunds, Inc. worked from 7 a.m. until 12 midnight\nevery night between April 1 and April 15.\nSection 274(n): Read \xc2\xa7 274(n)(1).\nCriminal activity increases after midnight, so\nHow does it affect the rule of \xc2\xa7\nLotsa Refunds paid for Uber rides for all its\n132(e)(2)? Pay attention to the\nemployees on those days \xe2\x80\x93 both from and to\ndifference between a deduction\nwork in the morning. Assume that a typical fare\nand an exclusion.\nis $15.\n\xe2\x80\xa2Tax consequences to the employees? See Reg.\n\xc2\xa7 1.132-6(d)(2)(iii)(A, B, and C).\n\xe2\x80\xa2Are there any more facts you might wish to know?\n6. Springfield Memorial Hospital operates a cafeteria for its workers. Its prices for\neach food item cover the direct operating costs of selling that item. This price is\nless than the price for which it would be sold in a for-profit cafeteria. Some of the\nhospital\xe2\x80\x99s workers are on call for emergencies at all times, even during their\nmealtimes. The mealtime of these workers is 30 minutes. These employees have\nspecial vouchers in the cafeteria which permit them to take food equal to $9 \xe2\x80\x9cworth\xe2\x80\x9d\nof food. Other personnel may eat in the cafeteria, but must pay the charge listed for\neach food item; these persons are not on call, and many of them do not eat in the\ncafeteria. Overall, the cafeteria loses money because most employees in the first\ngroup do eat in the cafeteria.\n\xe2\x80\xa2Tax consequences to the first group of employees?\n\xe2\x80\xa2Tax consequences to the second group of employees?\n\xe2\x80\xa2See \xc2\xa7 132(e)(2), including carryout paragraph.\n7. Assume that the indexed amounts applicable to \xc2\xa7 132(f)(2)(A and B) is $260 per\nmonth. Delphic Paperworks, Inc.\xe2\x80\x99s headquarters are situated in the downtown area\nof Metroville, a large city with a lot of traffic. Four hundred people work at the\nheadquarters. Next door to the headquarters is a parking lot that charges\n$260/month for a parking place. In recognition of the traffic and parking problems\nthat its employees face, Delphic gives every employee at its headquarters a choice:\nit will provide transportation in a commuter highway vehicle as defined in\n189\n\n\x0c\xc2\xa7 132(f)(5)(B)), or it will arrange\nwith the garage to provide a parking\nplace for the employee, or pay $260\ncash to the employee.\nSome\nemployees take only the \xe2\x80\x9cfree\xe2\x80\x9d ride\nto work, some take only the parking\nplace, and others take the cash.\n\xe2\x80\xa2Tax consequences to the\nemployees who take the ride\nto work?\n\xe2\x80\xa2Tax consequences to the\nemployees who take the\nparking place?\n\xe2\x80\xa2Tax consequences to the\nemployees who take the\ncash?\n\xe2\x80\xa2Delphic\xe2\x80\x99s expenses would\nbe deductible under \xc2\xa7 162,\nright? See \xc2\xa7\xc2\xa7 274(a)(4) and\n274(l)(1).\n\nDo the CALI Lesson,\nBasic Federal Income Taxation:\nGross Income: The Taxability of\nEmployment Connected Payments:\nFringe Benefits, Meals and\nLodging,\nUnemployment\nCompensation, and Social Security\nBenefits.\n\nTax Cuts and Jobs Act: The Tax Cuts and Jobs Act\nsuspends from 2018 through 2025 exclusion of an\nemployer-provided qualified bicycle commuting\nfringe. \xc2\xa7 132(a)(5), (f)(1)(D), (f)(8). The Act also\nsuspends for the same years an exclusion for\nemployer-paid moving expenses. \xc2\xa7\xc2\xa7 132(a)(6), (g)(1\nand 2).\nSection 274(l) now denies employers a deduction for\nany expense (the word \xe2\x80\x9cexpense\xe2\x80\x9d does not have the\nsame meaning as the word \xe2\x80\x9cvalue\xe2\x80\x9d) incurred to\nprovide transportation to an employee for \xe2\x80\x9ctravel\nbetween the employee\xe2\x80\x99s residence and place of\nemployment, except as necessary for ensuring the\nsafety of the employee.\xe2\x80\x9d \xc2\xa7 274(l)(1). For tax years\n2018 to 2025, this limitation does not apply in\nconnection with a \xe2\x80\x9cqualified bicycle commuting\nreimbursement[.]\xe2\x80\x9d \xc2\xa7 274(l)(2). Expenses in excess of\nthe statutorily prescribed maxima (as indexed for\ninflation) are deductible by employers and are\nincluded in the gross income of employees. See\ngenerally, I.R.S. Notice 2018-52, 2018-52 I.R.B.\n1067 (\xe2\x80\x9cParking Expenses for Qualified\nTransportation Fringes Under \xc2\xa7 274(a) and\n\xc2\xa7 512(a)(7) of the Internal Revenue Code\xe2\x80\x9d).\nBe alert to congressional treatment of transportation\nfringes. Whereas most fringe benefits are not subject\nto income taxation at either the employer or\nemployee level, transportation fringes might be\nsubject to income taxation at one level \xe2\x80\x93 and that\nlevel might be the employer level. Read the\napplicable statutes carefully.\n\n190\n\n\x0cG. Cafeteria Plans, \xc2\xa7 125\nNormally, a taxpayer may not avoid realizing gross income by turning her back on\ncash. Hence, if an employer were to give all employees a choice between, say,\n$5000 cash or $5000 of dependent care assistance, taxpayer would have to realize\ngross income no matter which choice she made. Either the employee accepted the\ncash (taxable) or could have accepted the cash (also taxable).\n\xe2\x80\xa2Some of an employer\xe2\x80\x99s workforce might be parents whose children require,\nsay, after-school care. To avoid application of this \xe2\x80\x9cconstructive receipt\xe2\x80\x9d\ndoctrine, the employer would have to offer a dependent care assistance\nprogram to all employees.\n\xe2\x80\xa2The non-parents would give up wages for this benefit, even though\nthey derive no value from it.\n\xe2\x80\xa2If the employer did not offer such a program, the parents could not\navail themselves of the \xc2\xa7 129 exclusion.\nSection 125 mitigates these effects substantially, and gives employers and\nemployees the power to customize a benefits package to a point \xe2\x80\x93 or to accept cash.\nA participant in a \xe2\x80\x9ccafeteria plan\xe2\x80\x9d does not realize gross income simply because\nshe may choose to receive cash or to choose to receive one of the plan\xe2\x80\x99s qualified\nbenefits that the employer offers.\n\xe2\x80\xa2Section 125(f) defines a \xe2\x80\x9cqualified benefit\xe2\x80\x9d to be any benefit which is not\nincludible in the gross income of an employee except for \xc2\xa7 106(b) (Archer\nMSAs), \xc2\xa7 117 (scholarships, qualified tuition reduction), \xc2\xa7 127 (employer\neducational assistance programs), and \xc2\xa7 132 (fringe benefits).\n\xe2\x80\xa2However, qualified transportation fringes are treated in the same\nmanner as other qualified benefits of a cafeteria plan, \xc2\xa7 132(f)(4).\n\xe2\x80\xa2Moreover, group-term life insurance (see \xc2\xb6 79) in excess of $50,000 is a\nqualified benefit.\n\xe2\x80\xa2Reg. \xc2\xa7 1.125-1(a)(3) lists qualified benefits\nthat an employer may offer in a cafeteria plan. CAA, Taxpayer Certainty\nand Disaster Relief Act of\nSection 125(j) authorizes \xe2\x80\x9csimple cafeteria plans for 2020 \xc2\xa7 214 provides that\ntaxpayers may carry over\nsmall businesses.\xe2\x80\x9d\nunused amounts in their\nflexible spending accounts for\nhealth and dependent care\nexpenses from 2020 to 2021,\nand from 2021 to 2022.\n191\n\n\x0cProposed Reg. \xc2\xa7 1.125-5(a)(1) authorizes flexible spending arrangements whereby\nemployees agree to a reduction in their salary to be spent on a use-it-or-lose it basis\non qualified benefits.\nWhy should an employer offer a cafeteria plan?\n\nWrap-up Questions for Chapter 3\n1. In what ways \xe2\x80\x93 good or bad \xe2\x80\x93 do you think exclusions from gross income affect\nmarkets? It may help to consider one example, e.g., the market for health care.\n2. What does it mean that an exclusion may be \xe2\x80\x9ccaptured\xe2\x80\x9d by someone other than\nthe taxpayer Congress intended to benefit? Consider the exclusion from gross\nincome of scholarships offered by someone other than the school or the rental value\nof parsonages.\n3. Why is the receipt of cash so rarely excluded from a taxpayer\xe2\x80\x99s gross income?\nIf an employer gave an employee a gift card to a particular store, should the\nemployee be treated as having received cash for purposes of the income tax? Are\nthere additional facts you might want to know?\n4. Are there any statutory exclusions from gross income that you feel should be\nrepealed? Which ones and why? Can you think of any benefits that should be\nexcluded? How about identity theft protection services provided to data breach\nvictims? See I.R.S. Announcement 2015-22 (Aug. 14, 2015), available at 2015 WL\n4769571.\n5. What is deadweight loss? Which exclusions do you think cause the most\ndeadweight loss?\n\nWhat have you learned?\nCan you explain or define \xe2\x80\x93\n\xe2\x80\xa2The difference between an exclusion and a deduction\n\xe2\x80\xa2Capture of the benefit of an exclusion\n\xe2\x80\xa2How exclusions distort markets; how they cause deadweight loss\n\xe2\x80\xa2Gifts under the Code and their treatment\n\xe2\x80\xa2The effect of gift tax paid on the donee\xe2\x80\x99s basis\n\xe2\x80\xa2The limitations of the excludability from income of a bequest\n192\n\n\x0c\xe2\x80\xa2The limitations of the excludability from income of a prize (\xc2\xa7\xc2\xa7 74, 274(j))\n\xe2\x80\xa2Why only high-income people (should) purchase the bonds of state and local\ngovernments\n\xe2\x80\xa2What are the important exclusions from gross income that the Code provides\n\xe2\x80\xa2What are the important employment-based exclusions from gross income that the\nCode provides\n\n193\n\n\x0cChapter 4: Loans and Cancellation of Indebtedness\nI. Tax Consequences of Borrowing Money\nThe Tax Formula:\n\xe2\x9e\x94(gross income)\nMINUS deductions named in \xc2\xa7 62\nEQUALS (adjusted gross income (AGI))\nMINUS (standard deduction or itemized\ndeductions)\nMINUS (deduction for \xe2\x80\x9cqualified business\nincome\xe2\x80\x9d)\nEQUALS (taxable income)\nCompute income tax liability from tables\nin \xc2\xa7 1(j) (indexed for inflation)\nMINUS (credits against tax)\nTaxpayer\xe2\x80\x99s expenditure entitles him to\nbasis in whatever asset he may purchase.\n\nIn this chapter, we consider the tax\nconsequences of borrowing money. A\ntaxpayer who borrows money has that\nmuch more money to spend. It also\nmeans that he has incurred an\nobligation to repay the loan. One\nprecisely offsets the other. For this\nreason, there are no tax consequences to\ntaking out a loan. Furthermore,\ntaxpayer is entitled to spend the\nborrowed money on investment or\nconsumption \xe2\x80\x93 and we treat such a\ntaxpayer the same as we would a\ntaxpayer who made such a purchase or\ninvestment with after-tax income.\nThe Tax Code and Economic Growth: A\ntaxpayer\xe2\x80\x99s opportunity to invest borrowed\nfunds prior to the time that he has paid\nincome tax on the income necessary to invest\nan equivalent amount has tremendous growth\nimplications for the nation\xe2\x80\x99s economy.\nImagine how much more slowly the economy\nwould grow if borrowed funds were subject\nto income tax immediately upon receipt.\nThere would still be markets for credit, but\nthe higher cost of borrowing would mean that\nthere would be less borrowing \xe2\x80\x93 and slower\ngrowth.\n\nThis does not mean that taxpayer is\nentitled to income that is not subject to\nincome tax. Consider how taxpayer will\nmeet his obligation to repay the loan.\nTaxpayer will have to acquire money that\nis subject to income tax \xe2\x80\x93 perhaps by\nworking at a job in exchange for wages.\nTaxpayer will pay income tax on that\nincome, and use what remains after\npayment of taxes to repay the loan. By\ntaking out a loan, taxpayer has made a\nfuture\nconsumption\nchoice,\ni.e.,\nrepayment of the loan. Consistent with the principle that borrowing money is not\nincome to the taxpayer is the rule that repayment of loan principal is not deductible.\n194\n\n\x0cFor a good summary of the topics\ncovered in this chapter, see\nDouglas Kahn & Jeffrey H. Kahn,\nCancellation of Debt and Related\nTransactions, 69 TAX LAW. 161\n(2015).\n\nII. Cancellation of Indebtedness\n\nAll of this assumes that taxpayer will indeed\nrepay the full amount of the loan. Consider now\nwhat happens when we no longer make this\nassumption. Taxpayer does not repay the loan,\nand for whatever reason, no longer owes it.\n\xe2\x80\xa2Taxpayer has enjoyed the benefits of an expenditure on consumption or\ninvestment without paying income tax on that consumption or investment.\n\xe2\x80\xa2Taxpayer no longer commits his future consumption choices to repayment\nof the loan.\n\xe2\x80\xa2Should we not regard this as an accession to wealth and treat it as gross\nincome? See \xc2\xa7 61(a)(11).\nOr: perhaps the assets that taxpayer purchased with the borrowed funds (e.g., a\nbusiness venture) and upon which taxpayer relies to repay the loan shrink in value\nso that taxpayer is no longer able to repay the loan.\n\xe2\x80\xa2Should this excuse a failure to repay the loan because such shrinkage can\nhardly be regarded as an \xe2\x80\x9caccession to wealth?\xe2\x80\x9d\n\xe2\x80\xa2If we deem such a shrinkage not to be an \xe2\x80\x9caccession to wealth,\xe2\x80\x9d we\neffectively merge the borrowing transaction and the spending or investing\nof the loan proceeds into one transaction. Is this appropriate? Or should we\naccount separately for \xe2\x80\x93\n\xe2\x80\xa2the borrowing and repayment, and\n\xe2\x80\xa2the fate of the enterprise in which taxpayer spends or invests the\nloan proceeds?\nOr: Perhaps taxpayer can take advantage of market conditions to satisfy his\nobligation by paying less than the amount that he originally borrowed.\nWhat answers to these questions does this leading case suggest?\n\n195\n\n\x0cUnited States v. Kirby Lumber Co., 284 U.S. 1 (1931)\nMR. JUSTICE HOLMES delivered the opinion of the court.\nIn July, 1923, the plaintiff, the Kirby Lumber Company, issued its own bonds for\n$12,126,800 for which it received their par value. Later in the same year, it\npurchased in the open market some of the same bonds at less than par, the difference\nof price being $137,521.30. The question is whether this difference is a taxable gain\nor income of the plaintiff for the year 1923. By the Revenue Act of (November 23)\n1921, c. 136, \xc2\xa7 213(a), gross income includes \xe2\x80\x9cgains or profits and income derived\nfrom any source whatever,\xe2\x80\x9d and, by the Treasury Regulations authorized by \xc2\xa7 1303,\nthat have been in force through repeated reenactments, \xe2\x80\x9cIf the corporation\npurchases and retires any of such bonds at a price less than the issuing price or face\nvalue, the excess of the issuing price or face value over the purchase price is gain\nor income for the taxable year.\xe2\x80\x9d Article 545(1)(c) of Regulations 62, under Revenue\nAct of 1921. [citations to more regulations omitted]. We see no reason why the\nRegulations should not be accepted as a correct statement of the law.\nIn Bowers v. Kerbaugh-Empire Co., 271 U.S. 170, the defendant in error owned\nthe stock of another company that had borrowed money repayable in marks or their\nequivalent for an enterprise that failed. At the time of payment, the marks had fallen\nin value, which, so far as it went, was a gain for the defendant in error, and it was\ncontended by the plaintiff in error that the gain was taxable income. But the\ntransaction as a whole was a loss, and the contention was denied. Here, there was\nno shrinkage of assets, and the taxpayer made a clear gain. As a result of its\ndealings, it made available $137,521.30 assets previously offset by the obligation\nof bonds now extinct. We see nothing to be gained by the discussion of judicial\ndefinitions. The defendant in error has realized within the year an accession to\nincome, if we take words in their plain popular meaning, as they should be taken\nhere. Burnet v. Sanford & Brooks Co., 282 U.S. 359, 364.\nJudgment reversed.\n\n196\n\n\x0cNotes and Questions:\n1. How does it happen that Kirby Lumber Company could buy back its bonds in\nthe open market for less than it obtained when it issued the bond?\n2. What is a \xe2\x80\x9cshrinkage of assets?\xe2\x80\x9d Was the holding in Kerbaugh-Empire wrong?\nWhy (or why not)?\n\xe2\x80\xa2Evidently, there was a \xe2\x80\x9cshrinkage of assets\xe2\x80\x9d in Kerbaugh-Empire, but not\nin Kirby Lumber.\n3. What should we make of the \xe2\x80\x9cmade available\xe2\x80\x9d language of the Court?\n\xe2\x80\xa2Suppose that taxpayer is hopelessly insolvent. Let\xe2\x80\x99s say that taxpayer has assets\nwith a fmv of $152,000, but has liabilities of $379,000. Liabilities exceed assets by\n$227,000. One creditor settles a $110,000 debt for property worth $18,000. Now\nthe taxpayer has assets with a fmv of $134,000 and liabilities of $269,000.\nLiabilities now exceed assets by $135,000, i.e., $92,000 less than before this\nsettlement. Has this transaction really \xe2\x80\x9cmade available\xe2\x80\x9d $92,000 to taxpayer?\n\xe2\x80\xa2No, said the Fifth Circuit in Dallas Transfer & Terminal Warehouse Co. v.\nCommissioner, 70 F.2d 95, 96 (5th Cir. 1934):\nThere is a reduction or extinguishment of liabilities without any\nincrease of assets. There is an absence of such a gain or profit as is\nrequired to come within the accepted definition of income. ... [T]he\ncancellation of the respondent\xe2\x80\x99s past due debt ... did not have the\neffect of making the respondent\xe2\x80\x99s assets greater than they were\nbefore that transaction occurred. Taxable income is not acquired by\na transaction which does not result in the taxpayer getting or having\nanything he did not have before. Gain or profit is essential to the\nexistence of taxable income. A transaction whereby nothing of\nexchangeable value comes to or is received by a taxpayer does not\ngive rise to or create taxable income.\n\xe2\x80\xa2Reducing the degree by which taxpayer is insolvent from $227,000 to\n$135,000 is not sufficient to constitute gross income. What if the reduction\nhad been from $227,000 to $100. Where is the line?\n4. (note 3 continued) In Lakeland Grocery Co. v. Commissioner, 36 B.T.A. 289,\n291-92 (1937), taxpayer was insolvent and had filed a petition for voluntary\n197\n\n\x0cbankruptcy. Taxpayer\xe2\x80\x99s creditors wrote off $104,000 of debt in exchange for\npayments totaling $15,000 to keep taxpayer from further pursuing relief through a\nbankruptcy proceeding. After this exchange, the value of taxpayer\xe2\x80\x99s assets\nexceeded its liabilities by $40,000. Taxpayer\xe2\x80\x99s\nnet assets were increased from zero to $39,596.93 as a result of the\ncancellation of indebtedness by its creditors, and to that extent it had assets\nwhich ceased to be offset by any liability. ... [T]he cancellation of\n[taxpayer\xe2\x80\x99s] debts had the effect of making its assets greater than they were\nbefore that transaction occurred. It is true that \xe2\x80\x98gain\xe2\x80\x99 or \xe2\x80\x98profit\xe2\x80\x99 is essential\nto the existence of taxable \xe2\x80\x98income\xe2\x80\x99 ... and we believe that \xe2\x80\x98gain\xe2\x80\x99, as\ncommonly understood, was realized here when [taxpayer], who was\nhopelessly insolvent, received by the action of its creditors an increment to\nits assets clear and free of any claims of the creditors. ... [W]e conclude that\nthe assets freed to the [taxpayer] by the composition of creditors had an\nexchange value. Under such facts ..., [taxpayer] realized taxable gain ...\nId. at 292.\n5. The \xe2\x80\x9cmaking available assets\xe2\x80\x9d language meant \xe2\x80\x93 practically uniformly among\nlower courts \xe2\x80\x93 that an insolvent debtor realized gross income from cancellation of\nindebtedness only to the extent such cancellation made the debtor solvent. In fact,\nsome courts held that the cancellation of debt of an insolvent debtor was not\n\xe2\x80\x9cincome\xe2\x80\x9d under the Sixteenth Amendment. See Ann K. Wooster, Application of the\n16th Amendment to U.S. Constitution \xe2\x80\x93 Taxation of Specific Types of Income, 46\nA.L.R. FED. 2d 301 (2010) \xc2\xa7 12 (debt forgiveness income).\n6. Back to Kerbaugh-Empire: A loan is a transaction. Taxpayer may use loan\nproceeds in another transaction. Logically, the loan and the spending or investment\nof proceeds are two different transactions that taxpayer should have to account for\nseparately. In the absence of any statutory provision governing exclusion of\ncancellation of indebtedness income, the Code essentially required the\nCommissioner prior to 1954 to kick a taxpayer when he was down. We see what\nhappened. Dallas Transfer and Lakeland Grocery focused on taxpayer\xe2\x80\x99s insolvency\nto exclude at least some coi income from taxpayer\xe2\x80\x99s gross income. The holding in\nKerbaugh-Empire seemed to permit a court to focus on the success of the enterprise\nin which taxpayer invested loan proceeds to determine whether taxpayer had to\ninclude cancellation of indebtedness in his gross income.\n\xe2\x80\xa2Section 108 changes this, infra, but \xc2\xa7 108 does not convert business losses\n198\n\n\x0cinto excludable cancellation of indebtedness income.\n\xe2\x80\xa2The court in United States v. Gehl, 50 F.3d 12, 1995 WL 115589 (8th Cir.),\ncert. denied, 516 U.S. 899 (1995), chapter 3, supra sorted all this out.\n7. In 1954, Congress added \xc2\xa7\xc2\xa7 61(a)(11), 108, and 1017 to the Code.55 Read\n\xc2\xa7\xc2\xa7 61(a)(11),56 108(a)(1)(A and B), 108(d)(1 through 3). Do you see the influence\nof cases such as Dallas Transfer & Terminal Warehouse and Lakeland Grocery \xe2\x80\x93\nas well as of cases holding that the meaning of \xe2\x80\x9cincome\xe2\x80\x9d in the 16th Amendment\ndoes not encompass discharge of indebtedness (doi) when taxpayer does not\nthereby become solvent? See also Reg. \xc2\xa7 1.61-12(b)(1) (adopted in 1957).\n8. Section 108(e)(1) provides that there is no insolvency exception from the general\nrule that gross income includes income from discharge of indebtedness other than\nwhat \xc2\xa7 108 provides.\n\xe2\x80\xa2When the other provisions of \xc2\xa7 108 apply, \xc2\xa7 108 appears to \xe2\x80\x9cpreempt the\nfield\xe2\x80\x9d \xe2\x80\x93 much as \xc2\xa7\xc2\xa7 119 and 132 preempt their respective fields. See BORIS\nI. BITTKER, MARTIN J. MCMAHON, JR., & LAWRENCE A. ZELENAK, supra at\n4-21 to 4-22.\n9. Read \xc2\xa7 108(b). It implicitly requires a taxpayer who enjoys doi income to\ndetermine how much doi income he is not recognizing. What is a \xe2\x80\x9ctax attribute?\xe2\x80\x9d\n\xe2\x80\xa2It is a phrase that we use often, but that the Code does not define. We\nsurmise its meaning by reading \xc2\xa7 108(b).\n\xe2\x80\xa2A \xe2\x80\x9ctax attribute\xe2\x80\x9d is a tax characteristic of a taxpayer. Section 108(b) lists\nvarious \xe2\x80\x9ctax attributes\xe2\x80\x9d that might reduce taxpayer\xe2\x80\x99s tax liability in the\nfuture. That list includes: net operating loss, general business credit,\nminimum tax credit, capital loss carryover, basis, passive activity loss and\ncredit carryovers, and foreign tax credit carryovers.\n\xe2\x80\xa2What is the effect of \xc2\xa7 108(b) on the holdings of cases such as Dallas\nTransfer & Terminal Warehouse and Lakeland Grocery? Define the\n\xe2\x80\x9cexclusion\xe2\x80\x9d from gross income that \xc2\xa7 108 provides a taxpayer who is in\nbankruptcy or insolvent.\n\xe2\x80\xa2Tax attributes named in \xc2\xa7 108(b) reduce a taxpayer\xe2\x80\x99s tax liability at some\nSee Boris I. Bittker, Martin J. McMahon, Jr., & Lawrence A. Zelenak, Federal Income Taxation of\nIndividuals \xc2\xb6 4.05[2] at 4-21 (3d ed. 2002).\n55\n\nThe Tax Cuts and Jobs Act (2017) deleted alimony from the list of items included in \xe2\x80\x9cgross income\xe2\x80\x9d\nand renumbered the remaining items. \xe2\x80\x9cDischarge of indebtedness income\xe2\x80\x9d is now included in \xe2\x80\x9cgross\nincome\xe2\x80\x9d at \xc2\xa7 61(a)(11).\n56\n\n199\n\n\x0cfuture time. Does it matter how far into the future the reduction occurs?\n\xe2\x80\xa2The consequence of reducing a tax attribute is that taxpayer\xe2\x80\x99s future\ntax liability will not decrease.\n\xe2\x80\xa2To the extent that a taxpayer has tax attributes, \xc2\xa7 108 does not in\nfact exclude doi income from taxpayer\xe2\x80\x99s gross income, but instead\ndefers the effect of its recognition to the day that a tax attribute\nwould have reduced taxpayer\xe2\x80\x99s tax liability.\n10. Section 108(b)(2)(E) provides for basis reductions, and \xc2\xa7 108(b)(5) permits the\ntaxpayer to elect to reduce his basis in depreciable property before reducing other\ntax attributes. Such an election would matter to the taxpayer only if he has attributes\nlisted in \xc2\xa7 108(b)(2)(A, B, C, or D) and wants to preserve them.\n11. (Note 10 continued): Reduction of tax attributes and reductions of basis:\nSection 1017 and Reg. \xc2\xa7 1.1017-1 provide some rather technical rules governing\nthe sequence of reductions in taxpayer\xe2\x80\x99s basis in his property.\n\xe2\x80\xa2Read \xc2\xa7 1017(b)(2). What rule does it state for basis reductions under\n108(b)(2)(E) and under 108(b)(5)?\n\xe2\x80\xa2Read 1017(a). The reduction is made to the basis of any property held by\nthe taxpayer at the beginning of the tax year following the tax year in which\nthe debt discharge occurs (\xc2\xa7 1017(a)).\n\xe2\x80\xa2Taxpayer need not reduce (\xe2\x80\x9cspend\xe2\x80\x9d) his tax attributes upon the\ndischarge of indebtedness but rather may use them to reduce tax\nliability for the year of discharge.\n\xe2\x80\xa2Then taxpayer may also reduce basis.\n12. Consider:\n\xe2\x80\xa212a. Taxpayer owns real property, fmv = $100,000, ab = $135,000. This\nis all of taxpayer\xe2\x80\x99s property. Taxpayer has no other assets, not even cash.\nTaxpayer has liabilities of $120,000. Is taxpayer insolvent for purposes of\n\xc2\xa7 108? By how much?\n\xe2\x80\xa212b. Taxpayer owns real property, fmv = $135,000, ab = $100,000. This\nis all of taxpayer\xe2\x80\x99s property. Taxpayer has no other assets, not even cash.\nTaxpayer has liabilities of $120,000. Is taxpayer insolvent for purposes of\n\xc2\xa7 108? By how much?\n\xe2\x80\xa212c. Taxpayer owns real property, ab = $80,000, fmv = $125,000. This is\nall of taxpayer\xe2\x80\x99s property, except that taxpayer also has $5000 of cash.\n200\n\n\x0cTaxpayer\xe2\x80\x99s real property is subject to a debt of $110,000 that he owes to\ncreditor. Taxpayer did not purchase the property from creditor. Taxpayer\nwas having difficulty making payments, so creditor agreed to reduce\ntaxpayer\xe2\x80\x99s debt to $95,000. How much doi income must taxpayer include\nin his gross income under \xc2\xa7\xc2\xa7 61(a)(11)/108?\n\xe2\x80\xa212d. Taxpayer owns real property, ab = $80,000, fmv = $125,000. This is\nall of Taxpayer\xe2\x80\x99s property, except that Taxpayer has $20,000 of cash.\nTaxpayer\xe2\x80\x99s real property is subject to a debt of $150,000 that she owes to\ncreditor. Taxpayer did not purchase the property from creditor. Taxpayer\nwas having difficulty making payments. Creditor agreed to reduce\ntaxpayer\xe2\x80\x99s debt from $150,000 to $130,000 in exchange for an immediate\ncash payment of $10,000. Taxpayer agreed and made the payment. How\nmuch doi income must taxpayer include in her gross income under\n\xc2\xa7\xc2\xa7 61/108?\n\xe2\x80\xa212e. Same facts as 12d, except that taxpayer has filed for bankruptcy. The\ncreditor makes the same arrangement with taxpayer. How much doi income\nmust taxpayer include in her gross income under \xc2\xa7\xc2\xa7 61/108? [Disregard the\neffect of such a payment on the bankruptcy proceeding.]\n\nIII. Settlements of Legal Disputes Over Obligations to Pay or\nRepay\nWhen a borrower does not repay a loan, a creditor may quite predictably sue. The\nensuing court case may raise certain issues57 such as whether the parties intended a\nloan and repayment, whether a putative loan agreement is legally (un)enforceable,\nwhether the parties even know the amount of the loan, and so on. The parties may\nseek to reduce litigation costs and risks by settling for a known and certain amount\nthat the debtor can and will pay. What should be the tax consequences of such\nsettlements? Keep in mind that one party transferred money or money\xe2\x80\x99s worth to\nthe other who spent it on consumption, an element of the SHS definition of\n\xe2\x80\x9cincome.\xe2\x80\x9d The following case involves a settlement. The court discusses Zarin. Pay\nclose attention to the court\xe2\x80\x99s description of Zarin and its criticism of the holding in\nZarin. Note also the court\xe2\x80\x99s brief but important definition of a nonrecourse\nAn afternoon of weekday television courtroom shows demonstrates the myriad ways such claims are\nraised and resolved.\n57\n\n201\n\n\x0cmortgage and how its characteristics affect the assumptions that we usually make\nabout liability for repayment of a loan.\nPreslar v. Commissioner, 167 F.3d 1323 (CA10 1999).\nBRISCOE, Circuit Judge.\n... The Tax Court held the Preslars\xe2\x80\x99 settlement of a loan obligation for less than the\nface amount of the loan did not create taxable income because the contested\nliability/disputed debt exception to the general discharge-of-indebtedness income\nrule rendered the write-off nontaxable. We ... reverse and remand.\nI.\nLayne Preslar, a real estate agent of twenty-five years, commenced negotiations in\n1983 to purchase a 2500-acre ranch near Cloudcroft, New Mexico. High Nogal\nRanch, Inc., owned the ranch and was a debtor-in-possession in a Chapter 11\nbankruptcy proceeding. Citizens State Bank of Carrizozo, Security Bank and Trust\nof Alamogordo, and Moncor Bank held mortgages in the ranch. Moncor Bank,\nwhich had been experiencing serious financial difficulties and whose interest was\nsubordinate to the other banks, took the lead in assisting in negotiations between\nHigh Nogal and Preslar. Moncor Bank\xe2\x80\x99s actions were designed to avoid foreclosure\nand recoup as much of its loan as possible.\nOn July 12, 1983 ..., Layne and Sue Preslar agreed to purchase the ranch for $1\nmillion, with the sale to be financed by Moncor Bank. The agreement expressly\nreferred to the fact that Moncor Bank was financing the purchase, but only the\nPreslars and the president of High Nogal signed the contract on September 1, 1983.\nThe Preslars executed a $1 million promissory note in favor of Moncor Bank,\nsecured by a mortgage on the ranch. The Preslars were to pay fourteen annual\ninstallments of $66,667, with interest at twelve percent per annum, with final\npayment due September 1, 1998. Moncor Bank used $760,000 of the loan proceeds\nto satisfy the mortgages of Citizens State Bank and Security Bank and Trust. The\nPreslars thus received title to the ranch free and clear of all of High Nogal\xe2\x80\x99s prior\nmortgages.\nThe Preslars intended to develop the ranch as a sportsman\xe2\x80\x99s resort by subdividing\n160 acres and selling one- to two-acre lots for cabins or vacation homes, and\n202\n\n\x0cpermitting lot owners to hunt and engage in other outdoor recreational activities on\nthe remaining 2,340 acres. The goal was to sell each cabin lot for approximately\n$16,500, with total gross revenues exceeding $1.5 million. The Preslars\xe2\x80\x99 1989 joint\ntax return indicates several lots sold for substantially higher amounts.\nMoncor Bank permitted the Preslars to repay their loan by assigning the installment\nsales contracts of purchasers of cabin lots to Moncor Bank at a discount. \xe2\x80\xa6 When\neach cabin lot was sold, the Preslars assigned and physically transferred the written\nsales contract to Moncor Bank. In return, Moncor Bank credited the Preslars\xe2\x80\x99 debt\nobligation in an amount equal to 95 percent of the stated principal contract price,\nregardless of actual payments received from the purchaser. Moncor Bank received\na security interest in each lot sold to protect its interests in the event a purchaser\ndefaulted. Between September 1983 and August 1985, the Preslars sold nineteen\ncabin lots and had assigned most of the contracts to Moncor Bank prior to its\ndeclared insolvency. Moncor Bank had credited the Preslars\xe2\x80\x99 principal loan\nbalance with approximately $200,000. Funds applied to interest are not included\nin this amount; thus, the aggregate amount of discounted installment contracts\nassigned to Moncor Bank exceeded $200,000.\nIn August 1985, Moncor Bank was declared insolvent and the Federal Deposit\nInsurance Corporation (FDIC) was appointed as receiver. The FDIC notified the\nPreslars of the insolvency and advised them to make all future payments on their\nloan to the FDIC. The FDIC refused to accept further assignments of sale contracts\nas repayment and ordered the Preslars to suspend sales of cabin lots. The Preslars\ncomplied with the suspension directive, but made no further payments on the loan.\nThe Preslars filed an action against the FDIC for breach of contract in September\n1985, seeking an order requiring the FDIC to accept assignment of sales contracts\nas loan repayment. The parties settled the action in December 1988 after the FDIC\nagreed to accept $350,000 in full satisfaction of the Preslars\xe2\x80\x99 indebtedness. The\nPreslars borrowed the $350,000 from another bank and, after the funds were\nremitted to the FDIC, the original $1 million promissory note was marked paid.\nAt the time of the settlement, the unpaid balance on the Preslars\xe2\x80\x99 loan was\n$799,463. The Preslars paid a total of $550,537 on the loan ($350,000 settlement\nplus $200,537 credited for assignment of sales contracts). Therefore, as a result of\nthe settlement, the Preslars\xe2\x80\x99 outstanding debt obligation was reduced by $449,463\n($1 million less $550,537).\nThe Preslars did not include the $449,463 debt write-off as discharge-of203\n\n\x0cindebtedness income on their 1989 joint tax return. Rather, they opted to reduce\ntheir basis in the ranch by $430,000 pursuant to ... Code \xc2\xa7 108(e)(5) ... The Preslars\xe2\x80\x99\n1989 tax return was audited and they were assessed a deficiency because (1) they\nhad realized $449,463 in discharge-of-indebtedness income, and (2) they were not\neligible to treat such income as a purchase price adjustment under \xc2\xa7 108(e)(5). ...\nThe Preslars sought a redetermination of the deficiency in United States Tax Court,\ninsisting they were free to treat their settlement with the FDIC as a purchase price\nadjustment pursuant to \xc2\xa7 108(e)(5) and/or common law. They supported this theory\nin part by claiming the FDIC\xe2\x80\x99s refusal to honor their repayment agreement with\nMoncor Bank amounted to an infirmity relating back to the original sale, thereby\nnegating the general prohibition against treating debt reductions as purchase price\nadjustments. ... At no time, however, did the Preslars dispute their underlying\nliability on the $1 million note.\nThe Commissioner responded that the Preslars could not invoke \xc2\xa7 108(e)(5)\nbecause that provision applies only to situations where the seller of property agrees\nto reduce the amount of the purchaser\xe2\x80\x99s debt flowing from the property sale. In this\ncase, the Commissioner argued, the property seller was High Nogal. The party\nresponsible for reducing the Preslars\xe2\x80\x99 debt was not the seller but was the FDIC (as\nreceiver for Moncor Bank), thereby rendering \xc2\xa7 108(e)(5) inapplicable. The\nCommissioner also argued the common law purchase price adjustment rule did not\nsurvive the adoption of \xc2\xa7 108(e)(5). ...\nThe Tax Court ruled in favor of the Preslars without addressing the purchase price\nadjustment issue. Instead, the court sua sponte invoked the contested liability\ndoctrine and held the Preslars\xe2\x80\x99 unusual payment arrangement with Moncor Bank\ncaused their liability for the full $1 million loan to be brought into question. The\ncourt determined the true amount of the Preslars\xe2\x80\x99 indebtedness was not firmly\nestablished until they settled with the FDIC; thus, no discharge-of-indebtedness\nincome could have accrued to the Preslars as a result of the settlement. ...\nII.\n....\nDischarge-of-Indebtedness Income\nSection 61(a) of the ... Code broadly defines \xe2\x80\x9cgross income\xe2\x80\x9d as all income from\nwhatever source derived except as expressly provided otherwise. ... The phrase is\n204\n\n\x0cintended to capture all accessions to wealth, clearly realized, and over which the\ntaxpayers have complete dominion. Commissioner v. Glenshaw Glass Co., 348\nU.S. 426, 431 (1955). From its enactment, the sweeping scope of this provision\nand its statutory predecessors has been consistently emphasized by the Supreme\nCourt. See Commissioner v. Schleier, 515 U.S. 323, 327-28 (1995); Glenshaw\nGlass, 348 U.S. at 429-32 & n. 11.\nThis case centers around the Commissioner\xe2\x80\x99s determination of the Preslars\xe2\x80\x99\ndischarge-of-indebtedness income after they settled their loan obligation with the\nFDIC in December 1988. The concept of discharge-of-indebtedness income, first\narticulated in United States v. Kirby Lumber Co., 284 U.S. 1 (1931), and later\ncodified in 26 U.S.C. \xc2\xa7 61(a)[(11)], requires taxpayers who have incurred a\nfinancial obligation that is later discharged in whole or in part, to recognize as\ntaxable income the extent of the reduction in the obligation. Two rationales have\nbeen identified for this rule:\nThis rule is based on the premise that the taxpayer has an increase in wealth\ndue to the reduction in valid claims against the taxpayer\xe2\x80\x99s assets. In the\nalternative it has been suggested that taxation is appropriate because the\nconsideration received by a taxpayer in exchange for [his] indebtedness is\nnot included in income when received because of the obligation to repay\nand the cancellation of that obligation removes the reason for the original\nexclusion.\n2 Jacob Mertens, Jr., Mertens Law of Federal Income Taxation \xc2\xa7 11.01 (1996).\nLoans ordinarily are not taxable because the borrower has assumed an obligation\nto repay the debt in full at some future date. See Commissioner v. Tufts, 461 U.S.\n300, 307 (1983). Discharge-of-indebtedness principles come into play, however,\nif that assumption of repayment proves erroneous. Otherwise, taxpayers could\nsecure income with no resulting tax liability.\nIt is undisputed that the Preslars financed their purchase of the ranch in 1983 by\nexecuting a $1 million promissory note in favor of Moncor Bank. It is similarly\nuncontested that when the Preslars settled their lawsuit with the FDIC in 1988,\nthereby extinguishing all obligations arising from the 1983 loan, only $550,537 had\nbeen paid on the loan principal. Nevertheless, the Tax Court ruled the Preslars\xe2\x80\x99\nunderlying debt was disputed and fell within the judicially-created contested\nliability exception to discharge-of-indebtedness income.\n205\n\n\x0cContested Liability/Disputed Debt Exception\nThe contested liability or, as it is occasionally known, disputed debt doctrine rests\non the premise that if a taxpayer disputes the original amount of a debt in good\nfaith, a subsequent settlement of that dispute is treated as the amount of debt\ncognizable for tax purposes. Zarin v. Commissioner, 916 F.2d 110, 115 (3d\nCir.1990). In other words, the excess of the original debt over the amount\ndetermined to have been due may be disregarded in calculating gross income. Id.\nThe few decisions that have interpreted this doctrine have generated considerable\ncontroversy.\nThe origins of the contested liability doctrine can be traced to N. Sobel, Inc. v.\nCommissioner, 40 B.T.A. 1263 (1939), a case arising during the Great Depression.\nIn that case, a New York corporation purchased 100 shares of a bank\xe2\x80\x99s stock and\nsigned a $21,700 note as payment. When the note matured, the stock was\nworthless. The corporation sued the bank for rescission, insisting the loan\ncontravened state law and the bank had failed to fulfill its promise to guarantee the\ncorporation against loss. Shortly thereafter, the state superintendent of banks closed\nthe bank because of insolvency and initiated a countersuit against the corporation\nfor the amount of the note. The parties ultimately settled the consolidated\nproceedings with the corporation paying the superintendent $10,850 in return for\ndischarge of the debt. ... The Commissioner ... assessed a $10,850 deficiency,\nrepresenting the amount of the original loan over the settlement figure. The Board\nof Tax Appeals reversed the ruling ..., concluding the corporation\xe2\x80\x99s ownership of\nthe shares and the degree of liability on the note were highly unclear. See id. at\n1265 (There is question whether the taxpayer bought property in 1929 and question\nas to its liability and the amount thereof.) (emphasis added). The Board found the\ncorporation\xe2\x80\x99s financial obligations could not be assessed definitively prior to\nresolution of its dispute with the superintendent and, since settlement compromised\nthe parties\xe2\x80\x99 claims and precluded recognition of their legal rights, the existence and\namount of the corporation liability were not fixed until the date of settlement. Thus,\nrelease of the note did not amount to a gain for the corporation.\nIn Zarin, the court embraced the reasoning of N. Sobel while reversing the\nCommissioner\xe2\x80\x99s recognition of discharge-of-indebtedness income. The state\ngaming commission identified Zarin as a compulsive gambler and ordered an\nAtlantic City casino to refrain from issuing him additional credit, but the casino\nignored the commission. When Zarin\xe2\x80\x99s debt surpassed $3.4 million, the casino filed\na state action to collect the funds. Zarin initially denied liability on the grounds the\ncasino\xe2\x80\x99s claim was unenforceable under New Jersey law. The parties later settled\n206\n\n\x0cthe dispute for $500,000. After Zarin failed to account for the debt write-off on his\ntax return, the Commissioner assessed a deficiency for approximately $2.9 million,\nthe amount by which Zarin\xe2\x80\x99s underlying debt exceeded his settlement with the\ncasino. The Tax Court affirmed. However, a divided Third Circuit held Zarin had\nno discharge-of-indebtedness income because, inter alia, his transaction with the\ncasino arose from a contested liability. 916 F.2d at 115-16. Citing no authority,\nthe majority reasoned that [w]hen a debt is unenforceable, it follows that the amount\nof the debt, and not just the liability thereon, is in dispute. Id. at 116. Therefore,\nthe $500,000 settlement fixed the amount of loss and the amount of debt cognizable\nfor tax purposes. Id.\nThe problem with the Third Circuit\xe2\x80\x99s holding is it treats liquidated and unliquidated\ndebts alike. The whole theory behind requiring that the amount of a debt be\ndisputed before the contested liability exception can be triggered is that only in the\ncontext of disputed debts is the ... IRS unaware of the exact consideration initially\nexchanged in a transaction. See Daniel Shaviro, The Man Who Lost Too Much:\nZarin v. Commissioner and the Measurement of Taxable Consumption, 45 Tax\nL.Rev. 215, 256 (1990). The mere fact that a taxpayer challenges the enforceability\nof a debt in good faith does not necessarily mean he or she is shielded from\ndischarge-of-indebtedness income upon resolution of the dispute. To implicate the\ncontested liability doctrine, the original amount of the debt must be unliquidated.\nA total denial of liability is not a dispute touching upon the amount of the\nunderlying debt. [footnote omitted]. One commentator has observed:\nEnforceability of the debt ... should not affect the tax treatment of the\ntransaction. If the parties initially treated the transaction as a loan when the\nloan proceeds were received, thereby not declaring the receipt as income,\nthen the transaction should be treated consistently when the loan is\ndischarged and income should be declared in the amount of the discharge.\nGregory M. Giangiordano, Taxation \xe2\x80\x93 Discharge of Indebtedness Income \xe2\x80\x93 Zarin\nv. Commissioner, 64 Temp. L.Rev. 1189, 1202 n.88 (1991). A holding to the\ncontrary would strain IRS treatment of unenforceable debts and, in large part,\ndisavow the Supreme Court\xe2\x80\x99s mandate that the phrase gross income be interpreted\nas broadly as the Constitution permits. See Glenshaw Glass, 348 U.S. at 432 & n.\n11.\n....\n207\n\n\x0cThe Tax Court in this case and the court in Zarin cited United States v. Hall, 307\nF.2d 238 (10th Cir.1962), in support of their contested liability holdings. In Hall,\nthe taxpayer incurred gambling losses at a Las Vegas club in an estimated range of\n$145,000 to $478,000. One of the owners of the club agreed to forgive the debt in\nreturn for a one-half interest in the taxpayer\xe2\x80\x99s cattle. Just prior to transfer of the\ninterest in the cattle, which had a base value of $148,110, the parties mutually\nagreed to assess the taxpayer\xe2\x80\x99s losses at $150,000. The Commissioner sought to\nassess the taxpayer with $1,890 as discharge-of-indebtedness income. Without\nraising the contested liability doctrine, we rejected the Commissioner\xe2\x80\x99s position\nand held a gambling debt, being unenforceable in every state, has but slight\npotential and does not meet the requirements of debt necessary to justify the\nmechanical operation of general rules of tax law relating to cancellation of debt.\nId. at 241.\n... Even if parts of Hall remain viable, however, the opinion would offer little refuge\nto the Preslars. The debt in Hall was unliquidated. The taxpayer\xe2\x80\x99s underlying\nobligation, therefore, could not be assessed prior to settlement with the club owner.\nSuch a scenario is not present here.\n....\n... The Tax Court\xe2\x80\x99s invocation of the contested liability doctrine in the face of the\nrecord presented was unwarranted.\nPurchase Price Adjustment\nAnother method by which taxpayers can avoid discharge-of-indebtedness income\nis to classify their debt reductions as purchase price adjustments. This rule permits\ntaxpayers to reflect their debt reduction by adjusting the basis of their property\nrather than recognizing an immediate gain as cancellation of indebtedness.\nAlthough this principle had been part of the common law for decades, Congress\ncodified the rule as part of the Bankruptcy Tax Act of 1980, Pub.L. No. 96-589,\n\xc2\xa7 2(a), 94 Stat. 3389, 3389-90 (1980) (codified at 26 U.S.C. \xc2\xa7 108(e)(5)). The\nstatute now provides:\n\n208\n\n\x0cIf \xe2\x80\x93\n(A) the debt of a purchaser of property to the seller of such property\nwhich arose out of the purchase of such property is reduced,\n(B) such reduction does not occur \xe2\x80\x93\n(i) in a title 11 case, or\n(ii) when the purchaser is insolvent, and\n(C) but for this paragraph, such reduction would be treated as\nincome to the purchaser from the discharge of indebtedness,\nthen such reduction shall be treated as a purchase price adjustment.\n26 U.S.C. \xc2\xa7 108(e)(5) (1988).\nThe Preslars cannot treat their settlement with the FDIC as a purchase price\nreduction. Section 108(e)(5) applies only to direct agreements between a purchaser\nand seller. S.Rep. No. 96-1035 at 16 (1980), reprinted in 1980 U.S.C.C.A.N. 7017,\n7031. If the debt has been transferred by the seller to a third party (whether or not\nrelated to the seller), or if the property has been transferred by the buyer to a third\nparty (whether or not related to the buyer), the purchase price reduction exception\nis not available and normal discharge-of-indebtedness rules control. Id.; see 2\nMertens Law of Federal Income Taxation \xc2\xa7\xc2\xa7 11.20, 11.25. The seller in this case\nwas High Nogal. ... As neither Moncor Bank nor its receiver, the FDIC, was the\nseller of the property, the loan settlement the Preslars negotiated with the FDIC\ndoes not permit them to invoke the debt reduction as a purchase price adjustment\nunder \xc2\xa7 108(e)(5). [footnoted omitted].\nThe Preslars seek to avoid the requirements of \xc2\xa7 108(e)(5) by arguing the\ntransaction is embraced by: \xe2\x80\xa6 the common law purchase price reduction doctrine[.]\n\xe2\x80\xa6\n\xe2\x80\xa6.\nCommon Law Purchase Price Reduction Doctrine \xe2\x80\x93 The Preslars insist the\ncommon law purchase price reduction doctrine may be invoked in cases where 26\nU.S.C. \xc2\xa7 108(e)(5) is inapplicable. The Commissioner responds that \xc2\xa7 108(e)(5)\nhas displaced the common law on this issue and, in any event, a debt reduction by\na third-party lender was not considered a purchase price adjustment under common\nlaw. [citation omitted].\n....\n209\n\n\x0c... [Section] 108(e)(5) was intended, at least in part, to create uniformity in this\njurisprudence. See S.Rep. No. 96-1035 at 16-17 (1980), reprinted in 1980\nU.S.C.C.A.N. 7017, 7031-32 (This provision is intended to eliminate\ndisagreements between the IRS and the debtor as to whether, in a particular case to\nwhich the provision applies, the debt reduction should be treated as discharge\nincome or a true price adjustment.). If, as the Preslars argue, the common law rule\nremains viable and permits taxpayers involved in third-party transactions to treat\ntheir debt reductions as purchase price adjustments rather than additions to their\ngross income, \xc2\xa7 108(e)(5) would be rendered meaningless. We agree with the\nCommissioner\xe2\x80\x99s rationale for imposing the direct seller-purchaser negotiation\nrequirement, as articulated in a 1992 revenue ruling:\nAn agreement to reduce a debt between a purchaser and a third-party lender\nis not a true adjustment of the purchase price paid for the property because\nthe seller has received the entire purchase price from the purchaser and is\nnot a party to the debt reduction agreement. The debt reduction relates\nsolely to the debt and results in discharge of indebtedness income to the\ndebtor.\nRev. Rul. 92-99, 1992-2 C.B. 35. Accordingly, the Preslars may not treat their\nsettlement with the FDIC as a common law purchase price reduction.\n\xe2\x80\xa6.\nIII.\nWe REVERSE the Tax Court\xe2\x80\x99s vacatur of the Commissioner\xe2\x80\x99s determination of tax\ndeficiency and imposition of untimely filing penalties and REMAND the case with\ninstructions to enter judgment in favor of the Commissioner.\nEBEL, Circuit Judge, dissenting [omitted].\n\nNotes and Questions:\n1. What was the holding of Hall as the court articulated it? Is such a holding sound?\n2. The court reviewed the facts and holding of N. Sobel v. Commissioner. Was there\n210\n\n\x0cany question that the face amount of taxpayer\xe2\x80\x99s note was $21,700? What facts seem\nto lead to a conclusion that there was a question as to the amount of the liability?\nPerhaps N. Sobel itself was wrongly decided.\n3. Zarin was a compulsive gambler who incurred debts to the casino from which he\nobtained chips on credit. He always intended to repay his obligations. What form\ndid Zarin\xe2\x80\x99s consumption take?\n\xe2\x80\xa2gambling?\n\xe2\x80\xa2losing at gambling?\n\xe2\x80\xa2Should it make a difference?\n\xe2\x80\xa2Does a compulsive gambler such as Mr. Zarin realize an accession to\nwealth or \xe2\x80\x9cvalue\xe2\x80\x9d by gambling more?\n4. Taxpayer argued that \xe2\x80\x9cdischarge of his gambling debt was income from gambling\nagainst which he may offset his losses.\xe2\x80\x9d\n\xe2\x80\xa2This does not treat the loan and use of the chips as separate transactions.\n5. Articulate the policies behind state laws that make contracts unenforceable. Do\nany of these policies suggest anything about whether there was an accession to\nwealth and so also doi income?\n\xe2\x80\xa2unconscionable contracts are not enforceable because of unequal\nbargaining power;\n\xe2\x80\xa2illegal contracts are not enforceable because the state will not lend its\nassistance to enforce an illegal bargain;\n\xe2\x80\xa2some contracts are unenforceable because the state deems normal\npresumptions about rationality and the ability to know what is beneficial to\noneself inapplicable in certain circumstances, e.g., contract with a minor or\nincompetent.\n6. Are there not unenforceable contracts that nevertheless create an accession to\nwealth? On the other hand, are there not enforceable contracts that include an\nobligation to make a payment that do not create an accession to wealth? See\nDouglas Kahn & Jeffrey H. Kahn, Cancellation of Debt and Related Transactions,\n69 TAX LAW. 161, 200 (2015) (e.g., enforceable promise to contribute money to a\ncharity).\n7. What if the debtor reaches a compromise with the creditor, but never actually\ndisputed that he owed the creditor a sum certain? See Melvin v. Commissioner, T.C.\nMemo 2009-199, 2009 WL 2869816 (2009); Rood v. Commissioner, TC Memo\n211\n\n\x0c1996-248, 1996 WL 280899 (1996) (gambling debt).\n8. For a debt to be cancelled, the creditor must receive nothing in return. The\ncreditor is entitled to a bad debt deduction. \xc2\xa7 166. What treatment does \xc2\xa7 166 accord\nnon-business bad debts?\n9. Consider:\n\xe2\x80\xa29a. Taxpayer engaged the services of Attorney and incurred a bill of\n$1000. The fmv of taxpayer\xe2\x80\x99s assets is $10,000, and taxpayer has $5000 of\ncash. Taxpayer has liabilities of $25,000. Taxpayer entered an agreement to\ndo 80 hours of filing and word processing for Attorney. After taxpayer\nperformed these services, Attorney told taxpayer that \xe2\x80\x9cyou owe me\nnothing.\xe2\x80\x9d Now taxpayer\xe2\x80\x99s liabilities are $24,000, and she has assets with\nfmv = $10,000 plus $5000 cash. How much doi income must Taxpayer\nreport?\n\xe2\x80\xa2See Canton v. United States, 226 F.2d 313, 317-18 (8th Cir. 1955),\ncert. denied, 350 U.S. 965 (1956).\n\xe2\x80\xa29b. Taxpayer borrowed $25,000 from her uncle to pay for her third year\nof law school at one of America\xe2\x80\x99s \xe2\x80\x9cBest Value Law Schools\xe2\x80\x9d (according to\npreLaw Magazine). Taxpayer and her uncle formalized the arrangement in\nwriting, Taxpayer to pay 6% interest on her declining balance once she\nbegan making payments to her uncle after completing law school. At\nTaxpayer\xe2\x80\x99s commencement day party, her uncle announced to her that \xe2\x80\x9cI\nforgive the loan I made to you. You are free and clear as far as I\xe2\x80\x99m\nconcerned.\xe2\x80\x9d At the time, Taxpayer\xe2\x80\x99s liabilities (including the $25,000 owed\nto her uncle) did not exceed the fmv of her assets. How much doi income\nmust taxpayer report?\n\xe2\x80\xa29c. Taxpayer, a highly skilled craftsman, entered into a contract to produce\na custom-made table for Customer\xe2\x80\x99s dining room. Customer paid Taxpayer\n$4000 on the day they entered the agreement with a promise to pay $4000\nmore on delivery. Taxpayer was to deliver the table six months after\nsigning. Taxpayer never got around to making the table. At first, Customer\npatiently waited past the contractual deadline for the table, but finally sued\nfor a refund of the $4000. Customer had waited more than 6 years to bring\nthe suit, so it was dismissed as not having been brought within the limitation\nperiod.\n212\n\n\x0c\xe2\x80\xa2True or false: Taxpayer does not have doi income because the debt\nis unenforceable.\n\xe2\x80\xa2See, e.g., Securities Co. v. United States, 85 F. Supp. 532, (S.D.N.Y.\n1948).\n\xe2\x80\xa29d. Taxpayer took his automobile to Repair Shop to have some routine\nmaintenance work done. Repair Shop promised to do the work for $300.\nWhen Taxpayer returned to pick up his automobile, he told Repair Shop\nthat he only had $250 in cash, but would get the rest by tomorrow. Repair\nShop manager responded by saying, \xe2\x80\x9cGimme the $250 and forget the rest.\xe2\x80\x9d\nTaxpayer is solvent throughout. How much doi income must Taxpayer\nreport?\n10. In dissenting from the Tax Court\xe2\x80\x99s holding in Zarin that taxpayer did derive\ngross income from the cancellation of indebtedness, Judge Tannenwald observed:\nI think it highly significant that in all the decided cases involving the\ncancellation of indebtedness, the taxpayer had, \xe2\x80\xa6 when the indebtedness\nwas created, received a nontaxable benefit clearly measurable in monetary\nterms which would remain untaxed if the subsequent cancellation of the\nindebtedness were held to be tax free.\nIs consumption, i.e., spending the borrowed money for something, a necessary\nelement to treating a discharge of indebtedness as gross income? Suppose that\ntaxpayer had agreed to pay another\xe2\x80\x99s debt. The creditor subsequently discharged\ntaxpayer from this obligation. Should that discharge be considered gross income?\nAfter all, taxpayer received no funds from the \xe2\x80\x9ccreditor\xe2\x80\x9d with which he could\nexercise any right of consumption. See Douglas Kahn & Jeffrey H. Kahn,\nCancellation of Debt and Related Transactions, 69 TAX LAW. 161, 200 (2015)\n(\xe2\x80\x9cThe gist of the transactional approach is to examine the entire transaction\nbeginning with the creation of the debt and ending with the cancellation. [footnote\nomitted]. If the debtor did not obtain a tax benefit because of the debt, the debtor\nshould not have COD income.\xe2\x80\x9d)\n11. Note on Modifications of Loans and Discharge of Indebtedness: Recall that in\nCottage Savings Ass\xe2\x80\x99n v. CIR (supra chapter 2), two savings and loan associations\nexchanged the debt obligations of homeowners. Each s&l \xe2\x80\x9crealized\xe2\x80\x9d the fmv of the\ndebt obligations that it received from the other and computed its tax losses\naccording to the formula of \xc2\xa7 1001. This realization helped the taxpayers in their\n213\n\n\x0cefforts to recognize tax losses. Suppose that a creditor and debtor modify the terms\nof their agreement, e.g., reduced (increased) payments, reduced (increased) interest\nrates, longer (shorter) term. We can imagine a multitude of reasons a modification\nmight occur. A significant modification of a debt obligation can amount to a\nrealization event, requiring creditor and debtor to compute gain or loss on the\nmodification, coupled with debtor\xe2\x80\x99s possible recognition of doi income. See Reg.\n\xc2\xa7 1.1001-3(a)(1) (rules for determining whether modification of debt instrument\nresults in exchange).58 The modification must be \xe2\x80\x9csignificant.\xe2\x80\x9d Reg. \xc2\xa7 1.10013(b). The regulations\xe2\x80\x9959 treatment of a modification as an exchange contemplate\ntwo considerations: (1) whether there is a \xe2\x80\x9cmodification,\xe2\x80\x9d see Reg. \xc2\xa7 1.1001-3(c),\nand (2) whether a modification is \xe2\x80\x9csignificant,\xe2\x80\x9d see Reg. \xc2\xa7 1.1001-3(e).\nA \xe2\x80\x9cmodification\xe2\x80\x9d is \xe2\x80\x9cany alteration, including any deletion or addition, in whole or\nin part, of a legal right or obligation of the issuer or a holder of a debt instrument\n\xe2\x80\xa6\xe2\x80\x9d Reg. \xc2\xa7 1.1001-3(c)(1)(i). This does not include alterations that occur by\noperation of the debt instrument itself, e.g., annual resetting of interest rate based\nupon an index. Reg. \xc2\xa7 1.1001-3(c)(1)(ii). The substitution of a new obligor, the\naddition or deletion of a co-obligor, or a change in an obligation from recourse to\nnon-recourse (or vice versa) is a modification. Reg. \xc2\xa7 1.1001-3(c)(2)(i). An\nalteration that results in an instrument or property right that is not debt is a\nmodification, unless the alteration occurs pursuant to a holder\xe2\x80\x99s option to convert\nthe debt into equity. Reg. \xc2\xa7 1.1001-3(c)(2)(ii). Except for certain unilateral\nexercises of an option, the exercise of an option by either the issuer or holder that\nresults in change to a term of the debt instrument is a modification. Reg. \xc2\xa7 1.10013(c)(2 and 3). Neither the issuer\xe2\x80\x99s failure to perform nor the holder\xe2\x80\x99s temporary\nforbearance to exercise rights upon default is a modification. Reg. \xc2\xa7 1.1001-3(c)(4).\nA modification is \xe2\x80\x9csignificant\xe2\x80\x9d if \xe2\x80\x9cthe legal rights or obligations that are altered and\nthe degree to which they are altered are economically significant.\xe2\x80\x9d Reg. \xc2\xa7 1.10013(e)(1). A change in the yield of a debt instrument is \xe2\x80\x9csignificant\xe2\x80\x9d if it varies from\nthe unmodified instrument by more than the greater of 25 basis points or 5% of the\nannual yield. Reg. \xc2\xa7 1.1001-3(e)(2)(ii). A change in the timing of payments is\n\xe2\x80\x9csignificant\xe2\x80\x9d if it results in the \xe2\x80\x9cmaterial deferral of scheduled payments.\xe2\x80\x9d Reg. \xc2\xa7\n1.1001-3(e)(3)(i). With some exceptions, the substitution of a new obligor on a\nThe cited regulation does not apply to exchanges of debt instruments between holders and so does\nnot apply to cases such as Cottage Savings Ass\xe2\x80\x99n v. CIR.\n58\n\n59\n\nThese paragraphs summarize the regulations at Reg. \xc2\xa7 1.1001-3 \xe2\x80\x93 and admittedly omit many details.\n\n214\n\n\x0crecourse debt instrument is \xe2\x80\x9csignificant.\xe2\x80\x9d Reg. \xc2\xa7 1001-3(e)(4)(i)(A). The\nsubstitution of a new obligor on a nonrecourse debt instrument is not a significant\nmodification. Reg. \xc2\xa7 1.1001-3(e)(4)(ii). A change in the collateral securing a debt\nobligation that results in a change in payment expectations is \xe2\x80\x9csignificant.\xe2\x80\x9d Reg.\n\xc2\xa7 1.1001-3(e)(4)(iv)(A and B). A change in the priority of a debt instrument relative\nto other debt instruments is significant if it results in a change in payment\nexpectations. Reg. \xc2\xa7 1.1001-3(e)(4)(v). An alteration that results in an instrument\nor property right that is not debt is significant. Reg. \xc2\xa7 1.1001-3(e)(5)(i). A change\nin an obligation from recourse to non-recourse (or vice versa) is significant. Reg.\n\xc2\xa7 1.1001-3(e)(5)(ii).\nProblems:\n1. Harry Homeowner borrowed $500,000 to purchase a home from First National\nBank at 2% interest. When the prevailing interest rate on home mortgage rose to\n8%, First National Bank told Harry that it would accept a cash payment of $350,000\nin full satisfaction of the outstanding loan balance of $490,000. Harry paid the bank\n$350,000. What should be the tax consequences of this restructuring? Why would\nFirst National Bank make such an offer?\n2. Hillary Carbuyer borrowed $20,000 for five years from Churn \xe2\x80\x99n\xe2\x80\x99 Burn Autos,\na used car dealership, to buy a used pickup truck. The interest rate on the loan was\n6.5%. Her monthly payment was $391.32. After making twenty-four payments,\nCarbuyer still owed $12,769.89. Carbuyer lost her job, but quickly found another\none that did not pay quite as well. She spoke with the credit manager at Churn \xe2\x80\x99n\xe2\x80\x99\nBurn Autos and obtained an agreement to stretch her remaining payments out over\nfive years, but the interest rate on the loan increased to 7.5%. Her monthly payment\nwould now be $255.88.\n\xe2\x80\xa2Should there be any tax consequences? What approach would you use to\ndetermine what those tax consequences would be?\n\nIV. Section 108(a)\'s Other Provisions\nSection 108(a)(1)(A and B) codifies and limits court-developed rules that govern\nthe discharge of indebtedness of debtors who are in bankruptcy or insolvent.\nSection 108 also provides rules governing discharge of indebtedness of a (1)\ntaxpayer\xe2\x80\x99s qualified farm indebtedness (\xc2\xa7 108(a)(1)(C)), (2) a non-subchapter C\ntaxpayer\xe2\x80\x99s qualified real property business indebtedness (\xc2\xa7 108(a)(1)(D)), (3) a\n215\n\n\x0ctaxpayer\xe2\x80\x99s qualified principal residence indebtedness discharged before January 1,\n2018 or pursuant to an arrangement entered before that date (\xc2\xa7 108(a)(1)(D)), (4) a\ntaxpayer\xe2\x80\x99s student loan indebtedness (\xc2\xa7 108(f)), and (5) a taxpayer\xe2\x80\x99s purchase\nmoney indebtedness (\xc2\xa7 108(e)(5)). Section 108(i) also provided for deferral of gain\nresulting from a taxpayer\xe2\x80\x99s reacquisition of a debt instrument as in Kirby Lumber.\n\xe2\x80\xa2\xe2\x80\x9cQualified farm indebtedness\xe2\x80\x9d is debt (but not purchase money debt) that\na taxpayer incurred \xe2\x80\x9cin connection with\xe2\x80\x9d taxpayer\xe2\x80\x99s operation of a farming\ntrade or business, \xc2\xa7 108(g)(1). The \xe2\x80\x9cqualified farm indebtedness\xe2\x80\x9d rules give\nsolvent farmers many of the benefits that \xc2\xa7 108 gives to insolvent debtors.\n\xe2\x80\xa2\xe2\x80\x9cQualified real property business CAA, Covid-Related Tax Relief Act of\nindebtedness\xe2\x80\x9d is debt (other than 2020, \xc2\xa7\xc2\xa7 276, 278 provide that\n\xe2\x80\x9cqualified farm indebtedness\xe2\x80\x9d) that forgiveness of \xe2\x80\x9cPaycheck Protection\ntaxpayer (other than a C corporation, Program Loans\xe2\x80\x9d are not included in a\n\xc2\xa7 108(a)(1)(D)) incurs or assumes \xe2\x80\x9cin taxpayer\xe2\x80\x99s gross income.\nconnection with\xe2\x80\x9d real property that\nsecures the debt that taxpayer uses in a trade or business. \xc2\xa7 108(c)(3)(A).\nTaxpayer may elect, \xc2\xa7 108(c)(3)(C), to have the amount discharged reduce\nthe bases of taxpayer\xe2\x80\x99s \xe2\x80\x9cdepreciable real property\xe2\x80\x9d to the extent that the loan\nprincipal immediately before the discharge exceeds the fmv of such\nproperty (less the principal amount of any other loans that the same property\nsecures). \xc2\xa7 108(c)(2)(A). The amount discharged may not exceed the\naggregate bases of taxpayer\xe2\x80\x99s depreciable real property. \xc2\xa7 108(c)(2)(B).\n\xe2\x80\xa2\xe2\x80\x9cQualified principal residence indebtedness\xe2\x80\x9d is up to $750,000 of debt that\ntaxpayer incurred to acquire, construct, or substantially improve taxpayer\xe2\x80\x99s\nprincipal residence, which secures the loan. \xc2\xa7 108(h)(2), \xc2\xa7 108(h)(5). The\namount discharged reduces taxpayer\xe2\x80\x99s basis in the home, but not below $0.\n\xc2\xa7 108(h)(1). Congress enacted \xc2\xa7 108(a)(1)(E) in response to the financial\ncrisis and to encourage homeowners not to default on their home mortgages\nwhen they are \xe2\x80\x9cunder water.\xe2\x80\x9d Notice that unlike the case of \xe2\x80\x9cqualified real\nproperty business indebtedness,\xe2\x80\x9d the amount of permissible basis reduction\nis the taxpayer\xe2\x80\x99s basis in the home, not the amount by which taxpayer\xe2\x80\x99s\nbasis exceeds the property\xe2\x80\x99s fmv. This provision will not apply to\ndischarges of \xe2\x80\x9cqualified principal residence indebtedness\xe2\x80\x9d that occur after\nDecember 31, 2025 or pursuant to a written arrangement entered after\nDecember 31, 2025.\n\n216\n\n\x0c\xe2\x80\xa2\xe2\x80\x9cDischarges of Student Loans\xe2\x80\x9d are excluded from a taxpayer\xe2\x80\x99s gross\nincome when the discharge is pursuant to a provision of the loan whereby\nthe discharge is on condition that an individual work for a certain period in\ncertain professions60 for any of a broad class\n(as opposed to one or a few specific A student receiving a\nemployers) of employers. \xc2\xa7 108(f)(1). The \xe2\x80\x9cqualified emergency\nfinancial aid grant\xe2\x80\x9d does not\nlender must be \xe2\x80\x93\n\xe2\x80\xa2the\nUnited\nStates\n(or\nan include the amount in his/her\ngross income. CAA, Covidinstrumentality\nor\nagency),\n\xc2\xa7\nRelated Tax Relief Act of\n108(f)(1)(A),\n2020 \xc2\xa7 277.\n\xe2\x80\xa2a state, territory, possession, the\nDistrict of Columbia, or political\nsubdivision, \xc2\xa7 108(f)(1)(B),\n\xe2\x80\xa2a public benefit corporation exempt from income tax under\n\xc2\xa7 501(c)(3) that has assumed control over a state, county, or\nmunicipal hospital and whose employees are deemed to be public\nemployees under state law, \xc2\xa7 108(f)(1)(C), OR\n\xe2\x80\xa2an educational institution when funds are provided by an entity\nalready named OR pursuant to the institution\xe2\x80\x99s program designed to\nencourage students to serve in occupations with unmet needs or in\nareas with unmet needs under the supervision of a governmental unit\nor organization exempt from income tax under \xc2\xa7\xc2\xa7 501(a) and\n501(c)(3), \xc2\xa7 108(f)(1)(D). The discharge may not be for services\nperformed for any of these entities. \xc2\xa7 108(f)(3).\nGross income also does not include loan repayments or forgiveness under\ncertain federal and state programs \xe2\x80\x9cintended to provide for the increased\navailability of health care services in underserved or health shortage areas\n\xe2\x80\xa6\xe2\x80\x9d \xc2\xa7 108(f)(4). For tax years 2021 to 2025, gross income does not include\ndischarged student loans incurred for post-secondary educational expenses.\n\xc2\xa7 108(f)(5).\n\xe2\x80\xa2\xe2\x80\x9cDischarge of Purchase Money Indebtedness\xe2\x80\x9d is not excluded from a\ntaxpayer\xe2\x80\x99s gross income but rather is treated as a purchase price reduction.\n\xc2\xa7 108(e)(5). The debt must be owed by the purchaser of property to the\nseller of the property and arise from the purchase. \xc2\xa7 108(e)(5)(A). The\n\xe2\x80\x9cThe professions to which the provision refers are medicine, nursing, and teaching.\xe2\x80\x9d STAFF OF JT.\nCOMM. ON TAXATION, GENERAL EXPLANATION OF THE REVENUE PROVISIONS OF THE DEFICIT\nREDUCTION ACT OF 1984 1200 (Jt. Comm. Print 1984).\n60\n\n217\n\n\x0cdebtor must be solvent and not in bankruptcy. \xc2\xa7 108(e)(5)(B). The reduction\nmust otherwise constitute discharge of indebtedness income \xe2\x80\x93 as opposed\nto, say, reduction of debt principal in exchange for services. \xc2\xa7 108(e)(5)(C).\nThis provision is useful when buyer and seller resolve a dispute over the\nquality of goods by a reduction in the purchaser\xe2\x80\x99s debt obligation.\n\nV. Transactions Involving Property Subject to a Loan\nTaxpayer may use the proceeds of a loan \xe2\x80\x93from the seller of the property or from a\nthird-party lender \xe2\x80\x93 to purchase property and to give the property so purchased as\nsecurity or collateral for the loan. Such property is \xe2\x80\x9cencumbered by\xe2\x80\x9d or \xe2\x80\x9csubject to\xe2\x80\x9d\nthe outstanding principal amount of the loan. Can borrower count the money that\nhe borrowed as part of his basis when in fact taxpayer did not purchase the property\nwith after-tax money?\n\xe2\x80\xa2Yes. Borrower has an obligation to repay the loan and will repay it with\nmoney that has been subject to income tax. It does not matter whether\nborrower borrowed the money from the seller or from a third party.\n\xe2\x80\xa2When borrower sells the property subject to the loan, the buyer will pay\nthe fmv of the property minus the loan balance. The buyer is treated as\nhaving paid the borrower/seller cash equal to the amount of the loan\nbalance. Thus, the seller must include the loan balance in his \xe2\x80\x9camount\nrealized\xe2\x80\x9d under \xc2\xa7 1001(a).\n\xe2\x80\xa2Once we permit the borrower to use untaxed borrowed funds to obtain basis\nin property, the rest of the analysis must follow.\n\xe2\x80\xa2We assume that the borrower will honor his obligation to repay the loan.\n\xe2\x80\xa2Consider:\n\xe2\x80\xa2Taxpayer owns Blackacre. She bought it for $10,000, and its ab =\n$10,000. At a time when the fmv of Blackacre was $50,000,\nTaxpayer borrowed $30,000 and put up Blackacre as collateral.\nTaxpayer sold Blackacre to Buyer who paid her $20,000 cash and\nassumed the $30,000 loan secured by Blackacre. What is Taxpayer\xe2\x80\x99s\ntaxable gain? May taxpayer treat the amount borrowed as part of his\nadjusted basis in the property? Why?\n\xe2\x80\xa2Taxpayer borrows $30,000 from Bank. Taxpayer uses the\nborrowed money to purchase Whiteacre for $30,000; taxpayer also\ngives a mortgage to Bank. Taxpayer sold Whiteacre to Buyer for\n$20,000 cash plus assumption of the $30,000 loan. What is\n218\n\n\x0ctaxpayer\xe2\x80\x99s taxable gain?\n\xe2\x80\xa2May taxpayer treat the amount borrowed as part of his\nadjusted basis in the property? Why?\n\xe2\x80\xa2When do loan proceeds count in basis? When do they not count in\nbasis? What does the Supreme Court say about this in Tufts, infra?\n\xe2\x80\xa2Now consider the following two arrangements by which lender and borrower\nmight structure a loan:\nRecourse obligation: A recourse obligation is one for which the borrower is\npersonally liable. If the borrower defaults and the collateral that the borrower put\nup to obtain the loan is insufficient to satisfy the borrower\xe2\x80\x99s obligation, the lender\nmay pursue other assets of the borrower to satisfy the debt. The risk that a loss may\noccur because the fmv of the property decreases prior to default thus falls on the\nborrower.\n\xe2\x80\xa2This point may encourage a borrower to pay down a loan, even when its\nprincipal amount is greater than the fmv of the property securing the loan.\nOtherwise, the borrower may lose other assets that he owns.\n\xe2\x80\xa2If the creditor accepts the collateral as full payment, taxpayer/borrower\nmust recognize gain on the disposition of the collateral as if he had sold it\nfor its fmv.\n\xe2\x80\xa2If the creditor accepts the collateral as full payment and the fmv of the\nproperty is less than the principal amount of the loan, the difference is doi\nincome. Gehl, supra.\nNonrecourse obligation: A nonrecourse obligation is one for which the borrower is\nnot personally liable. Thus, if the borrower defaults, the lender may pursue only\nthe property offered as collateral for the loan. The risk that a loss may occur because\nthe fmv of the property decreases prior to default falls on the lender.\n\xe2\x80\xa2When the fmv of the property is greater than the loan amount, the borrower\nhas an economic incentive to continue making payments on a nonrecourse\nloan. A borrower should willingly repay a nonrecourse loan of $80 to obtain\nproperty whose fmv is $100.\n\xe2\x80\xa2But: if the fmv of the property is less than the outstanding balance of a\nnonrecourse loan, the borrower may (should?) profitably \xe2\x80\x9cwalk away.\xe2\x80\x9d\nAfter all, why should a borrower pay down a nonrecourse loan of $100 to\nobtain a piece of property whose fmv is $80?\n\xe2\x80\xa2This point might encourage lenders to reduce the amount of\n219\n\n\x0cnonrecourse debt that borrowers owe them when the value of the\nunderlying collateral decreases. Cf. \xc2\xa7 108(a)(1)(C, D, E). After all, the\nproperty\xe2\x80\x99s fmv is not greater when the lender owns it than it was\nwhen the borrower owned it. If the creditor reduces the loan\nprincipal to the property\xe2\x80\x99s fmv or less, borrower is more likely to\nmake payments on the loan and not to \xe2\x80\x9cwalk away.\xe2\x80\x9d\n\xe2\x80\xa2If a nonrecourse borrower defaults on a loan and surrenders the property\nhe put up as collateral whose fmv is less than the loan principal, exactly how\nmuch doi results from a freeing of assets?\n\xe2\x80\xa2This question may arise when a borrower sells or surrenders\nproperty subject to a nonrecourse obligation at a time when the fmv\nof the underlying property is less than the principal of the\nnonrecourse obligation.\n\xe2\x80\xa2What would be the rule if the obligation were a recourse\nobligation?\n\xe2\x80\xa2Arguably, a taxpayer who sells or surrenders property subject to a\nnonrecourse obligation should be permitted to deduct loss to the\nextent \xc2\xa7 165 permits. The loss on the sale or surrender of property\nsubject to a non-recourse obligation would be the adjusted basis in\nthe property minus its fmv. Prior to Tufts, this was the position many\ntaxpayers took upon sale or surrender of property subject to a\nnonrecourse obligation because\n[t]he return of a note which represents no personal liability\nof a taxpayer does not free any assets except those from\nwhich the note might otherwise have been paid. Since the\nunderlying theory of income from cancellation of\nindebtedness is the freeing of the debtor\xe2\x80\x99s assets from\nliability for the debt, any such income is limited to the\namount of assets freed by the cancellation.\nCollins v. CIR, T.C. Memo 1963-285, 1963 WL 613 (1963).\n\xe2\x80\xa2How does the treatment that taxpayers routinely accorded loss\nproperty subject to a nonrecourse obligation violate the first guiding\nprinciple of the income tax noted in chapter 1, supra?\n\xe2\x80\xa2Notice the contention of the taxpayer in the following important case.\n220\n\n\x0cCommissioner v. Tufts, 461 U.S. 300 (1983).\nJUSTICE BLACKMUN delivered the opinion of the Court.\nOver 35 years ago, in Crane v. Commissioner, 331 U.S. 1 (1947), this Court ruled\nthat a taxpayer, who sold property encumbered by a nonrecourse mortgage (the\namount of the mortgage being less than the property\xe2\x80\x99s value), must include the\nunpaid balance of the mortgage in the computation of the amount the taxpayer\nrealized on the sale. The case now before us presents the question whether the same\nrule applies when the unpaid amount of the nonrecourse mortgage exceeds the fair\nmarket value of the property sold.\nI\nOn August 1, 1970, respondent Clark Pelt, a builder, and his wholly owned\ncorporation, respondent Clark, Inc., formed a general partnership. The purpose of\nthe partnership was to construct a 120-unit apartment complex in Duncanville,\nTex., a Dallas suburb. Neither Pelt nor Clark, Inc., made any capital contribution\nto the partnership. Six days later, the partnership entered into a mortgage loan\nagreement with the Farm & Home Savings Association (F&H). Under the\nagreement, F&H was committed for a $1,851,500 loan for the complex. In return,\nthe partnership executed a note and a deed of trust in favor of F&H. The partnership\nobtained the loan on a nonrecourse basis: neither the partnership nor its partners\nassumed any personal liability for repayment of the loan. Pelt later admitted four\nfriends and relatives, respondents Tufts, Steger, Stephens, and Austin, as general\npartners. None of them contributed capital upon entering the partnership.\nThe construction of the complex was completed in August, 1971. During 1971,\neach partner made small capital contributions to the partnership; in 1972, however,\nonly Pelt made a contribution. The total of the partners\xe2\x80\x99 capital contributions was\n$44,212. In each tax year, all partners claimed as income tax deductions their\nallocable shares of ordinary losses and depreciation. The deductions taken by the\npartners in 1971 and 1972 totalled $439,972. Due to these contributions and\ndeductions, the partnership\xe2\x80\x99s adjusted basis in the property in August, 1972, was\n$1,455,740.\nIn 1971 and 1972, major employers in the Duncanville area laid off significant\nnumbers of workers. As a result, the partnership\xe2\x80\x99s rental income was less than\nexpected, and it was unable to make the payments due on the mortgage. Each\npartner, on August 28, 1972, sold his partnership interest to an unrelated third party,\n221\n\n\x0cFred Bayles. As consideration, Bayles agreed to reimburse each partner\xe2\x80\x99s sale\nexpenses up to $250; he also assumed the nonrecourse mortgage.\nOn the date of transfer, the fair market value of the property did not exceed\n$1,400,000. Each partner reported the sale on his federal income tax return and\nindicated that a partnership loss of $55,740 had been sustained. 61 The\nCommissioner of Internal Revenue, on audit, determined that the sale resulted in a\npartnership capital gain of approximately $400,000. His theory was that the\npartnership had realized the full amount of the nonrecourse obligation.62\nRelying on Millar v. Commissioner, 577 F.2d 212, 215 (CA3), cert. denied, 439\nU.S. 1046 (1978), the United States Tax Court, in an unreviewed decision, upheld\nthe asserted deficiencies. The United States Court of Appeals for the Fifth Circuit\nreversed. That court expressly disagreed with the Millar analysis, and, in limiting\nCrane v. Commissioner, supra, to its facts, questioned the theoretical underpinnings\nof the Crane decision. We granted certiorari to resolve the conflict.\nII\n... Section 1001 governs the determination of gains and losses on the disposition of\nproperty. Under \xc2\xa7 1001(a), the gain or loss from a sale or other disposition of\nproperty is defined as the difference between \xe2\x80\x9cthe amount realized\xe2\x80\x9d on the\ndisposition and the property\xe2\x80\x99s adjusted basis. Subsection (b) of \xc2\xa7 1001 defines\n\xe2\x80\x9camount realized:\xe2\x80\x9d \xe2\x80\x9cThe amount realized from the sale or other disposition of\nproperty shall be the sum of any money received plus the fair market value of the\nproperty (other than money) received.\xe2\x80\x9d At issue is the application of the latter\nprovision to the disposition of property encumbered by a nonrecourse mortgage of\nan amount in excess of the property\xe2\x80\x99s fair market value.\nA\nIn Crane v. Commissioner, supra, this Court took the first and controlling step\nThe loss was the difference between the adjusted basis, $1,455,740, and the fair market value of the\nproperty, $1,400,000. ... [You should recognize that this was the treatment that the Tax Court accorded\nsuch transactions in Collins, supra.]\n61\n\nThe Commissioner determined the partnership\xe2\x80\x99s gain on the sale by subtracting the adjusted basis,\n$1,455,740, from the liability assumed by Bayles, $1,851,500. Of the resulting figure, $395,760, the\nCommissioner treated $348,661 as capital gain, pursuant to \xc2\xa7 741 of the Internal Revenue Code of 1954,\nand $47,099 as ordinary gain under the recapture provisions of \xc2\xa7 1250 of the Code. The application of\n\xc2\xa7 1250 in determining the character of the gain is not at issue here.\n62\n\n222\n\n\x0ctoward the resolution of this issue. Beulah B. Crane was the sole beneficiary under\nthe will of her deceased husband. At his death in January, 1932, he owned an\napartment building that was then mortgaged for an amount which proved to be\nequal to its fair market value, as determined for federal estate tax purposes. The\nwidow, of course, was not personally liable on the mortgage. She operated the\nbuilding for nearly seven years, hoping to turn it into a profitable venture; during\nthat period, she claimed income tax deductions for depreciation, property taxes,\ninterest, and operating expenses, but did not make payments upon the mortgage\nprincipal. In computing her basis for the depreciation deductions, she included the\nfull amount of the mortgage debt. In November, 1938, with her hopes unfulfilled\nand the mortgagee threatening foreclosure, Mrs. Crane sold the building. The\npurchaser took the property subject to the mortgage and paid Crane $3,000; of that\namount, $500 went for the expenses of the sale.\nCrane reported a gain of $2,500 on the transaction. She reasoned that her basis in\nthe property was zero (despite her earlier depreciation deductions based on\nincluding the amount of the mortgage) and that the amount she realized from the\nsale was simply the cash she received. The Commissioner disputed this claim. He\nasserted that Crane\xe2\x80\x99s basis in the property, under [what is now \xc2\xa7 1014] was the\nproperty\xe2\x80\x99s fair market value at the time of her husband\xe2\x80\x99s death, adjusted for\ndepreciation in the interim, and that the amount realized was the net cash received\nplus the amount of the outstanding mortgage assumed by the purchaser.\nIn upholding the Commissioner\xe2\x80\x99s interpretation of \xc2\xa7 [1014] [footnote omitted], the\nCourt observed that to regard merely the taxpayer\xe2\x80\x99s equity in the property as her\nbasis would lead to depreciation deductions less than the actual physical\ndeterioration of the property, and would require the basis to be recomputed with\neach payment on the mortgage. The Court rejected Crane\xe2\x80\x99s claim that any loss due\nto depreciation belonged to the mortgagee. The effect of the Court\xe2\x80\x99s ruling was that\nthe taxpayer\xe2\x80\x99s basis was the value of the property undiminished by the mortgage.\nThe Court next proceeded to\ndetermine the amount realized under\n[what is now \xc2\xa7 1001(b)]. In order to\navoid the \xe2\x80\x9cabsurdity,\xe2\x80\x9d of Crane\xe2\x80\x99s\nrealizing only $2,500 on the sale of\nproperty worth over a quarter of a\nmillion dollars, the Court treated the\namount realized as it had treated\n\nTaxpayer\xe2\x80\x99s equity in property: Taxpayer\xe2\x80\x99s\n\xe2\x80\x9cequity in property\xe2\x80\x9d is the value of taxpayer\xe2\x80\x99s\nownership interest. If the property is subject to\na liability, then taxpayer\xe2\x80\x99s equity interest\nEQUALS the fmv of the property MINUS the\nliability to which the property is subject.\n\n223\n\n\x0cbasis, that is, by including the outstanding value of the mortgage. To do otherwise\nwould have permitted Crane to recognize a tax loss unconnected with any actual\neconomic loss. The Court refused to construe one section of the Revenue Act so\nas \xe2\x80\x9cto frustrate the Act as a whole.\xe2\x80\x9d\nCrane, however, insisted that the nonrecourse nature of the mortgage required\ndifferent treatment. The Court, for two reasons, disagreed. First, excluding the\nnonrecourse debt from the amount realized would result in the same absurdity and\nfrustration of the Code. Second, the Court concluded that Crane obtained an\neconomic benefit from the purchaser\xe2\x80\x99s assumption of the mortgage identical to the\nbenefit conferred by the cancellation of personal debt. Because the value of the\nproperty in that case exceeded the amount of the mortgage, it was in Crane\xe2\x80\x99s\neconomic interest to treat the mortgage as a personal obligation; only by so doing\ncould she realize upon sale the appreciation in her equity represented by the $2,500\nboot. The purchaser\xe2\x80\x99s assumption of the liability thus resulted in a taxable economic\nbenefit to her, just as if she had been given, in addition to the boot, a sum of cash\nsufficient to satisfy the mortgage. [footnote omitted].\nIn a footnote, pertinent to the present case, the Court observed:\n\xe2\x80\x9cObviously, if the value of the property is less than the amount of the\nmortgage, a mortgagor who is not personally liable cannot realize a benefit\nequal to the mortgage. Consequently, a different problem might be\nencountered where a mortgagor abandoned the property or transferred it\nsubject to the mortgage without receiving boot. That is not this case.\xe2\x80\x9d 331\nU.S. at 14, n. 37.\nB\nThis case presents that unresolved issue. We are disinclined to overrule Crane, and\nwe conclude that the same rule\napplies when the unpaid amount\nBoot: The term \xe2\x80\x9cboot\xe2\x80\x9d comes from the phrase\nof the nonrecourse mortgage\n\xe2\x80\x9cto boot.\xe2\x80\x9d This colloquialism has become an\nexceeds the value of the property\nimportant concept in much of tax law. In this\ntransferred. Crane ultimately\ncase, there was an exchange of property for\ndoes not rest on its limited theory\nassumption of a mortgage, plus a little cash \xe2\x80\x9cto\nof economic benefit; instead, we\nboot.\xe2\x80\x9d If you take more tax courses, you will\nread Crane to have approved the\nencounter the term \xe2\x80\x9cboot\xe2\x80\x9d many more times.\nCommissioner\xe2\x80\x99s decision to treat\na nonrecourse mortgage in this\n224\n\n\x0ccontext as a true loan. This approval underlies Crane\xe2\x80\x99s holdings that the amount of\nthe nonrecourse liability is to be included in calculating both the basis and the\namount realized on disposition. That the amount of the loan exceeds the fair market\nvalue of the property thus becomes irrelevant.\nWhen a taxpayer receives a loan, he incurs an obligation to repay that loan at some\nfuture date. Because of this obligation, the loan proceeds do not qualify as income\nto the taxpayer. When he fulfills the obligation, the repayment of the loan likewise\nhas no effect on his tax liability.\nAnother consequence to the taxpayer from this obligation occurs when the taxpayer\napplies the loan proceeds to the purchase price of property used to secure the loan.\nBecause of the obligation to repay, the taxpayer is entitled to include the amount of\nthe loan in computing his basis in the property; the loan, under \xc2\xa7 1012, is part of\nthe taxpayer\xe2\x80\x99s cost of the property. Although a different approach might have been\ntaken with respect to a nonrecourse mortgage loan,63 the Commissioner has chosen\nto accord it the same treatment he gives to a recourse mortgage loan. The Court\napproved that choice in Crane, and the respondents do not challenge it here. The\nchoice and its resultant benefits to the taxpayer are predicated on the assumption\nthat the mortgage will be repaid in full.\nWhen encumbered property is sold or otherwise disposed of and the purchaser\nassumes the mortgage, the associated extinguishment of the mortgagor\xe2\x80\x99s obligation\nto repay is accounted for in the computation of the amount realized. [footnote\nThe Commissioner might have adopted the theory, implicit in Crane\xe2\x80\x99s contentions, that a\nnonrecourse mortgage is not true debt, but, instead, is a form of joint investment by the mortgagor and\nthe mortgagee. On this approach, nonrecourse debt would be considered a contingent liability, under\nwhich the mortgagor\xe2\x80\x99s payments on the debt gradually increase his interest in the property while\ndecreasing that of the mortgagee. Note, Federal Income Tax Treatment of Nonrecourse Debt, 82 COLUM. L.\nREV. 1498, 1514 (1982); Lurie, Mortgagor\xe2\x80\x99s Gain on Mortgaging Property for More than Cost Without Personal\nLiability, 6 TAX L. REV. 319, 323 (1951); cf. Brief for Respondents 16 (nonrecourse debt resembles\npreferred stock). Because the taxpayer\xe2\x80\x99s investment in the property would not include the nonrecourse\ndebt, the taxpayer would not be permitted to include that debt in basis. Note, 82 COLUM. L. REV. at\n1515; [citation omitted].\n63\n\n... We note only that the Crane Court\xe2\x80\x99s resolution of the basis issue presumed that, when property is\npurchased with proceeds from a nonrecourse mortgage, the purchaser becomes the sole owner of the\nproperty. 331 U.S. at 6. Under the Crane approach, the mortgagee is entitled to no portion of the basis.\nId. at 10, n. 28. The nonrecourse mortgage is part of the mortgagor\xe2\x80\x99s investment in the property, and\ndoes not constitute a coinvestment by the mortgagee. But see Note, 82 COLUM. L. REV. at 1513 (treating\nnonrecourse mortgage as coinvestment by mortgagee and critically concluding that Crane departed from\ntraditional analysis that basis is taxpayer\xe2\x80\x99s investment in property).\n\n225\n\n\x0comitted]. See United States v. Hendler, 303 U.S. 564, 566-567 (1938). Because no\ndifference between recourse and nonrecourse obligations is recognized in\ncalculating basis [footnote omitted], Crane teaches that the Commissioner may\nignore the nonrecourse nature of the obligation in determining the amount realized\nupon disposition of the encumbered property. He thus may include in the amount\nrealized the amount of the nonrecourse mortgage assumed by the purchaser. The\nrationale for this treatment is that the original inclusion of the amount of the\nmortgage in basis rested on the assumption that the mortgagor incurred an\nobligation to repay. Moreover, this treatment balances the fact that the mortgagor\noriginally received the proceeds of the nonrecourse loan tax-free on the same\nassumption. Unless the outstanding amount of the mortgage is deemed to be\nrealized, the mortgagor effectively will have received untaxed income at the time\nthe loan was extended, and will have received an unwarranted increase in the basis\nof his property. [footnote omitted]. The Commissioner\xe2\x80\x99s interpretation of \xc2\xa7 1001(b)\nin this fashion cannot be said to be unreasonable.\nC\nThe Commissioner, in fact, has applied this rule even when the fair market value of\nthe property falls below the amount of the nonrecourse obligation. Reg. \xc2\xa7 1.10012(b) [footnote omitted]; Rev. Rul. 76-111. Because the theory on which the rule is\nbased applies equally in this situation, see Millar v. Commissioner, 67 T.C. 656,\n660 (1977), aff\xe2\x80\x99d on this issue, 577 F.2d 212, 215-216 (CA3), cert. denied, 439 U.S.\n1046 (1978); [footnote omitted] Mendham Corp. v. Commissioner, 9 T.C. 320, 323324 (1947); Lutz & Schramm Co. v. Commissioner, 1 T.C. 682, 688-689 (1943),\nwe have no reason, after Crane, to question this treatment.64\nProfessor Wayne G. Barnett, as amicus in the present case, argues that the liability and property\nportions of the transaction should be accounted for separately. Under his view, there was a transfer of\nthe property for $1.4 million, and there was a cancellation of the $1.85 million obligation for a payment\nof $1.4 million. The former resulted in a capital loss of $50,000, and the latter in the realization of\n$450,000 of ordinary income. Taxation of the ordinary income might be deferred under \xc2\xa7 108 by a\nreduction of respondents\xe2\x80\x99 bases in their partnership interests.\n64\n\nAlthough this indeed could be a justifiable mode of analysis, it has not been adopted by the\nCommissioner. Nor is there anything to indicate that the Code requires the Commissioner to adopt it.\nWe note that Professor Barnett\xe2\x80\x99s approach does assume that recourse and nonrecourse debt may be\ntreated identically.\nThe Commissioner also has chosen not to characterize the transaction as cancellation of indebtedness.\nWe are not presented with, and do not decide, the contours of the cancellation-of-indebtedness\ndoctrine. We note only that our approach does not fall within certain prior interpretations of that\ndoctrine. In one view, the doctrine rests on the same initial premise as our analysis here \xe2\x80\x93 an obligation\nto repay \xe2\x80\x93 but the doctrine relies on a freeing-of-assets theory to attribute ordinary income to the debtor\n\n226\n\n\x0cRespondents received a mortgage loan with the concomitant obligation to repay by\nthe year 2012. The only difference between that mortgage and one on which the\nborrower is personally liable is that the mortgagee\xe2\x80\x99s remedy is limited to\nforeclosing on the securing property. This difference does not alter the nature of the\nobligation; its only effect is to shift from the borrower to the lender any potential\nloss caused by devaluation of the property. [footnote omitted]. If the fair market\nvalue of the property falls below the amount of the outstanding obligation, the\nmortgagee\xe2\x80\x99s ability to protect its interests is impaired, for the mortgagor is free to\nabandon the property to the mortgagee and be relieved of his obligation.\nThis, however, does not erase the fact that the mortgagor received the loan proceeds\ntax-free, and included them in his basis on the understanding that he had an\nobligation to repay the full amount. See Woodsam Associates, Inc. v.\nCommissioner, 198 F.2d 357, 359 (CA2 1952); Bittker, Tax Shelters, Nonrecourse\nDebt, and the Crane Case, 33 TAX L. REV. 277, at 284 n.7 (1978). When the\nobligation is canceled, the mortgagor is relieved of his responsibility to repay the\nsum he originally received, and thus realizes value to that extent within the meaning\nof \xc2\xa7 1001(b). From the mortgagor\xe2\x80\x99s point of view, when his obligation is assumed\nby a third party who purchases the encumbered property, it is as if the mortgagor\nfirst had been paid with cash borrowed by the third party from the mortgagee on a\nnonrecourse basis, and then had used the cash to satisfy his obligation to the\nmortgagee.\nMoreover, this approach avoids the absurdity the Court recognized in Crane.\nupon cancellation. See Commissioner v. Jacobson, 336 U.S. 28, 38-40 (1949); United States v. Kirby Lumber Co.,\n284 U.S. 1, 284 U.S. 3 (1931). According to that view, when nonrecourse debt is forgiven, the debtor\xe2\x80\x99s\nbasis in the securing property is reduced by the amount of debt canceled, and realization of income is\ndeferred until the sale of the property. See Fulton Gold Corp. v. Commissioner, 31 B.T.A. 519, 520 (1934).\nBecause that interpretation attributes income only when assets are freed, however, an insolvent debtor\nrealizes income just to the extent his assets exceed his liabilities after the cancellation. Lakeland Grocery\nCo. v. Commissioner, 36 B.T.A. 289, 292 (1937). Similarly, if the nonrecourse indebtedness exceeds the\nvalue of the securing property, the taxpayer never realizes the full amount of the obligation canceled,\nbecause the tax law has not recognized negative basis.\nAlthough the economic benefit prong of Crane also relies on a freeing-of-assets theory, that theory is\nirrelevant to our broader approach. In the context of a sale or disposition of property under \xc2\xa7 1001, the\nextinguishment of the obligation to repay is not ordinary income; instead, the amount of the canceled\ndebt is included in the amount realized, and enters into the computation of gain or loss on the\ndisposition of property. According to Crane, this treatment is no different when the obligation is\nnonrecourse: the basis is not reduced as in the cancellation-of-indebtedness context, and the full value\nof the outstanding liability is included in the amount realized. Thus, the problem of negative basis is\navoided.\n\n227\n\n\x0cBecause of the remedy accompanying the mortgage in the nonrecourse situation,\nthe depreciation in the fair market value of the property is relevant economically\nonly to the mortgagee, who, by lending on a nonrecourse basis, remains at risk. To\npermit the taxpayer to limit his realization to the fair market value of the property\nwould be to recognize a tax loss for which he has suffered no corresponding\neconomic loss. [footnote omitted]. Such a result would be to construe \xe2\x80\x9cone section\nof the Act ... so as ... to defeat the intention of another or to frustrate the Act as a\nwhole.\xe2\x80\x9d 331 U.S. at 13.\nIn the specific circumstances of Crane, the economic benefit theory did support the\nCommissioner\xe2\x80\x99s treatment of the nonrecourse mortgage as a personal obligation.\nThe footnote in Crane acknowledged the limitations of that theory when applied to\na different set of facts. Crane also stands for the broader proposition, however, that\na nonrecourse loan should be treated as a true loan. We therefore hold that a\ntaxpayer must account for the proceeds of obligations he has received tax-free and\nincluded in basis. Nothing in either \xc2\xa7 1001(b) or in the Court\xe2\x80\x99s prior decisions\nrequires the Commissioner to permit a taxpayer to treat a sale of encumbered\nproperty asymmetrically, by including the proceeds of the nonrecourse obligation\nin basis but not accounting for the proceeds upon transfer of the encumbered\nproperty. [citation omitted].\nIII\n....\nIV\nWhen a taxpayer sells or disposes of property encumbered by a nonrecourse\nobligation, the Commissioner properly requires him to include among the assets\nrealized the outstanding amount of the obligation. The fair market value of the\nproperty is irrelevant to this calculation. We find this interpretation to be consistent\nwith Crane v. Commissioner, 331 U.S. 1 (1947), and to implement the statutory\nmandate in a reasonable manner. [citation omitted].\nThe judgment of the Court of Appeals is therefore reversed.\nIt is so ordered.\n\n228\n\n\x0cJUSTICE O\xe2\x80\x99CONNOR, concurring.\nI concur in the opinion of the Court, accepting the view of the Commissioner. I do\nnot, however, endorse the Commissioner\xe2\x80\x99s view. Indeed, were we writing on a\nslate clean except for the decision in Crane v. Commissioner, 331 U.S. 1 (1947), I\nwould take quite a different approach \xe2\x80\x93 that urged upon us by Professor Barnett as\namicus.\nCrane established that a taxpayer could treat property as entirely his own, in spite\nof the \xe2\x80\x9ccoinvestment\xe2\x80\x9d provided by his mortgagee in the form of a nonrecourse loan.\nThat is, the full basis of the property, with all its tax consequences, belongs to the\nmortgagor. That rule alone, though, does not in any way tie nonrecourse debt to\nthe cost of property or to the proceeds upon disposition. I see no reason to treat the\npurchase, ownership, and eventual disposition of property differently because the\ntaxpayer also takes out a mortgage, an independent transaction. In this case, the\ntaxpayer purchased property, using nonrecourse financing, and sold it after it\ndeclined in value to a buyer who assumed the mortgage. \xe2\x80\xa6\nThe logical way to treat \xe2\x80\xa6 this case \xe2\x80\xa6 is to separate the two aspects of these events\nand to consider, first, the ownership and sale of the property, and, second, the\narrangement and retirement of the loan. Under Crane, the fair market value of the\nproperty on the date of acquisition \xe2\x80\x93 the purchase price \xe2\x80\x93 represents the taxpayer\xe2\x80\x99s\nbasis in the property, and the fair market value on the date of disposition represents\nthe proceeds on sale. The benefit received by the taxpayer in return for the property\nis the cancellation of a mortgage that is worth no more than the fair market value\nof the property, for that is all the mortgagee can expect to collect on the mortgage.\nHis gain or loss on the disposition of the property equals the difference between the\nproceeds and the cost of acquisition. Thus, the taxation of the transaction in\nproperty reflects the economic fate of the property. If the property has declined in\nvalue, as was the case here, the taxpayer recognizes a loss on the disposition of the\nproperty. The new purchaser then takes as his basis the fair market value as of the\ndate of the sale. [citations omitted].\nIn the separate borrowing transaction, the taxpayer acquires cash from the\nmortgagee. He need not recognize income at that time, of course, because he also\nincurs an obligation to repay the money. Later, though, when he is able to satisfy\nthe debt by surrendering property that is worth less than the face amount of the debt,\nwe have a classic situation of cancellation of indebtedness, requiring the taxpayer\nto recognize income in the amount of the difference between the proceeds of the\n229\n\n\x0cloan and the amount for which he is able to satisfy his creditor. 26 U.S.C.\n\xc2\xa7 [61(a)(11)]. The taxation of the financing transaction then reflects the economic\nfate of the loan.\nThe reason that separation of the two aspects of the events in this case is important\nis, of course, that the Code treats different sorts of income differently. A gain on\nthe sale of the property may qualify for capital gains treatment, \xc2\xa7\xc2\xa7 1202, 1221,\nwhile the cancellation of indebtedness is ordinary income, but income that the\ntaxpayer may be able to defer. \xc2\xa7\xc2\xa7 108, 1017. Not only does Professor Barnett\xe2\x80\x99s\ntheory permit us to accord appropriate treatment to each of the two types of income\nor loss present in these sorts of transactions, it also restores continuity to the system\nby making the taxpayer-seller\xe2\x80\x99s proceeds on the disposition of property equal to the\npurchaser\xe2\x80\x99s basis in the property. Further, and most important, it allows us to tax\nthe events in this case in the same way that we tax the economically identical\nhypothesized transaction.\nPersuaded though I am by the\nlogical coherence and internal\nconsistency of this approach, I\nagree with the Court\xe2\x80\x99s decision not\nto adopt it judicially. We do not\nwrite on a slate marked only by\nCrane.\nThe Commissioner\xe2\x80\x99s\nlongstanding position, Rev. Rul.\n76-111, is now reflected in the\nregulations.\nReg. \xc2\xa7 1.1001-2\n(1982). In the light of the numerous cases in the lower courts including the amount\nof the unrepaid proceeds of the mortgage in the proceeds on sale or disposition\n[citations omitted], it is difficult to conclude that the Commissioner\xe2\x80\x99s interpretation\nof the statute exceeds the bounds of his discretion. As the Court\xe2\x80\x99s opinion\ndemonstrates, his interpretation is defensible. One can reasonably read \xc2\xa7 1001(b)\xe2\x80\x99s\nreference to \xe2\x80\x9cthe amount realized from the sale or other disposition of property\xe2\x80\x9d\n(emphasis added) to permit the Commissioner to collapse the two aspects of the\ntransaction. As long as his view is a reasonable reading of \xc2\xa7 1001(b), we should\ndefer to the regulations promulgated by the agency charged with interpretation of\nthe statute. [citations omitted]. Accordingly, I concur.\n\nTax Shelters: Tax shelters create a mismatch in\ntiming between claiming deductions and\nreporting taxable gain. Taxpayer claims\ndeductions against borrowed money and\nreports taxable gain only upon sale of the\nproperty. What might this mismatch in timing of\ndeductions and taxable gain be worth? See\npresent value tables, chapter 2, supra?\n\n230\n\n\x0cNotes and Questions:\n1. Notice that taxpayers\xe2\x80\x99 allowable depreciation deductions reduced their adjusted\nbasis in the property. Why is it necessary that this be the rule?\n\xe2\x80\xa2Aside from computation of gain under \xc2\xa7 1001, what significance is there\nin the fact that taxpayer includes borrowed money in determining his\nadjusted basis in property?\n2. What was in this for Fred Bayles? How was he going to profit by assuming a\nnonrecourse obligation that was greater than the fmv of the property?\n3. Does this case unmoor cancellation of indebtedness income from the necessity\nof establishing a \xe2\x80\x9cfreeing of assets\xe2\x80\x9d or a \xe2\x80\x9cshrinking of assets?\xe2\x80\x9d\n\xe2\x80\xa2The Court\xe2\x80\x99s opinion does not treat any of the loan as having been cancelled.\nIt is all included in \xe2\x80\x9camount realized.\xe2\x80\x9d\n4. Read Reg. \xc2\xa7 1.1001-2(a)(2). It seems to apply Justice O\xe2\x80\x99Connor\xe2\x80\x99s/Professor\nBarnett\xe2\x80\x99s theory to discharge of recourse liability when the fmv of the property is\nless than the outstanding principal of the loan. Why the difference?\n\xe2\x80\xa2Did the lender Farm & Home Savings Association discharge any\nindebtedness in Tufts?\nTaxpayer\xe2\x80\x99s Minimum Gain:\nAfter Tufts,\nirrespective of the fmv of the property,\ntaxpayer\xe2\x80\x99s minimum gain on its disposition is\nthe amount of the nonrecourse loan assumed by\nthe purchaser MINUS the adjusted basis of the\nproperty. Taxpayer will not realize less gain\nthan that upon disposition of property subject\nto a nonrecourse loan. Do you see why?\n\n5. Property that is subject to\ndepreciation is not a capital asset.\n\xc2\xa7 1221(a)(2). A special wartime\nmeasure, \xc2\xa7 1231, allows taxpayer\nto treat such property held for\nmore than one year as a capital\nasset if a sale or disposition\nproduces gain.\n\nRev. Rul. 90-16, 1990-1 C.B. 12\n....\nProperty transfer by insolvent taxpayer in satisfaction of debt secured by property.\nA transfer of property to a bank in satisfaction of a debt on which the taxpayer is\n231\n\n\x0cpersonally liable and which is secured by the property is a disposition upon which\ngain is recognized under \xc2\xa7\xc2\xa7 1001(c) and 61(a)(3) of the Code to the extent the fair\nmarket value of the property exceeds the taxpayer\xe2\x80\x99s adjusted basis in the property.\nISSUE\nA taxpayer transfers to a creditor a residential subdivision that has a fair market\nvalue in excess of the taxpayer\xe2\x80\x99s basis in satisfaction of a debt for which the\ntaxpayer was personally liable. Is the transfer a sale or disposition resulting in the\nrealization and recognition of gain by the taxpayer under \xc2\xa7\xc2\xa7 1001(c) and 61(a)(3)\nof the Internal Revenue Code?\nFACTS\nX was the owner and developer of a residential subdivision. To finance the\ndevelopment of the subdivision, X obtained a loan from an unrelated bank. X was\nunconditionally liable for repayment of the debt. The debt was secured by a\nmortgage on the subdivision.\nX became insolvent (within the meaning of \xc2\xa7 108(d)(3) of the Code) and defaulted\non the debt. X negotiated an agreement with the bank whereby the subdivision was\ntransferred to the bank and the bank released X from all liability for the amounts\ndue on the debt. When the subdivision was transferred pursuant to the agreement,\nits fair market value was 10,000x dollars, X\xe2\x80\x99s adjusted basis in the subdivision was\n8,000x dollars, and the amount due on the debt was 12,000x dollars, which did not\nrepresent any accrued but unpaid interest. After the transaction X was still\ninsolvent.\nLAW AND ANALYSIS\nSections 61(a)(3) and [61(a)(11)] of the Code provide that, except as otherwise\nprovided, gross income means all income from whatever source derived, including\n(but not limited to) gains from dealings in property and income from discharge of\nindebtedness.\nSection 108(a)(1)(B) of the Code provides that gross income does not include any\namount that would otherwise be includible in gross income by reason of discharge\n(in whole or in part) of indebtedness of the taxpayer if the discharge occurs when\nthe taxpayer is insolvent. Section 108(a)(3) provides that, in the case of a discharge\n232\n\n\x0cto which \xc2\xa7 108(a)(1)(B) applies, the amount excluded under \xc2\xa7 108(a)(1)(B) shall\nnot exceed the amount by which the taxpayer is insolvent (as defined in\n\xc2\xa7 108(d)(3)).\nReg. \xc2\xa7 1.61-6(a) provides that the specific rules for computing the amount of gain\nor loss from dealings in property under \xc2\xa7 61(a)(3) are contained in \xc2\xa7 1001 and the\nregulations thereunder.\nSection 1001(a) of the Code provides that gain from the sale or other disposition of\nproperty shall be the excess of the amount realized therefrom over the adjusted\nbasis provided in \xc2\xa7 1011 for determining gain.\nSection 1001(b) of the Code provides that the amount realized from the sale or other\ndisposition of property shall be the sum of any money received plus the fair market\nvalue of the property (other than money) received.\nSection 1001(c) of the Code provides that, except as otherwise provided in subtitle\nA, the entire amount of the gain or loss, determined under \xc2\xa7 1001, on the sale or\nexchange of property shall be recognized.\nReg. \xc2\xa7 1.1001-2(a)(1) provides that, except as provided in \xc2\xa7 1.1001-2(a)(2) and (3),\nthe amount realized from a sale or other disposition of property includes the amount\nof liabilities from which the transferor is discharged as a result of the sale or\ndisposition. Section 1.1001-2(a)(2) provides that the amount realized on a sale or\nother disposition of property that secures a recourse liability does not include\namounts that are (or would be if realized and recognized) income from the\ndischarge of indebtedness under [\xc2\xa7 61(a)(11)]. Example (8) under \xc2\xa7 1.1001-2(c)\nillustrates these rules as follows:\nExample (8). In 1980, F transfers to a creditor an asset with a fair market\nvalue of $6,000 and the creditor discharges $7,500 of indebtedness for\nwhich F is personally liable. The amount realized on the disposition of the\nasset is its fair market value ($6,000). In addition, F has income from the\ndischarge of indebtedness of $1,500 ($7,500 \xe2\x88\x92 $6,000).\nIn the present situation, X transferred the subdivision to the bank in satisfaction of\nthe 12,000x dollar debt. To the extent of the fair market value of the property\ntransferred to the creditor, the transfer of the subdivision is treated as a sale or\ndisposition upon which gain is recognized under \xc2\xa7 1001(c) of the Code. To the\n233\n\n\x0cextent the fair market value of the subdivision, 10,000x dollars, exceeds its adjusted\nbasis, 8,000x dollars, X realizes and recognizes gain on the transfer. X thus\nrecognizes 2,000x dollars of gain.\nTo the extent the amount of debt, 12,000x dollars, exceeds the fair market value of\nthe subdivision, 10,000x dollars, X realizes income from the discharge of\nindebtedness. However, under \xc2\xa7 108(a)(1)(B) of the Code, the full amount of X\xe2\x80\x99s\ndischarge of indebtedness income is excluded from gross income because that\namount does not exceed the amount by which X was insolvent.\nIf the subdivision had been transferred to the bank as a result of a foreclosure\nproceeding in which the outstanding balance of the debt was discharged (rather than\nhaving been transferred pursuant to the settlement agreement), the result would be\nthe same. A mortgage foreclosure, like a voluntary sale, is a \xe2\x80\x98disposition\xe2\x80\x99 within\nthe scope of the gain or loss provisions of \xc2\xa7 1001 of the Code. See Helvering v.\nHammel, 311 U.S. 504 (1941); Electro-Chemical Engraving Co. v. Commissioner,\n311 U.S. 513 (1941); and Danenberg v. Commissioner, 73 T.C. 370 (1979), acq.,\n1980-2 C.B. 1.\nHOLDING\nThe transfer of the subdivision by X to the bank in satisfaction of a debt on which\nX was personally liable is a sale or disposition upon which gain is realized and\nrecognized by X under \xc2\xa7\xc2\xa7 1001(c) and 61(a)(3) of the Code to the extent the fair\nmarket value of the subdivision transferred exceeds X\xe2\x80\x99s adjusted basis. Subject to\nthe application of \xc2\xa7 108 of the Code, to the extent the amount of debt exceeds the\nfair market value of the subdivision, X would also realize income from the\ndischarge of indebtedness.\nNotes and Questions:\n1. What would have been the result if the adjusted basis of the property had been\n$7000x?\n2. Why is it so important to this revenue ruling that taxpayer is insolvent?\n3. You should recognize that the holding in Gehl is in exact accord with the IRS\xe2\x80\x99s\nposition in this revenue ruling.\n234\n\n\x0c4. Read Reg. \xc2\xa7 1.1001-3(b). You might have to get this regulation on Westlaw or\nLexis. A \xe2\x80\x9cmaterial modification\xe2\x80\x9d of a debt instrument results in an exchange for\npurposes of \xc2\xa7 1001(a). What is the effect of this treatment?\n5. Would the result have been the same if the loan had been without recourse? Read\non.\nRev. Rul. 91-31, 1991-C.B. 19-1\nDISCHARGE OF INDEBTEDNESS\n...\nISSUE\nIf the principal amount of an undersecured nonrecourse debt is reduced by the\nholder of the debt who was not the seller of the property securing the debt, does this\ndebt reduction result in the realization of discharge of indebtedness income for the\nyear of the reduction under [\xc2\xa7 61(a)(11)] of the Internal Revenue Code or in the\nreduction of the basis in the property securing the debt?\nFACTS\nIn 1988, individual A borrowed $1,000,000 from C and signed a note payable to C\nfor $1,000,000 that bore interest at a fixed market rate payable annually. A had no\npersonal liability with respect to the note, which was secured by an office building\nvalued at $1,000,000 that A acquired from B with the proceeds of the nonrecourse\nfinancing. In 1989, when the value of the office building was $800,000 and the\noutstanding principal on the note was $1,000,000, C agreed to modify the terms of\nthe note by reducing the note\xe2\x80\x99s principal amount to $800,000. The modified note\nbore adequate stated interest within the meaning of \xc2\xa7 1274(c)(2).\nThe facts here do not involve the bankruptcy, insolvency, or qualified farm\nindebtedness of the taxpayer. Thus, the specific exclusions provided by \xc2\xa7 108(a)\ndo not apply.\nLAW AND ANALYSIS\nSection [61(a)(11)] of the Code provides that gross income includes income from\n235\n\n\x0cthe discharge of indebtedness. Reg. \xc2\xa7 1.61-12(a) provides that the discharge of\nindebtedness, in whole or in part, may result in the realization of income.\nIn Rev. Rul. 82-202, a taxpayer prepaid the mortgage held by a third party lender\non the taxpayer\xe2\x80\x99s residence for less than the principal balance of the mortgage. At\nthe time of the prepayment, the fair market value of the residence was greater than\nthe principal balance of the mortgage. The revenue ruling holds that the taxpayer\nrealizes discharge of indebtedness income under [\xc2\xa7 61(a)(11)] of the Code, whether\nthe mortgage is recourse or nonrecourse and whether it is partially or fully prepaid.\nRev. Rul. 82-202 relies on United States v. Kirby Lumber Co., 284 U.S. 1 (1931),\nin which the United States Supreme Court held that a taxpayer realized ordinary\nincome upon the purchase of its own bonds in an arm\xe2\x80\x99s length transaction at less\nthan their face amount.\nIn Commissioner v. Tufts, 461 U.S. 300 (1983), the Supreme Court held that when\na taxpayer sold property encumbered by a nonrecourse obligation that exceeded the\nfair market value of the property sold, the amount realized included the amount of\nthe obligation discharged. The Court reasoned that because a nonrecourse note is\ntreated as a true debt upon inception (so that the loan proceeds are not taken into\nincome at that time), a taxpayer is bound to treat the nonrecourse note as a true debt\nwhen the taxpayer is discharged from the liability upon disposition of the collateral,\nnotwithstanding the lesser fair market value of the collateral. See \xc2\xa7 1.1001-2(c),\nExample 7, of the Income Tax Regulations.\nIn Gershkowitz v. Commissioner, 88 T.C. 984 (1987), the Tax Court, in a reviewed\nopinion, concluded, in part, that the settlement of a nonrecourse debt of $250,000\nfor a $40,000 cash payment (rather than surrender of the $2,500 collateral) resulted\nin $210,000 of discharge of indebtedness income. The court, following the Tufts\nholding that income results when a taxpayer is discharged from liability for an\nundersecured nonrecourse obligation upon the disposition of the collateral, held\nthat the discharge from a portion of the liability for an undersecured nonrecourse\nobligation through a cash settlement must also result in income.\nThe Service will follow the holding in Gershkowitz where a taxpayer is discharged\nfrom all or a portion of a nonrecourse liability when there is no disposition of the\ncollateral. Thus, in the present case, A realizes $200,000 of discharge of\nindebtedness income in 1989 as a result of the modification of A\xe2\x80\x99s note payable to\nC.\n236\n\n\x0cIn an earlier Board of Tax Appeals decision, Fulton Gold Corp. v. Commissioner,\n31 B.T.A. 519 (1934), a taxpayer purchased property without assuming an\noutstanding mortgage and subsequently satisfied the mortgage for less than its face\namount. In a decision based on unclear facts, the Board of Tax Appeals, for\npurposes of determining the taxpayer\xe2\x80\x99s gain or loss upon the sale of the property in\na later year, held that the taxpayer\xe2\x80\x99s basis in the property should have been reduced\nby the amount of the mortgage debt forgiven in the earlier year.\nThe Tufts and Gershkowitz decisions implicitly reject any interpretation of Fulton\nGold that a reduction in the amount of a nonrecourse liability by the holder of the\ndebt who was not the seller of the property securing the liability results in a\nreduction of the basis in that property, rather than discharge of indebtedness income\nfor the year of the reduction. Fulton Gold, interpreted in this manner, is inconsistent\nwith Tufts and Gershkowitz. Therefore, that interpretation is rejected and will not\nbe followed.\nHOLDING\nThe reduction of the principal amount of an undersecured nonrecourse debt by the\nholder of a debt who was not the seller of the property securing the debt results in\nthe realization of discharge of indebtedness income under \xc2\xa7 [61(a)(11)] of the Code.\nNotes and Questions:\n1. Compare Gershkowitz (summarized in Rev. Rul. 91-31) and Tufts. When and\nwhy does it matter whether taxpayer is relieved of a nonrecourse obligation through\ndoi or through realization of the amount of the obligation?\n2. What is the rule of Rev. Rul. 82-202, as stated in Rev. Rul. 91-31?\n\xe2\x80\xa2We\xe2\x80\x99ve asked about this before.\n3. If the creditor is the seller of the property \xe2\x80\x93 i.e., the debt was purchase money\ndebt \xe2\x80\x93 the revenue ruling implies that the holding might be different.\n\xe2\x80\xa2What do you think should be the result in such a case?\n\xe2\x80\xa2No doi income, but a reduction of basis?\n\xe2\x80\xa2A purchase price (and basis) reduction if taxpayer is solvent?\n\xe2\x80\xa2No doi income, and amount of debt included in debtor\xe2\x80\x99s \xe2\x80\x9camount\nrealized\xe2\x80\x9d \xe2\x80\x93 as in Tufts?\n\xe2\x80\xa2See Reg. \xc2\xa7 1.1001-2(c), Example 7 (which the IRS cites in connection with\n237\n\n\x0cits discussion of Tufts).\n4. To what extent should taxpayer take account of nonrecourse debt in determining\nwhether he is insolvent for purposes of applying \xc2\xa7 108? In Rev. Rul. 92-53, 19922 C.B. 48, the IRS stated that\nthe amount by which a nonrecourse debt exceeds the fair market value of\nthe property securing the debt is taken into account in determining whether,\nand to what extent, a taxpayer is insolvent within the meaning of \xc2\xa7 108(d)(3)\nof the Code, but only to the extent that the excess nonrecourse debt is\ndischarged.\nNonrecourse debt up to the fmv of the property is taken into account. Why shouldn\xe2\x80\x99t\nthe full excess of the amount of the nonrecourse debt over the fmv of the property\n\xe2\x80\x93 even that which is not discharged \xe2\x80\x93 be taken into account? How does the IRS\xe2\x80\x99s\ntreatment of nonrecourse debt preserve taxpayer\xe2\x80\x99s \xe2\x80\x9cfresh start\xe2\x80\x9d \xe2\x80\x93 but no more?\n\nVI. Transactions Treated as Loans\nThe use of borrowed money for a term is not free, just as the use of a \xe2\x80\x9cborrowed\xe2\x80\x9d\napartment for a term is not free. A person pays for the use of another\xe2\x80\x99s money by\npaying interest. The payment and receipt of interest have certain tax consequences.\nPayment of interest might be deductible from a taxpayer\xe2\x80\x99s ordinary income. See\n\xc2\xa7 163. The recipient of interest realizes gross income. See 61(a)(4). Lenders and\nborrowers usually create loans with another transaction in mind, e.g., purchase of\nproperty, investment. Those transactions generate certain tax consequences that\nmay differ from the tax consequences of payment of interest, e.g., taxation of capital\ngains at a rate lower than the tax rate on ordinary income (see chapter 10, infra).\nWhen parties to a transaction combine a loan with another transaction (e.g., a sellerfinanced purchase), the Code\xe2\x80\x99s rules may create and carve out an interest element.\nThe Code also provides some timing rules that govern transactions in which the\nparties fail to specify when interest is paid.\nConsider: (1) Clifton Corporation issued $10M worth of bonds on January 1, 2016.\nFor each $10,000 bond that an investor purchased, Clifton Corporation promised to\npay $15,007.30 on January 1, 2022. Taxpayer Linda invested $10,000 on January\n1, 2016 in Clifton Corporation bonds. She held the Clifton Corporation bonds until\ntheir maturity on January 1, 2022 at which time Clifton Corporation paid her\n238\n\n\x0c$15,007.30. Obviously, Linda realized $5007.30 of interest income. When?\nObviously, Clifton Corporation paid $5007.30 in interest. When?\n(1a) Suppose that Linda had sold the Clifton Corporation bond on January 1, 2019\nfor $13,000. Obviously (?) Linda realized a total of $3000 of income. When? How\nmuch of it was interest income and how much of it was gain derived from dealing\nin property? The Buyer would have a $13,000 basis in the bond. How should Buyer\ntreat his eventual receipt of $15,007.30? When?\n(2) Seller agreed to sell Blackacre to Buyer for $3,500,000. Seller\xe2\x80\x99s basis in\nBlackacre was $2,500,000. The terms of the agreement were that Buyer would pay\nSeller $350,000 every year for ten years. The parties stated no other terms of their\nagreement. Assume that Buyer made all the required payments. Upon fulfillment\nof all his obligations, what is Buyer\xe2\x80\x99s basis in Blackacre? How much interest\nincome must Seller recognize in each of years 1 through 10? How much must Seller\nrecognize as gain derived from dealing in property?\nThese transactions all involve the unstated payment and receipt of interest. Sections\n1271 to 1288 and 48365 deal with variations of the issues that these hypothetical\nfact patterns raise. Our concern is with basic principles and not the details of\nimplementation. These provisions essentially \xe2\x80\x9cread into\xe2\x80\x9d the parties\xe2\x80\x99 agreements\nthe payment and receipt of interest annually and require tax treatment to track such\npayment and receipt. The effect of such requirements is that the parties must\naccount for interest on a compounding basis. When the principal does not decline\n\xe2\x80\x93 as with Clifton Corporation\xe2\x80\x99s payment of interest on a bond \xe2\x80\x93 the amount of\ninterest per period (one year) will increase over time. When the principal does\ndecline \xe2\x80\x93 as with Buyer\xe2\x80\x99s payment of principal plus interest on the declining\nprincipal in the second example \xe2\x80\x93 the amount of interest per period will decrease\nfrom one year to the next.66\nThe terms of these arrangements all required performance of obligations at different\ntimes and thereby raised time value of money issues. The Code sections create an\nWe will not consider \xc2\xa7 483, but its rules are similar to those we examine here for the transactions to\nwhich it applies.\n65\n\nGoogle \xe2\x80\x9cmortgage interest amortization schedule.\xe2\x80\x9d Choose one. I found the one at https://financialcalculators.com/amortization-schedule to be user friendly to political science majors and others\nresistant to finance formulas. The user can play around with the variables that determine interest and\nprincipal.\n66\n\n239\n\n\x0cinterest rate and prescribe a certain compounding period \xe2\x80\x93 essentially semi-annual.\nWe will note the compounding period that the sections relevant to this discussion\nrequires, but we will borrow from the tables in chapter 2 that follow the Bruun case.\nThose tables reflect compounding interest on an annual basis.\nExamples (1) and (1a): Section 1272(a)(1) provides for inclusion of interest income\nin the gross income of a holder of a debt instrument as the interest accrues, i.e.,\ntaxpayer Linda in Example (1) must include in her gross income interest as if\nClifton had paid it and it was compounded semi-annually (\xc2\xa7 1272(a)(5)).\n\xe2\x80\xa2Section 1273(a)(1) defines \xe2\x80\x9coriginal issue discount\xe2\x80\x9d to be the redemption\nprice at maturity minus the issue price.\n\xe2\x80\xa2In Example (1) above, the \xe2\x80\x9coriginal issue discount\xe2\x80\x9d would be $15,007.30\n\xe2\x88\x92 $10,000 = $5007.30. This happens to be the interest that would be paid if\nthe interest rate were 7%. Use that figure when working from table 1 in\nchapter 2.67\n\xe2\x80\xa2By using table 1, we learn that Linda should include $700 in her gross\nincome one year after making her investment. Because she has paid income\ntax on $700, Linda\xe2\x80\x99s basis in the bond increases to $10,700. \xc2\xa7 1272(d)(2).\n\xe2\x80\xa2Section 163(e)(1) provides for the same measurement of any allowable\ninterest deduction for the Clifton Corporation.\n\xe2\x80\xa2After two years, Linda\xe2\x80\x99s interest income will total $1449. Because she\nalready included $700 in her gross income, her interest income for year 2\nthat she must include in her gross income is $749.68 Notice that it was more\nthan it was in year 1.\nAfter three years, Linda would have paid tax on a total of $2250 of interest income.\nShe must include $801 of interest income in her gross income for year 3 \xe2\x80\x93 again,\nmore than her interest income in year 2. The basis in her bond would be $12,250.\nShe would realize $750 of gain from dealing in property upon its sale for $13,000.\nSee Example (1a).\n\xe2\x80\xa2Buyer paid a \xe2\x80\x9cpremium,\xe2\x80\x9d i.e., Buyer paid $750 more than Linda\xe2\x80\x99s adjusted\nbasis in the bond. Buyer will step into Linda\xe2\x80\x99s shoes and recognize interest\nincome on the bond. However, Buyer will reduce the interest based upon a\nsimilar calculation of the $750 premium spread over the time remaining to\nTable 1 in chapter 2 provides values that are compounded annually. Hence, these values are not\nquite accurate in the context of \xc2\xa7 1272, which requires daily compounding.\n67\n\nTechnically, \xc2\xa7 1272(a)(3 and 4) requires a recalculation of interest based upon an increasing \xe2\x80\x9cissue\nprice\xe2\x80\x9d and a decreasing length of time until redemption.\n68\n\n240\n\n\x0cmaturity of the bond. \xc2\xa7 1272(a)(7).\nExample 2: Section 1274 provides that when a debt instrument is given in exchange\nfor property (\xc2\xa7 1274(c)(1)), the interest must be at least the \xe2\x80\x9capplicable federal rate\xe2\x80\x9d\n(AFR). If it is not, then the debt payments are structured as if the interest rate is the\nAFR.\n\xe2\x80\xa2The AFR depends on the term of the debt instrument \xe2\x80\x93 whether short-term,\nmid-term, or long-term. The Treasury Department determines AFRs\nmonthly. \xc2\xa7 1274(d).\n\xe2\x80\xa2The imputed principal amount of a debt instrument is the sum of the\npresent values of all future payments. The present value is determined by\nusing the AFR compounded semi-annually. \xc2\xa7 1274(b)(1 and 2).\n\xe2\x80\xa2In Example 2, assume again that the interest rate is 7%. Refer to table 369\nin the materials following Bruun, i.e., the table that gives the present value\nof a fixed annuity payment. The multiplier for ten years is 7.0236. The\nannual payment is $350,000. $350,000 x 7.0236 = $2,458,260.\n\xe2\x80\xa2Since Seller will receive a total of $3,500,000, the difference between that\namount and $2,458,260 must be interest, i.e., $1,041,740. The parties will\nallocate it on the same yield-to-maturity principles of \xc2\xa7 1272 applicable to OID.\n\xe2\x80\xa2Even though Seller will have $1M of income from the transaction, Seller\nactually lost money on the sale. Seller will realize substantial interest\nincome \xe2\x80\x93 which is subject to a higher tax rate than long-term capital gain.\nReminder: For a good summary\nof the topics covered in this\nchapter, see Douglas Kahn &\nJeffrey H. Kahn, Cancellation of\nDebt and Related Transactions, 69\nTAX LAW. 161 (2015).\n\nWrap-up Questions for Chapter 4\n1. What is wrong with the shrinkage of assets\ndoctrine? Why should a loan and the use of loan\nproceeds be treated as separate transactions?\n\n2. What should be the applicability of the \xe2\x80\x9cdisputed debt doctrine\xe2\x80\x9d to cases where\nthe amount of a debt is fixed and determined, but its enforceability (in a court) is\nhighly unlikely? Taxpayer borrows money to engage in an illegal transaction.\n3. The Bankruptcy Code, 11 U.S.C. \xc2\xa7 523(a)(8) makes discharge of a student loan\nquite difficult, i.e., bankrupt must show \xe2\x80\x9cundue hardship on the debtor and the\nTable 3 in chapter 2 provides values that are compounded annually. Hence, these values are not\nquite accurate in the context of \xc2\xa7 1274, which requires semiannual compounding.\n69\n\n241\n\n\x0cdebtor\xe2\x80\x99s dependents.\xe2\x80\x9d Section 108(f)(1) of the I.R.C. excludes doi income from a\ntaxpayer\xe2\x80\x99s gross income when \xe2\x80\x9cdischarge was pursuant to a provision of such loan\nunder which all or part of the indebtedness of the individual would be discharged\nif the individual worked for a certain period in certain professions for any of a broad\nclass of employers.\xe2\x80\x9d What should be the practical effect of these provisions?\n4. What reasons might support treating receipt of loan proceeds as gross income\nand treating repayment of the loan as deductible? What would be the effects on the\neconomy?\n5. You have seen that various types of loans fall within \xc2\xa7 108 and are therefore\nsubject to the favorable treatment that that section provides. Should there be others?\nSome argue that any forgiveness of a student loan should be excluded from gross\nincome. Do you agree?\n\nWhat have you learned?\nCan you explain or define \xe2\x80\x93\n\xe2\x80\xa2Why a taxpayer does not in fact exclude the proceeds of a loan from his gross\nincome\n\xe2\x80\xa2What is \xc2\xa7108\xe2\x80\x99s treatment of doi income if taxpayer is in a bankruptcy proceeding\n\xe2\x80\xa2What is \xc2\xa7 108\xe2\x80\x99s treatment of doi income if taxpayer is insolvent\n\xe2\x80\xa2When a taxpayer is insolvent\n\xe2\x80\xa2What are the conditions of excludability of a purchase money debt reduction under\n\xc2\xa7 108(e)(5)\n\xe2\x80\xa2What a recourse loan is; what a non-recourse loan is\n\xe2\x80\xa2Why the buyer\xe2\x80\x99s assumption of a loan to which property is subject must be\nincluded in the seller\xe2\x80\x99s \xe2\x80\x9camount realized\xe2\x80\x9d\n\n242\n\n\x0cChapter 5: Progressivity and Assignment of Income\nThe principle of progressive taxation\nis that tax rates applicable to\nincrements of taxable income\nincrease. Currently there are seven\nmarginal brackets \xe2\x80\x93 eight if we count\nincome that is below the threshold of\ntaxable income.70 If a taxpayer can\nspread her income among other\ntaxpayers, more of taxpayer\xe2\x80\x99s\nincome will be subject to the lowest\nmarginal rates of tax and less to the\nhigher rates of tax.\n\nThe Tax Formula:\n(gross income)\nMINUS deductions named in \xc2\xa7 62\nEQUALS (adjusted gross income (AGI))\nMINUS (standard deduction or itemized\ndeductions)\nMINUS (deduction for \xe2\x80\x9cqualified business\nincome\xe2\x80\x9d)\nEQUALS (taxable income)\n\xe2\x9e\x94Compute income tax liability from\ntables in \xc2\xa7 1(j) (indexed for inflation)\nMINUS (credits against tax)\n\nThe following table illustrates the\npoint. It shows the income tax\nburden of a person whose taxable\nincome is $210,000. Hypothetical\nmarginal tax brackets are as noted. The total tax burden of this taxpayer is $50,000.\nTaxable Income range\n\nMarginal Tax Rate\n\nTax\n\n$0 to $10,000\n\n0%\n\n$0\n\n$10,000 to $60,000\n\n10%\n\n$5000\n\n$60,000 to $110,000\n\n20%\n\n$10,000\n\n$110,000 to $160,000\n\n30%\n\n$15,000\n\n$160,000 to $210,000\n\n40%\n\n$20,000\n\nTotal\n\n$50,000\n\nOur taxpayer might try to reduce her tax burden by \xe2\x80\x9cassigning\xe2\x80\x9d some of her taxable\nincome to persons she controls \xe2\x80\x93 perhaps two children. Our taxpayer might decide\n70\n\nThe standard deduction assures that some income is not subject to any income tax.\n\n243\n\n\x0cthat she and each of the two children should receive $70,000 of the original\n$210,000 total. The new tax computation table would be the following:\nTaxable Income range\n\nMarginal Tax Rate\n\nTax\n\n$0 to $10,000\n\n0%\n\n$0\n\n$10,000 to $60,000\n\n10%\n\n$5000\n\n$60,000 to $110,000\n\n20%\n\n$200071\n\nTotal\n\n$7000 x 3 = $21,000\n\nThe total tax burden of three different persons, each with taxable income of\n$70,000, would be less than half the tax burden of one person with taxable income\nof $210,000.72 This characteristic of progressive tax rates has led taxpayers to create\nmany schemes to \xe2\x80\x9csplit income\xe2\x80\x9d so that more of it would be subject to lower rates\nof income tax.\nThe courts have created the \xe2\x80\x9cassignment of income\xe2\x80\x9d73 doctrine to prevent abusive\nincome splitting. In addition, Congress has created some statutory rules that limit\nassignments of income. We begin with the leading case.\n\nI. Compensation for Services\nLucas v. Earl, 281 U.S. 111 (1930).\nJUSTICE HOLMES delivered the opinion of the Court.\nThis case presents the question whether the respondent, Earl, could be taxed for the\nwhole of the salary and attorney\xe2\x80\x99s fees earned by him in the years 1920 and 1921,\nor should be taxed for only a half of them in view of a contract with his wife which\nwe shall mention. The Commissioner of Internal Revenue and the Board of Tax\n71\n\nOnly $10,000 of each taxpayer\xe2\x80\x99s taxable income would be subject to the 20% rate of income tax.\n\n72\n\nThree different standard deductions would alter the precise tax burdens.\n\nThis is really a misnomer. The \xe2\x80\x9cassignment of income\xe2\x80\x9d doctrine prevents assignment of income. A\nmore accurate name would be the \xe2\x80\x9cnon-assignment of income\xe2\x80\x9d doctrine.\n73\n\n244\n\n\x0cAppeals imposed a tax upon the whole, but their decision was reversed by the\ncircuit court of appeals. A writ of certiorari was granted by this Court.\nBy the contract, made in 1901, Earl and his wife agreed \xe2\x80\x9cthat any property either\nof us now has or may hereafter acquire ... in any way, either by earnings (including\nsalaries, fees, etc.), or any rights by contract or otherwise, during the existence of\nour marriage, or which we or either of us may receive by gift, bequest, devise, or\ninheritance, and all the proceeds, issues, and profits of any and all such property\nshall be treated and considered, and hereby is declared to be received, held, taken,\nand owned by us as joint tenants, and not otherwise, with the right of survivorship.\xe2\x80\x9d\nThe validity of the contract is not questioned, and we assume it to be unquestionable\nunder the law of the California, in which the parties lived. Nevertheless we are of\nopinion that the Commissioner and Board of Tax Appeals were right.\nThe Revenue Act of 1918 approved February 24, 1919, c. 18, \xc2\xa7\xc2\xa7 210, 211, 212(a),\n213(a), 40 Stat. 1057, 1062, 1064, 1065, imposes a tax upon the net income of every\nindividual including \xe2\x80\x9cincome derived from salaries, wages, or compensation for\npersonal service ... of whatever kind and in whatever form paid,\xe2\x80\x9d \xc2\xa7 213(a). The\nprovisions of the Revenue Act of 1921 \xe2\x80\xa6 are similar to those of the above. A very\nforcible argument is presented to the effect that the statute seeks to tax only income\nbeneficially received, and that, taking the question more technically, the salary and\nfees became the joint property of Earl and his wife on the very first instant on which\nthey were received. We well might hesitate upon the latter proposition, because,\nhowever the matter might stand between husband and wife, he was the only party\nto the contracts by which the salary and fees were earned, and it is somewhat hard\nto say that the last step in the performance of those contracts could be taken by\nanyone but himself alone. But this case is not to be decided by attenuated subtleties.\nIt turns on the import and reasonable construction of the taxing act. There is no\ndoubt that the statute could tax salaries to those who earned them, and provide that\nthe tax could not be escaped by anticipatory arrangements and contracts, however\nskillfully devised, to prevent the salary when paid from vesting even for a second\nin the man who earned it. That seems to us the import of the statute before us, and\nwe think that no distinction can be taken according to the motives leading to the\narrangement by which the fruits are attributed to a different tree from that on which\nthey grew.\nJudgment reversed.\n\n245\n\n\x0cNotes and Questions:\n1. This case is the origin of the \xe2\x80\x9cassignment of income\xe2\x80\x9d doctrine, i.e., a taxpayer\ncannot assign her income tax liability to another by assigning income not yet earned\nto another.\n2. The Earls entered their contract in 1901 \xe2\x80\x93 at a time when most people believed\nthat a federal personal income tax was unconstitutional and fifteen years before\nCongress enacted the income tax statute. This \xe2\x80\x9canticipatory assignment\xe2\x80\x9d could\nhardly have had as a purpose the avoidance of federal income tax liability.\n\xe2\x80\xa2In fact, Guy Earl probably utilized the contract as an estate planning device.\nHe was not in good health, and by this simple contract, he was able to pass\nhalf of his property \xe2\x80\x93 already owned or to be acquired \xe2\x80\x93 to his wife without\nneed of probate. At the time, there was no right of survivorship in California\ncommunity property. See Patricia A. Cain, The Story of Earl: How Echoes\n(and Metaphors) from the Past Continue to Shape the Assignment of Income\nDoctrine, in TAX STORIES 305, 315 (Paul Caron, ed., 2d ed. 2009).\n3. Is Mr. Earl subject to income tax in this case because he earned the income or\nbecause he exercised a right to assign its receipt prospectively?\n4a. Consider: Taxpayer was a waitress at a restaurant and collected tips from\ncustomers. At the end of each shift, she would \xe2\x80\x9ctip out\xe2\x80\x9d various other restaurant\nemployees, including busboys, bartenders, cooks, and other waitresses and waiters\nwho assisted her during particularly busy times.\n\xe2\x80\xa2The Commissioner argues that Taxpayer\xe2\x80\x99s gross income includes all the\ntip income. Taxpayer may deduct as a trade or business expense what she\npays other employees.\n\xe2\x80\xa2Taxpayer argued that what she paid other employees was not even gross\nincome to her.\n\xe2\x80\xa2Why does one characterization rather than the other matter? Read\n\xc2\xa7\xc2\xa7 62(a)(1), 67(a, b, g).\n\xe2\x80\xa2What result?\n\xe2\x80\xa2See, e.g., Brown v. Commissioner, T.C. Memo 1996-310, 1996 WL 384904\n(1996).\n4b. Taxpayer was a partner in a partnership. Partnerships do not pay income taxes.\nRather, individual partners are liable for income tax on their individual distributive\nshares of partnership profits. Taxpayer and his wife entered an agreement whereby\n246\n\n\x0cshe was made a full and equal partner with him. Wife performed no services and\nthe other partners were not a party to this agreement.\n\xe2\x80\xa2Taxpayer argued that he should be taxed on one half of his partnership\ndistributive share, and his wife should be taxed on one half of his\ndistributive share. This case predates married filing jointly tax returns.\n\xe2\x80\xa2What result?\n\xe2\x80\xa2See Burnet v. Leininger, 285 U.S. 136, 142 (1932).\n5. How useful is the tree-fruits metaphor in resolving difficult questions of\nassignment of income?\n\xe2\x80\xa2Taxpayer works for Mega Corporation. Taxpayer was personally\nresponsible for generating $1M of new business for Mega. Mega paid\ntaxpayer his usual salary of $100,000. Next year, Mega will give taxpayer\na 50% raise. On how much income should taxpayer be liable for income\ntax \xe2\x80\x93\n\xe2\x80\xa2in year 1?\n\xe2\x80\xa2in year 2?\nPoe v. Seaborn, 282 U.S. 101 (1930).\nMR. JUSTICE ROBERTS delivered the opinion of the Court.\nSeaborn and his wife, citizens and residents of the State of Washington, made for\nthe year 1927 separate income tax returns as permitted by the Revenue Act of 1926,\nc. 27, \xc2\xa7 223 (U.S.C.App., Title 26, \xc2\xa7 964).\nDuring and prior to 1927, they accumulated property comprising real estate, stocks,\nbonds and other personal property. While the real estate stood in his name alone, it\nis undisputed that all of the property, real and personal, constituted community\nproperty, and that neither owned any separate property or had any separate income.\nThe income comprised Seaborn\xe2\x80\x99s salary, interest on bank deposits and on bonds,\ndividends, and profits on sales of real and personal property. He and his wife each\nreturned one-half the total community income as gross income, and each deducted\none-half of the community expenses to arrive at the net income returned.\nThe Commissioner of Internal Revenue determined that all of the income should\nhave been reported in the husband\xe2\x80\x99s return, and made an additional assessment\n247\n\n\x0cagainst him. Seaborn paid under protest, claimed a refund, and, on its rejection,\nbrought this suit.\nThe district court rendered judgment for the plaintiff; the Collector appealed, and\nthe circuit court of appeals certified to us the question whether the husband was\nbound to report for income tax the entire income, or whether the spouses were\nentitled each to return one-half thereof. This Court ordered the whole record to be\nsent up.\nThe case requires us to construe \xc2\xa7\xc2\xa7 210(a) and 211(a) of the Revenue Act of 1926\n(44 Stat. 21, U.S.C.App. Tit. 26, \xc2\xa7\xc2\xa7 951 and 952), and apply them, as construed, to\nthe interests of husband and wife in community property under the law of\nWashington. These sections lay a tax upon the net income of every individual.\n[footnote omitted] The Act goes no farther, and furnishes no other standard or\ndefinition of what constitutes an individual\xe2\x80\x99s income. The use of the word \xe2\x80\x9cof\xe2\x80\x9d\ndenotes ownership. It would be a strained construction, which, in the absence of\nfurther definition by Congress, should impute a broader significance to the phrase.\nThe Commissioner concedes that the answer to the question involved in the cause\nmust be found in the provisions of the law of the state as to a wife\xe2\x80\x99s ownership of\nor interest in community property. What, then, is the law of Washington as to the\nownership of community property and of community income including the earnings\nof the husband\xe2\x80\x99s and wife\xe2\x80\x99s labor?\nThe answer is found in the statutes of the state [footnote omitted] and the decisions\ninterpreting them.\nThese statutes provide that, save for property acquired by gift, bequest, devise, or\ninheritance, all property however acquired after marriage by either husband or wife\nor by both is community property. On the death of either spouse, his or her interest\nis subject to testamentary disposition, and, failing that, it passes to the issue of the\ndecedent, and not to the surviving spouse. While the husband has the management\nand control of community personal property and like power of disposition thereof\nas of his separate personal property, this power is subject to restrictions which are\ninconsistent with denial of the wife\xe2\x80\x99s interest as co owner. The wife may borrow\nfor community purposes and bind the community property. [citation omitted]. Since\nthe husband may not discharge his separate obligation out of community property,\nshe may, suing alone, enjoin collection of his separate debt out of community\nproperty. [citation omitted]. She may prevent his making substantial gifts out of\n248\n\n\x0ccommunity property without her consent. [citation omitted]. The community\nproperty is not liable for the husband\xe2\x80\x99s torts not committed in carrying on the\nbusiness of the community. [citation omitted].\nThe books are full of expressions such as \xe2\x80\x9cthe personal property is just as much\nhers as his\xe2\x80\x9d [citation omitted]; \xe2\x80\x9cher property right in it [(an automobile)] is as great\nas his\xe2\x80\x9d [citation omitted]; \xe2\x80\x9cthe title of the spouse therein was a legal title, as well as\nthat of the other\xe2\x80\x9d [citation omitted].\nWithout further extending this opinion, it must suffice to say that it is clear the wife\nhas, in Washington, a vested property right in the community property equal with\nthat of her husband, and in the income of the community, including salaries or\nwages of either husband or wife, or both. ...\nThe taxpayer contends that, if the test of taxability under Sections 210 and 211 is\nownership, it is clear that income of community property is owned by the\ncommunity, and that husband and wife have each a present vested one-half interest\ntherein.\nThe Commissioner contends, however, that we are here concerned not with mere\nnames, nor even with mere technical legal titles; that calling the wife\xe2\x80\x99s interest\nvested is nothing to the purpose, because the husband has such broad powers of\ncontrol and alienation that, while the community lasts, he is essentially the owner\nof the whole community property, and ought so to be considered for the purposes\nof \xc2\xa7\xc2\xa7 210 and 211. He points out that, as to personal property, the husband may\nconvey it, may make contracts affecting it, may do anything with it short of\ncommitting a fraud on his wife\xe2\x80\x99s rights. And though the wife must join in any sale\nof real estate, he asserts that the same is true, by virtue of statutes, in most states\nwhich do not have the community system. He asserts that control without\naccountability is indistinguishable from ownership, and that, since the husband has\nthis, quoad community property and income, the income is that \xe2\x80\x9cof\xe2\x80\x9d the husband\nunder \xc2\xa7\xc2\xa7 210, 211 of the income tax law.\nWe think, in view of the law of Washington\nquoad: as to; as long as; until\nabove stated, this contention is unsound. The\nacqu\xc3\xaat: property\ncommunity must act through an agent. This\nCourt has said with respect to the community\nproperty system [citation omitted] that \xe2\x80\x9cproperty acquired during marriage with\ncommunity funds became an acqu\xc3\xaat of the community, and not the sole property of\n249\n\n\x0cthe one in whose name the property was bought, although by the law existing at the\ntime the husband was given the management, control, and power of sale of such\nproperty. This right being vested in him not because he was the exclusive owner,\nbut because, by law, he was created the agent of the community.\xe2\x80\x9d\n....\nThe obligations of the husband as agent of the community are no less real because\nthe policy of the state limits the wife\xe2\x80\x99s right to call him to account in a court. Power\nis not synonymous with right. Nor is obligation coterminous with legal remedy.\nThe law\xe2\x80\x99s investiture of the husband with broad powers by no means negatives the\nwife\xe2\x80\x99s present interest as a co-owner.\nWe are of opinion that, under the law of Washington, the entire property and\nincome of the community can no more be said to be that of the husband than it\ncould rightly be termed that of the wife.\n....\nThe Commissioner urges that we have, in principle, decided the instant question in\nfavor of the government. He relies on [citations omitted] and Lucas v. Earl, 281 U.\nS. 111.\n....\nIn the Earl case, a husband and wife contracted that any property they had or might\nthereafter acquire in any way, either by earnings (including salaries, fees, etc.) or\nany rights by contract or otherwise, \xe2\x80\x9cshall be treated and considered, and hereby is\ndeclared to be received, held, taken, and owned by us as joint tenants. ...\xe2\x80\x9d We held\nthat assuming the validity of the contract under local law, it still remained true that\nthe husband\xe2\x80\x99s professional fees, earned in years subsequent to the date of the\ncontract, were his individual income, \xe2\x80\x9cderived from salaries, wages, or\ncompensation for personal service\xe2\x80\x9d under \xc2\xa7 210, 211, 212(a) and 213 of the\nRevenue Act of 1918. The very assignment in that case was bottomed on the fact\nthat the earnings would be the husband\xe2\x80\x99s property, else there would have been\nnothing on which if could operate. That case presents quite a different question\nfrom this, because here, by law, the earnings are never the property of the husband,\nbut that of the community.\n250\n\n\x0cFinally the argument is pressed upon us that the Commissioner\xe2\x80\x99s ruling will work\nuniformity of incidence and operation of the tax in the various states, while the view\nurged by the taxpayer will make the tax fall unevenly upon married people. This\nargument cuts both ways. When it is remembered that a wife\xe2\x80\x99s earnings are a part\nof the community property equally with her husband\xe2\x80\x99s, it may well seem to those\nwho live in states where a wife\xe2\x80\x99s earnings are her own that it would not tend to\npromote uniformity to tax the husband on her earnings as part of his income. The\nanswer to such argument, however, is that the constitutional requirement of\nuniformity is not intrinsic, but geographic. [citations omitted]. And differences of\nstate law, which may bring a person within or without the category designated by\nCongress as taxable, may not be read into the Revenue Act to spell out a lack of\nuniformity. [citation omitted].\nThe district court was right in holding that the husband and wife were entitled to\nfile separate returns, each treating one-half of the community income as his or her\nrespective incomes, and its judgment is\nAffirmed.\nTHE CHIEF JUSTICE and MR. JUSTICE STONE took no part in the\nconsideration or decision of this case.\nNotes and Questions:\n1. Is the distinction of ownership by operation of state law rather than by operation\nof a contract convincing? Would you expect the same resolution of the conflict to\nbe applied to partnership allocations of income embodied in a partnership\nagreement, i.e., in a contract? Why the difference?\n2. When taxpayer lawfully performed services for which insurance commissions\nwere paid but which taxpayer could not legally receive, the Supreme Court held\nthat taxpayer did not have sufficient dominion over the income to be required to\ninclude it in its gross income. Comm\xe2\x80\x99r v. First Security Bank of Utah, 405 U.S. 394,\n405 (1972) (\xe2\x80\x9cWe think that fairness requires the tax to fall on the party that actually\nreceives the premiums, rather than on the party that cannot.\xe2\x80\x9d).\n3. Rather than assign salary income to another, can a taxpayer effectively waive\nher right to receive a salary? See Giannini v. Commissioner, 129 F.2d 638 (9th Cir.\n1942).\n251\n\n\x0cDo the CALI Lesson, Basic Federal Income Taxation: Assignment of Income:\nServices.\n\nII. Income Splitting: the Joint Return\nThe following excerpt from a legislative report from 2001 reviews the ebb and flow\nof policy in the choice of tax bracket breakpoints for different filing statuses. In\n2001, there was a \xe2\x80\x9cmarriage penalty\xe2\x80\x9d at all income levels. Not everyone liked this.\nWho would prefer it? The tax brackets to which the excerpt refers have changed,\nbut the policy considerations remain relevant.\nJoint Committee on Taxation, Overview of Present Law and Economic Analysis\nRelating to the Marriage Tax Penalty, the Child Tax Credit, and the Alternative\nMinimum Tax 2-11 (March 7, 2001).\nI. Marriage Tax Penalty\nA. Present Law and Legislative Background\nPresent Law\nIn general\nA marriage penalty exists when the sum of the tax liabilities of two unmarried\nindividuals filing their own tax returns (either single or head of household returns) is\nless than their tax liability under a joint return (if the two individuals were to marry).\nA marriage bonus exists when the sum of the tax liabilities of the individuals is\ngreater than their combined tax liability under a joint return.\n\xe2\x80\xa6 [A]s a general rule married couples whose earnings are split more evenly than\n70-30 suffer a marriage penalty. Married couples whose earnings are largely\nattributable to one spouse generally receive a marriage bonus. \xe2\x80\xa6 [T]he marginal tax\nrate breakpoints74 and the standard deduction are typically considered the major\nelements of the Federal income tax system that create marriage penalties and bonuses\n\xe2\x80\xa6\n74\n\nA bracket breakpoint is the dividing point between two marginal rate brackets.\n\n252\n\n\x0cMarriage penalties due to rate brackets and the standard deduction\nUnder [prior] law, the size of the standard deduction and the bracket breakpoints\nfollow[ed] certain customary ratios across filing statuses. For taxpayers in the 15-,\n28- and 31-percent marginal tax rate brackets, the bracket breakpoints and the\nstandard deduction for single filers [were] roughly 60 percent of those for joint filers\nand those for head of household filers [were] about 85 percent of those for joint\nfilers. \xe2\x80\xa6\nWith these ratios, the sum of the standard deductions two unmarried individuals\nwould receive exceeds the standard deduction they would receive as a married\ncouple filing a joint return. Thus, their taxable income as joint filers may exceed the\nsum of their taxable incomes as unmarried individuals. Furthermore, because of the\nway the bracket breakpoints are structured, taxpayers filing joint returns may have\nmore of their taxable income pushed into a higher marginal tax bracket than when\nthey were unmarried. In order for there to be no marriage penalties as a result of the\nrate structure and the standard deduction, the standard deduction and the bracket\nbreakpoints for married taxpayers filing joint returns would have to be at least twice\nthat for both single and head of household filers. Such a structure would greatly\nenhance marriage bonuses, however.\n\xe2\x80\xa6.\nLegislative Background\nThe marriage penalty \xe2\x80\xa6 dates from changes in the structure of individual income tax\nrates in 1969.75 To understand the effect of those changes, one needs to go back to\n1948, when separate rate schedules for married couples filing joint returns and single\ntaxpayers were introduced.\nBefore 1948, there was only one income tax schedule, and all individuals were liable\nfor tax as separate filing units. Under this tax structure, there was neither a marriage\npenalty nor a marriage bonus. However, this structure created an incentive to split\nincomes because, with a progressive income tax rate structure, a married couple with\nonly one spouse earning income could reduce their combined tax liability if they\nIn 1951, a separate rate schedule was created for unmarried heads of household with dependents (\xe2\x80\x9chead\nof household\xe2\x80\x9d status). Because the bracket breakpoints and standard deduction were more than half of\nthose for joint returns, marriage penalties arose for some taxpayers eligible for filing as head of household.\n75\n\n253\n\n\x0ccould split their income and assign half to each spouse. While the Supreme Court\nupheld the denial of contractual attempts to split income,76 it ruled that in States with\ncommunity property laws, income splitting was required for community income.77\nAs income tax rates and the number of individuals liable for income taxes increased\nbefore and during World War II, States had an increasing incentive to adopt\ncommunity property statutes to give their citizens the tax benefits of income splitting.\nThe Revenue Act of 1948 provided the benefit of income splitting to all married\ncouples by establishing a separate tax schedule for married couples filing joint\nreturns. That schedule was designed so that married couples would pay twice the tax\nof a single taxpayer having one-half the couple\xe2\x80\x99s taxable income.78 While this new\nschedule equalized treatment between married couples in States with community\nproperty laws and those in States with separate property laws, it introduced a\nmarriage bonus into the tax law for couples in States with separate property laws.79\nAs a result of this basic rate structure, by 1969, an individual with the same income\nas a married couple could have had a tax liability as much as 40 percent higher than\nthat of the married couple. To address this perceived inequity, which was labeled a\n\xe2\x80\x9csingles penalty\xe2\x80\x9d by some commentators, a special rate schedule was introduced for\nsingle taxpayers (leaving the old schedule solely for married individuals filing\nseparate returns). The bracket breakpoints and standard deduction amounts for single\ntaxpayers were set at about 60 percent of those for married couples filing joint returns.\nThis schedule created a marriage penalty for some taxpayers.\n\xe2\x80\xa6.\nAnalysis\n\xe2\x80\xa6.\n\n76\n\nLucas v. Earl, 281 U.S. 111 (1930).\n\n77\n\nPoe v. Seaborn, 282 U.S. 101 (1930).\n\nThis relationship between rate schedules is the same as that between joint returns and separate returns\nfor married couples under present law.\n78\n\nBecause income splitting had been available in community property States prior to 1948, a marriage\nbonus had already existed in such States.\n79\n\n254\n\n\x0cMarriage neutrality versus equal taxation of married couples with equal incomes\nAny system of taxing married couples requires making a choice among three different\nconcepts of tax equity. One concept is that the tax system should be \xe2\x80\x9cmarriage\nneutral;\xe2\x80\x9d that is, the tax burden of a married couple should be exactly equal to the\ncombined tax burden of two single persons where one has the same income as the\nhusband and the other has the same income as the wife. A second concept of equity\nis that, because married couples frequently consume as a unit, couples with the same\nincome should pay the same amount of tax regardless of how the income is divided\nbetween them. \xe2\x80\xa6 A third concept of equity is that the income tax should be\nprogressive; that is, as income rises, the tax burden should rise as a percentage of\nincome.\nThese three concepts of equity are mutually inconsistent. A tax system can generally\nsatisfy any two of them, but not all three. The current tax system is progressive: as a\ntaxpayer\xe2\x80\x99s income rises, the tax burden increases as a percentage of income. It also\ntaxes married couples with equal income equally: It specifies the married couple as\nthe tax unit so that married couples with the same income pay the same tax. But it is\nnot marriage neutral.80 A system of mandatory separate filing for married couples\nwould sacrifice the principle of equal taxation of married couples with equal\nincomes for the principle of marriage neutrality unless it were to forgo progressivity.\n[footnote omitted]\nThere is disagreement as to whether equal taxation of couples with equal incomes is\na better principle than marriage neutrality.81 Those who hold marriage neutrality to\nbe more important tend to focus on marriage penalties that may arise \xe2\x80\xa6 and argue\nEven if the bracket breakpoints and the standard deduction amounts for unmarried taxpayers (and for\nmarried taxpayers filing separate returns) were half of those for married couples filing a joint return, the\ncurrent tax system would not be marriage neutral. Many married couples would still have marriage\nbonuses. As described below, the joint return in such a system would allow married couples to pay twice\nthe tax of a single taxpayer having one-half the couple\xe2\x80\x99s taxable income. With progressive rates, this income\nsplitting may result in reduced tax liabilities for some couples filing joint returns. For example, consider\na married couple in which one spouse has $60,000 of income and the other has none. By filing a joint\nreturn, the couple pays the same tax as a pair of unmarried individuals each with $30,000 of income. With\nprogressive taxation, the tax liability on $30,000 would be less than half of the tax liability on $60,000.\nThus the married couple has a marriage bonus: the joint return results in a smaller tax liability than the\ncombined tax liability of the spouses if they were not married.\n80\n\nThis discussion assumes that the dilemma cannot be resolved by moving to a proportional tax (i.e. a\nsingle rate on all income for all taxpayers) system. A proportional system would automatically produce\nmarriage neutrality and equal taxation of couples with equal incomes.\n81\n\n255\n\n\x0cthat tax policy discourages marriage and encourages unmarried individuals to cohabit\nwithout getting married, thereby lowering society\xe2\x80\x99s standard of morality. Also, they\nargue that it is simply unfair to impose a marriage penalty even if the penalty does\nnot actually deter anyone from marrying.\nThose who favor the principle of equal taxation of married couples with equal\nincomes argue that as long as most couples pool their income and consume as a unit,\ntwo married couple[s] with $20,000 of income are equally well off regardless of\nwhether their income is divided $10,000-$10,000 or $15,000-$5,000. Thus, it is\nargued, those two married couples should pay the same tax, as they do under present\nlaw. By contrast, a marriage-neutral system with progressive rates would involve a\nlarger combined tax on the married couple with the unequal income division. The\nattractiveness of the principle of equal taxation of couples with equal incomes may\ndepend on the extent to which married couples actually pool their incomes. [footnote\nomitted]\nAn advocate of marriage neutrality could respond that the relevant comparison is not\nbetween a two-earner married couple where the spouses have equal incomes and a\ntwo-earner married couple with an unequal income division, but rather between a\ntwo-earner married couple and a one-earner married couple with the same total\nincome. Here, the case for equal taxation of the two couples may be weaker, because\nthe non-earner in the one-earner married couple benefits from more time that may be\nused for unpaid work inside the home, other activities or leisure. \xe2\x80\xa6\nMarriage penalty, labor supply, and economic efficiency\nMost analysts discuss the marriage penalty or marriage bonus as an issue of fairness,\nbut the marriage penalty or bonus also may create economic inefficiencies. The\nmarriage penalty or bonus may distort taxpayer behavior. The most obvious decision\nthat may be distorted is the decision to marry. For taxpayers for whom the marriage\npenalty exists, the tax system increases the \xe2\x80\x9cprice\xe2\x80\x9d of marriage. For taxpayers for\nwhom the marriage bonus exists, the tax system reduces the \xe2\x80\x9cprice\xe2\x80\x9d of marriage.\nMost of what is offered as evidence of distorted choice is anecdotal. There is no\nstatistical evidence that the marriage penalty or marriage bonus has altered\ntaxpayers\xe2\x80\x99 decisions to marry. Even if the marriage decision were distorted, it would\nbe difficult to measure the cost to society of delayed or accelerated marriages or\nalternative family structures.\n\n256\n\n\x0cSome analysts have suggested that the marriage penalty may alter taxpayers\xe2\x80\x99\ndecisions to work. As explained above, a marriage penalty exists when the sum of\nthe tax liabilities of two unmarried individuals filing their own tax returns (either\nsingle or head of household returns) is less than their tax liability under a joint return\n(if the two individuals were to marry). This is the result of a tax system with\nincreasing marginal tax rates. The marriage penalty not only means the total tax\nliability of the two formerly single taxpayers is higher after marriage than before\nmarriage, but it also generally may result in one or both of the formerly single\ntaxpayers being in a higher marginal tax rate bracket. That is, the additional tax on\nan additional dollar of income of each taxpayer is greater after marriage than it was\nwhen they were both single. Economists argue that changes in marginal tax rates may\naffect taxpayers\xe2\x80\x99 decisions to work. Higher marginal tax rates may discourage\nhousehold saving and labor supply by the newly married household. \xe2\x80\xa6 Some have\nsuggested that the labor supply decision of the lower earner or \xe2\x80\x9csecondary earner\xe2\x80\x9d\nin married households may be quite sensitive to the household\xe2\x80\x99s marginal tax rate.\n[footnote omitted]\nThe possible disincentive effects of a higher marginal tax rate on the secondary\nworker arise in the case of couples who experience a marriage bonus as well. In the\nspecific example above, the couple consisted of one person in the labor force and\none person not in the labor force. As noted previously, such a circumstance generally\nresults in a marriage bonus. By filing a joint return, the lower earner may become\nsubject to the marginal tax rate of the higher earner. By creating higher marginal tax\nrates on secondary earners, joint filing may discourage a number of individuals from\nentering the work force or it may discourage those already in the labor force from\nworking additional hours. [footnote omitted]\nEliminating or reducing the marriage penalty\n\xe2\x80\xa6.\nTo eliminate the marriage penalty through a change in the rate structure, the brackets\nfor all unmarried taxpayers (both singles and heads of household) would have to be\nhalf as large as the married, filing joint brackets. \xe2\x80\xa6 This change would exacerbate\nexisting marriage bonuses if the rate schedule for married taxpayers filing jointly\nwere increased. Regardless of the manner in which the rates were adjusted (i.e., by\nincreasing bracket breakpoints for married taxpayers or reducing them for singles\nand heads of households), a structure with rates for married taxpayers at twice the\nlevel of single and heads of households would cause marriage bonuses. Another effect\n257\n\n\x0cof such a step would be that single individuals and heads of household with identical\nincomes would find their tax liabilities nearly the same. \xe2\x80\xa6\nQuestions and comments:\n1. Examine the tax brackets at the front of your Code as well as the current standard\ndeduction for the different filing statuses. To whom and to what extent did Congress\nrespond when it created these relationships in brackets in 2017?\n2. What percentage of married filing jointly is the breakpoint for single taxpayers\nin the 10% bracket, the 12% bracket, the 22% bracket, the 24% bracket, the 32%\nbracket, the 35% bracket, and the 37% bracket?\n\xe2\x80\xa2What would happen to the marriage penalty as the breakpoint percentage\nincreases? What is the breakpoint percentage at the 37% bracket?\n3. The excerpt identifies three policies that \xe2\x80\x9cbracketologists\xe2\x80\x9d might pursue. What\nare they? Is it possible to pursue all three policies? What policies did the Code\npursue in 2001? Examine the brackets for taxpayers who are married filing jointly\nand for taxpayer who are single. What policies does the Code pursue after 2017?\n4. Are the current (2018 through 2025) brackets marriage neutral? See 7th footnote\nof the excerpt and second to last paragraph of excerpt.\n\nIII. Income Derived from Property\nRe-read Helvering v. Horst in Chapter 2. Why did taxpayer Horst lose?\nHelvering v. Eubank, 311 U.S. 122 (1940).\nMR. JUSTICE STONE delivered the opinion of the Court.\nThis is a companion case to Helvering v. Horst, ... and presents issues not\ndistinguishable from those in that case.\nRespondent, a general life insurance agent, after the termination of his agency\ncontracts and services as agent, made assignments in 1924 and 1928, respectively,\n258\n\n\x0cof renewal commissions to become payable to him for services which had been\nrendered in writing policies of insurance under two of his agency contracts. The\nCommissioner assessed the renewal commissions paid by the companies to the\nassignees in 1933 as income taxable to the assignor in that year ... The Court of\nAppeals for the Second Circuit reversed the order of the Board of Tax Appeals\nsustaining the assessment. We granted certiorari.\nNo purpose of the assignments appears other than to confer on the assignees the\npower to collect the commissions, which they did in the taxable year. ...\nFor the reasons stated at length in the opinion in the Horst case, we hold that the\ncommissions were taxable as income of the assignor in the year when paid. The\njudgment below is\nReversed.\nThe separate opinion of MR. JUSTICE McREYNOLDS.\n...\nThe assignment in question denuded the assignor of all right to commissions\nthereafter to accrue under the contract with the insurance company. He could do\nnothing further in respect of them; they were entirely beyond his control. In no\nproper sense were they something either earned or received by him during the\ntaxable year. The right to collect became the absolute property of the assignee,\nwithout relation to future action by the assignor.\nA mere right to collect future payments for services already performed is not\npresently taxable as \xe2\x80\x9cincome derived\xe2\x80\x9d from such services. It is property which may\nbe assigned. Whatever the assignor receives as consideration may be his income,\nbut the statute does not undertake to impose liability upon him because of payments\nto another under a contract which he had transferred in good faith under\ncircumstances like those here disclosed.\n....\nTHE CHIEF JUSTICE and MR. JUSTICE ROBERTS concur in this opinion.\n\n259\n\n\x0cNotes and Questions:\n1. The Court\xe2\x80\x99s majority says that this case presents issues like those in Horst,\nsupra?\n\xe2\x80\xa2Is that accurate?\n2. Should the right to collect compensation income for services performed become\nproperty simply by the passage of time, e.g., one year?\n\xe2\x80\xa2Should the tax burden fall upon the one who earns the income only if that\nperson receives the compensation in the same year?\n3. Do you see any latent problems of horizontal equity in the opinion of Justice\nMcReynolds? Taxpayers have endeavored from the beginning to convert\ncompensation income from ordinary income into property. Courts are very careful\nnot to permit this to occur.\n\xe2\x80\xa2Why do you think that taxpayer wanted to transfer his rights to receive\nfuture renewal commissions to a corporation that he controlled? Were there\ntax advantages to doing this?\nBlair v. Commissioner, 300 U.S. 5 (1937)\nMR. CHIEF JUSTICE HUGHES delivered the opinion of the Court.\nThis case presents the question of the liability of a beneficiary of a testamentary\ntrust for a tax upon the income which he had assigned to his children prior to the\ntax years and which the trustees had paid to them accordingly.\nThe trust was created by the will of William Blair, a resident of Illinois who died\nin 1899, and was of property located in that State. One-half of the net income was\nto be paid to the donor\xe2\x80\x99s widow during her life. His son, the petitioner Edward Tyler\nBlair, was to receive the other one-half and, after the death of the widow, the whole\nof the net income during his life. In 1923, after the widow\xe2\x80\x99s death, petitioner\nassigned to his daughter, Lucy Blair Linn, an interest amounting to $6,000 for the\nremainder of that calendar year, and to $9,000 in each calendar year thereafter, in\nthe net income which the petitioner was then or might thereafter be entitled to\nreceive during his life. At about the same time, he made like assignments of\ninterests, amounting to $9,000 in each calendar year, in the net income of the trust\nto his daughter Edith Blair and to his son, Edward Seymour Blair, respectively. In\n260\n\n\x0clater years, by similar instruments, he assigned to these children additional interests,\nand to his son William McCormick Blair other specified interests, in the net income.\nThe trustees accepted the assignments and distributed the income directly to the\nassignees.\n....\n... The Board [of Tax Appeals] ... overruled the Commissioner\xe2\x80\x99s determination as\nto the petitioner\xe2\x80\x99s [income tax] liability. The Circuit Court of Appeals ... reversed\nthe Board. That court \xe2\x80\xa6 decided that the income was still taxable to the petitioner\nupon the ground that his interest was not attached to the corpus of the estate, and\nthat the income was not subject to his disposition until he received it.\n....\n\xe2\x80\xa6 The question [is] whether, treating the assignments as valid, the assignor was\nstill taxable upon the income under the federal income tax act. That is a federal\nquestion.\n\xe2\x80\xa6 In [Lucas v. Earl, 281 U.S. 111], the question was whether an attorney was\ntaxable for the whole of his salary and fees earned by him in the tax years, or only\nupon one-half by reason of an agreement with his wife by which his earnings were\nto be received and owned by them jointly. We were of the opinion that the case\nturned upon the construction of the taxing act. We said that \xe2\x80\x9cthe statute could tax\nsalaries to those who earned them, and provide that the tax could not be escaped by\nanticipatory arrangements and contracts, however skilfully devised, to prevent the\nsalary when paid from vesting even for a second in the man who earned it.\xe2\x80\x9d That\nwas deemed to be the meaning of the statute as to compensation for personal\nservice, and the one who earned the income was held to be subject to the tax. \xe2\x80\xa6\n[This case is] not on point. The tax here is not upon earnings which are taxed to the\none who earns them. Nor is it a case of income attributable to a taxpayer by reason\nof the application of the income to the discharge of his obligation. Old Colony Trust\nCo. v. Commissioner, 279 U.S. 716; [citations omitted]. There is here no question\nof evasion or of giving effect to statutory provisions designed to forestall evasion;\nor of the taxpayer\xe2\x80\x99s retention of control. Corliss v. Bowers, 281 U.S. 376; Burnet v.\nGuggenheim, 288 U.S. 280.\n\n261\n\n\x0cIn the instant case, the tax is upon income as to which, in the general application of\nthe revenue acts, the tax liability attaches to ownership. See Poe v. Seaborn, supra;\n[citation omitted].\nThe Government points to the provisions of the revenue acts imposing upon the\nbeneficiary of a trust the liability for the tax upon the income distributable to the\nbeneficiary. But the term is merely descriptive of the one entitled to the beneficial\ninterest. These provisions cannot be taken to preclude valid assignments of the\nbeneficial interest, or to affect the duty of the trustee to distribute income to the\nowner of the beneficial interest, whether he was such initially or becomes such by\nvalid assignment. The one who is to receive the income as the owner of the\nbeneficial interest is to pay the tax. If, under the law governing the trust, the\nbeneficial interest is assignable, and if it has been assigned without reservation, the\nassignee thus becomes the beneficiary, and is entitled to rights and remedies\naccordingly. We find nothing in the revenue acts which denies him that status.\nThe decision of the Circuit Court of Appeals turned upon the effect to be ascribed\nto the assignments. The court held that the petitioner had no interest in the corpus\nof the estate, and could not dispose of the income until he received it. Hence, it was\nsaid that \xe2\x80\x9cthe income was his,\xe2\x80\x9d and his assignment was merely a direction to pay\nover to others what was due to himself. The question was considered to involve\n\xe2\x80\x9cthe date when the income became transferable.\xe2\x80\x9d The Government refers to the\nterms of the assignment \xe2\x80\x93 that it was of the interest in the income \xe2\x80\x9cwhich the said\nparty of the first part now is, or may hereafter be, entitled to receive during his life\nfrom the trustees.\xe2\x80\x9d From this, it is urged that the assignments \xe2\x80\x9cdealt only with a\nright to receive the income,\xe2\x80\x9d and that \xe2\x80\x9cno attempt was made to assign any equitable\nright, title or interest in the trust itself.\xe2\x80\x9d This construction seems to us to be a\nstrained one. We think it apparent that the conveyancer was not seeking to limit the\nassignment so as to make it anything less than a complete transfer of the specified\ninterest of the petitioner as the life beneficiary of the trust, but that, with ample\ncaution, he was using words to effect such a transfer. \xe2\x80\xa6\nThe will creating the trust entitled the petitioner during his life to the net income of\nthe property held in trust. He thus became the owner of an equitable interest in the\ncorpus of the property. Brown v. Fletcher, 235 U.S. 589, 598-599; Irwin v. Gavit,\n268 U.S. 161, 167-168; Senior v. Braden, 295 U.S. 422, 432; Merchants\xe2\x80\x99 Loan &\nTrust Co. v. Patterson, 308 Ill. 519, 530, 139 N.E. 912. By virtue of that interest,\nhe was entitled to enforce the trust, to have a breach of trust enjoined, and to obtain\nredress in case of breach. The interest was present property alienable like any other,\n262\n\n\x0cin the absence of a valid restraint upon alienation. [citations omitted]. The\nbeneficiary may thus transfer a part of his interest, as well as the whole. See\nRESTATEMENT OF THE LAW OF TRUSTS, \xc2\xa7\xc2\xa7 130, 132 et seq. The assignment of the\nbeneficial interest is not the assignment of a chose in action, but of the \xe2\x80\x9cright, title,\nand estate in and to property.\xe2\x80\x9d Brown v. Fletcher, supra; Senior v. Braden, supra.\nSee BOGERT, TRUSTS AND TRUSTEES, vol. 1, \xc2\xa7 183, pp. 516, 517; 17 COLUMBIA\nLAW REVIEW, 269, 273, 289, 290.\nWe conclude that the assignments were valid, that the assignees thereby became\nthe owners of the specified beneficial interests in the income, and that, as to these\ninterests, they, and not the petitioner, were taxable for the tax years in question.\nThe judgment of the Circuit Court of Appeals is reversed, and the cause is remanded\nwith direction to affirm the decision of the Board of Tax Appeals.\nIt is so ordered.\n\n263\n\n\x0cNotes and Questions:\n1. The Court spent several paragraphs establishing that Edward Tyler Blair had the\npower to dispose of his interest as he wished. Why was the exercise of this\ndiscretion sufficient to shift the tax burden to the recipient when it was not sufficient\nin Helvering v. Horst?\n2. William Blair died. Through his will, he devised part of his property to a trust.\nWe are not told who received the remainder of his property. Edward Tyler William\nBlair was an income beneficiary of part of the trust. We are not told of the final\ndisposition of the corpus of the trust. We are told that Edward had no interest in the\ncorpus of the estate. Edward assigned fractional interests \xe2\x80\x9cin each calendar year\nthereafter, in the net income which [Edward] was\nHorst\nthen or might thereafter be entitled to receive during\nhis life.\xe2\x80\x9d It appears that Edward\xe2\x80\x99s entire interest was\nas a beneficiary of the trust. He then assigned to\nvarious sons and daughters a fraction of his entire\nCorpus\ninterest.\n\xe2\x80\xa2Exactly what interest did William Blair, Jr.\nretain after these dispositions?\nConversion\nRights, Etc.\n\xe2\x80\xa2Compare this to what the taxpayer in\nHelvering v. Horst, supra, chapter 3, retained.\n1929\n\xe2\x80\xa2Is this difference a sound basis upon which\n1930\nDividends\n1931\nthe Court may reach different results?\n1932\n1933\n\n1934\n3. Think of the ownership of \xe2\x80\x9cproperty\xe2\x80\x9d as the\n1935\nownership of a \xe2\x80\x9cbundle of sticks.\xe2\x80\x9d Each stick\n1936\n1937\nrepresents a particular right. For example, a holder of\n1938\na bond may own several sticks, e.g., the right to\n1939\nDividends for 1933 & etc.\nreceive an interest payment in each of ten consecutive\n1934 gifted to son\nyears might be ten sticks, the right to sell the bond\nmight be another stick, the right to the proceeds upon\nmaturity might be another stick. Imagine that we lay the sticks comprising a bond,\none on top of the other. Then we slice off a piece of the property. We might slice\nhorizontally \xe2\x80\x93 and thereby take all or a portion of only one or a few sticks. Or we\nmight slice vertically \xe2\x80\x93 and thereby take an identically proportional piece of every\nstick.\n\nConsider the accompanying diagrams of Horst and Blair. Do they suggest an\n264\n\n\x0canalytical model in \xe2\x80\x9cassignment of income derived from property\xe2\x80\x9d cases?\n\xe2\x80\xa2Slice vertically rather than horizontally?\n4. Taxpayer was the life beneficiary of a testamentary trust. In December 1929,\nshe assigned a specified number of dollars from the income of the trust to certain\nof her children for 1930. The trustee paid the specified children as per Taxpayer\xe2\x80\x99s\ninstructions.\n\xe2\x80\xa2Exactly what interest did Taxpayer retain after these dispositions?\n\xe2\x80\xa2Should Taxpayer-life beneficiary or the children that she named to receive\nmoney in 1930 be subject to income tax on the trust income paid over to the\nchildren? See Harrison v.\nSchaffner, 312 U.S. 579, 582Blair\n83 (1941).\n5. Taxpayer established a trust\nwith himself as trustee and his\nMother\xe2\x80\x99s\nEdward\nwife as beneficiary. The trust\n\xc2\xbd income\nTyler\ninterest\nwas to last for five years unless\nBlair\xe2\x80\x99s \xc2\xbd\nafter\neither Taxpayer or his wife died\nincome\nMother\xe2\x80\x99s\ninterest\nearlier.\nTaxpayer\nplaced\nDeath\nsecurities that he owned in the\ntrust. The trust\xe2\x80\x99s net income\nwas to be held for Taxpayer\xe2\x80\x99s\nwife. Upon termination of the\ntrust, the corpus was to revert to\nTaxpayer and any accumulated\nincome was to be paid to his\nEdward Seymour\nEdith Blair\nwife.\nBlair\nLucy Blair\nWilliam\n\xe2\x80\xa2Exactly what interest did\nMcCormick\nTaxpayer retain after these\nBlair\ndispositions?\n\xe2\x80\xa2Should Taxpayer-settlor-trustee or his wife be subject to income tax on the\ntrust income paid over to Taxpayer\xe2\x80\x99s wife? See Helvering v. Clifford, 309\nU.S. 331, 335 (1940).\n1923\n1924\n1925\n1926\n1927\n1928\n1929\n1930\n1931\n1932\n1933\n1934\n1935\n1936\n1937\n1938\n1939\netc.\n\n5a. Now suppose that Taxpayer placed property in trust, the income from which\nwas to be paid to his wife until she died and then to their children. Taxpayer\n\xe2\x80\x9creserved power \xe2\x80\x98to modify or alter in any manner, or revoke in whole or in part,\nthis indenture and the trusts then existing, and the estates and interests in property\n265\n\n\x0chereby created[.]?\xe2\x80\x99\xe2\x80\x9d Taxpayer did not in fact exercise this power, and the trustee\npaid income to Taxpayer\xe2\x80\x99s wife.\n\xe2\x80\xa2Exactly what interest did Taxpayer retain after this disposition?\n\xe2\x80\xa2Should the trust income be taxable income to Taxpayer or to his wife?\n\xe2\x80\xa2See Corliss v. Bowers, 281 U.S. 376, 378 (1930).\n6. Again: is the tree-fruits analogy useful in difficult cases? Consider what happens\nwhen the fruit of labor is property from which income may be derived.\nHeim v. Fitzpatrick, 262 F.2d 887 (2d Cir. 1959).\nBefore SWAN and MOORE, Circuit Judges, and KAUFMAN, District Judge.\nSWAN, Circuit Judge.\nThis litigation involves income taxes of Lewis R. Heim, for the years 1943 through\n1946. On audit of the taxpayer\xe2\x80\x99s returns, the Commissioner of Internal Revenue\ndetermined that his taxable income in each of said years should be increased by\nadding thereto patent royalty payments received by his wife, his son and his\ndaughter. The resulting deficiencies were paid under protest to defendant\nFitzpatrick, Collector of Internal Revenue for the District of Connecticut.\nThereafter claims for refund were filed and rejected. The present action was timely\ncommenced ... It was heard upon an agreed statement of facts and supplemental\naffidavits. Each party moved for summary judgment. The plaintiff\xe2\x80\x99s motion was\ndenied and the defendant\xe2\x80\x99s granted. ...\nPlaintiff was the inventor of a new type of rod end and spherical bearing. In\nSeptember 1942 he applied for a patent thereon. On November 5, 1942 he applied\nfor a further patent on improvements of his original invention. Thereafter on\nNovember 17, 1942 he executed a formal written assignment of his invention and\nof the patents which might be issued for it and for improvements thereof to The\nHeim Company.82 This was duly recorded in the Patent Office and in January 1945\nand May 1946 plaintiff\xe2\x80\x99s patent applications were acted on favorably and patents\nThe stock of The Heim Company was owned as follows: plaintiff 1%, his wife 41%, his son and\ndaughter 27% each, and his daughter-in-law and son-in-law 2% each\n82\n\n266\n\n\x0cthereon were issued to the Company. The assignment to the Company was made\npursuant to an oral agreement, subsequently reduced to a writing dated July 29,\n1943, by which it was agreed (1) that the Company need pay no royalties on\nbearings manufactured by it prior to July 1, 1943; (2) that after that date the\nCompany would pay specified royalties on 12 types of bearings; (3) that on new\ntypes of bearings it would pay royalties to be agreed upon prior to their\nmanufacture; (4) that if the royalties for any two consecutive months or for any one\nyear should fall below stated amounts, plaintiff at his option might cancel the\nagreement and thereupon all rights granted by him under the agreement and under\nany and all assigned patents should revert to him, his heirs and assigns; and (5) that\nthis agreement is not transferable by the Company.\nIn August 1943 plaintiff assigned to his wife \xe2\x80\x98an undivided interest of 25 per cent\nin said agreement with The Heim Company dated July 29, 1943, and in all his\ninventions and patent rights, past and future, referred to therein and in all rights and\nbenefits of the First Party (plaintiff) thereunder * * *.\xe2\x80\x99 A similar assignment was\ngiven to his son and another to his daughter. Plaintiff paid gift taxes on the\nassignments. The Company was notified of them and thereafter it made all royalty\npayments accordingly. As additional types of bearings were put into production\nfrom time to time the royalties on them were fixed by agreement between the\nCompany and the plaintiff and his three assignees.\nThe Commissioner of Internal Revenue decided that all of the royalties paid by the\nCompany to plaintiff\xe2\x80\x99s wife and children during the taxable years in suit were\ntaxable to him. This resulted in a deficiency which the plaintiff paid ...\nThe appellant contends that the assignments to his wife and children transferred to\nthem income-producing property and consequently the royalty payments were\ntaxable to his donees, as held in Blair v. Commissioner, 300 U.S. 5. [footnote\nomitted]. Judge Anderson, however, was of opinion that (151 F. Supp. 576):\n\xe2\x80\x98The income-producing property, i.e., the patents, had been assigned by the\ntaxpayer to the corporation. What he had left was a right to a portion of the\nincome which the patents produced. He had the power to dispose of and\ndivert the stream of this income as he saw fit.\xe2\x80\x99\nConsequently he ruled that the principles applied by the Supreme Court in\nHelvering v. Horst, 311 U.S. 112 and Helvering v. Eubank, 311 U.S. 122 required\nall the royalty payments to be treated as income of plaintiff.\n267\n\n\x0cThe question is not free from doubt, but the court believes that the transfers in this\ncase were gifts of income-producing property and that neither Horst nor Eubank\nrequires the contrary view. In the Horst case the taxpayer detached interest coupons\nfrom negotiable bonds, which he retained, and made a gift of the coupons, shortly\nbefore their due date, to his son who collected them in the same year at maturity.\nLucas v. Earl, 281 U.S. 111, which held that an assignment of unearned future\nincome for personal services is taxable to the assignor, was extended to cover the\nassignment in Horst, the court saying,\n\xe2\x80\x98Nor is it perceived that there is any adequate basis for distinguishing\nbetween the gift of interest coupons here and a gift of salary or\ncommissions.\xe2\x80\x99\nIn the Eubank case the taxpayer assigned a contract which entitled him to receive\npreviously earned insurance renewal commissions. In holding the income taxable\nto the assignor the court found that the issues were not distinguishable from those\nin Horst. No reference was made to the assignment of the underlying contract.83\nIn the present case more than a bare right to receive future royalties was assigned\nby plaintiff to his donees. Under the terms of his contract with The Heim Company\nhe retained the power to bargain for the fixing of royalties on new types of bearings,\ni.e., bearings other than the 12 products on which royalties were specified. This\npower was assigned and the assignees exercised it as to new products. Plaintiff also\nretained a reversionary interest in his invention and patents by reason of his option\nto cancel the agreement if certain conditions were not fulfilled. This interest was\nalso assigned. The fact that the option was not exercised in 1945, when it could\nhave been, is irrelevant so far as concerns the existence of the reversionary interest.\nWe think that the rights retained by plaintiff and assigned to his wife and children\nwere sufficiently substantial to justify the view that they were given incomeproducing property.\nIn addition to Judge Anderson\xe2\x80\x99s ground of decision appellee advances a further\nThese decisions were distinguished by Judge Magruder in Commissioner v. Reece, 1 Cir., 233 F.2d\n30. In that case, as in the case at bar, the taxpayer assigned his patent to a corporation in return for its\npromise to pay royalties, and later made a gift of the royalty contract to his wife. It was held that this\nwas a gift of income-producing property and was effective to make the royalties taxable to her. See also\nNelson v. Ferguson, 56 F.2d 121 (3rd Cir.), cert. denied, 286 U.S. 565; Commissioner v. Hopkinson, 126\nF.2d 406 (2d Cir.); and 71 HARVARD LAW REVIEW 378.\n83\n\n268\n\n\x0cargument in support of the judgment, namely, that the plaintiff retained sufficient\ncontrol over the invention and the royalties to make it reasonable to treat him as\nowner of that income for tax purposes. Commissioner v. Sunnen, 333 U.S. 591 is\nrelied upon. There a patent was licensed under a royalty contract with a corporation\nin which the taxpayer-inventor held 89% of the stock. An assignment of the royalty\ncontract to the taxpayer\xe2\x80\x99s wife was held ineffective to shift the tax, since the\ntaxpayer retained control over the royalty payments to his wife by virtue of his\ncontrol of the corporation, which could cancel the contract at any time. The\nargument is that, although plaintiff himself owned only 1% of The Heim Company\nstock, his wife and daughter together owned 68% and it is reasonable to infer from\ndepositions introduced by the Commissioner that they would follow the plaintiff\xe2\x80\x99s\nadvice. Judge Anderson did not find it necessary to pass on this contention. But we\nare satisfied that the record would not support a finding that plaintiff controlled the\ncorporation whose active heads were the son and son-in-law. No inference can\nreasonably be drawn that the daughter would be likely to follow her father\xe2\x80\x99s advice\nrather than her husband\xe2\x80\x99s or brother\xe2\x80\x99s with respect to action by the corporation.\n\xe2\x80\xa6.\nFor the foregoing reasons we hold that the judgment should be reversed and the\ncause remanded with directions to grant plaintiff\xe2\x80\x99s motion for summary judgment.\nSo ordered.\nNotes and Questions:\n1. Eubank involved labor that created an identifiable and assignable right to receive\nincome in the future. How does Heim v. Fitzpatrick differ from Eubank? After all,\na patent is the embodiment of (considerable) work.\n2. A patent is no longer, (\xc2\xa7 1221(a)(3)(A)) a capital asset to the taxpayer whose\npersonal efforts created it. Otherwise it is a capital asset that the holder has\npresumptively held for more than one year. \xc2\xa7 1235(a), (b)(1). However, this rule\ndoes not apply to transfers between related persons as defined in \xc2\xa7\xc2\xa7 267(b, c) or\n707(b) and modified by \xc2\xa7 1235(c)(1, 2).\n\xe2\x80\xa2In Heim, to whom would \xc2\xa7 1235 matter?\n\n269\n\n\x0cDo the CALI Lesson, Basic Federal Income Taxation: Assignment of Income:\nProperty.\n\nContingent fee arrangements: When a taxpayer-plaintiff enters a contingent fee\narrangement with her attorney, has taxpayer entered an anticipatory assignment of\nincome? Or has taxpayer partially assigned income-producing property?\n\xe2\x80\xa2Is the contingent-fee attorney a joint owner of the client\xe2\x80\x99s claim?\n\xe2\x80\xa2Does it matter that the relationship between client and attorney is principal\nand agent?\n\xe2\x80\xa2No and yes, said the Supreme Court in CIR v. Banks, 543 U.S. 426 (2005). State\nlaws that may protect the attorney do not change this, so long as they do not alter the\nfundamental principal-agent relationship.\n\xe2\x80\xa2So: taxpayer-plaintiff must otherwise include whatever damages she receives in her\ngross income, including the amount of the contingent fee that she must pay her attorney.\nIf the expenses of producing taxable income are deductible, what difference does it\nmake? See \xc2\xa7\xc2\xa7 67(a), 67(g) (\xe2\x80\x9cmiscellaneous deductions\xe2\x80\x9d), and 55(a), 56(b)(1)(A)(i)\n(alternative minimum tax). And see \xc2\xa7 62(a)(20). When would \xc2\xa7 62(a)(20) affect your\nanswer?\nIf the damages plaintiff recovers are not otherwise included in her gross income (see,\ne.g., \xc2\xa7 104(a)(2)), she is not permitted to deduct the expenses of litigation? Why not?\n\nIV. Interest Free Loans and Unstated Interest\nConsider these scenarios:\n\xe2\x80\xa2Father has a large savings account, and daughter is 18 years old. Daughter is\nenrolled at Private University. Father and mother have planned for many years for\nthis day and saved enough to pay for Daughter\xe2\x80\x99s tuition. They have saved $1M, and\nthe annual interest income on this amount is $80,000. Father and mother are in the\n37% marginal income tax bracket. Daughter is in the 0% marginal income tax\nbracket. An income of $80,000 would place Daughter in the 22% marginal tax\nbracket \xe2\x80\x93 although some of that income would not be subject to any tax, some would\nbe subject to 10% tax, and some would be subject to 12% tax. Father and mother\ndecide to loan Daughter $1M interest free. Daughter will deposit the money in an\ninterest-bearing account and use the interest income to pay her tuition and other\n270\n\n\x0cexpenses for four years. With diploma in hand, Daughter will repay the loan.\n\xe2\x80\xa2Are there any income tax problems with this?\n\xe2\x80\xa2Read \xc2\xa7 7872(a)(1), (c)(1)(A), (e), (f)(2), (f)(3).\n\xe2\x80\xa2[By the way, \xc2\xa7 7872 applies both to the income tax and to the gift\ntax.]\n\xe2\x80\xa2What result under these provisions?\n\xe2\x80\xa2Corporation very much wants to hire Star Employee and has made a generous\nsalary offer. To sweeten the deal, Corporation offers to loan $1M to Star Employee\ninterest free so that Star Employee can purchase a house in an otherwise expensive\nhousing market. Star Employee will repay the loan at the rate of $40,000 per year\nfor the next 25 years. Star Employee must pay the full principal of the loan if she\nstops working for corporation. Star Employee may not transfer her interest in the\nloan.\n\xe2\x80\xa2Are there any income tax problems with this?\n\xe2\x80\xa2Read \xc2\xa7 7872(a), (c)(1)(B), (e), (f)(2), (f)(5).\n\xe2\x80\xa2What result under these provisions?\n\xe2\x80\xa2Closely-held Corporation is owned by four shareholders. If the corporation pays\ndividends to shareholders, the dividend income is subject to income tax for the\nshareholders. The payments are not deductible to Corporation. Closely-held\nCorporation loans each shareholder $100,000 interest free. Shareholders will repay\nthe loans at the rate of $1000 per year for the next 100 years.\n\xe2\x80\xa2Are there any income tax problems with this?\n\xe2\x80\xa2Read \xc2\xa7 7872(b), (c)(1)(C), (e), (f)(1), (f)(2), (f)(6).\n\xe2\x80\xa2What result under these provisions?\n\xe2\x80\xa2The \xe2\x80\x9cKiddie\xe2\x80\x9d Tax\n\xe2\x80\xa2 Read \xc2\xa7\xc2\xa7 1(g); 1(h).\nDo the CALI Lesson, Basic Federal Income Taxation: Taxable Income and Tax\nComputation: Taxation of Minor Children\xe2\x80\x99s Income\n\xe2\x80\xa2Note: the \xc2\xa7 63(c)(5)(A) amount is indexed. Assume for purposes of this\nLesson that the amount is $900. Assume that the \xc2\xa7 63(c)(5)(B) amount is\n$300. [These values are subject to change.]\n\n271\n\n\x0cDo the CALI Lesson, Basic Federal Income Taxation: Deductions: Below Market\nLoans.\n\xe2\x80\xa2Note: Learn the points made in questions 1-2, but keep in mind that we are\nconcerned with income tax, not gift tax. Read \xc2\xa7 7872(d)(2) carefully.\n\nWrap-Up Questions for Chapter 5\n1. It has been observed that the actual federal tax84 burdens among different\nAmerican taxpayers are not very progressive. Federal tax burdens could be made\nmore progressive simply by capping a taxpayer\xe2\x80\x99s total allowable exclusions,\ndeductions, and credits. Perhaps a cap of $25,000 would be appropriate. Maybe it\nshould be more, maybe less. What do you think of the idea of increasing\nprogressivity by enacting such caps?\n2. At what point does it not pay to spend money to gain income that will not be\nsubject to federal income tax?\n3. When the IRS in its enforcement mission must come up with an interest rate, it\nturns to the \xe2\x80\x9capplicable Federal rate.\xe2\x80\x9d When \xc2\xa7 7872 is applicable, what might be\nwrong with reliance on such a uniform rate?\n4. Congress has made the tax burden on the combined income of taxpayers who\nfile married filing jointly exactly twice the tax burden on single persons with half\nthe income of the couple. This arrangement applies to those taxpayers whose\ntaxable income places them in all but the 35% or 37% tax brackets. This reduced\nthe tax rate on married persons from what it was before Congress enacted this\nchange. Is that preferable to giving relief only to those couples where both spouses\nwork, as was the case when the Code provided for a credit based on the amount of\nincome earned by the spouse who earned less?\n5. Comment on the following rough outline of a flat tax: Remove all deductions,\nexclusions, and credits from the Code. Retain only those associated with the\nproduction of income so that the income tax is a tax only on \xe2\x80\x9cnet\xe2\x80\x9d income. All\ntaxpayers would be entitled to a $40,000 exemption. The tax would be a flat rate\non all taxpayers to the extent their gross income exceeds $40,000.\n84 ... including social security, medicare, and unemployment taxes, as well as income taxes.\n\n272\n\n\x0cWhat have you learned?\nCan you explain or define \xe2\x80\x93\n\xe2\x80\xa2What is income splitting?\n\xe2\x80\xa2What is the marriage penalty? What is the marriage bonus?\n\xe2\x80\xa2What is the assignment-of-income doctrine? How does it apply to income derived\nfrom services? How does it apply to income derived from property?\n\xe2\x80\xa2In what way is a below-market loan an assignment of income?\n\n273\n\n\x0cChapter 6: Deductions: Business Expenses\nThe Tax Formula:\n(gross income)\n\xe2\x9e\x94MINUS deductions named in \xc2\xa7 62\nEQUALS (adjusted gross income (AGI))\n\xe2\x9e\x94MINUS (standard deduction or itemized\ndeductions)\nMINUS (deduction for \xe2\x80\x9cqualified business\nincome\xe2\x80\x9d)\nEQUALS (taxable income)\nCompute income tax liability from tables\nin \xc2\xa7 1(j) (indexed for inflation)\nMINUS (credits against tax)\n\nOur income tax system taxes only\n\xe2\x80\x9cnet income.\xe2\x80\x9d The Code incorporates\nprinciples that prevent taxing as\nincome the expenses of deriving that\nincome. Section 162 provides a\ndeduction for \xe2\x80\x9call the ordinary and\nnecessary expenses paid or incurred\nduring the taxable year in carrying on\nany trade or business[.]\xe2\x80\x9d Read\n\xc2\xa7 162(a).\nThe Code does not provide a\ndefinition of \xe2\x80\x9ctrade or business.\xe2\x80\x9d85\nThe Supreme Court observed the\nfollowing when it held that a full-time\ngambler was engaged in a \xe2\x80\x9ctrade or\nbusiness:\xe2\x80\x9d\n\nOf course, not every income-producing and profit-making endeavor\nconstitutes a trade or business. The income tax law, almost from the\nbeginning, has distinguished between a business or trade, on the one hand,\nand \xe2\x80\x9ctransactions entered into for profit but not connected with ... business\nor trade,\xe2\x80\x9d on the other. See Revenue Act of 1916, \xc2\xa7 5(a), Fifth, 39 Stat. 759.\nCongress \xe2\x80\x9cdistinguished the broad range of income or profit producing\nactivities from those satisfying the narrow category of trade or business.\xe2\x80\x9d\nWe accept the fact that to be engaged in a trade or business, the taxpayer\nmust be involved in the activity with continuity and regularity and that the\ntaxpayer\xe2\x80\x99s primary purpose for engaging in the activity must be for income\nor profit. A sporadic activity, a hobby, or an amusement diversion does not\nqualify.86\nThis excerpt informs that there is a distinction between a \xe2\x80\x9ctrade or business\xe2\x80\x9d and\nSee generally Paula Wolff, Annot., What constitutes trade or business under Internal Revenue Code\n(U.S.C.A. Title 26), 161 A.L.R. FED. 245 (2008).\n85\n\n86\n\nCommissioner v. Groetzinger, 480 U.S. 23, 35 (1987) (alternative minimum tax; citation omitted).\n\n274\n\n\x0c\xe2\x80\x9ctransactions entered into for profit but not connected with\xe2\x80\x9d a trade or business.\nInvesting fits the latter description. Congress extended the principles of \xc2\xa7 162(a) to\n\xe2\x80\x9cexpenses for the production of income\xe2\x80\x9d when it added \xc2\xa7 212 to the Code.\nHowever, expenses for the production of income \xe2\x80\x93 as contrasted with a trade or\nbusiness \xe2\x80\x93 are not deductible \xe2\x80\x9cabove the line.\xe2\x80\x9d \xc2\xa7 62(a)(1). There is also a distinction\nbetween a \xe2\x80\x9ctrade or business\xe2\x80\x9d and a hobby or amusement. The Code limits\ndeductions for an activity \xe2\x80\x9cnot engaged in for profit\xe2\x80\x9d to the gross income derived\nfrom the activity.87 For the years 2018 to 2025, Congress suspended these so-called\n\xe2\x80\x9cmiscellaneous deductions\xe2\x80\x9d \xe2\x80\x93 thereby treating such endeavors as \xe2\x80\x9cpersonal\nactivities.\xe2\x80\x9d See \xc2\xa7 67(g).\nSection 162 limits deductibility of trade or business expenses to those that are\n\xe2\x80\x9cordinary and necessary.\xe2\x80\x9d Section 162 allows a deduction only for expenses of\n\xe2\x80\x9ccarrying on\xe2\x80\x9d a trade or business. Hence, the costs of searching for a business to\npurchase, pre-opening organization costs, etc. are not deductible. \xc2\xa7 195. Taxpayer\nin such cases has no trade or business to \xe2\x80\x9ccarry on.\xe2\x80\x9d On the other hand, an existing\nbusiness that incurs the same expenses to expand its business may deduct them.\nWhether an existing business is seeking merely to expand or to enter a new trade\nor business \xe2\x80\x9cdepends on the facts and circumstances of each case.\xe2\x80\x9d88\nIn addition to \xc2\xa7 162, \xc2\xa7 163(a) allows a deduction for interest paid or accrued. For\ntaxpayers whose average gross receipts for the 3-year period ending with the\nimmediately preceding tax year are $25,000,000 or more, \xc2\xa7 448(c)(1), \xc2\xa7 163(j)\nlimits their interest deduction to the amount of their business interest income plus\n30% of their trade or business income. \xc2\xa7 163(j)(1 and 8).89 Section 165(a) allows\na deduction for losses.\nTiming of Trade or Business Expense Deductions: Taxpayer may \xe2\x80\x9cconsume\xe2\x80\x9d (i.e.,\n\xc2\xa7\xc2\xa7 183(a) and (b)(2). Furthermore, a taxpayer must attribute to such an activity a share of deductions\nallowable without regard to whether an activity is engaged in for profit, e.g., real estate taxes, to the\nactivity, \xc2\xa7 183(b)(1). This may have the effect of reducing by displacement the allowable deduction for\nexpenses attributable to the hobby or amusement activity. Moreover, the deductions are \xe2\x80\x9cbelow-theline\xe2\x80\x9d and subject to the 2% floor of \xc2\xa7 67 for miscellaneous deductions. A presumption in favor of the\ntaxpayer to the effect that the \xe2\x80\x9cactivity is engaged in for profit\xe2\x80\x9d arises if he derives gross income from\nthe activity greater than deductions attributable to it for three of the previous five consecutive tax years.\n\xc2\xa7 183(d).\n87\n\n88\n\nPrivate Letter Ruling 9331001.\n\nA special rule applies to taxpayers who sell motor vehicles from inventory. \xc2\xa7 163(j)(1 and 9)\n(additional floor financing costs also deductible).\n89\n\n275\n\n\x0cuse up) what he buys to produce income in his trade or business at different rates.\nWith regard to such consumption, consider the following possibilities:\n\xe2\x80\xa2Taxpayer may purchase an input and\nimmediately consume it to make taxable\nincome. Taxpayer purchases a tank of\ngasoline. We expect that such\nexpenditures would be immediately\ndeductible in full. We sometimes call such\ntreatment \xe2\x80\x9cexpensing.\xe2\x80\x9d\n\nRead \xc2\xa7 263: Capital\nExpenditures: Notice that\n\xc2\xa7 263(a)(1) denies a deduction\nfor \xe2\x80\x9camounts paid out\xe2\x80\x9d for\n\xe2\x80\x9cpermanent improvements or\nbetterments\xe2\x80\x9d to increase the\nvalue of taxpayer\xe2\x80\x99s property.\nThis does not mean that such\namounts are never deductible.\n\xe2\x80\x9cAmounts paid out\xe2\x80\x9d are\ndeductible as the improvement\nor betterment is consumed.\nSee \xc2\xa7\xc2\xa7 167, 168.\n\n\xe2\x80\xa2Alternatively, taxpayer may purchase an\ninput that he will consume more slowly\nand that will enable him to earn income for\nmore than the current tax year. Taxpayer\nwill eventually \xe2\x80\x9cconsume\xe2\x80\x9d that input.\nTaxpayer might purchase a machine that\nwill enable him to generate income for the next ten years. Taxpayer has\nmade an \xe2\x80\x9cinvestment\xe2\x80\x9d rather than an expenditure on an item that he\nimmediately consumes. A mere change in the form in which taxpayer holds\nwealth is not a taxable event. We implement this principle by crediting\ntaxpayer with basis equal to the cost of the input (e.g., the machine).\nTaxpayer then consumes only a part of the item that he purchased to\ngenerate income. What taxpayer consumes is no longer invested, and\ntaxpayer has to that extent \xe2\x80\x9cde-invested\xe2\x80\x9d the amount consumed. The Code\nimplements in several places a scheme that (theoretically) matches such\nconsumption with the income that the expenditure generates.90 The Code\npermits a deduction for such partial consumption under the headings of\ndepreciation, amortization, or more recently, cost recovery. Since such\nconsumption represents a \xe2\x80\x9cdeinvestment,\xe2\x80\x9d taxpayer must adjust his basis in\nthe productive asset downward. We sometimes call this tax treatment of the\npurchase and use of a productive asset \xe2\x80\x9ccapitalization.\xe2\x80\x9d\n\xe2\x80\xa2Yet another possibility is that taxpayer may purchase an input that enables\nhim to produce income but never consumes that input, e.g., land, a legal\nThe Code also implements a matching of income with expenses when taxpayer derives gross income\nby selling from inventory. The Code has special rules that prohibit taxpayer from deferring recognition\nof income derived from sales from inventory by building up deductions through purchase of inventory\nin advance of the time he makes sales.\n90\n\n276\n\n\x0ceducation. There should logically be no deduction \xe2\x80\x93 immediately or in the\nfuture \xe2\x80\x93 for such expenditures. Taxpayer will have a basis in such an asset,\nbut can only recover it for income tax purposes upon sale of the asset. We\nalso call this tax treatment of the purchase and use of such an asset\n\xe2\x80\x9ccapitalization.\xe2\x80\x9d\nBusiness Expenses: Deduction Disputes: We think of disputes between a taxpayer\nand the Commissioner as binary in nature. The taxpayer argues one thing and the\nCommissioner argues the (only) opposite. For example, money that the taxpayer\nfinds in a piano is or is not gross income; there are no other possibilities. Disputes\nconcerning trade or business expenditures involve more possibilities. Initially\nexpenditures are \xe2\x80\x9cordinary and necessary\xe2\x80\x9d or they are not (binary). Cf. Gilliam,\ninfra. Assuming an expenditure is an \xe2\x80\x9cordinary and necessary\xe2\x80\x9d trade or business\nexpense, it may be immediately deductible, it may never be deductible, or it may\nbe deductible over an extended period during which it is consumed. Any of these\nmatters can be the point on which a case turns.\n\nDepreciable Capital Asset (e.g., property,\nplant, & equipment) = Cost Recovery\nDeductions\n\nOrdinary and Necessary\nTrade or Business Expense\nNon-depreciable Capital\nAsset (e.g., land) = Increase\nTaxpayer\xe2\x80\x99s Basis\n\n\xc2\xa7 162 Ordinary and Necessary\nExpenses (e.g., wages paid) =\n\xe2\x80\x9cExpensing\xe2\x80\x9d\n\nIn the materials ahead, we very roughly consider the placement of expenditures into\none group or another \xe2\x80\x93 whether expense or capital. Both the Commissioner and\ntaxpayers are aware of the time value of money. Taxpayer usually wants to classify\npurchases of inputs that enable him to generate income in a manner to permit the\nearliest deduction. The Commissioner of course wants the opposite result. Try to\ndetermine the controlling principles by which to resolve these issues of\nclassification.\n277\n\n\x0cI. Expense or Capital\nThe following cases involve the proper tax treatment of expenditures to purchase\nincome-producing assets \xe2\x80\x93 whether immediately deductible, deductible over their\nuseful life, or not deductible.\nWelch v. Helvering, 290 U.S. 114 (1933)\nMR. JUSTICE CARDOZO delivered the opinion of the Court.\nThe question to be determined is whether payments by a taxpayer, who is in\nbusiness as a commission agent, are allowable deductions in the computation of his\nincome if made to the creditors of a bankrupt corporation in an endeavor to\nstrengthen his own standing and credit.\nIn 1922, petitioner was the secretary of the E.L. Welch Company, a Minnesota\ncorporation, engaged in the grain business. The company was adjudged an\ninvoluntary bankrupt, and had a discharge from its debts. Thereafter the petitioner\nmade a contract with the Kellogg Company to purchase grain for it on a\ncommission. In order to reestablish his relations with customers whom he had\nknown when acting for the Welch Company and to solidify his credit and standing,\nhe decided to pay the debts of the Welch business so far as he was able. In\nfulfillment of that resolve, he made payments of substantial amounts during five\nsuccessive years. ... The Commissioner ruled that these payments were not\ndeductible from income as ordinary and necessary expenses, but were rather in the\nnature of capital expenditures, an outlay for the development of reputation and\ngoodwill. The Board of Tax Appeals sustained the action of the Commissioner and\nthe Court of Appeals for the Eighth Circuit affirmed. The case is here on certiorari.\n...\nWe may assume that the payments to creditors of the Welch Company were\nnecessary for the development of the petitioner\xe2\x80\x99s business, at least in the sense that\nthey were appropriate and helpful. [citation omitted]. He certainly thought they\nwere, and we should be slow to override his judgment. But the problem is not solved\nwhen the payments are characterized as necessary. Many necessary payments are\ncharges upon capital. There is need to determine whether they are both necessary\nand ordinary. Now, what is ordinary, though there must always be a strain of\nconstancy within it, is nonetheless a variable affected by time and place and\n278\n\n\x0ccircumstance. \xe2\x80\x9cOrdinary\xe2\x80\x9d in this context does not mean that the payments must be\nhabitual or normal in the sense that the same taxpayer will have to make them often.\nA lawsuit affecting the safety of a business may happen once in a lifetime. The\ncounsel fees may be so heavy that repetition is unlikely. Nonetheless, the expense\nis an ordinary one because we know from experience that payments for such a\npurpose, whether the amount is large or small, are the common and accepted means\nof defense against attack. Cf. Kornhauser v. United States, 276 U.S. 145. The\nsituation is unique in the life of the individual affected, but not in the life of the\ngroup, the community, of which he is a part. At such times, there are norms of\nconduct that help to stabilize our judgment, and make it certain and objective. The\ninstance is not erratic, but is brought within a known type.\nThe line of demarcation is now visible between the case that is here and the one\nsupposed for illustration. We try to classify this act as ordinary or the opposite, and\nthe norms of conduct fail us. No longer can we have recourse to any fund of\nbusiness experience, to any known business practice. Men do at times pay the debts\nof others without legal obligation or the lighter obligation imposed by the usages\nof trade or by neighborly amenities, but they do not do so ordinarily, not even\nthough the result might be to heighten their reputation for generosity and opulence.\nIndeed, if language is to be read in its natural and common meaning [citations\nomitted], we should have to say that payment in such circumstances, instead of\nbeing ordinary, is in a high degree extraordinary. There is nothing ordinary in the\nstimulus evoking it, and none in the response. Here, indeed, as so often in other\nbranches of the law, the decisive distinctions are those of degree, and not of kind.\nOne struggles in vain for any verbal formula that will supply a ready touchstone.\nThe standard set up by the statute is not a rule of law; it is rather a way of life. Life\nin all its fullness must supply the answer to the riddle.\nThe Commissioner of Internal Revenue resorted to that standard in assessing the\npetitioner\xe2\x80\x99s income, and found that the payments in controversy came closer to\ncapital outlays than to ordinary and necessary expenses in the operation of a\nbusiness. His ruling has the support of a presumption of correctness, and the\npetitioner has the burden of proving it to be wrong. [citations omitted]. Unless we\ncan say from facts within our knowledge that these are ordinary and necessary\nexpenses according to the ways of conduct and the forms of speech prevailing in\nthe business world, the tax must be confirmed. But nothing told us by this record\nor within the sphere of our judicial notice permits us to give that extension to what\nis ordinary and necessary. Indeed, to do so would open the door to many bizarre\nanalogies. One man has a family name that is clouded by thefts committed by an\n279\n\n\x0cancestor. To add to his own standing he repays the stolen money, wiping off, it may\nbe, his income for the year. The payments figure in his tax return as ordinary\nexpenses. Another man conceives the notion that he will be able to practice his\nvocation with greater ease and profit if he has an opportunity to enrich his culture.\nForthwith the price of his education becomes an expense of the business, reducing\nthe income subject to taxation. There is little difference between these expenses and\nthose in controversy here. Reputation and learning are akin to capital assets, like\nthe goodwill of an old partnership. [citation omitted]. For many, they are the only\ntools with which to hew a pathway to success. The money spent in acquiring them\nis well and wisely spent. It is not an ordinary expense of the operation of a business.\nMany cases in the federal courts deal with phases of the problem presented in the\ncase at bar. To attempt to harmonize them would be a futile task. They involve the\nappreciation of particular situations at times with border-line conclusions. Typical\nillustrations are cited in the margin.91\nThe decree should be\nAffirmed.\n\nOrdinary expenses: Commissioner v. People\xe2\x80\x99s Pittsburgh Trust Co., 60 F.2d 187, expenses incurred\nin the defense of a criminal charge growing out of the business of the taxpayer; American Rolling Mill\nCo. v. Commissioner, 41 F.2d 314, contributions to a civic improvement fund by a corporation\nemploying half of the wage earning population of the city, the payments being made, not for charity,\nbut to add to the skill and productivity of the workmen ...; Corning Glass Works v. Lucas, 59 App. D.C.\n168, 37 F.2d 798, donations to a hospital by a corporation whose employees with their dependents\nmade up two-thirds of the population of the city; Harris & Co. v. Lucas, 48 F.2d 187, payments of debts\ndischarged in bankruptcy, but subject to be revived by force of a new promise. Cf. Lucas v. Ox Fibre\nBrush Co., 281 U.S. 115, where additional compensation, reasonable in amount, was allowed to the\nofficers of a corporation for services previously rendered.\n91\n\nNot ordinary expenses: Hubinger v. Commissioner, 36 F.2d 724, payments by the taxpayer for the\nrepair of fire damage, such payments being distinguished from those for wear and tear; Lloyd v.\nCommissioner, 55 F.2d 842, counsel fees incurred by the taxpayer, the president of a corporation, in\nprosecuting a slander suit to protect his reputation and that of his business; One Hundred Five West\nFifty-Fifth Street v. Commissioner, 42 F.2d 849, and Blackwell Oil & Gas Co. v. Commissioner, 60\nF.2d 257, gratuitous payments to stockholders in settlement of disputes between them, or to assume\nthe expense of a lawsuit in which they had been made defendants; White v. Commissioner, 61 F.2d 726,\npayments in settlement of a lawsuit against a member of a partnership, the effect being to enable him\nto devote his undivided efforts to the partnership business and also to protect its credit.\n\n280\n\n\x0cNotes and Questions:\n1. The word \xe2\x80\x9cordinary\xe2\x80\x9d as used in the phrase \xe2\x80\x9cordinary and necessary\xe2\x80\x9d provides a\nline of demarcation between expenditures currently deductible and those that are\neither never deductible or deductible only over time, i.e., through depreciation,\namortization, or cost recovery allowances.\n\xe2\x80\xa2Since the expenses in Welch were not \xe2\x80\x9cordinary,\xe2\x80\x9d the next question is\nwhether taxpayer could deduct them over time through depreciation or\namortization.\n\xe2\x80\xa2What should be relevant in making this determination?\n\xe2\x80\xa2Do you think that the expenses in Welch v. Helvering should be recoverable\nthrough depreciation or amortization allowances?\n\xe2\x80\xa2In the second paragraph of the Court\xe2\x80\x99s footnote, the Court cited several\ncases. Which expenditures should taxpayer be able to deduct over time\nthrough depreciation or amortization, and which should taxpayer not be able\ndeduct at all \xe2\x80\x93 probably ever?\n2. Consider these three rationales of the Court\xe2\x80\x99s opinion: the expenditures were too\npersonal to be deductible, were too bizarre to be ordinary, and were capital so not\ndeductible.\n\xe2\x80\xa2Personal: Welch felt a moral obligation, as many in Minnesota in such\ncircumstances did at the time, to pay the corporation\xe2\x80\x99s debts. In fact, Welch\nrepaid the debts on the advice of bankers. This would seem to make business\nthe motivation for repaying these debts.\n\xe2\x80\xa2Bizarre: Others in Minnesota behaved the same way, i.e., repaid the debts\nof a bankrupt predecessor.\n\xe2\x80\xa2Capital: The expenditures were no doubt capital in nature. However, they\nwere arguably only an investment designed to generate income for a finite\nperiod. As such, the expenditures should be depreciable or amortizable.\n\xe2\x80\xa2See Joel S. Newman, The Story of Welch: The Use (and Misuse) of the\n\xe2\x80\x9cOrdinary and Necessary\xe2\x80\x9d Test for Deducting Business Expenses, in TAX\nSTORIES 197-224 (Paul Caron ed., 2d ed. 2009).\n3. What should be the tax consequences of making payments to create goodwill?\nWhat should be the tax consequences of maintaining or repairing goodwill?\n4. By paying the debts of a bankrupt, no-longer-in-existence corporation, was\nThomas Welch trying to create goodwill or to maintain or repair it? Whose\ngoodwill?\n281\n\n\x0c\xe2\x80\xa2Consider: Conway Twitty (actually Harold Jenkins) was a famous country\nmusic singer. He formed a chain of fast food restaurants (\xe2\x80\x9cTwitty Burger,\nInc.\xe2\x80\x9d). He persuaded seventy-five friends in the country music business to\ninvest with him. The venture failed. Twitty was concerned about the effect\nof the adverse publicity on his country music career. He repaid the investors\nhimself.\n\xe2\x80\xa2If Twitty were trying to protect the reputation of Twitty Burger, the\nexpenditures would surely have been nondeductible. Twitty Burger\nafter all was defunct.\n\xe2\x80\xa2The court found as a fact that one\xe2\x80\x99s reputation in the country music\nbusiness is very important.\n\xe2\x80\xa2Deductible? See Harold L. Jenkins v. Commissioner, T.C. Memo\n1983-667, 1983 WL 14653.\n5. What should be the tax treatment of expenditures incurred to acquire property\nthat has an indefinite useful life?\nWoodward v. Commissioner, 397 U.S. 572 (1970)\nMR. JUSTICE MARSHALL delivered the opinion of the Court.\n....\nTaxpayers owned or controlled a majority of the common stock of the TelegraphHerald, an Iowa publishing corporation. The Telegraph-Herald was incorporated in\n1901, and its charter was extended for 20-year periods in 1921 and 1941. On June\n9, 1960, taxpayers voted their controlling share of the stock of the corporation in\nfavor of a perpetual extension of the charter. A minority stockholder voted against\nthe extension. Iowa law requires \xe2\x80\x9cthose stockholders voting for such renewal . . .\n[to] purchase at its real value the stock voted against such renewal.\xe2\x80\x9d Iowa Code\n\xc2\xa7 491.25 (1966).\nTaxpayers attempted to negotiate purchase of the dissenting stockholder\xe2\x80\x99s shares,\nbut no agreement could be reached on the \xe2\x80\x9creal value\xe2\x80\x9d of those shares.\nConsequently, in 1962, taxpayers brought an action in state court to appraise the\nvalue of the minority stock interest. The trial court fixed a value, which was slightly\nreduced on appeal by the Iowa Supreme Court, [citations omitted]. In July, 1965,\ntaxpayers purchased the minority stock interest at the price fixed by the court.\n282\n\n\x0cDuring 1963, taxpayers paid attorneys\xe2\x80\x99, accountants\xe2\x80\x99, and appraisers\xe2\x80\x99 fees of over\n$25,000, for services rendered in connection with the appraisal litigation. On their\n1963 federal income tax returns, taxpayers claimed deductions for these expenses,\nasserting that they were \xe2\x80\x9cordinary and necessary expenses paid ... for the\nmanagement, conservation, or maintenance of property held for the production of\nincome\xe2\x80\x9d deductible under \xc2\xa7 212 ... The Commissioner of Internal Revenue\ndisallowed the deduction \xe2\x80\x9cbecause the fees represent capital expenditures incurred\nin connection with the acquisition of capital stock of a corporation.\xe2\x80\x9d The Tax Court\nsustained the Commissioner\xe2\x80\x99s determination, with two dissenting opinions, and the\nCourt of Appeals affirmed. We granted certiorari to resolve the conflict over the\ndeductibility of the costs of appraisal proceedings between this decision and the\ndecision of the Court of Appeals for the Seventh Circuit in United States v. Hilton\nHotels Corp., [397 U.S. 580 (1970)]. [footnote omitted] We affirm.\nSince the inception of the present federal income tax in 1913, capital expenditures\nhave not been deductible. [footnote omitted] See \xc2\xa7 263. Such expenditures are\nadded to the basis of the capital asset with respect to which they are incurred, and\nare taken into account for tax purposes either through depreciation or by reducing\nthe capital gain (or increasing the loss) when the asset is sold. If an expense is\ncapital, it cannot be deducted as \xe2\x80\x9cordinary and necessary,\xe2\x80\x9d either as a business\nexpense under \xc2\xa7 162 of the Code or as an expense of \xe2\x80\x9cmanagement, conservation,\nor maintenance\xe2\x80\x9d under \xc2\xa7 212.92\nIt has long been recognized, as a general matter, that costs incurred in the\nacquisition or disposition of a capital asset are to be treated as capital expenditures.\nThe most familiar example of such treatment is the capitalization of brokerage fees\nfor the sale or purchase of securities, as explicitly provided by a longstanding\nTreasury regulation, Reg. \xc2\xa7 1.263(a)-2(e), and as approved by this Court in\nHelvering v. Winmill, 305 U.S. 79 (1938), and Spreckels v. Commissioner, 315 U.S.\n626 (1942). The Court recognized that brokers\xe2\x80\x99 commissions are \xe2\x80\x9cpart of the\nacquisition cost of the securities,\xe2\x80\x9d Helvering v. Winmill, supra, at 305 U.S. 84, and\nrelied on the Treasury regulation, which had been approved by statutory\nreenactment, to deny deductions for such commissions even to a taxpayer for whom\nthey were a regular and recurring expense in his business of buying and selling\nsecurities.\nThe two sections are in pari materia with respect to the capital-ordinary distinction, differing only in\nthat \xc2\xa7 212 allows deductions for the ordinary and necessary expenses of nonbusiness profitmaking\nactivities. See United States v. Gilmore, 372 U.S. 39, 44-45 (1963). ...\n92\n\n283\n\n\x0cThe regulations do not specify other sorts of acquisition costs, but rather provide\ngenerally that \xe2\x80\x9c[t]he cost of acquisition ... of ... property having a useful life\nsubstantially beyond the taxable year\xe2\x80\x9d is a capital expenditure. Reg. \xc2\xa7 1.263(a)2(a). Under this general provision, the courts have held that legal, brokerage,\naccounting, and similar costs incurred in the acquisition or disposition of such\nproperty are capital expenditures. See, e.g., Spangler v. Commissioner, 323 F.2d\n913, 921 (C.A. 9th Cir.1963); United States v. St. Joe Paper Co., 284 F.2d 430, 432\n(C.A. 5th Cir.1960). [citation omitted]. The law could hardly be otherwise, for such\nancillary expenses incurred in acquiring or disposing of an asset are as much part\nof the cost of that asset as is the price paid for it.\nMore difficult questions arise with respect to another class of capital expenditures,\nthose incurred in \xe2\x80\x9cdefending or perfecting title to property.\xe2\x80\x9d Reg. \xc2\xa7 1.263(a)-2(c).\nIn one sense, any lawsuit brought against a taxpayer may affect his title to property\n\xe2\x80\x93 money or other assets subject to lien. [footnote omitted] The courts, not believing\nthat Congress meant all litigation expenses to be capitalized, have created the rule\nthat such expenses are capital in nature only where the taxpayer\xe2\x80\x99s \xe2\x80\x9cprimary\npurpose\xe2\x80\x9d in incurring them is to defend or perfect title. See, e.g., Rassenfoss v.\nCommissioner, 158 F.2d 764 (C.A. 7th Cir.1946); Industrial Aggregate Co. v.\nUnited States, 284 F.2d 639, 645 (C.A. 8th Cir.1960). This test hardly draws a\nbright line, and has produced a melange of decisions which, as the Tax Court has\nnoted, \xe2\x80\x9c[i]t would be idle to suggest ... can be reconciled.\xe2\x80\x9d Ruoff v. Commissioner,\n30 T.C. 204, 208 (1958). [footnote omitted]\nTaxpayers urge that this \xe2\x80\x9cprimary purpose\xe2\x80\x9d test, developed in the context of cases\ninvolving the costs of defending property, should be applied to costs incurred in\nacquiring or disposing of property as well. And if it is so applied, they argue, the\ncosts here in question were properly deducted, since the legal proceedings in which\nthey were incurred did not directly involve the question of title to the minority\nstock, which all agreed was to pass to taxpayers, but rather was concerned solely\nwith the value of that stock. [footnote omitted]\nWe agree with the Tax Court and the Court of Appeals that the \xe2\x80\x9cprimary purpose\xe2\x80\x9d\ntest has no application here. That uncertain and difficult test may be the best that\ncan be devised to determine the tax treatment of costs incurred in litigation that may\naffect a taxpayer\xe2\x80\x99s title to property more or less indirectly, and that thus calls for a\njudgment whether the taxpayer can fairly be said to be \xe2\x80\x9cdefending or perfecting\ntitle.\xe2\x80\x9d Such uncertainty is not called for in applying the regulation that makes the\n\xe2\x80\x9ccost of acquisition\xe2\x80\x9d of a capital asset a capital expense. In our view, application of\n284\n\n\x0cthe latter regulation to litigation expenses involves the simpler inquiry whether the\norigin of the claim litigated is in the process of acquisition itself.\nA test based upon the taxpayer\xe2\x80\x99s \xe2\x80\x9cpurpose\xe2\x80\x9d in undertaking or defending a particular\npiece of litigation would encourage resort to formalism and artificial distinctions.\nFor instance, in this case, there can be no doubt that legal, accounting, and appraisal\ncosts incurred by taxpayers in negotiating a purchase of the minority stock would\nhave been capital expenditures. See Atzingen-Whitehouse Dairy Inc. v.\nCommissioner, 36 T.C. 173 (1961). Under whatever test might be applied, such\nexpenses would have clearly been \xe2\x80\x9cpart of the acquisition cost\xe2\x80\x9d of the stock.\nHelvering v. Winmill, supra. Yet the appraisal proceeding was no more than the\nsubstitute that state law provided for the process of negotiation as a means of fixing\nthe price at which the stock was to be purchased. Allowing deduction of expenses\nincurred in such a proceeding, merely on the ground that title was not directly put\nin question in the particular litigation, would be anomalous.\nFurther, a standard based on the origin of the claim litigated comports with this\nCourt\xe2\x80\x99s recent ruling on the characterization of litigation expenses for tax purposes\nin United States v. Gilmore, 372 U.S. 39 (1963). This Court there held that the\nexpense of defending a divorce suit was a nondeductible personal expense, even\nthough the outcome of the divorce case would affect the taxpayer\xe2\x80\x99s property\nholdings, and might affect his business reputation. The Court rejected a test that\nlooked to the consequences of the litigation, and did not even consider the\ntaxpayer\xe2\x80\x99s motives or purposes in undertaking defense of the litigation, but rather\nexamined the origin and character of the claim against the taxpayer, and found that\nthe claim arose out of the personal relationship of marriage.\nThe standard here pronounced may, like any standard, present borderline cases, in\nwhich it is difficult to determine whether the origin of particular litigation lies in\nthe process of acquisition. [footnote omitted] This is not such a borderline case.\nHere state law required taxpayers to \xe2\x80\x9cpurchase\xe2\x80\x9d the stock owned by the dissenter.\nIn the absence of agreement on the price at which the purchase was to be made,\nlitigation was required to fix the price. Where property is acquired by purchase,\nnothing is more clearly part of the process of acquisition than the establishment of\na purchase price.93 Thus, the expenses incurred in that litigation were properly\n... [W]herever a capital asset is transferred to a new owner in exchange for value either agreed upon\nor determined by law to be a fair quid pro quo, the payment itself is a capital expenditure, and there is\nno reason why the costs of determining the amount of that payment should be considered capital in the\ncase of the negotiated price and yet considered deductible in the case of the price fixed by law. See Isaac\n93\n\n285\n\n\x0ctreated as part of the cost of the stock that the taxpayers acquired.\nAffirmed.\nNotes and Questions:\n1. Will taxpayers be permitted to claim depreciation or amortization deductions for\nthe expenditures in question? Why or why not?\n2. This case arose under \xc2\xa7 212, not \xc2\xa7 162. Section 212 deductions are\n\xe2\x80\x9cmiscellaneous deductions\xe2\x80\x9d under \xc2\xa7 67 and are disallowed until tax year 2026.\n\xc2\xa7 67(g). However, \xc2\xa7 162 and \xc2\xa7 212 are in pari materia with each other. See the\nCourt\xe2\x80\x99s first footnote.\n3. M owned certain real estate in Memphis, Tennessee. In 2018, M entered into\ncontracts to lease the properties for a term of fifty years, and in 2018 paid\ncommissions and fees to a real estate broker and attorney for services in obtaining\nthe contracts.\n\xe2\x80\xa2For tax purposes, how should M treat the real estate brokerage\ncommissions?\n\xe2\x80\xa2See Renwick v. United States, 87 F.2d 123, 125 (7th Cir. 1936); Meyran v.\nCommissioner, 63 F.2d 986 (3d Cir. 1933).\n4. S owned stock in several\ndifferent companies. He sold 100\nshares of IBM stock for a nice\nprofit and incurred a brokerage\ncommission of $500. For tax\npurposes, how should S treat the\nbrokerage commissions?\n\xe2\x80\xa2Does it make any difference\nwhether S treats the brokerage commission as an ordinary and necessary\nexpense of investment activity or as a decrease in his \xe2\x80\x9camount realized?\xe2\x80\x9d\n\xe2\x80\xa2See Spreckels v. Commissioner, 315 U.S. 626 (1942); cf. 67(g).\n\nStart-up Expenses of a Business: No deduction is\npermitted for the start-up expenses of a\nproprietorship (\xc2\xa7 195), corporation (\xc2\xa7 248), or\npartnership (\xc2\xa7 709) \xe2\x80\x93 except as specifically\nprovided. What would be the rationale of this\ntreatment?\n\nG. Johnson & Co. v. United States, 149 F.2d 851 (C.A.2d Cir.1945) (expenses of litigating amount of\nfair compensation in condemnation proceeding held capital expenditures).\n\n286\n\n\x0c5. W purchased the IBM stock that S sold, supra. W incurred a brokerage\ncommission of $500. For tax purposes, how should W treat the brokerage\ncommissions?\n\xe2\x80\xa2Does it make any difference whether W treats the brokerage commission\nas an ordinary and necessary expense of investment activity or as an\nincrease in his basis?\n\xe2\x80\xa2See Helvering v. Winmill, 305 U.S. 79 (1938).\nA. Expense or Capital: Cost of Constructing a Tangible Capital Asset\nWhat should be the tax treatment of the cost of taxpayer\xe2\x80\x99s self-construction of a\nproductive asset for it to use in its own business? Should there be a parallel between\nsuch activity and the tax treatment we accord imputed income?\nCommissioner v. Idaho Power Co., 418 U.S. 1 (1974)\nMR. JUSTICE BLACKMUN delivered the opinion of the Court.\nThis case presents the sole issue whether, for federal income tax purposes, a\ntaxpayer is entitled to a deduction from gross income, under [I.R.C.] \xc2\xa7 167(a) ...94\n... for depreciation on equipment the taxpayer owns and uses in the construction of\nits own capital facilities, or whether the capitalization provision of \xc2\xa7 263(a)(1) of\nthe Code95 ..., bars the deduction.\nThe taxpayer claimed the deduction, but the Commissioner ... disallowed it. The\nTax Court ... upheld the Commissioner\xe2\x80\x99s determination. The United States Court\nof Appeals for the Ninth Circuit, declining to follow a Court of Claims decision,\nSouthern Natural Gas Co. v. United States, 412 F.2d 1222, 1264-1269 (1969),\n94\n\n\xc2\xa7 167. Depreciation.\n(a) General rule. There shall be allowed as a depreciation deduction a reasonable allowance\nfor the exhaustion, wear and tear (including a reasonable allowance for obsolescence) \xe2\x80\x93\n(1) of property used in the trade or business, or\n(2) of property held for the production of income.\n\n95\n\n\xc2\xa7 263. Capital expenditures.\n(a) General rule. No deduction shall be allowed for \xe2\x80\x93\n(1) Any amount paid out for new buildings or for permanent improvements or\nbetterments made to increase the value of any property or estate.\n\n287\n\n\x0creversed. We granted certiorari in order to resolve the apparent conflict between the\nCourt of Claims and the Court of Appeals.\nI\n... The taxpayer-respondent, Idaho Power Company, ... is a public utility engaged\nin the production, transmission, distribution, and sale of electric energy. The\ntaxpayer keeps its books and files its federal income tax returns on the calendar\nyear accrual basis. The tax years at issue are 1962 and 1963.\nFor many years, the taxpayer has used its own equipment and employees in the\nconstruction of improvements and additions to its capital facilities. [footnote\nomitted]. The major work has consisted of transmission lines, transmission\nswitching stations, distribution lines, distribution stations, and connecting facilities.\nDuring 1962 and 1963, the tax years in question, taxpayer owned and used in its\nbusiness a wide variety of automotive transportation equipment, including\npassenger cars, trucks of all descriptions, power-operated equipment, and trailers.\nRadio communication devices were affixed to the equipment, and were used in its\ndaily operations. The transportation equipment was used in part for operation and\nmaintenance and in part for the construction of capital facilities having a useful life\nof more than one year.\n....\n... [O]n its books, in accordance with Federal Power Commission-Idaho Public\nUtilities Commission prescribed methods, the taxpayer capitalized the\nconstruction-related depreciation, but, for income tax purposes, that depreciation\nincrement was [computed on a composite life of ten years under straight-line and\ndeclining balance methods, and] claimed as a deduction under \xc2\xa7 167(a). [footnote\nomitted]\nUpon audit, the Commissioner ... disallowed the deduction for the constructionrelated depreciation. He ruled that that depreciation was a nondeductible capital\nexpenditure to which \xc2\xa7 263(a)(1) had application. He added the amount of the\ndepreciation so disallowed to the taxpayer\xe2\x80\x99s adjusted basis in its capital facilities,\nand then allowed a deduction for an appropriate amount of depreciation on the\naddition, computed over the useful life (30 years or more) of the property\nconstructed. A deduction for depreciation of the transportation equipment to the\nextent of its use in day-to-day operation and maintenance was also allowed. The\n288\n\n\x0cresult of these adjustments was the disallowance of depreciation, as claimed by the\ntaxpayer on its returns, in the net amounts of $140,429.75 and $96,811.95 for 1962\nand 1963, respectively. This gave rise to asserted deficiencies in taxpayer\xe2\x80\x99s income\ntaxes for those two years of $73,023.47 and $50,342.21.\nThe Tax Court agreed with the [Commissioner.] ...\nThe Court of Appeals, on the other hand, perceived in the ... Code ... the presence\nof a liberal congressional policy toward depreciation, the underlying theory of\nwhich is that capital assets used in business should not be exhausted without\nprovision for replacement. The court concluded that a deduction expressly\nenumerated in the Code, such as that for depreciation, may properly be taken, and\nthat \xe2\x80\x9cno exception is made should it relate to a capital item.\xe2\x80\x9d Section 263(a)(1) ...\nwas found not to be applicable, because depreciation is not an \xe2\x80\x9camount paid out,\xe2\x80\x9d\nas required by that section. ...\nThe taxpayer asserts that its transportation equipment is used in its \xe2\x80\x9ctrade or\nbusiness,\xe2\x80\x9d and that depreciation thereon is therefore deductible under \xc2\xa7 167(a)(1)\n... The Commissioner concedes that \xc2\xa7 167 may be said to have a literal application\nto depreciation on equipment used in capital construction,96 but contends that the\nprovision must be read in light of \xc2\xa7 263(a)(1), which specifically disallows any\ndeduction for an amount \xe2\x80\x9cpaid out for new buildings or for permanent\nimprovements or betterments.\xe2\x80\x9d He argues that \xc2\xa7 263 takes precedence over \xc2\xa7 167\nby virtue of what he calls the \xe2\x80\x9cpriority-ordering\xe2\x80\x9d terms (and what the taxpayer\ndescribes as \xe2\x80\x9chousekeeping\xe2\x80\x9d provisions) of \xc2\xa7 161 of the Code97 ... and that sound\nprinciples of accounting and taxation mandate the capitalization of this\ndepreciation.\nIt is worth noting the various items that are not at issue here. ... There is no\nFor purposes of the issue here presented, the key phrase of \xc2\xa7 167(a)(1) is \xe2\x80\x9cproperty used in the trade\nor business.\xe2\x80\x9d ...\n96\n\nSince the Commissioner appears to have conceded the literal application of \xc2\xa7 167(a) to Idaho Power\xe2\x80\x99s\nequipment depreciation, we need not reach the issue whether the Court of Appeals has given the phrase\n\xe2\x80\x9cused in the trade or business\xe2\x80\x9d a proper construction. For purposes of this case, we assume, without\ndeciding, that \xc2\xa7 167(a) does have a literal application to the depreciation of the taxpayer\xe2\x80\x99s transportation\nequipment used in the construction of its capital improvements.\n\xc2\xa7 161. Allowance of deductions. In computing taxable income under \xc2\xa7 63(a), there shall be allowed\nas deductions the items specified in this part, subject to the exceptions provided in part IX (\xc2\xa7\xc2\xa7 261 and\nfollowing, relating to items not deductible).\xe2\x80\x9d\n97\n\n289\n\n\x0cdisagreement as to the allocation of depreciation between construction and\nmaintenance. The issue thus comes down primarily to a question of timing, ... that\nis, whether the construction-related depreciation is to be amortized and deducted\nover the shorter life of the equipment or, instead, is to be amortized and deducted\nover the longer life of the capital facilities constructed.\nII\nOur primary concern is with the necessity to treat construction-related depreciation\nin a manner that comports with accounting and taxation realities. Over a period of\ntime, a capital asset is consumed and, correspondingly over that period, its\ntheoretical value and utility are thereby reduced. Depreciation is an accounting\ndevice which recognizes that the physical consumption of a capital asset is a true\ncost, since the asset is being depleted.98 As the process of consumption continues,\nand depreciation is claimed and allowed, the asset\xe2\x80\x99s adjusted income tax basis is\nreduced to reflect the distribution of its cost over the accounting periods affected.\nThe Court stated in Hertz Corp. v. United States, 364 U.S. 122, 126 (1960): [T]he\npurpose of depreciation accounting is to allocate the expense of using an asset to\nthe various periods which are benefited by that asset. [citations omitted]. When the\nasset is used to further the taxpayer\xe2\x80\x99s day-to-day business operations, the periods\nof benefit usually correlate with the production of income. Thus, to the extent that\nequipment is used in such operations, a current depreciation deduction is an\nappropriate offset to gross income currently produced. It is clear, however, that\ndifferent principles are implicated when the consumption of the asset takes place in\nthe construction of other assets that, in the future, will produce income themselves.\nIn this latter situation, the cost represented by depreciation does not correlate with\nproduction of current income. Rather, the cost, although certainly presently\nincurred, is related to the future and is appropriately allocated as part of the cost of\nacquiring an income-producing capital asset.\nThe Court of Appeals opined that the purpose of the depreciation allowance under\nThe Committee on Terminology of the American Institute of Certified Public Accountants has\ndiscussed various definitions of depreciation and concluded that:\n98\n\nThese definitions view depreciation, broadly speaking, as describing not downward changes\nof value regardless of their causes, but a money cost incident to exhaustion of usefulness. The\nterm is sometimes applied to the exhaustion itself, but the committee considers it desirable to\nemphasize the cost concept as the primary, if not the sole, accounting meaning of the term:\nthus, depreciation means the cost of such exhaustion, as wages means the cost of labor.\xe2\x80\x9d 2\nAPB Accounting Principles, Accounting Terminology Bulletin No. 1 -- Review and Resume\n48, p. 9512 (1973) (emphasis in original).\n\n290\n\n\x0cthe Code was to provide a means of cost recovery, Knoxville v. Knoxville Water\nCo., 212 U.S. 1, 13-14 (1909), and that this Court\xe2\x80\x99s decisions, e.g., Detroit Edison\nCo. v. Commissioner, 319 U.S. 98, 101 (1943), endorse a theory of replacement\nthrough \xe2\x80\x9ca fund to restore the property.\xe2\x80\x9d Although tax-free replacement of a\ndepreciating investment is one purpose of depreciation accounting, it alone does\nnot require the result claimed by the taxpayer here. Only last Term, in United States\nv. Chicago, B. & Q. R. Co., 412 U.S. 401 (1973), we rejected replacement as the\nstrict and sole purpose of depreciation:\n\xe2\x80\x9cWhatever may be the desirability of creating a depreciation reserve under\nthese circumstances, as a matter of good business and accounting practice,\nthe answer is ... [depreciation] reflects the cost of an existing capital asset,\nnot the cost of a potential replacement.\xe2\x80\x9d Id. at 415.\nEven were we to look to replacement, it is the replacement of the constructed\nfacilities, not the equipment used to build them, with which we would be concerned.\nIf the taxpayer now were to decide not to construct any more capital facilities with\nits own equipment and employees, it, in theory, would have no occasion to replace\nits equipment to the extent that it was consumed in prior construction.\nAccepted accounting practice99 and established tax principles require the\ncapitalization of the cost of acquiring a capital asset. In Woodward v.\nCommissioner, 397 U.S. 572, 575 (1970), the Court observed: \xe2\x80\x9cIt has long been\nrecognized, as a general matter, that costs incurred in the acquisition ... of a capital\nasset are to be treated as capital expenditures.\xe2\x80\x9d This principle has obvious\napplication to the acquisition of a capital asset by purchase, but it has been applied,\nas well, to the costs incurred in a taxpayer\xe2\x80\x99s construction of capital facilities.\n[citations omitted]. [footnote omitted]\nThere can be little question that other construction-related expense items, such as\ntools, materials, and wages paid construction workers, are to be treated as part of\nThe general proposition that good accounting practice requires capitalization of the cost of acquiring\na capital asset is not seriously open to question. The Commissioner urges, however, that accounting\nmethods, as a rule, require the treatment of construction-related depreciation of equipment as a capital\ncost of the facility constructed. Indeed, there is accounting authority for this. See, e.g., W. PATON, ASSET\nACCOUNTING 188, 192-193 (1952); H. FINNEY & H. MILLER, PRINCIPLES OF ACCOUNTING \xe2\x80\x93\nINTRODUCTORY 246-247 (6th ed. 1963) (depreciation as an expense should be matched with the\nproduction of income); W. PATON, ACCOUNTANTS\xe2\x80\x99 HANDBOOK 652 (3d ed. 1943); Note, 1973 DUKE\nL.J. 1377, 1384; Note, 52 N.C. L. REV. 684, 692 (1974).\n99\n\n291\n\n\x0cthe cost of acquisition of a capital asset. The taxpayer does not dispute this. Of\ncourse, reasonable wages paid in the carrying on of a trade or business qualify as a\ndeduction from gross income. \xc2\xa7 162(a)(1) ... But when wages are paid in connection\nwith the construction or acquisition of a capital asset, they must be capitalized, and\nare then entitled to be amortized over the life of the capital asset so acquired.\n[citations omitted].\nConstruction-related depreciation is not unlike expenditures for wages for\nconstruction workers. The significant fact is that the exhaustion of construction\nequipment does not represent the final disposition of the taxpayer\xe2\x80\x99s investment in\nthat equipment; rather, the investment in the equipment is assimilated into the cost\nof the capital asset constructed. Construction-related depreciation on the equipment\nis not an expense to the taxpayer of its day-to-day business. It is, however,\nappropriately recognized as a part of the taxpayer\xe2\x80\x99s cost or investment in the capital\nasset. ... By the same token, this capitalization prevents the distortion of income\nthat would otherwise occur if depreciation properly allocable to asset acquisition\nwere deducted from gross income currently realized. [citations omitted].\nAn additional pertinent factor is that capitalization of construction-related\ndepreciation by the taxpayer who does its own construction work maintains tax\nparity with the taxpayer who has its construction work done by an independent\ncontractor. The depreciation on the contractor\xe2\x80\x99s equipment incurred during the\nperformance of the job will be an element of cost charged by the contractor for his\nconstruction services, and the entire cost, of course, must be capitalized by the\ntaxpayer having the construction work performed. The Court of Appeals\xe2\x80\x99 holding\nwould lead to disparate treatment among taxpayers, because it would allow the firm\nwith sufficient resources to construct its own facilities and to obtain a current\ndeduction, whereas another firm without such resources would be required to\ncapitalize its entire cost, including depreciation charged to it by the contractor.\n....\n[Taxpayer argued that the language of \xc2\xa7 263(a)(1), which denies a current\ndeduction for \xe2\x80\x9cnew buildings or for permanent improvements or betterments,\xe2\x80\x9d only\napplies when taxpayer has \xe2\x80\x9cpaid out\xe2\x80\x9d an \xe2\x80\x9camount.\xe2\x80\x9d Depreciation, taxpayer argued,\nrepresented a decrease in value \xe2\x80\x93 not an \xe2\x80\x9camount ... paid out.\xe2\x80\x9d The Court rejected\nthis limitation on \xc2\xa7 263\'s applicability. Instead, the Court accepted the IRS\xe2\x80\x99s\nadministrative construction of that phrase to mean \xe2\x80\x9ccost incurred.\xe2\x80\x9d Constructionrelated depreciation is such a cost.] In acquiring the transportation equipment,\n292\n\n\x0ctaxpayer \xe2\x80\x9cpaid out\xe2\x80\x9d the equipment\xe2\x80\x99s purchase price; depreciation is simply the\nmeans of allocating the payment over the various accounting periods affected. As\nthe Tax Court stated in Brooks v. Commissioner, 50 T.C. at 935, \xe2\x80\x9cdepreciation \xe2\x80\x93\ninasmuch as it represents a using up of capital \xe2\x80\x93 is as much an expenditure\xe2\x80\x99 as the\nusing up of labor or other items of direct cost.\xe2\x80\x9d\nFinally, the priority-ordering directive of \xc2\xa7 161 \xe2\x80\x93 or, for that matter, ... \xc2\xa7 261100 \xe2\x80\x93\nrequires that the capitalization provision of \xc2\xa7 263(a) take precedence, on the facts\nhere, over \xc2\xa7 167(a). Section 161 provides that deductions specified in Part VI of\nSubchapter B of the Income Tax Subtitle of the Code are \xe2\x80\x9csubject to the exceptions\nprovided in part IX.\xe2\x80\x9d Part VI includes \xc2\xa7 167, and Part IX includes \xc2\xa7 263. The clear\nimport of \xc2\xa7 161 is that, with stated exceptions set forth either in \xc2\xa7 263 itself or\nprovided for elsewhere (as, for example, in \xc2\xa7 404, relating to pension\ncontributions), none of which is applicable here, an expenditure incurred in\nacquiring capital assets must be capitalized even when the expenditure otherwise\nmight be deemed deductible under Part VI.\nThe Court of Appeals concluded, without reference to \xc2\xa7 161, that \xc2\xa7 263 did not\napply to a deduction, such as that for depreciation of property used in a trade or\nbusiness, allowed by the Code even though incurred in the construction of capital\nassets. [footnote omitted] We think that the court erred in espousing so absolute a\nrule, and it obviously overlooked the contrary direction of \xc2\xa7 161. To the extent that\nreliance was placed on the congressional intent, in the evolvement of the 1954\nCode, to provide for \xe2\x80\x9cliberalization of depreciation,\xe2\x80\x9d H.R. Rep. No. 1337, 83d\nCong., 2d Sess., 22 (1954), that reliance is misplaced. The House Report also states\nthat the depreciation provisions would \xe2\x80\x9cgive the economy added stimulus and\nresilience without departing from realistic standards of depreciation accounting.\xe2\x80\x9d\nId. at 24. To be sure, the 1954 Code provided for new and accelerated methods for\ndepreciation, resulting in the greater depreciation deductions currently available.\nThese changes, however, relate primarily to computation of depreciation. Congress\ncertainly did not intend that provisions for accelerated depreciation should be\nconstrued as enlarging the class of depreciable assets to which \xc2\xa7 167(a) has\napplication or as lessening the reach of \xc2\xa7 263(a). [citation omitted].\n\n\xc2\xa7 261. General rule for disallowance of deductions. In computing taxable income no deduction\nshall in any case be allowed in respect of the items specified in this part.\n100\n\n293\n\n\x0cWe hold that the equipment depreciation allocable to taxpayer\xe2\x80\x99s construction of\ncapital facilities is to be capitalized.\nThe judgment of the Court of Appeals is reversed.\nIt is so ordered.\nMR. JUSTICE DOUGLAS, dissenting. [omitted].\nNotes and Questions:\n1. The Court noted that the net of taxpayer\xe2\x80\x99s disallowed depreciation deductions\nwas $140,429.75 and $96,811.95 for 1962 and 1963 respectively. The useful life of\nthe items that taxpayer was constructing was three or more times as long as the\nuseful life of the equipment it used to construct those items. This case is about the\nfraction of the figures noted here that taxpayer may deduct \xe2\x80\x93 after the item is placed\nin service.\n\xe2\x80\xa2Assuming straight-line depreciation of the equipment, the difference in the\nparties\xe2\x80\x99 treatment of a depreciation deduction was the difference between 1/10\nand 1/30 of 1/10 of the cost of equipment.\n2. Why do we allow deductions for\nTaxpayer\xe2\x80\x99s books and taxpayer\xe2\x80\x99s tax books:\ndepreciation? Is it that \xe2\x80\x93\nDistinguish between taxpayer\xe2\x80\x99s books (\xe2\x80\x9cits\n\xe2\x80\xa2\xe2\x80\x9ccapital assets used in\nbooks\xe2\x80\x9d) and taxpayer\xe2\x80\x99s tax books (\xe2\x80\x9cfor\nbusiness should not be\nfederal income tax purposes\xe2\x80\x9d). For what\nexhausted without provision\npurposes does taxpayer keep each set of\nfor replacement\xe2\x80\x9d?\nbooks? Do you think that they would ever be\n\xe2\x80\xa2physical consumption of a\ndifferent? Why or why not?\ncapital asset reduces its value\nand utility, and a depreciation\ndeduction implicitly recognizes this.\n\xe2\x80\xa2obsolescence may reduce the value and utility of an asset, even if the asset\nis not exhausted and could still function, e.g., a twenty-year old personal\ncomputer? See the Court\xe2\x80\x99s fifth footnote.\n\xe2\x80\xa2a depreciation deduction in effect allocates the expense of using an asset to\nthe various periods which are benefitted by that asset?\nHow do these rationales apply to a case where taxpayer consumes depreciable\nassets in the construction of income-producing capital assets?\n294\n\n\x0c3. Aside from the Code\xe2\x80\x99s mandate in \xc2\xa7 1016(a)(2), why must a taxpayer reduce its\nadjusted basis in an asset subject to depreciation?\n4. How did the Court\xe2\x80\x99s treatment of depreciation in this case prevent the distortion\nof income?\n5. Why might Congress want\nto mismatch the timing of\nincome and expenses and\nthereby distort income?\n\nSections 161 and 261: How does the language of\n\xc2\xa7\xc2\xa7 161 and 261 create an ordering rule? What\ndeductions do \xc2\xa7\xc2\xa7 262 to 280H create?\n\n6. The case demonstrates again\nhow important the time value of money is.\nB. Expense or Capital: Cost of \xe2\x80\x9cConstructing\xe2\x80\x9d an Intangible Capital\nAsset\nWhat should be the rule when taxpayer self-creates an intangible asset that it can\nuse to generate taxable income? Are there any (obvious) difficulties to applying the\nrule of Idaho Power to such a situation? Identify what taxpayer in INDOPCO\nargued was the rule of Lincoln Savings? Would taxpayer\xe2\x80\x99s statement of that rule\nsolve those difficulties?\nINDOPCO, Inc. v. Commissioner, 503 U.S. 79 (1992)\nJUSTICE BLACKMUN delivered the opinion of the Court.\nIn this case we must decide whether certain professional expenses incurred by a\ntarget corporation in the course of a friendly takeover are deductible by that\ncorporation as \xe2\x80\x9cordinary and necessary\xe2\x80\x9d business expenses under \xc2\xa7 162(a) of the\nInternal Revenue Code.\nI\n... Petitioner INDOPCO, Inc., formerly named National Starch and Chemical\nCorporation and hereinafter referred to as National Starch, ... manufactures and\nsells adhesives, starches, and specialty chemical products. In October 1977,\nrepresentatives of Unilever United States, Inc., ... (Unilever), [footnote omitted]\n295\n\n\x0cexpressed interest in acquiring National Starch, which was one of its suppliers,\nthrough a friendly transaction. National Starch at the time had outstanding over\n6,563,000 common shares held by approximately 3,700 shareholders. The stock\nwas listed on the New York Stock Exchange. Frank and Anna Greenwall were the\ncorporation\xe2\x80\x99s largest shareholders and owned approximately 14.5% of the\ncommon. The Greenwalls, getting along in years and concerned about their estate\nplans, indicated that they would transfer their shares to Unilever only if a\ntransaction tax free for them could be arranged.\nLawyers representing both sides devised a \xe2\x80\x9creverse subsidiary cash merger\xe2\x80\x9d that\nthey felt would satisfy the Greenwalls\xe2\x80\x99 concerns. Two new entities would be\ncreated \xe2\x80\x93 National Starch and Chemical Holding Corp. (Holding), a subsidiary of\nUnilever, and NSC Merger, Inc., a subsidiary of Holding that would have only a\ntransitory existence. ... [Some of National Starch\xe2\x80\x99s shares were exchanged for\npreferred shares of Unilever (not taxed), and some were exchanged for cash\n(taxed).]\nIn November 1977, National Starch\xe2\x80\x99s directors were formally advised of Unilever\xe2\x80\x99s\ninterest and the proposed transaction. At that time, Debevoise, Plimpton, Lyons &\nGates, National Starch\xe2\x80\x99s counsel, told the directors that under Delaware law they\nhad a fiduciary duty to ensure that the proposed transaction would be fair to the\nshareholders. National Starch thereupon engaged the investment banking firm of\nMorgan Stanley & Co., Inc., to evaluate its shares, to render a fairness opinion, and\ngenerally to assist in the event of the emergence of a hostile tender offer.\nAlthough Unilever originally had suggested a price between $65 and $70 per share,\nnegotiations resulted in a final offer of $73.50 per share, a figure Morgan Stanley\nfound to be fair. Following approval by National Starch\xe2\x80\x99s board and the issuance\nof a favorable private ruling from the Internal Revenue Service that the transaction\nwould be tax free ... for those National Starch shareholders who exchanged their\nstock for Holding preferred, the transaction was consummated in August 1978.101\nMorgan Stanley charged National Starch a fee of $2,200,000, along with $7,586 for\nout-of-pocket expenses and $18,000 for legal fees. The Debevoise firm charged\nNational Starch $490,000, along with $15,069 for out-of-pocket expenses. National\nStarch also incurred expenses aggregating $150,962 for miscellaneous items \xe2\x80\x93 such\nApproximately 21% of National Starch common was exchanged for Holding preferred. The\nremaining 79% was exchanged for cash.\n101\n\n296\n\n\x0cas accounting, printing, proxy solicitation, and Securities and Exchange\nCommission fees \xe2\x80\x93 in connection with the transaction. No issue is raised as to the\npropriety or reasonableness of these charges.\nOn its federal income tax return ... National Starch claimed a deduction for the\n$2,225,586 paid to Morgan Stanley, but did not deduct the $505,069 paid to\nDebevoise or the other expenses. Upon audit, the Commissioner of Internal\nRevenue disallowed the claimed deduction and issued a notice of deficiency.\nPetitioner sought redetermination in the United States Tax Court, asserting,\nhowever, not only the right to deduct the investment banking fees and expenses but,\nas well, the legal and miscellaneous expenses incurred.\nThe Tax Court, in an unreviewed decision, ruled that the expenditures were capital\nin nature and therefore not deductible under \xc2\xa7 162(a) in the 1978 return as \xe2\x80\x9cordinary\nand necessary expenses.\xe2\x80\x9d The court based its holding primarily on the long-term\nbenefits that accrued to National Starch from the Unilever acquisition. The United\nStates Court of Appeals for the Third Circuit affirmed, upholding the Tax Court\xe2\x80\x99s\nfindings that \xe2\x80\x9cboth Unilever\xe2\x80\x99s enormous resources and the possibility of synergy\narising from the transaction served the long-term betterment of National Starch.\xe2\x80\x9d\nIn so doing, the Court of Appeals rejected National Starch\xe2\x80\x99s contention that,\nbecause the disputed expenses did not \xe2\x80\x9ccreate or enhance ... a separate and distinct\nadditional asset,\xe2\x80\x9d see Commissioner v. Lincoln Savings & Loan Assn., 403 U.S.\n345, 354 (1971), they could not be capitalized and therefore were deductible under\n\xc2\xa7 162(a). We granted certiorari to resolve a perceived conflict on the issue among\nthe Courts of Appeals.102\nII\nSection 162(a) ... allows the deduction of \xe2\x80\x9call the ordinary and necessary expenses\npaid or incurred during the taxable year in carrying on any trade or business.\xe2\x80\x9d In\ncontrast, \xc2\xa7 263 ... allows no deduction for a capital expenditure \xe2\x80\x93 an \xe2\x80\x9camount paid\nCompare the Third Circuit\xe2\x80\x99s opinion, 918 F.2d at 430, with NCNB Corp. v. United States, 684 F.2d 285,\n293-294 (4th Cir. 1982) (bank expenditures for expansion-related planning reports, feasibility studies,\nand regulatory applications did not \xe2\x80\x9ccreate or enhance separate and identifiable assets,\xe2\x80\x9d and therefore\nwere ordinary and necessary expenses under \xc2\xa7 162(a)), and Briarcliff Candy Corp. v. Commissioner, 475 F.2d\n775, 782 (2d Cir. 1973) (suggesting that Lincoln Savings \xe2\x80\x9cbrought about a radical shift in emphasis,\xe2\x80\x9d\nmaking capitalization dependent on whether the expenditure creates or enhances a separate and distinct\nadditional asset). See also Central Texas Savings & Loan Assn. v. United States, 731 F.2d 1181, 1184 (5th Cir.\n1984) (inquiring whether establishment of new branches \xe2\x80\x9ccreates a separate and distinct additional\nasset\xe2\x80\x9d so that capitalization is the proper tax treatment).\n102\n\n297\n\n\x0cout for new buildings or for permanent improvements or betterments made to\nincrease the value of any property or estate.\xe2\x80\x9d \xc2\xa7 263(a)(1). The primary effect of\ncharacterizing a payment as either a business expense or a capital expenditure\nconcerns the timing of the taxpayer\xe2\x80\x99s cost recovery: While business expenses are\ncurrently deductible, a capital expenditure usually is amortized and depreciated\nover the life of the relevant asset, or, where no specific asset or useful life can be\nascertained, is deducted upon dissolution of the enterprise. See 26 U.S.C. \xc2\xa7\xc2\xa7 167(a)\nand 336(a); Reg. \xc2\xa7 1.167(a) (1991). Through provisions such as these, the Code\nendeavors to match expenses with the revenues of the taxable period to which they\nare properly attributable, thereby resulting in a more accurate calculation of net\nincome for tax purposes. See, e. g., Commissioner v. Idaho Power Co., 418 U.S. 1,\n16 (1974); Ellis Banking Corp. v. Commissioner, 688 F.2d 1376, 1379 (CA ll 1982),\ncert. denied, 463 U.S. 1207 (1983).\nIn exploring the relationship between deductions and capital expenditures, this\nCourt has noted the \xe2\x80\x9cfamiliar rule\xe2\x80\x9d that \xe2\x80\x9can income tax deduction is a matter of\nlegislative grace and that the burden of clearly showing the right to the claimed\ndeduction is on the taxpayer.\xe2\x80\x9d Interstate Transit Lines v. Commissioner, 319 U.S.\n590, 593 (1943); Deputy v. Du Pont, 308 U.S. 488, 493 (1940); New Colonial Ice\nCo. v. Helvering, 292 U.S. 435, 440 (1934). The notion that deductions are\nexceptions to the norm of capitalization finds support in various aspects of the\nCode. Deductions are specifically enumerated and thus are subject to disallowance\nin favor of capitalization. See \xc2\xa7\xc2\xa7 161 and 261. Nondeductible capital expenditures,\nby contrast, are not exhaustively enumerated in the Code; rather than providing a\n\xe2\x80\x9ccomplete list of nondeductible expenditures,\xe2\x80\x9d Lincoln Savings, 403 U.S. at 358,\n\xc2\xa7 263 serves as a general means of distinguishing capital expenditures from current\nexpenses. See Commissioner v. Idaho Power Co., 418 U.S. at 16. For these reasons,\ndeductions are strictly construed and allowed only \xe2\x80\x9cas there is a clear provision\ntherefor.\xe2\x80\x9d New Colonial Ice Co. v. Helvering, 292 U.S., at 440; Deputy v. Du Pont,\n308 U.S., at 493. [footnote omitted]\nThe Court also has examined the interrelationship between the Code\xe2\x80\x99s business\nexpense and capital expenditure provisions. [footnote omitted.] In so doing, it has\nhad occasion to parse \xc2\xa7 162(a) and explore certain of its requirements. For example,\nin Lincoln Savings, we determined that, to qualify for deduction under \xc2\xa7 162(a),\n\xe2\x80\x9can item must (1) be \xe2\x80\x98paid or incurred during the taxable year,\xe2\x80\x99 (2) be for \xe2\x80\x98carrying\non any trade or business,\xe2\x80\x99 (3) be an \xe2\x80\x98expense,\xe2\x80\x99 (4) be a \xe2\x80\x98necessary\xe2\x80\x99 expense, and (5)\nbe an \xe2\x80\x98ordinary\xe2\x80\x99 expense.\xe2\x80\x9d 403 U.S. at 352. See also Commissioner v. Tellier, 383\nU.S. 687, 689 (1966) (the term \xe2\x80\x9cnecessary\xe2\x80\x9d imposes \xe2\x80\x9conly the minimal requirement\n298\n\n\x0cthat the expense be \xe2\x80\x98appropriate and helpful\xe2\x80\x99 for \xe2\x80\x98the development of the\n[taxpayer\xe2\x80\x99s] business,\xe2\x80\x99\xe2\x80\x9d quoting Welch v. Helvering, 290 U.S. 111, 113 (1933));\nDeputy v. Du Pont, 308 U.S. at 495 (to qualify as \xe2\x80\x9cordinary,\xe2\x80\x9d the expense must\nrelate to a transaction \xe2\x80\x9cof common or frequent occurrence in the type of business\ninvolved\xe2\x80\x9d). The Court has recognized, however, that the \xe2\x80\x9cdecisive distinctions\xe2\x80\x9d\nbetween current expenses and capital expenditures \xe2\x80\x9care those of degree and not of\nkind,\xe2\x80\x9d Welch v. Helvering, 290 U.S. at 114, and that because each case \xe2\x80\x9cturns on\nits special facts,\xe2\x80\x9d Deputy v. Du Pont, 308 U.S. at 496, the cases sometimes appear\ndifficult to harmonize. See Welch v. Helvering, 290 U.S. at 116.\nNational Starch contends that the decision in Lincoln Savings changed these\nfamiliar backdrops and announced an exclusive test for identifying capital\nexpenditures, a test in which \xe2\x80\x9ccreation or enhancement of an asset\xe2\x80\x9d is a prerequisite\nto capitalization, and deductibility under \xc2\xa7 162(a) is the rule rather than the\nexception. We do not agree, for we conclude that National Starch has overread\nLincoln Savings.\nIn Lincoln Savings, we were asked to decide whether certain premiums, required\nby federal statute to be paid by a savings and loan association to the Federal Savings\nand Loan Insurance Corporation (FSLIC), were ordinary and necessary expenses\nunder \xc2\xa7 162(a), as Lincoln Savings argued and the Court of Appeals had held, or\ncapital expenditures under \xc2\xa7 263, as the Commissioner contended. We found that\nthe \xe2\x80\x9cadditional\xe2\x80\x9d premiums, the purpose of which was to provide FSLIC with a\nsecondary reserve fund in which each insured institution retained a pro rata interest\nrecoverable in certain situations, \xe2\x80\x9cserv[e] to create or enhance for Lincoln what is\nessentially a separate and distinct additional asset.\xe2\x80\x9d 403 U.S. at 354. \xe2\x80\x9c[A]s an\ninevitable consequence,\xe2\x80\x9d we concluded, \xe2\x80\x9cthe payment is capital in nature and not\nan expense, let alone an ordinary expense, deductible under \xc2\xa7 162(a).\xe2\x80\x9d Ibid.\nLincoln Savings stands for the simple proposition that a taxpayer\xe2\x80\x99s expenditure that\n\xe2\x80\x9cserves to create or enhance ... a separate and distinct\xe2\x80\x9d asset should be capitalized\nunder \xc2\xa7 263. It by no means follows, however, that only expenditures that create or\nenhance separate and distinct assets are to be capitalized under \xc2\xa7 263. We had no\noccasion in Lincoln Savings to consider the tax treatment of expenditures that,\nunlike the additional premiums at issue there, did not create or enhance a specific\nasset, and thus the case cannot be read to preclude capitalization in other\ncircumstances. In short, Lincoln Savings holds that the creation of a separate and\ndistinct asset well may be a sufficient, but not a necessary, condition to\nclassification as a capital expenditure. See General Bancshares Corp. v.\n299\n\n\x0cCommissioner, 326 F.2d 712, 716 (CA8) (although expenditures may not \xe2\x80\x9cresul[t]\nin the acquisition or increase of a corporate asset, ... these expenditures are not,\nbecause of that fact, deductible as ordinary and necessary business expenses\xe2\x80\x9d), cert.\ndenied, 379 U.S. 832 (1964).\nNor does our statement in Lincoln Savings, 403 U.S. at 354, that \xe2\x80\x9cthe presence of\nan ensuing benefit that may have some future aspect is not controlling\xe2\x80\x9d prohibit\nreliance on future benefit as a means of distinguishing an ordinary business expense\nfrom a capital expenditure.103 Although the mere presence of an incidental future\nbenefit \xe2\x80\x93 \xe2\x80\x9csome future aspect\xe2\x80\x9d \xe2\x80\x93 may not warrant capitalization, a taxpayer\xe2\x80\x99s\nrealization of benefits beyond the year in which the expenditure is incurred is\nundeniably important in determining whether the appropriate tax treatment is\nimmediate deduction or capitalization. See United States v. Mississippi Chemical\nCorp., 405 U.S. 298, 310 (1972) (expense that \xe2\x80\x9cis of value in more than one taxable\nyear\xe2\x80\x9d is a nondeductible capital expenditure); Central Texas Savings & Loan Assn.\nv. United States, 731 F.2d 1181, 1183 (CA5 1984) (\xe2\x80\x9cWhile the period of the\nbenefits may not be controlling in all cases, it nonetheless remains a prominent, if\nnot predominant, characteristic of a capital item\xe2\x80\x9d). Indeed, the text of the Code\xe2\x80\x99s\ncapitalization provision, \xc2\xa7 263(a)(1), which refers to \xe2\x80\x9cpermanent improvements or\nbetterments,\xe2\x80\x9d itself envisions an inquiry into the duration and extent of the benefits\nrealized by the taxpayer.\nIII\nIn applying the foregoing principles to the specific expenditures at issue in this case,\nwe conclude that National Starch has not demonstrated that the investment banking,\nlegal, and other costs it incurred in connection with Unilever\xe2\x80\x99s acquisition of its\nshares are deductible as ordinary and necessary business expenses under \xc2\xa7 162(a).\nAlthough petitioner attempts to dismiss the benefits that accrued to National Starch\nfrom the Unilever acquisition as \xe2\x80\x9centirely speculative\xe2\x80\x9d or \xe2\x80\x9cmerely incidental,\xe2\x80\x9d the\nTax Court\xe2\x80\x99s and the Court of Appeals\xe2\x80\x99 findings that the transaction produced\nsignificant benefits to National Starch that extended beyond the tax year in question\nare amply supported by the record. For example, in commenting on the merger with\nUnilever, National Starch\xe2\x80\x99s 1978 \xe2\x80\x9cProgress Report\xe2\x80\x9d observed that the company\nPetitioner contends that, absent a separate-and-distinct-asset requirement for capitalization, a\ntaxpayer will have no \xe2\x80\x9cprincipled basis\xe2\x80\x9d upon which to differentiate business expenses from capital\nexpenditures. We note, however, that grounding tax status on the existence of an asset would be unlikely\nto produce the bright-line rule that petitioner desires, given that the notion of an \xe2\x80\x9casset\xe2\x80\x9d is itself flexible\nand amorphous. See Johnson, 53 TAX NOTES, at 477-478.\n103\n\n300\n\n\x0cwould \xe2\x80\x9cbenefit greatly from the availability of Unilever\xe2\x80\x99s enormous resources,\nespecially in the area of basic technology.\xe2\x80\x9d (Unilever \xe2\x80\x9cprovides new opportunities\nand resources\xe2\x80\x9d). Morgan Stanley\xe2\x80\x99s report to the National Starch board concerning\nthe fairness to shareholders of a possible business combination with Unilever noted\nthat National Starch management \xe2\x80\x9cfeels that some synergy may exist with the\nUnilever organization given a) the nature of the Unilever chemical, paper, plastics\nand packaging operations ... and b) the strong consumer products orientation of\nUnilever United States, Inc.\xe2\x80\x9d\nIn addition to these anticipated resource-related benefits, National Starch obtained\nbenefits through its transformation from a publicly held, freestanding corporation\ninto a wholly owned subsidiary of Unilever. The Court of Appeals noted that\nNational Starch management viewed the transaction as \xe2\x80\x9c\xe2\x80\x98swapping approximately\n3500 shareholders for one.\xe2\x80\x99\xe2\x80\x9d Following Unilever\xe2\x80\x99s acquisition of National Starch\xe2\x80\x99s\noutstanding shares, National Starch was no longer subject to what even it terms the\n\xe2\x80\x9csubstantial\xe2\x80\x9d shareholder-relations expenses a publicly traded corporation incurs,\nincluding reporting and disclosure obligations, proxy battles, and derivative suits.\nThe acquisition also allowed National Starch, in the interests of administrative\nconvenience and simplicity, to eliminate previously authorized but unissued shares\nof preferred and to reduce the total number of authorized shares of common from\n8,000,000 to 1,000.\nCourts long have recognized that expenses such as these, \xe2\x80\x9c\xe2\x80\x98incurred for the purpose\nof changing the corporate structure for the benefit of future operations are not\nordinary and necessary business expenses.\xe2\x80\x99\xe2\x80\x9d General Bancshares Corp. v.\nCommissioner, 326 F.2d, at 715 (quoting Farmers Union Corp. v. Commissioner,\n300 F.2d 197, 200 (CA9), cert. denied, 371 U.S. 861 (1962)). See also B. BITTKER\n& J. EUSTICE, FEDERAL INCOME TAXATION OF CORPORATIONS AND SHAREHOLDERS\n5-33 to 5-36 (5th ed. 1987) (describing \xe2\x80\x9cwell-established rule\xe2\x80\x9d that expenses\nincurred in reorganizing or restructuring corporate entity are not deductible under\n\xc2\xa7 162(a)). Deductions for professional expenses thus have been disallowed in a\nwide variety of cases concerning changes in corporate structure.104 Although\nsupport for these decisions can be found in the specific terms of \xc2\xa7 162(a), which\nSee, e.g. McCrory Corp. v. United States, 651 F.2d 828 (2d Cir. 1981) (statutory merger under 26 U.S.C.\n\xc2\xa7 368(a)(1)(A)); Bilar Tool & Die Corp. v. Commissioner, 530 F.2d 708 (6th Cir. 1976) (division of\ncorporation into two parts); E. I. du Pont de Nemours & Co. v. United States, 432 F.2d 1052 (3rd Cir. 1970)\n(creation of new subsidiary to hold assets of prior joint venture); General Bancshares Corp. v. Commissioner,\n326 F.2d 712, 715 (8th Cir.) (stock dividends), cert. denied, 379 U.S. 832 (1964); Mills Estate, Inc. v.\nCommissioner, 206 F.2d 244 (2d Cir. 1953) (recapitalization).\n104\n\n301\n\n\x0crequire that deductible expenses be \xe2\x80\x9cordinary and necessary\xe2\x80\x9d and incurred \xe2\x80\x9cin\ncarrying on any trade or business,\xe2\x80\x9d105 courts more frequently have characterized an\nexpenditure as capital in nature because \xe2\x80\x9cthe purpose for which the expenditure is\nmade has to do with the corporation\xe2\x80\x99s operations and betterment, sometimes with a\ncontinuing capital asset, for the duration of its existence or for the indefinite future\nor for a time somewhat longer than the current taxable year.\xe2\x80\x9d General Bancshares\nCorp. v. Commissioner, 326 F.2d at 715. See also Mills Estate, Inc. v.\nCommissioner, 206 F.2d 244, 246 (CA2 1953). The rationale behind these\ndecisions applies equally to the professional charges at issue in this case.\nIV\nThe expenses that National Starch incurred in Unilever\xe2\x80\x99s friendly takeover do not\nqualify for deduction as \xe2\x80\x9cordinary and necessary\xe2\x80\x9d business expenses under\n\xc2\xa7 162(a). The fact that the expenditures do not create or enhance a separate and\ndistinct additional asset is not controlling; the acquisition-related expenses bear the\nindicia of capital expenditures and are to be treated as such.\nThe judgment of the Court of Appeals is affirmed.\nIt is so ordered.\nNotes and Questions:\n1. The INDOPCO decision was not well received in the business community. Why\nnot?\n\xe2\x80\xa2Should taxpayer in INDOPCO amortize the intangible that it purchased? \xe2\x80\x93\nover what period?\n2. Capitalization of expenditures to construct a tangible asset followed by\ndepreciation, amortization, or cost recovery works more predictably than when\nexpenditures are directed towards the \xe2\x80\x9cconstruction\xe2\x80\x9d of an intangible asset. Why do\nSee, e.g., Motion Picture Capital Corp. v. Commissioner, 80 F.2d 872, 873-874 (CA2 1936) (recognizing\nthat expenses may be \xe2\x80\x9cordinary and necessary\xe2\x80\x9d to corporate merger, and that mergers may be \xe2\x80\x9cordinary\nand necessary business occurrences,\xe2\x80\x9d but declining to find that merger is part of \xe2\x80\x9cordinary and necessary\nbusiness activities,\xe2\x80\x9d and concluding that expenses are therefore not deductible); Greenstein, The\nDeductibility of Takeover Costs After National Starch, 69 TAXES 48, 49 (1991) (expenses incurred to facilitate\ntransfer of business ownership do not satisfy the \xe2\x80\x9ccarrying on [a] trade or business\xe2\x80\x9d requirement of\n\xc2\xa7 162(a)).\n105\n\n302\n\n\x0cyou think that this is so?\n\xe2\x80\xa2Perhaps because a tangible asset physically deteriorates over time and so\nits useful life is more easily determinable.\n3. Advertising and marketing campaigns: A marketing campaign requires current\nand future expenditures, but the \xe2\x80\x9casset\xe2\x80\x9d it creates (consumer loyalty? brand\nrecognition?) should endure past the end of the campaign. It is not even possible to\nknow when this asset no longer generates income \xe2\x80\x93 as would be the case with an\nasset as tangible as, say, a building. A rational approach to depreciation,\namortization, or cost recovery requires that we not only be able to recognize when\nan expenditure no longer generates income, but also be able to predict how long\nthat would be.\n\xe2\x80\xa2Consider expenditures for advertising. Not only do these problems emerge,\nbut answers would be different from one taxpayer to the next.\n4. The compliance costs of a rule that requires taxpayer to capitalize expenditures\nthat generate income into the future can be enormous. At least one case was litigated\nall the way to the Supreme Court. Cf. Newark Morning Ledger Co. v. United States,\n507 U.S. 546 (1993) (at-will subscription list is not goodwill and purchaser of\nnewspaper permitted to depreciate it upon proof of value and useful life).\n5. Perhaps there is something to be said for National Starch\xe2\x80\x99s contention that\ncapitalization required the \xe2\x80\x9ccreation or enhancement of a separate and distinct\nasset.\xe2\x80\x9d Moreover, its statement in the third footnote (\xe2\x80\x9cabsent a separate-anddistinct-asset requirement for capitalization, a taxpayer will have no \xe2\x80\x98principled\nbasis\xe2\x80\x99 upon which to differentiate business expenses from capital expenditures\xe2\x80\x9d)\njust might be accurate. The Court dismissed this argument in the next sentence of\nthe footnote by observing that the Court\xe2\x80\x99s position essentially is no worse than\ntaxpayer\xe2\x80\x99s.\n6. \xe2\x80\x9cDeduction rather than capitalization becomes more likely as the link between\nthe outlay and a readily identifiable asset decreases, and as the asset to which the\noutlay is linked becomes less and less tangible.\xe2\x80\x9d Joseph Bankman, The Story of\nINDOPCO: What Went Wrong in the Capitalization v. Deduction Debate, in TAX\nSTORIES 228 (Paul Caron ed., 2d ed. 2009).\n\xe2\x80\xa2\xe2\x80\x9cDeduction also becomes more likely for expenses that are recurring, or fit\nwithin a commonsense definition of ordinary and necessary.\xe2\x80\x9d Id.\n7. Lower courts gradually began to read Lincoln Savings as requiring the creation\n303\n\n\x0cor enhancement of a separate and distinct asset. Id. at 233.\n\xe2\x80\xa2Nevertheless, the Supreme Court was correct in its reading of Lincoln\nSavings to the effect \xe2\x80\x9cthat the creation of a separate and distinct asset well\nmay be a sufficient, but not a necessary, condition to classification as a\ncapital expenditure.\xe2\x80\x9d\n8. On the other hand, does the Court announce that the presence of \xe2\x80\x9csome future\nbenefit\xe2\x80\x9d is a sufficient condition to classification as a capital expenditure?\n9. The INDOPCO holding called into question many long-standing positions that\ntaxpayers had felt comfortable in taking. The cost of complete and literal\ncompliance with every ramification of the holding would have been enormous. The\nIRS produced some (favorable to the taxpayer) clarifications in revenue rulings\nconcerning the deductibility of certain expenditures. See Joseph Bankman, The\nStory of INDOPCO: What Went Wrong in the Capitalization v. Deduction Debate,\nin TAX STORIES 244-45 (Paul Caron ed., 2d ed. 2009). In 2004, the IRS published\nfinal regulations. Guidance Regarding Deduction and Capitalization of\nExpenditures, 69 Fed. Reg. 436 (Jan. 5, 2004). The regulations represented an IRS\neffort to allay fears and/or provide predictability to the application of capitalization\nrules. In its \xe2\x80\x9cExplanation and Summary of Comments Concerning \xc2\xa7 1.263(a)-4,\xe2\x80\x9d\nthe IRS wrote:\nThe final regulations identify categories of intangibles for which\ncapitalization is required. ... [T]he final regulations provide that an amount\npaid to acquire or create an intangible not otherwise required to be\ncapitalized by the regulations is not required to be capitalized on the ground\nthat it produces significant future benefits for the taxpayer, unless the IRS\npublishes guidance requiring capitalization of the expenditure. If the IRS\npublishes guidance requiring capitalization of an expenditure that produces\nfuture benefits for the taxpayer, such guidance will apply prospectively. ...\nId. at 436. This positivist approach limits application of the \xe2\x80\x9csignificant future\nbenefits\xe2\x80\x9d theory to require capitalization of untold numbers of expenditures.\n10. The \xe2\x80\x9ccapitalization list\xe2\x80\x9d appears in Regs. \xc2\xa7\xc2\xa7 1.263(a)-4(b)(1) and 1.263(a)5(a).\n\xe2\x80\xa2an amount paid to another party to acquire an intangible;\n\xe2\x80\xa2an amount paid to create an intangible specifically named in Reg.\n\xc2\xa7 1.263(a)-4(d);\n304\n\n\x0c\xe2\x80\xa2an amount paid to create or enhance a separate and distinct intangible asset;\n\xe2\x80\xa2an amount paid to create or enhance a future benefit that the IRS has\nspecifically identified in published guidance;\n\xe2\x80\xa2an amount paid to \xe2\x80\x9cfacilitate\xe2\x80\x9d (as that term is specifically defined) an\nacquisition or creation of any of the above-named intangibles; and\n\xe2\x80\xa2amounts paid or incurred to facilitate acquisition of a trade or business, a\nchange in the capital structure of a business entity, and various other\ntransactions.\n11. Moreover, Reg. \xc2\xa7 1.263(a)-4(f)(1) states a 12-month rule, i.e., that\na taxpayer is not required to capitalize ... any right or benefit for the taxpayer\nthat does not extend beyond the earlier of \xe2\x80\x93\n(i) 12 months after the first date on which the taxpayer realizes the\nright or benefit; or\n(ii) The end of the taxable year following the taxable year in which\nthe payment is made.\n12. When taxpayers incur recurring expenses intended to provide future benefits \xe2\x80\x93\nnotably advertising \xe2\x80\x93 what is gained by strict adherence to capitalization principles?\n\xe2\x80\xa2In Encyclopaedia Britannica, Inc. v. Commissioner, 685 F.2d 212, 217 (7th\nCir. 1982), Judge Posner wrote:\nIf one really takes seriously the concept of a capital expenditure as\nanything that yields income, actual or imputed, beyond the period\n(conventionally one year, [citation omitted]) in which the\nexpenditure is made, the result will be to force the capitalization of\nvirtually every business expense. It is a result courts naturally shy\naway from. [citation omitted]. It would require capitalizing every\nsalesman\xe2\x80\x99s salary, since his selling activities create goodwill for the\ncompany and goodwill is an asset yielding income beyond the year\nin which the salary expense is incurred. The administrative costs of\nconceptual rigor are too great. The distinction between recurring and\nnonrecurring business expenses provides a very crude but perhaps\nserviceable demarcation between those capital expenditures that can\nfeasibly be capitalized and those that cannot be.\n13. (Note 12, continued): Imagine: An author spends $5 every year for pen and\npaper with which to write books. Each book will generate income for the author for\n5 years. Let\xe2\x80\x99s assume that \xe2\x80\x9cthe rules\xe2\x80\x9d permit such a taxpayer to deduct $1 of that\n305\n\n\x0c$5 expenditure in each of the succeeding five years. This tax treatment matches the\nauthor\xe2\x80\x99s expenses with his income. The accompanying table demonstrates that this\ntaxpayer will (eventually) be deducting $5 every year.\nyear # \xe2\x98\x9e\n\xe2\x9e\xb7amt spent\n\n1 2 3 4 5 6 7 8\n\n$5\n\n1 1 1 1 1\n\n$5\n\n1 1 1 1 1\n\n$5\n\n1 1 1 1 1\n\n$5\n\n1 1 1 1 1\n\n$5\n\n1 1 1 1\n\n$5\n\n1 1 1\n\n$5\n\n1 1\n\n$5\n\n1\n\nyear by year\ntotal\n\n1 2 3 4 5 5 5 5\n\n\xe2\x80\xa2Beginning in year 5, how much does the year by year total change? Does\nthis table suggest that there is an easier way to handle recurring capital\nexpenditures than to require taxpayer to capitalize and depreciate every such\nexpenditure?\n14. You are expected to recognize a capitalization of intangibles issue \xe2\x80\x93 but the\ndetails of the regulations are left to a more advanced tax course.\n\n306\n\n\x0cC. Expense or Capital: Protecting Stock Investment or Protecting\nEmployment\nUnited States v. Generes, 405 U.S. 93 (1972)\nMR. JUSTICE BLACKMUN delivered the opinion of the Court.\nA debt a closely held corporation owed to an indemnifying shareholder employee\nbecame worthless in 1962. The issue in this federal income tax refund suit is\nwhether, for the shareholder employee, that worthless obligation was a business or\na nonbusiness bad debt within the meaning and reach of \xc2\xa7\xc2\xa7 166(a) and (d) of the ...\nCode106 and of the implementing Regulations \xc2\xa7 1.166-5.107\n106\n\n\xc2\xa7 166. Bad debts.\n(a) General rule. \xe2\x80\x93\n(1) Wholly worthless debts. \xe2\x80\x93 There shall be allowed as a deduction any debt which\nbecomes worthless within the taxable year.\n****\n(d) Nonbusiness debts. \xe2\x80\x93\n(1) General rule. \xe2\x80\x93 In the case of a taxpayer other than a corporation \xe2\x80\x93\n(A) subsection[] (a) \xe2\x80\xa6 shall not apply to any nonbusiness debt; and\n(B) where any nonbusiness debt becomes worthless within the taxable year,\nthe loss resulting therefrom shall be considered a loss from the sale or\nexchange, during the taxable year, of a capital asset held for not more than\n6 months.\n(2) Nonbusiness debt defined. \xe2\x80\x93 For purposes of paragraph (1), the term\n\xe2\x80\x98nonbusiness debt\xe2\x80\x99 means a debt other than \xe2\x80\x93\n(A) a debt created or acquired (as the case may be) in connection with a\ntrade or business of the taxpayer; or\n(B) a debt the loss from the worthlessness of which is incurred in the\ntaxpayer\xe2\x80\x99s trade or business.\n\n107\n\nReg. \xc2\xa7 1.166-5 Nonbusiness debts.\n****\n(b) Nonbusiness debt defined. For purposes of section 166 and this section, a nonbusiness\ndebt is any debt other than \xe2\x80\x93\n****\n(2) A debt the loss from the worthlessness of which is incurred in the taxpayer\xe2\x80\x99s trade\nor business. The question whether a debt is a nonbusiness debt is a question of fact\nin each particular case. ...\nFor purposes of subparagraph (2) of this paragraph, the character of the debt is to\nbe determined by the relation which the loss resulting from the debt\xe2\x80\x99s becoming\n\n307\n\n\x0cThe issue\xe2\x80\x99s resolution is important for the taxpayer. If the obligation was a business\ndebt, he may use it to offset ordinary income and for carryback purposes under\n\xc2\xa7 172 of the Code ... On the other hand, if the obligation is a nonbusiness debt, it is\nto be treated as a short-term capital loss subject to the restrictions imposed on such\nlosses by \xc2\xa7 166(d)(1)(B) and \xc2\xa7\xc2\xa7 1211 and 1212, and its use for carryback purposes\nis restricted by \xc2\xa7 172(d)(4). The debt is one or the other in its entirety, for the Code\ndoes not provide for its allocation in part to business and in part to nonbusiness.\nIn determining whether a bad debt is a business or a nonbusiness obligation, the\nRegulations focus on the relation the loss bears to the taxpayer\xe2\x80\x99s business. If, at the\ntime of worthlessness, that relation is a \xe2\x80\x9cproximate\xe2\x80\x9d one, the debt qualifies as a\nbusiness bad debt and the aforementioned desirable tax consequences then ensue.\nThe present case turns on the proper measure of the required proximate relation.\nDoes this necessitate a \xe2\x80\x9cdominant\xe2\x80\x9d business motivation on the part of the taxpayer,\nor is a \xe2\x80\x9csignificant\xe2\x80\x9d motivation sufficient?\nTax in an amount somewhat in excess of $40,000 is involved. The taxpayer, Allen\nH. Generes, [footnote omitted] prevailed in a jury trial in the District Court. On the\nGovernment\xe2\x80\x99s appeal, the Fifth Circuit affirmed by a divided vote. Certiorari was\ngranted to resolve a conflict among the circuits. [footnote omitted.]\nI\nThe taxpayer, as a young man in 1909, began work in the construction business.\nHis son-in law, William F. Kelly, later engaged independently in similar work.\nDuring World War II, the two men formed a partnership in which their participation\nwas equal. The enterprise proved successful. In 1954, Kelly Generes Construction\nCo., Inc., was organized as the corporate successor to the partnership. It engaged in\nthe heavy-construction business, primarily on public works projects.\nThe taxpayer and Kelly each owned 44% of the corporation\xe2\x80\x99s outstanding capital\nstock. The taxpayer\xe2\x80\x99s original investment in his shares was $38,900. The remaining\n12% of the stock was owned by a son of the taxpayer and by another son-in law.\nMr. Generes was president of the corporation, and received from it an annual salary\nworthless bears to the trade or business of the taxpayer. If that relation is a proximate\none in the conduct of the trade or business in which the taxpayer is engaged at the\ntime the debt becomes worthless, the debt comes within the exception provided by\nthat subparagraph. ...\n\n308\n\n\x0cof $12,000. Mr. Kelly was executive vice-president, and received an annual salary\nof $15,000.\nThe taxpayer and Mr. Kelly performed different services for the corporation. Kelly\nworked full time in the field, and was in charge of the day-to-day construction\noperations. Generes, on the other hand, devoted no more than six to eight hours a\nweek to the enterprise. He reviewed bids and jobs, made cost estimates, sought and\nobtained bank financing, and assisted in securing the bid and performance bonds\nthat are an essential part of the public project construction business. Mr. Generes,\nin addition to being president of the corporation, held a full-time position as\npresident of a savings and loan association he had founded in 1937. He received\nfrom the association an annual salary of $19,000. The taxpayer also had other\nsources of income. His gross income averaged about $40,000 a year during 19591962.\nTaxpayer Generes from time to time advanced personal funds to the corporation to\nenable it to complete construction jobs. He also guaranteed loans made to the\ncorporation by banks for the purchase of construction machinery and other\nequipment. In addition, his presence with respect to the bid and performance bonds\nis of particular significance. Most of these were obtained from Maryland Casualty\nCo. That underwriter required the taxpayer and Kelly to sign an indemnity\nagreement for each bond it issued for the corporation. In 1958, however, in order\nto eliminate the need for individual indemnity contracts, taxpayer and Kelly signed\na blanket agreement with Maryland whereby they agreed to indemnify it, up to a\ndesignated amount, for any loss it suffered as surety for the corporation. Maryland\nthen increased its line of surety credit to $2,000,000. The corporation had over\n$14,000,000 gross business for the period 1954 through 1962.\nIn 1962, the corporation seriously underbid two projects and defaulted in its\nperformance of the project contracts. It proved necessary for Maryland to complete\nthe work. Maryland then sought indemnity from Generes and Kelly. The taxpayer\nindemnified Maryland to the extent of $162,104.57. In the same year, he also loaned\n$158,814.49 to the corporation to assist it in its financial difficulties. The\ncorporation subsequently went into receivership and the taxpayer was unable to\nobtain reimbursement from it.\nIn his federal income tax return for 1962 the taxpayer took his loss on his direct\nloans to the corporation as a nonbusiness bad debt. He claimed the indemnification\n309\n\n\x0closs as a business bad debt and deducted it against ordinary income. 108 Later, he\nfiled claims for refund for 1959-1961, asserting net operating loss carrybacks under\n\xc2\xa7 172 to those years for the portion, unused in 1962, of the claimed business bad\ndebt deduction.\nIn due course, the claims were made the subject of the jury trial refund suit in the\nUnited States District Court for the Eastern District of Louisiana. At the trial, Mr.\nGeneres testified that his sole motive in signing the indemnity agreement was to\nprotect his $12,000-a-year employment with the corporation. The jury, by special\ninterrogatory, was asked to determine whether taxpayer\xe2\x80\x99s signing of the indemnity\nagreement with Maryland \xe2\x80\x9cwas proximately related to his trade or business of being\nan employee\xe2\x80\x9d of the corporation. The District Court charged the jury, over the\nGovernment\xe2\x80\x99s objection, that significant motivation satisfies the Regulations\xe2\x80\x99\nrequirement of proximate relationship.109 The court refused the Government\xe2\x80\x99s\nrequest for an instruction that the applicable standard was that of dominant, rather\nthan significant, motivation.110\n... [T]he jury found that the taxpayer\xe2\x80\x99s signing of the indemnity agreement was\nproximately related to his trade or business of being an employee of the corporation.\nJudgment on this verdict was then entered for the taxpayer.\nThe Fifth Circuit majority approved the significant motivation standard so specified\nand agreed with a Second Circuit majority in Weddle v. Commissioner, 325 F.2d\n849, 851 (1963), in finding comfort for so doing in the tort law\xe2\x80\x99s concept of\nproximate cause. Judge Simpson dissented. 427 F.2d at 284. He agreed with the\nholding of the Seventh Circuit in Niblock v. Commissioner, 417 F.2d 1185 (1969),\nThis difference in treatment between the loss on the direct loan and that, on the indemnity is not\nexplained. See, however, Whipple v. Commissioner, 373 U. S. 193 (1963).\n108\n\n\xe2\x80\x9cA debt is proximately related to the taxpayer\xe2\x80\x99s trade or business when its creation was significantly\nmotivated by the taxpayer\xe2\x80\x99s trade or business, and it is not rendered a non-business debt merely because\nthere was a non-qualifying motivation as well, even though the non-qualifying motivation was the\nprimary one.\xe2\x80\x9d\n109\n\n\xe2\x80\x9cYou must, in short, determine whether Mr. Generes\xe2\x80\x99 dominant motivation in signing the indemnity\nagreement was to protect his salary and status as an employee or was to protect his investment in the\nKelly Generes Construction Co.\xe2\x80\x9d \xe2\x80\x9cMr. Generes is entitled to prevail in this case only if he convinces\nyou that the dominant motivating factor for his signing the indemnity agreement was to insure the\nreceiving of his salary from the company. It is insufficient if the protection or insurance of his salary\nwas only a significant secondary motivation for his signing the indemnity agreement. It must have been\nhis dominant or most important reason for signing the indemnity agreement.\xe2\x80\x9d\n110\n\n310\n\n\x0cand with Chief Judge Lumbard, separately concurring in Weddle, 325 F.2d at 852,\nthat dominant and primary motivation is the standard to be applied.\nII\nA. The fact responsible for the litigation is the taxpayer\xe2\x80\x99s dual status relative to the\ncorporation. Generes was both a shareholder and an employee. These interests are\nnot the same, and their differences occasion different tax consequences. In tax\njargon, Generes\xe2\x80\x99 status as a shareholder was a nonbusiness interest. It was capital\nin nature, and it was composed initially of tax-paid dollars. Its rewards were\nexpectative, and would flow not from personal effort, but from investment earnings\nand appreciation. On the other hand, Generes\xe2\x80\x99 status as an employee was a business\ninterest. Its nature centered in personal effort and labor, and salary for that endeavor\nwould be received. The salary would consist of pre-tax dollars.\nThus, for tax purposes, it becomes important and, indeed, necessary to determine\nthe character of the debt that went bad and became uncollectible. Did the debt center\non the taxpayer\xe2\x80\x99s business interest in the corporation or on his nonbusiness interest?\nIf it was the former, the taxpayer deserves to prevail here. [citations omitted.]\nB. Although arising in somewhat different contexts, two tax cases decided by the\nCourt in recent years merit initial mention. In each of these cases, a major\nshareholder paid out money to or on behalf of his corporation and then was unable\nto obtain reimbursement from it. In each, he claimed a deduction assertable against\nordinary income. In each, he was unsuccessful in this quest:\n1. In Putnam v. Commissioner, 352 U. S. 82 (1956), the taxpayer was a practicing\nlawyer who had guaranteed obligations of a labor newspaper corporation in which\nhe owned stock. He claimed his loss as fully deductible ... The Court ... held that\nthe loss was a nonbusiness bad debt subject to short-term capital loss treatment ...\nThe loss was deductible as a bad debt or not at all. See Rev. Rul. 60-48, 1961 Cum.\nBull. 112.\n2. In Whipple v. Commissioner, 373 U. S. 193 (1963), the taxpayer had provided\norganizational, promotional, and managerial services to a corporation in which he\nowned approximately an 80% stock interest. He claimed that this constituted a trade\nor business, and, hence, that debts owing him by the corporation were business bad\ndebts when they became worthless in 1953. The Court also rejected that contention,\nand held that Whipple\xe2\x80\x99s investing was not a trade or business, that is, that\n\xe2\x80\x9c[d]evoting one\xe2\x80\x99s time and energies to the affairs of a corporation is not, of itself,\n311\n\n\x0cand without more, a trade or business of the person so engaged.\xe2\x80\x9d 373 U.S. at 202.\nThe rationale was that a contrary conclusion would be inconsistent with the\nprinciple that a corporation has a personality separate from its shareholders, and\nthat its business is not necessarily their business. The Court indicated its approval\nof the Regulations\xe2\x80\x99 proximate relation test:\nMoreover, there is no proof (which might be difficult to furnish where the\ntaxpayer is the sole or dominant stockholder) that the loan was necessary to\nkeep his job or was otherwise proximately related to maintaining his trade\nor business as an employee. Compare Trent v. Commissioner, [291 F.2d\n669 (CA2 1961)]. 373 U.S. at 204.\nThe Court also carefully noted the distinction between the business and the\nnonbusiness bad debt for one who is both an employee and a shareholder.111\nThese two cases approach, but do not govern, the present one. They indicate,\nhowever, a cautious, and not a free-wheeling, approach to the business bad debt.\nObviously, taxpayer Generes endeavored to frame his case to bring it within the\narea indicated in the above quotation from Whipple v. Commissioner.\nIII\nWe conclude that, in determining whether a bad debt has a \xe2\x80\x9cproximate\xe2\x80\x9d relation to\nthe taxpayer\xe2\x80\x99s trade or business, as the Regulations specify, and thus qualifies as a\nbusiness bad debt, the proper measure is that of dominant motivation, and that only\nsignificant motivation is not sufficient. We reach this conclusion for a number of\nreasons:\nA. The Code itself carefully distinguishes between business and nonbusiness items.\nIt does so, for example, in \xc2\xa7 165 with respect to losses, in \xc2\xa7 166 with respect to bad\ndebts, and in \xc2\xa7 162 with respect to expenses. It gives particular tax benefits to\nbusiness losses, business bad debts, and business expenses, and gives lesser\nbenefits, or none at all, to nonbusiness losses, nonbusiness bad debts, and\nnonbusiness expenses. It does this despite the fact that the latter are just as adverse\nin financial consequence to the taxpayer as are the former. But this distinction has\nbeen a policy of the income tax structure ever since the Revenue Act of 1916 ...\n\xe2\x80\x9cEven if the taxpayer demonstrates an independent trade or business of his own, care must be taken\nto distinguish bad debt losses arising from his own business and those actually arising from activities\npeculiar to an investor concerned with, and participating in, the conduct of the corporate business.\xe2\x80\x9d\n373 U.S. at 202.\n111\n\n312\n\n\x0cThe point, however, is that the tax statutes have made the distinction, that the\nCongress therefore intended it to be a meaningful one, and that the distinction is\nnot to be obliterated or blunted by an interpretation that tends to equate the business\nbad debt with the nonbusiness bad debt. We think that emphasis upon the\nsignificant rather, than upon the dominant, would have a tendency to do just that.\nB. Application of the significant motivation standard would also tend to undermine\nand circumscribe the Court\xe2\x80\x99s holding in Whipple, and the emphasis there that a\nshareholder\xe2\x80\x99s mere activity in a corporation\xe2\x80\x99s affairs is not a trade or business. As\nChief Judge Lumbard pointed out in his separate and disagreeing concurrence in\nWeddle, supra, 325 F.2d at 852-853, both motives \xe2\x80\x93 that of protecting the\ninvestment and that of protecting the salary \xe2\x80\x93 are inevitably involved, and an\ninquiry whether employee status provides a significant motivation will always\nproduce an affirmative answer and result in a judgment for the taxpayer.\nC. The dominant motivation standard has the attribute of workability. It provides a\nguideline of certainty for the trier of fact. The trier then may compare the risk\nagainst the potential reward and give proper emphasis to the objective, rather than\nto the subjective. As has just been noted, an employee-shareholder, in making or\nguaranteeing a loan to his corporation, usually acts with two motivations, the one\nto protect his investment and the other to protect his employment. By making the\ndominant motivation the measure, the logical tax consequence ensues and prevents\nthe mere presence of a business motive, however small and however insignificant,\nfrom controlling the tax result at the taxpayer\xe2\x80\x99s convenience. This is of particular\nimportance in a tax system that is so largely dependent on voluntary compliance.\nD. The dominant motivation test strengthens, and is consistent with, the mandate\nof \xc2\xa7 262 of the Code, ... that \xe2\x80\x9cno deduction shall be allowed for personal, living, or\nfamily expenses\xe2\x80\x9d except as otherwise provided. It prevents personal considerations\nfrom circumventing this provision.\nE. The dominant motivation approach to \xc2\xa7 166(d) is consistent with that given the\nloss provisions in \xc2\xa7 165(c)(1), see, for example, Imbesi v. Commissioner, 361 F.2d\n640, 644 (CA3 1966), and in \xc2\xa7 165(c)(2), see Austin v. Commissioner, 298 F.2d\n583, 584 (CA2 1962). In these related areas, consistency is desirable. See also\nCommissioner v. Duberstein, 363 U. S. 278, 286 (1960).\nF. ...\n313\n\n\x0cG. The Regulations\xe2\x80\x99 use of the word \xe2\x80\x9cproximate\xe2\x80\x9d perhaps is not the most fortunate,\nfor it naturally tempts one to think in tort terms. The temptation, however, is best\nrejected, and we reject it here. In tort law, factors of duty, of foreseeability, of\nsecondary cause, and of plural liability are under consideration, and the concept of\nproximate cause has been developed as an appropriate application and measure of\nthese factors. It has little place in tax law, where plural aspects are not usual, where\nan item either is or is not a deduction, or either is or is not a business bad debt, and\nwhere certainty is desirable.\nIV\nThe conclusion we have reached means that the District Court\xe2\x80\x99s instructions, based\non a standard of significant, rather than dominant, motivation are erroneous, and\nthat, at least, a new trial is required. We have examined the record, however, and\nfind nothing that would support a jury verdict in this taxpayer\xe2\x80\x99s favor had the\ndominant motivation standard been embodied in the instructions. Judgment n.o.v.\nfor the United States, therefore, must be ordered. See Neely v. Eby Construction\nCo., 386 U. S. 317 (1967).\nAs Judge Simpson pointed out in his dissent, 427 F.2d at 284-285, the only real\nevidence offered by the taxpayer bearing upon motivation was his own testimony\nthat he signed the indemnity agreement \xe2\x80\x9cto protect my job,\xe2\x80\x9d that \xe2\x80\x9cI figured, in three\nyears\xe2\x80\x99 time, I would get my money out,\xe2\x80\x9d and that \xe2\x80\x9cI never once gave it [his\ninvestment in the corporation] a thought.\xe2\x80\x9d [footnote omitted]\nThe statements obviously are self-serving. In addition, standing alone, they do not\nbear the light of analysis. What the taxpayer was purporting to say was that his\n$12,000 annual salary was his sole motivation, and that his $38,900 original\ninvestment, the actual value of which, prior to the misfortunes of 1962, we do not\nknow, plus his loans to the corporation, plus his personal interest in the integrity of\nthe corporation as a source of living for his son-in law and as an investment for his\nson and his other son-in law, were of no consequence whatever in his thinking. The\ncomparison is strained all the more by the fact that the salary is pre-tax and the\ninvestment is tax-paid. With his total annual income about $40,000, Mr. Generes\nmay well have reached a federal income tax bracket of 40% or more for a joint\nreturn in 1958-1962. \xc2\xa7\xc2\xa7 1 and 2 of the 1954 Code ... The $12,000 salary thus would\nproduce for him only about $7,000 net after federal tax and before any state income\ntax. This is the figure, and not $12,000, that has any possible significance for\nmotivation purposes, and it is less than 1/5 of the original stock investment.\n[footnote omitted]\n314\n\n\x0cWe conclude on these facts that the taxpayer\xe2\x80\x99s explanation falls of its own weight,\nand that reasonable minds could not ascribe, on this record, a dominant motivation\ndirected to the preservation of the taxpayer\xe2\x80\x99s salary as president of Kelly Generes\nConstruction Co., Inc.\nThe judgment is reversed, and the case is remanded with direction that judgment\nbe entered for the United States.\nIt is so ordered.\nMR. JUSTICE POWELL and MR. JUSTICE REHNQUIST took no part in the\nconsideration or decision of this case.\nMR. JUSTICE MARSHALL, concurring (omitted).\nMR. JUSTICE WHITE, with whom MR. JUSTICE BRENNAN joins.\nWhile I join Parts I, II, and III of the Court\xe2\x80\x99s opinion and its judgment of reversal,\nI would remand the case to the District Court with directions to hold a hearing on\nthe issue of whether a jury question still exists as to whether taxpayer\xe2\x80\x99s motivation\nwas \xe2\x80\x9cdominantly\xe2\x80\x9d a business one in the relevant transactions ...\nMR. JUSTICE DOUGLAS, dissenting. [omitted.]\nNotes and Questions:\n1. What were the stakes in the outcome of the case? See \xc2\xa7\xc2\xa7 1211(b) ($1000 limit\nat the time the Court decided Generes), 1212(b).\n2. What about Kelly? Should he be permitted to deduct any amounts that he paid\nto Maryland Casualty Co.? Would it make a difference if Kelly were an employee\nrather than an owner of the business? Who was the owner of Kelly Generes\nConstruction, Inc.\xe2\x80\x99 business?\n3. Investing is not a trade or business. Rather it is comprised of transactions entered\nfor profit, but not connected with a trade or business. Section 212 defines the\n\xe2\x80\x9cbelow-the-line\xe2\x80\x9d deductions available to a taxpayer who incurs expenses in pursuit\nof profit outside of a trade or business\n\xe2\x80\xa2An employee is engaged in the trade or business of being an employee.\n315\n\n\x0c\xe2\x80\xa2Section 67(g) suspends until 2026 \xe2\x80\x9cmiscellaneous deductions\xe2\x80\x9d \xe2\x80\x93 which\ninclude investment expenses and the trade or business expenses of an\nemployee.\n4. What information should be critical to the valuation of taxpayer\xe2\x80\x99s stock? In a\nclosely-held corporation in which shareholders, officers, employees, and creditors\nare usually the same people who wear different hats on different occasions \xe2\x80\x93 is it\never realistic to say that a bad debt is \xe2\x80\x9cone or the other in its entirety?\xe2\x80\x9d\nD. Expense or Capital: Repair vs. Improvement\nA recurring question is whether an expenditure is to repair an asset and so\ndeductible or to improve an asset and so must be capitalized. Section 263(a) denies\na deduction for \xe2\x80\x9c[a]ny amount paid out for new buildings or for permanent\nimprovements or betterments made to increase the value of any property\xe2\x80\x9d and for\n\xe2\x80\x9c[a]ny amount expended in restoring property or in making good the exhaustion\nthereof for which an allowance is or has been made.\xe2\x80\x9d Sections 161 and 261 make\n\xc2\xa7 162 subject to and subordinate to \xc2\xa7 263. Reg. \xc2\xa7 1.162-4(a) restates this\nprioritization; it provides in part that \xe2\x80\x9c[a] taxpayer may deduct amounts paid for\nrepairs and maintenance to tangible property if the amounts paid are not otherwise\nrequired to be capitalized.\xe2\x80\x9d\nThe line between deductibility of repair expenditures and capitalization of\nimprovement expenditures has often been the subject of dispute between taxpayers\nand the government in the context of a taxpayer\xe2\x80\x99s trade or business. We look at two\nold cases and note what were important factors in deciding that an expenditure was\nfor a deductible repair or for a capital improvement. More recently, the IRS and\nTreasury have undertaken through regulations to articulate workable standards and\nprocedures to assure more taxpayers predictable treatment. We will explore the\nhigh points of the portions of these regulations most relevant to this topic.\n\n316\n\n\x0cMidland Empire Packing Co. v. Commissioner, 14 T.C. 635 (1950).\n....\nARUNDELL, Judge:\nThe issue in this case is whether an expenditure for a concrete lining in petitioner\xe2\x80\x99s\nbasement to oilproof it against an oil nuisance created by a neighboring refinery is\ndeductible as an ordinary and necessary expense under \xc2\xa7 [162(a)] ... on the theory\nit was an expenditure for a repair ...\nThe respondent [Commissioner] has contended, in part, that the expenditure is for\na capital improvement and should be recovered through depreciation charges and\nis, therefore, not deductible as an ordinary and necessary business expense or as a\nloss.\nIt is none too easy to determine on which side of the line certain expenditures fall\nso that they may be accorded their proper treatment for tax purposes. Treasury\nRegulations 111, from which we quote in the margin,[ 112] is helpful in\ndistinguishing between an expenditure to be classed as a repair and one to be treated\nas a capital outlay. In Illinois Merchants Trust Co., Executor, 4 B.T.A. 103, 106,\nwe discussed this subject in some detail and in our opinion said:\nIt will be noted that the first sentence of the [regulation] ... relates to repairs,\nwhile the second sentence deals in effect with replacements. In determining\nwhether an expenditure is a capital one or is chargeable against operating\nincome, it is necessary to bear in mind the purpose for which the\nexpenditure was made. To repair is to restore to a sound state or to mend,\nwhile a replacement connotes a substitution. A repair is an expenditure for\nthe purpose of keeping the property in an ordinarily efficient operating\ncondition. It does not add to the value of the property nor does it appreciably\n\xc2\xa7 29.23(a)-4. REPAIRS.\xe2\x80\x94 The cost of incidental repairs which neither materially add to the value\nof the property nor appreciably prolong its life, but keep it in an ordinarily efficient operating condition,\nmay be deducted as expense, provided the plant or property account is not increased by the amount of\nsuch expenditures. Repairs in the nature of replacements, to the extent that they arrest deterioration\nand appreciably prolong the life of the property, should be charged against the depreciation reserve if\nsuch account is kept. (See \xc2\xa7\xc2\xa7 29.23(l)-1 to 29.23(l)-10, inclusive.) [The regulation that the court quoted\nbecame the substance of Reg. \xc2\xa7 1.162-4 (superseded after 2011). As we shall see, Treasury and the IRS\nhave substantially revised it.]\n112\n\n317\n\n\x0cprolong its life. It merely keeps the property in an operating condition over\nits probable useful life for the uses for which it was acquired. Expenditures\nfor that purpose are distinguishable from those for replacements, alterations,\nimprovements, or additions which prolong the life of the property, increase\nits value, or make it adaptable to a different use. The one is a maintenance\ncharge, while the others are additions to capital investment which should\nnot be applied against current earnings.\n... [F]or some 25 years prior to the taxable year [(1943)] petitioner [Midland\nEmpire] had used the basement rooms of its plant [situated in Billings near the\nYellowstone River] as a place for the curing of hams and bacon and for the storage\nof meat and hides. The basement had been entirely satisfactory for this purpose over\nthe entire period in spite of the fact that there was some seepage of water into the\nrooms from time to time. In the taxable year it was found that not only water, but\noil, was seeping through the concrete walls of the basement of the packing plant\nand, while the water would soon drain out, the oil would not, and there was left on\nthe basement floor a thick scum of oil which gave off a strong odor that permeated\nthe air of the entire plant, and the fumes from the oil created a fire hazard. It appears\nthat the oil which came from a nearby refinery [of the Yale Oil Corporation] had\nalso gotten into the water wells which served to furnish water for petitioner\xe2\x80\x99s plant,\nand as a result of this whole condition the Federal meat inspectors advised petitioner\nthat it must discontinue the use of the water from the wells and oilproof the\nbasement, or else shut down its plant.\nTo meet this situation, petitioner during the taxable year undertook steps to oilproof\nthe basement by adding a concrete lining to the walls from the floor to a height of\nabout four feet and also added concrete to the floor of the basement. It is the cost\nof this work, [$4,868.81,] which it seeks to deduct as a repair. The basement was\nnot enlarged by this work [and in fact petitioner\xe2\x80\x99s operating space contracted], nor\ndid the oilproofing serve to make it more desirable for the purpose for which it had\nbeen used through the years prior to the time that the oil nuisance had occurred.\nThe evidence is that the expenditure did not add to the value or prolong the expected\nlife of the property over what they were before the event occurred which made the\nrepairs necessary. It is true that after the work was done the seepage of water, as\nwell as oil, was stopped, but, as already stated, the presence of the water had never\nbeen found objectionable. The repairs merely served to keep the property in an\noperating condition over its probable useful life for the purpose for which it was\nused.\n318\n\n\x0c[Midland charged the $4,868.81 to repair expense on its regular books and deducted\nthat amount on its tax returns as an ordinary and necessary business expense for the\nfiscal year 1943. The Commissioner, in his notice of deficiency, determined that\nthe cost of oilproofing was not deductible ... as an ordinary and necessary expense\n... in 1943.]\nWhile it is conceded on brief that the expenditure was \xe2\x80\x98necessary,\xe2\x80\x99 respondent\ncontends that the encroachment of the oil nuisance on petitioner\xe2\x80\x99s property was not\nan \xe2\x80\x98ordinary\xe2\x80\x99 expense in petitioner\xe2\x80\x99s particular business. But the fact that petitioner\nhad not theretofore been called upon to make a similar expenditure to prevent\ndamage and disaster to its property does not remove that expense from the\nclassification of \xe2\x80\x98ordinary\xe2\x80\x99 ... Steps to protect a business building from the seepage\nof oil from a nearby refinery, which had been erected long subsequent to the time\npetitioner started to operate its plant, would seem to us to be a normal thing to do,\nand in certain sections of the country it must be a common experience to protect\none\xe2\x80\x99s property from the seepage of oil. Expenditures to accomplish this result are\nlikewise normal.\n....\n[The petitioner thereafter filed suit against Yale, on April 22, 1944, in a cause of\naction sounding in tort ... This action was to recover damages for the nuisance\ncreated by the oil seepage. ... Petitioner subsequently settled its cause of action\nagainst Yale for $11,659.49 and gave Yale a complete release of all liability. This\nrelease was dated October 23, 1946.]\nIn our opinion, the expenditure of $4,868.81 for lining the basement walls and floor\nwas essentially a repair and, as such, it is deductible as an ordinary and necessary\nbusiness expense. ...\nNotes and Questions:\n1. The court said: \xe2\x80\x9cIt is none too easy to determine on which side of the line certain\nexpenditures fall so that they may be accorded their proper treatment for tax\npurposes.\xe2\x80\x9d\n\xe2\x80\xa2What facts convinced the court to place the expenditure on the \xe2\x80\x9crepair\xe2\x80\x9d\nside of the line?\n319\n\n\x0c2. In the fifth-to-last paragraph of the case, the court stated conclusions taken\nalmost verbatim from the regulation.\nDoes this give you any idea of the type\nof evidence that taxpayer must have\nWar-time and shortly thereafter: During\nWW I and WW II, tax rates were\npresented?\nconsiderably higher than they were in\n\xe2\x80\xa2Whether an expenditure added\npeacetime. In what ways did this make\nto the value of an asset or\ntiming an especially important matter?\nprolonged its useful life were\ncritical considerations.\n3. The Yale Oil Corporation owned a nearby oil-refining plant and storage area\nand its discharges caused the problems that Midland Empire had to address. Yale\nOil made a payment to Midland Empire to settle the nuisance suit brought against\nit. May Yale Oil deduct the amount it paid to settle the case, or should it capitalize\nthat amount? Cf. Mt. Morris Drive-In, infra?\n\xe2\x80\xa2What tax treatment should Midland accord the $11,659.49 payment it\nreceived from Yale?\nMt. Morris Drive-In Theatre Co. v. Commissioner, 25 T.C. 272 (1955), aff\xe2\x80\x99d,\n238 F.2d 85 (6th Cir. 1956)\n....\nFINDINGS OF FACT.\n....\nIn 1947 petitioner purchased 13 acres of farm land located on the outskirts of Flint,\nMichigan, upon which it proceeded to construct a drive-in or outdoor theatre. Prior\nto its purchase by the petitioner the land on which the theatre was built was farm\nland and contained vegetation. The slope of the land was such that the natural\ndrainage of water was from the southerly line to the northerly boundary of the\nproperty and thence onto the adjacent land, owned by David and Mary D. Nickola,\nwhich was used both for farming and as a trailer park. The petitioner\xe2\x80\x99s land sloped\nsharply from south to north and also sloped from the east downward towards the\nwest so that most of the drainage from the petitioner\xe2\x80\x99s property was onto the\nsouthwest corner of the Nickolas\xe2\x80\x99 land. The topography of the land purchased by\npetitioner was well known to petitioner at the time it was purchased and developed.\n320\n\n\x0cThe petitioner did not change the general slope of its land in constructing the drivein theatre, but it removed the covering vegetation from the land, slightly increased\nthe grade, and built aisles or ramps which were covered with gravel and were\nsomewhat raised so that the passengers in the automobiles would be able to view\nthe picture on the large outdoor screen.\nAs a result of petitioner\xe2\x80\x99s construction on and use of this land rain water falling\nupon it drained with an increased flow into and upon the adjacent property of the\nNickolas. This result should reasonably have been anticipated by petitioner at the\ntime when the construction work was done.\nThe Nickolas complained to the petitioner at various times after petitioner began\nthe construction of the theatre that the work resulted in an acceleration and\nconcentration of the flow of water which drained from the petitioner\xe2\x80\x99s property onto\nthe Nickolas\xe2\x80\x99 land causing damage to their crops and roadways. On or about\nOctober 11, 1948, the Nickolas filed a suit against the petitioner ... asking for an\naward for damages done to their property by the accelerated and concentrated\ndrainage of the water and for a permanent injunction restraining the defendant from\npermitting such drainage to continue. ... [T]he suit was settled by an agreement\ndated June 27, 1950. This agreement provided for the construction by the petitioner\nof a drainage system to carry water from its northern boundary across the Nickolas\xe2\x80\x99\nproperty and thence to a public drain. The cost of maintaining the system was to be\nshared by the petitioner and the Nickolas, and the latter granted the petitioner and\nits successors an easement across their land for the purpose of constructing and\nmaintaining the drainage system. The construction of the drain was completed in\nOctober 1950 under the supervision of engineers employed by the petitioner and\nthe Nickolas at a cost to the petitioner of $8,224, which amount was paid by it in\nNovember 1950. The performance by the petitioner on its part of the agreement to\nconstruct the drainage system and to maintain the portion for which it was\nresponsible constituted a full release of the Nickolas\xe2\x80\x99 claims against it. The\npetitioner chose to settle the dispute by constructing the drainage system because it\ndid not wish to risk the possibility that continued litigation might result in a\npermanent injunction against its use of the drive-in theatre and because it wished to\neliminate the cause of the friction between it and the adjacent landowners, who\nwere in a position to seriously interfere with the petitioner\xe2\x80\x99s use of its property for\noutdoor theatre purposes. A settlement based on a monetary payment for past\ndamages, the petitioner believed, would not remove the threat of claims for future\ndamages.\n321\n\n\x0c\xe2\x80\xa6 In its petition the petitioner asserted that the entire amount spent to construct the\ndrainage system was fully deductible in 1950 as an ordinary and necessary business\nexpense incurred in the settlement of a lawsuit, or, in the alternative, as a loss, and\nclaimed a refund of part of the $10,591.56 of income and excess profits tax paid by\nit for that year.\nThe drainage system was a permanent improvement to the petitioner\xe2\x80\x99s property,\nand the cost thereof constituted a capital expenditure.\n....\nKERN, Judge:\nWhen petitioner purchased, in 1947, the land which it intended to use for a drivein theatre, its president was thoroughly familiar with the topography of this land\nwhich was such that when the covering vegetation was removed and graveled\nramps were constructed and used by its patrons, the flow of natural precipitation on\nthe lands of abutting property owners would be materially accelerated. Some\nprovision should have been made to solve this drainage problem in order to avoid\nannoyance and harassment to its neighbors. If petitioner had included in its original\nconstruction plans an expenditure for a proper drainage system no one could doubt\nthat such an expenditure would have been capital in nature.\nWithin a year after petitioner had finished its inadequate construction of the drivein theatre, the need of a proper drainage system was forcibly called to its attention\nby one of the neighboring property owners, and under the threat of a lawsuit filed\napproximately a year after the theatre was constructed, the drainage system was\nbuilt by petitioner who now seeks to deduct its cost as an ordinary and necessary\nbusiness expenses, or as a loss.\nWe agree with respondent that the cost to petitioner of acquiring and constructing\na drainage system in connection with its drive-in theatre was a capital expenditure.\nHere was no sudden catastrophic loss caused by a \xe2\x80\x98physical fault\xe2\x80\x99 undetected by the\ntaxpayer in spite of due precautions taken by it at the time of its original\nconstruction work as in American Bemberg Corporation, 10 T.C. 361; no\nunforeseeable external factor as in Midland Empire Packing Co., 14 T.C. 635; and\nno change in the cultivation of farm property caused by improvements in technique\nand made many years after the property in question was put to productive use as in\n322\n\n\x0cJ. H. Collingwood, 20 T.C. 937. In the instant case it was obvious at the time when\nthe drive-in theatre was constructed, that a drainage system would be required to\nproperly dispose of the natural precipitation normally to be expected, and that until\nthis was accomplished, petitioner\xe2\x80\x99s capital investment was incomplete. In addition,\nit should be emphasized that here there was no mere restoration or rearrangement\nof the original capital asset, but there was the acquisition and construction of a\ncapital asset which petitioner had not previously had, namely, a new drainage\nsystem.\nThat this drainage system was acquired and constructed and that payments therefor\nwere made in compromise of a lawsuit is not determinative of whether such\npayments were ordinary and necessary business expenses or capital expenditures.\n\xe2\x80\x98The decisive test is still the character of the transaction which gives rise to the\npayment.\xe2\x80\x99 Hales-Mullaly v. Commissioner, 131 F.2d 509, 511, 512.\nIn our opinion the character of the transaction in the instant case indicates that the\ntransaction was a capital expenditure.\nReviewed by the Court.\nDecision will be entered for the respondent.\nRAUM, J., with whom FISHER, J., agrees, concurring: [omitted]\nRICE, J. dissenting:\n... [T]he expenditure which petitioner made was an ordinary and necessary business\nexpense, which did not improve, better, extend, increase, or prolong the useful life\nof its property. The expenditure did not cure the original geological defect of the\nnatural drainage onto the Nickolas\xe2\x80\x99 land, but only dealt with the intermediate\nconsequence thereof. ... I cannot agree with the majority that the expenditure here\nwas capital in nature.\nOPPER, JOHNSON, BRUCE, and MULRONEY, JJ., agree with this dissent.\nNotes and Questions:\n1. Upon reading Midland Empire and Mt. Morris Drive-In, do you get the feeling\nthat repair vs. improvement \xe2\x80\x93 at least in close cases \xe2\x80\x93 comes down to who can argue\n323\n\n\x0cfacts that fit within certain considerations better? Notice and consider:\n\xe2\x80\xa2The magnitude of what was done to the properties in the two cases was\nprobably comparable.\n\xe2\x80\xa2Neither taxpayer could continue in business without making the\nexpenditure.\n\xe2\x80\xa2Is \xe2\x80\x9cforeseeability\xe2\x80\x9d really the distinction between these two cases?\n\xe2\x80\x9cForeseeability\xe2\x80\x9d of course is a very malleable term.\n\xe2\x80\xa2On the other hand, did the expenditures in the two cases increase the value\nof taxpayers\xe2\x80\x99 properties for the use they made or their properties?\n2. Does \xe2\x80\x9cquantitative\xe2\x80\x9d eventually becomes \xe2\x80\x9cqualitative?\xe2\x80\x9d Suppose taxpayer makes\nmany discrete repairs; can they together add up to a renovation? Consider this\nexcerpt from United States v. Wehrli, 400 F.2d 686 (10th Cir. 1968):\nIn the continuing quest for formularization, the courts have superimposed\nupon the criteria in the repair regulation an overriding precept that an\nexpenditure made for an item which is part of a \xe2\x80\x9cgeneral plan\xe2\x80\x9d of\nrehabilitation, modernization, and improvement of the property, must be\ncapitalized, even though, standing along, the item may appropriately be\nclassified as one of repair. \xe2\x80\xa6 Whether the plan exists, and whether a\nparticular item is part of it, are usually questions of fact to be determined by\nthe fact finder based upon a realistic appraisal of all the surrounding facts\nand circumstances, including, but not limited to, the purpose, nature, extent,\nand value of the work done, e.g., whether the work was done to suit the\nneeds of an incoming tenant, or to adapt the property to a different use, or,\nin any event, whether what was done resulted in an appreciable\nenhancement of the property\xe2\x80\x99s value.\nId. at 689 (citations and footnotes omitted). Quantity does eventually become\nquality. Application of the general standards of Wehrli will certainly lead to\ndisputes between taxpayers and the IRS. Generalized standards can inherently be\nunpredictable in application. The IRS and Treasury have worked to provide more\npredictability in this area through a revenue ruling and most recently rulemaking.\nAs often happens, the difficulty that the IRS and Treasury faced in drafting\nregulations was to make them general enough to be applicable to a broad range of\nsituations and a great number of taxpayers, yet specific enough to provide\nmeaningful guidance.\n\n324\n\n\x0c3. The excerpt from Illinois Merchants Trust Co. that the court in Midland Empire\nquoted referenced \xe2\x80\x9creplacements, alterations, improvements, or additions which\nprolong the life of the property, increase its value, or make it adaptable to a different\nuse.\xe2\x80\x9d On the other hand, \xe2\x80\x9c[a] repair is an expenditure for the purpose of keeping the\nproperty in an ordinarily efficient operating condition.\xe2\x80\x9d Id. Consider some routine\n(?) maintenance procedures for an automobile. If the taxpayer uses the automobile\nin a trade or business, should taxpayer treat them as repairs or as expenditures to be\ncapitalized?\n\xe2\x80\xa2changing the oil every 6000 miles; this will certainly prolong the life of the\nautomobile, for failure to do so will destroy the engine;\n\xe2\x80\xa2replacing tires warranted for 20,000 miles with tires warranted for 60,000\nmiles;\n\xe2\x80\xa2equipping the automobile with a trailer hitch so that taxpayer can attach a\nflatbed trailer and transport large items;\n\xe2\x80\xa2replacing an engine block that cracked on a cold winter night because\ntaxpayer had not flushed the radiator and filled it with antifreeze.\n4. In Rev. Rul. 2001-4, the IRS reviewed the statements of several courts. The\nfollowing is an excerpt:\nAny properly performed repair, no matter how routine, could be considered\nto prolong the useful life and increase the value of the property if it is\ncompared with the situation existing immediately prior to the repair.\nConsequently, courts have articulated a number of ways to distinguish\nbetween deductible repairs and non-deductible capital improvements. For\nexample, in Illinois Merchants Trust Co. v. Commissioner, 4 B.T.A. 103,\n106 (1926), acq., V-2 C.B. 2, the court explained that repair and\nmaintenance expenses are incurred for the purpose of keeping the property\nin an ordinarily efficient operating condition over its probable useful life for\nthe uses for which the property was acquired. Capital expenditures, in\ncontrast, are for replacements, alterations, improvements, or additions that\nappreciably prolong the life of the property, materially increase its value, or\nmake it adaptable to a different use. In Estate of Walling v. Commissioner,\n373 F.2d 192-93 (3rd Cir. 1966), the court explained that the relevant\ndistinction between capital improvements and repairs is whether the\nexpenditures were made to \xe2\x80\x9cput\xe2\x80\x9d or \xe2\x80\x9ckeep\xe2\x80\x9d property in ordinary efficient\noperating condition. In Plainfield-Union Water Co. v. Commissioner, 39\nT.C. 333, 338 (1962), nonacq. on other grounds, 1964-2 C.B. 8, the court\nstated that if the expenditure merely restores the property to the state it was\n325\n\n\x0cin before the situation prompting the expenditure arose and does not make\nthe property more valuable, more useful, or longer-lived, then such an\nexpenditure is usually considered a deductible repair. In contrast, a capital\nexpenditure is generally considered to be a more permanent increment in\nthe longevity, utility, or worth of the property. \xe2\x80\xa6\nEven if the expenditures include the replacement of numerous parts of an\nasset, if the replacements are a relatively minor portion of the physical\nstructure of the asset, or of any of its major parts, such that the asset as [sic]\nwhole has not gained materially in value or useful life, then the costs\nincurred may be deducted as incidental repairs or maintenance expenses.\n[citations omitted]. The same conclusion is true even if such minor portion\nof the asset is replaced with new and improved materials. [citation omitted].\nIf, however, a major component or a substantial structural part of the asset\nis replaced and, as a result, the asset as a whole has increased in value, life\nexpectancy, or use then the costs of the replacement must be capitalized.\n[citations omitted].\nIn addition, although the high cost of work performed may be considered in\ndetermining whether an expenditure is capital in nature, cost alone is not\ndispositive. [citations omitted].\nSimilarly, the fact that a taxpayer is required by a regulatory authority to\nmake certain repairs or to perform certain maintenance on an asset in order\nto continue operating the asset in its business does not mean that the work\nperformed materially increases the value of such asset, substantially\nprolongs its useful life, or adapts it to a new use. [citations omitted].\nThe characterization of any cost as a deductible repair or capital\nimprovement depends on the context in which the cost is incurred.\nSpecifically, where an expenditure is made as part of a general plan of\nrehabilitation, modernization, and improvement of the property, the\nexpenditure must be capitalized, even though, standing alone, the item may\nbe classified as one of repair or maintenance. United States v. Wehrli, 400\nF.2d 686, 689 (10th Cir. 1968). Whether a general plan of rehabilitation\nexists, and whether a particular repair or maintenance item is part of it, are\nquestions of fact to be determined based upon all the surrounding facts and\ncircumstances, including, but not limited to, the purpose, nature, extent, and\n326\n\n\x0cvalue of the work done. Id. at 690. The existence of a written plan, by itself,\nis not sufficient to trigger the plan of rehabilitation doctrine. [citations\nomitted].\nIn general, the courts have applied the plan of rehabilitation doctrine to\nrequire a taxpayer to capitalize otherwise deductible repair and maintenance\ncosts where the taxpayer has a plan to make substantial capital\nimprovements to property and the repairs are incidental to that plan.\n[citations omitted].\nOn the other hand, the courts and the Service have not applied the plan of\nrehabilitation doctrine to situations where the plan did not include\nsubstantial capital improvements and repairs to the same asset, the plan\nprimarily involved repair and maintenance items, or the work was\nperformed merely to keep the property in an ordinarily efficient operating\ncondition. [citations omitted].\n5. Consider again our servicing of an automobile.\n\xe2\x80\xa2changing the oil \xe2\x80\x9ckeeps\xe2\x80\x9d the automobile in operating condition \xe2\x80\x93 it does\nnot \xe2\x80\x9cput\xe2\x80\x9d the automobile in an ordinarily efficient operating condition over\nits probable useful life for the uses for which it was acquired. It does not\nprolong the life of the automobile, materially increase its value, or make it\nadaptable to a different use. Deduct as repair.\n\xe2\x80\xa2replacing worn out tires with better tires has not appreciably prolonged the\nlife of the automobile or made it more useful. However, it may have\nincreased the value of the automobile to more than it was, even when the\n20,000-mile tires were new. Capitalize.\n\xe2\x80\xa2equipping the automobile with a trailer hitch may have adapted the\nautomobile to a different use than transporting passengers and made the\nautomobile more useful. Capitalize.\n\xe2\x80\xa2replacing the engine block is the replacement of a major component or a\nsubstantial structural part of the automobile that results in increasing the\nvalue, life expectancy, or use of an otherwise permanently and completely\ninoperable automobile. Capitalize.\nThese answers are obvious, right?\n6. This revenue ruling did not put an end to disputes between the government and\ntaxpayers. See Fedex Corp. v. United States, 291 F. Supp. 2d 699 (W.D. Tenn.\n327\n\n\x0c2003), aff\xe2\x80\x99d, 412 F.3d 617 (6th Cir. 2005). In Fedex, the court determined that an\nentire aircraft rather than one of its engines on which work was performed was the\nappropriate \xe2\x80\x9cunit of property\xe2\x80\x9d to distinguish between a repair and an improvement.\nId. at 712. The court considered four factors in making this determination:\nFirst, \xe2\x80\xa6 whether the taxpayer and the industry treat the component part as\npart of the larger unit of property for regulatory, market, management, or\naccounting purposes. Second, \xe2\x80\xa6 whether the economic useful life of the\ncomponent part is coextensive with the economic useful life of the larger\nunit of property. Third, \xe2\x80\xa6 whether the larger unit of property and smaller\nunit of property can function without each other. Finally, \xe2\x80\xa6 whether the\ncomponent part can be and is maintained while affixed to the larger unit of\nproperty.\nId. at 710. The court also addressed the problem that all repairs prolong the useful\nlife of an asset in the sense that but for certain repairs, the unit of property becomes\ninoperable. Rather than compare the condition of the property immediately before\nand immediately after the repair as the government had urged (id. at 714), the court\ncompared the condition of the property immediately after the repair with its\ncondition immediately after the last such repair. Id. at 716.113 The court found that\nthe airplane was not worth more than it was immediately after the last servicing of\nthe engine.\n7. In September 2013, the IRS and the Treasury Department announced final rules\nand regulations concerning taxpayer treatment of the costs of acquisition,\nproduction, or improvement of tangible property.114 The focus of these regulations\nis now on a \xe2\x80\x9cunit of property\xe2\x80\x9d rather than adding to the value of property or\nprolonging its useful life. Capitalization determinations are now made with respect\nto an appropriate \xe2\x80\x9cunit of property\xe2\x80\x9d \xe2\x80\x93 as in FedEx.\n\xe2\x80\xa2Unit of property: The regulations provide a definition of a \xe2\x80\x9cunit of\nproperty,\xe2\x80\x9d i.e., \xe2\x80\x9call the components that are functionally interdependent\ncomprise a single unit of property. Components of property are functionally\ninterdependent if the placing in service of one component by the taxpayer\nis dependent on the placing in service of the other component by the\nThis was the test of Plainfield-Union Water Co. v. Commissioner, 39 T.C. 333, 334 (1962), nonacq. on other\ngrounds, 1964-2 C.B. 8.\n113\n\nGuidance Regarding Deduction and Capitalization of Expenditures Related to Tangible Property,\n78 Fed. Reg. 57686-01 (2013).\n114\n\n328\n\n\x0ctaxpayer.\xe2\x80\x9d Reg. 1.263-3(e)(3)(i). There are some exceptions.\n\xe2\x80\xa2Focus on a \xe2\x80\x9cunit of property\xe2\x80\x9d often goes far to resolve questions of\ndeductible repair versus capitalized improvement. The larger the\n\xe2\x80\x9cunit of property,\xe2\x80\x9d the more substantial may be the components on\nwhich work is merely a \xe2\x80\x9crepair.\xe2\x80\x9d See e.g., Fedex Corp. v. United\nStates, 291 F. Supp. 2d 699, 712 (W.D. Tenn. 2003), aff\xe2\x80\x99d, 412 F.3d\n617 (6th Cir. 2005) (entire aircraft rather than engine was unit of\nproperty; cost of servicing engine deductible).\n8. The regulations create so-called safe harbor exceptions to these rules of\ncapitalization. Taxpayer conformance to the rules of these safe harbors assures\nthem of a certain tax treatment. The regulations also provide that taxpayers may\ntreat \xe2\x80\x9croutine maintenance\xe2\x80\x9d as a deductible expenditure. In many instances,\ntaxpayers may follow their own accounting practices.\n9. Per se Rules: The regulations create some per se rules that will require\ncapitalization of certain expenditures:\n\xe2\x80\xa2New buildings or permanent improvements or betterments to increase\nvalue: Reg. \xc2\xa7 1.263(a)-1(a) denies deductions for amounts paid for new\nbuildings or for permanent improvements or betterments to increase the\nvalue of any property or estate. It also denies deductions for amounts paid\nto restore property or to make good the exhaustion of property for which an\nallowance has been made.\n\xe2\x80\xa2Buildings as units of property: Each building and each structural\ncomponent is a separate single unit of property. Reg. \xc2\xa7 1.263(a)-3(e)(2)(i).\nThe structural components of a building include HVAC systems, plumbing\nsystems, electrical systems, all escalators, all elevators, fire-protection and\nalarm systems, security systems, gas distribution systems, and other\ncomponents identified in published guidance in the Federal Register or the\nInternal Revenue Bulletin. Reg. \xc2\xa7 1.263(a)-3(e)(2)(B).\n\xe2\x80\xa2Acquired or produced tangible property: Reg. \xc2\xa7 1.263(a)-2(d)(1) provides\nin part: \xe2\x80\x9cAcquired or produced tangible property \xe2\x80\x93 (1) Requirement to\ncapitalize. Except [for maintenance and supplies and for the de minimis safe\nharbor,] a taxpayer must capitalize amounts paid to acquire or produce a\nunit of real or personal property \xe2\x80\xa6 including leasehold improvements, land\nand land improvements, buildings, machinery and equipment, and furniture\nand fixtures. \xe2\x80\xa6\n\xe2\x80\xa2Improvements. Reg. \xc2\xa7 1.263(a)-3(d) provides in part: \xe2\x80\x9cRequirement to\ncapitalize amounts paid for improvements. Except [for \xe2\x80\x9csmall taxpayers,\xe2\x80\x9d\n329\n\n\x0creliance on taxpayer\xe2\x80\x99s own accounting treatment of expenditures, and de\nminimis expenditures,] \xe2\x80\xa6 a taxpayer generally must capitalize the related\namounts \xe2\x80\xa6 paid to improve a unit of property owned by the taxpayer. \xe2\x80\xa6\nFor purposes of this section, a unit of property is improved if the amounts\npaid for activities performed after the property is placed in service by the\ntaxpayer \xe2\x80\x93\n(1) Are for a betterment to the unit of property \xe2\x80\xa6;\n(2) Restore the unit of property ...; or\n(3) Adapt the unit of property to a new or different use \xe2\x80\xa6\xe2\x80\x9d\n\xe2\x80\xa2Betterments: Taxpayer must capitalize a \xe2\x80\x9cbetterment to a unit of property.\xe2\x80\x9d\nReg. \xc2\xa7 1.263(a)-3(j)(1). A \xe2\x80\x9cbetterment\xe2\x80\x9d \xe2\x80\x93\n\xe2\x80\x9c(i) Ameliorates a material condition or defect that either existed\nprior to the taxpayer\xe2\x80\x99s acquisition of the unit of property or arose\nduring the production of the unit of property, whether or not the\ntaxpayer was aware of the condition or defect at the time of\nacquisition or production;\n(ii) Is for a material addition, including a physical enlargement,\nexpansion, extension, or addition of a major component \xe2\x80\xa6 to the\nunit of property or a material increase in the capacity, including\nadditional cubic or linear space, of the unit of property; or\n(iii) Is reasonably expected to materially increase the productivity,\nefficiency, strength, quality, or output of the unit of property.\xe2\x80\x9d\nReg. \xc2\xa7 1.263(a)-3(j)(1).\n\xe2\x80\xa2Would the improvement in Mr. Morris Drive-In be a betterment?\n\xe2\x80\xa2Restoration: Taxpayer must capitalize amounts paid to restore property.\nReg. \xc2\xa7 1.263(a)-3(k)(1). A \xe2\x80\x9crestoration\xe2\x80\x9d \xe2\x80\x93\n\xe2\x80\x9c(i) Is for the replacement of a component of a unit of property for\nwhich the taxpayer has properly deducted a loss for that component,\nother than a casualty loss \xe2\x80\xa6;\n(ii) Is for the replacement of a component of a unit of property for\nwhich the taxpayer has properly taken into account the adjusted\nbasis of the component in realizing gain or loss resulting from the\nsale or exchange of the component;\n(iii) Is for the restoration of damage to a unit of property for which\nthe taxpayer is required to take a basis adjustment as a result of a\ncasualty loss \xe2\x80\xa6 or relating to a casualty event \xe2\x80\xa6;\n(iv) Returns the unit to its ordinarily efficient operating condition if\nthe property has deteriorated to a state of disrepair and is no longer\n330\n\n\x0cfunctional for its intended use;\n(v) Results in the rebuilding of the unit of property to a like-new\ncondition after the end of its class life \xe2\x80\xa6; or\n(vi) Is for the replacement of a part or a combination of parts that\ncomprise a major component or a substantial structural part of a unit\nof property \xe2\x80\xa6\xe2\x80\x9d\nReg. \xc2\xa7 1.263(a)-3(k)(1). Whether \xe2\x80\x9ca part or a combination of parts \xe2\x80\xa6\ncomprise a major component or a substantial structural part of a unit of\nproperty\xe2\x80\x9d depends on all of the facts and circumstances, including \xe2\x80\x9cthe\nquantitative and qualitative significance of the part or combination of parts\nin relation to the unit of property.\xe2\x80\x9d Reg. \xc2\xa7 1.263(a)-3(k)(6)(i). Application\nof this regulation will require distinguishing between parts that are \xe2\x80\x9ca major\ncomponent or a substantial structural part of a unit of property\xe2\x80\x9d and those\nthat are not.\n\xe2\x80\xa2Adaptation: Taxpayer must capitalize amounts paid to adapt a unit of\nproperty to a new use. Reg. \xc2\xa7 1.263(a)-3(l)(1). An \xe2\x80\x9cadaptation\xe2\x80\x9d adapts \xe2\x80\x9ca\nunit of property to a new or different use if the adaptation is not consistent\nwith the taxpayer\xe2\x80\x99s ordinary use of the unit of property at the time originally\nplaced in service by the taxpayer.\xe2\x80\x9d Reg. \xc2\xa7 1.263(a)-3(l)(1). In the case of a\nbuilding, the adaptation adapts the building to a \xe2\x80\x9cnew or different use.\xe2\x80\x9d Reg.\n\xc2\xa7 1.263(a)-3(l)(2).\n10. Safe Harbors: The capitalization rules create several safe harbors:\n\xe2\x80\xa2De minimis Expenditures: Reg. \xc2\xa7 1.263(a)-1(f)(1)(i) provides an elective\nde minimis safe harbor under which taxpayers with \xe2\x80\x9capplicable financial\nstatements\xe2\x80\x9d may deduct expenditures of up to $5000 per invoice that it treats\nas an expense on its \xe2\x80\x9capplicable financial statement\xe2\x80\x9d and in accord with its\nwritten accounting procedures. There is no limit to the number of times\ntaxpayer may rely on this safe harbor during a tax year.\n\xe2\x80\xa2An \xe2\x80\x9capplicable financial statement\xe2\x80\x9d is \xe2\x80\x93 in order of preference \xe2\x80\x93 (1)\na financial statement that taxpayer must file with the SEC, (2) a\ncertified audited financial statement that taxpayer uses for credit\npurposes, reports to shareholders or the like, or for any other\nsubstantial non-tax purpose, and (3) a financial statement that\ntaxpayer must provide to a federal or state government agency other\nthan the SEC or the IRS. Reg. \xc2\xa7 1.263-1(f)(4).\n\xe2\x80\xa2Taxpayers without an applicable financial statement, but who\nmaintain throughout the year accounting procedures that treat an\n331\n\n\x0citem as an expense for non-tax purposes, may expense up to $500\nper invoice. Reg. \xc2\xa7 1.263(a)-1(f)(1)(ii).\nThe importance of this safe harbor is that it eases the accounting burdens of\ntaxpayers \xe2\x80\x93 both by not requiring capitalization of de minimis amounts and\nby allowing taxpayer to use the same accounting information that it uses for\ncertain parties other than the IRS.\n\xe2\x80\xa2\xe2\x80\x9cSmall Taxpayers\xe2\x80\x9d: A \xe2\x80\x9csmall taxpayer\xe2\x80\x9d \xe2\x80\x93 one whose average gross receipts\nfor the three preceding taxable years does not exceed $10M \xe2\x80\x93 may elect not\nto apply the improvements provision to building property \xe2\x80\x9cif the total\namount paid during the taxable year for repairs, maintenance,\nimprovements, and similar activities performed on the \xe2\x80\xa6 building property\ndoes not exceed the lesser of\xe2\x80\x9d 2% of the unadjusted basis [of $1M or less]\nof the building property or $10,000. Reg. \xc2\xa7 1.263(a)-3(h)(1, 3, and 4).\n\xe2\x80\xa2\xe2\x80\x9cRoutine Maintenance\xe2\x80\x9d: \xe2\x80\x9cRoutine maintenance\xe2\x80\x9d does not improve\nproperty. Reg. \xc2\xa7 1.263(a)-3(i)(1). \xe2\x80\x9cRoutine maintenance\xe2\x80\x9d is\nrecurring activities that a taxpayer expects to perform in order to\nkeep the building or each building system in \xe2\x80\x9cordinarily efficient\noperating condition.\xe2\x80\x9d In order to be \xe2\x80\x9croutine\xe2\x80\x9d in the case of a\nbuilding, taxpayer must expect to perform the activities more than\nonce during the 10-year period following placement in service. In\norder to be \xe2\x80\x9croutine\xe2\x80\x9d in the case of other property, taxpayer must\nexpect at the time of placement into service to perform the activities\nmore than once during the class life of the property. Reg. \xc2\xa7 1.263(a)3(i)(i, ii).\n\xe2\x80\xa2\xe2\x80\x9cElections to Capitalize\xe2\x80\x9d: A taxpayer may elect to capitalize all\nrepair and maintenance costs as improvements consistent with the\nmanner in which it keeps its own books and records. \xc2\xa7 1.263(a)3(n)(1). This permits taxpayers who conservatively capitalized all\nrepair and maintenance costs to elect not to undertake the burden of\nchanging their practices.\n11. Reg. \xc2\xa7 1.162-4(a) permits expensing of residual amounts as \xe2\x80\x9crepairs and\nmaintenance.\xe2\x80\x9d Additionally, Reg. \xc2\xa7 1.162-3 establishes rules for the timing and\ndeductibility of incidental and non-incidental \xe2\x80\x9cmaterials and supplies.\xe2\x80\x9d \xe2\x80\x9cMaterials\nand supplies\xe2\x80\x9d are tangible property that taxpayer uses or consumes in its operations\nthat is not inventory that\n\xe2\x80\xa2is a component that taxpayer acquires to maintain, repair, or improve a unit\nof tangible property and that is not acquired as a part of any single unit of\n332\n\n\x0ctangible property,\n\xe2\x80\xa2is fuel, lubricants, water, and the like \xe2\x80\x93 that taxpayer reasonably expects to\nconsume in 12 months or less, beginning when taxpayer uses the items in\nits operations,\n\xe2\x80\xa2is a unit of property with an \xe2\x80\x9ceconomic useful life\xe2\x80\x9d (i.e., the period over\nwhich taxpayer may reasonably expect the property to be useful and relying\non taxpayer\xe2\x80\x99s assessment in its \xe2\x80\x9capplicable financial statement\xe2\x80\x9d if it has one,\nReg. \xc2\xa7 1.162-3(c)(4)), of 12 months or less, beginning when the taxpayer\nuses or consumes the item in its operations,\n\xe2\x80\xa2is a unit of property whose acquisition cost or production cost is $200 or\nless, or\n\xe2\x80\xa2is identified in the Federal Register or the Internal Revenue Bulletin as\n\xe2\x80\x9cmaterials and supplies.\xe2\x80\x9d\nReg. \xc2\xa71.162-3(c)(1).\n\xe2\x80\x9cIncidental materials and supplies\xe2\x80\x9d are those that taxpayer keeps on hand and of\nwhich taxpayer keeps no record of consumption or takes no physical inventory at\nthe beginning and end of the taxable year. Taxpayer may deduct the costs of\n\xe2\x80\x9cincidental materials and supplies\xe2\x80\x9d in the year in which it pays for them, provided\nthat its income is clearly reflected. Reg. \xc2\xa7 1.162-3(a)(2). \xe2\x80\x9cNon-incidental materials\nand supplies\xe2\x80\x9d are, presumably, all other materials and supplies. Taxpayer may\ndeduct their costs when it first uses or consumes them in its operations. Reg.\n\xc2\xa7 1.162-3(a)(1).\n\xe2\x80\x9cMaterials and supplies\xe2\x80\x9d are neither a capital asset under \xc2\xa7 1221 nor \xe2\x80\x9cproperty used\nin the trade or business\xe2\x80\x9d under \xc2\xa7 1231. Reg. \xc2\xa7 1.162-3(g). There is no provision to\ncapitalize \xe2\x80\x9cmaterials and supplies\xe2\x80\x9d except for rotable spare parts, temporary spare\nparts, and standby emergency spare parts. Taxpayer must deduct expenditures for\nother \xe2\x80\x9cmaterials and supplies\xe2\x80\x9d at the appropriate time.\n12. Examples and hypotheticals:\n12a. J provides legal services to its clients. J purchases a laptop computer and a\nprinter for its employees to use in providing legal services. Are the computer and\nprinter a single unit of property or separate units of property? See Reg. \xc2\xa7 1.263(a)3(e)(6), Example 9.\n12b. H owns locomotives that it uses in its railroad business. Each locomotive\n333\n\n\x0cconsists of various components, such as an engine, generators, batteries, and trucks.\nH acquired a locomotive with all its components. Is the locomotive a single unit of\nproperty? See Reg. \xc2\xa7 1.263(a)-3(e)(6), Example 8.\n12c. In Year 1, A purchases 10 printers at $250 each for a total cost of $2500 as\nindicated by the invoice. Assume that each printer is a unit of property. A does not\nhave an AFS. A has accounting procedures in place at the beginning of Year 1 to\nexpense amounts paid for property that costs less than $500, and A treats the\namounts paid for the printers as an expense on its books and records. May A deduct\nthe cost of the printers? See Reg. \xc2\xa7 1.263(a)-1(f)(7), Example 1.\n\xe2\x80\xa2Same facts, except that the printers cost $600 each. A has accounting\nprocedures in place at the beginning of Year 1 to expense amounts paid for\nproperty costing less than $1000, and A treats the amounts paid for the\nprinters as an expense on its books and records. May A deduct the cost of\nthe printers? See Reg. \xc2\xa7 1.263(a)-1(f)(7), Example 2.\n12d. A purchases new cash registers for use in its retail store located in leased space\nin a shopping mall that cost $6000 each. Assume each cash register is a unit of\nproperty and is not a material or supply. May A deduct the cost of the cash registers?\nSee Reg. \xc2\xa7 1.263(a)-2(d)(2), Example 1.\n12e. E is a towboat operator that owns and leases a fleet of towboats. Each towboat\nis equipped with two diesel-powered engines. Each towboat, including its engines,\nis the unit of property and has a class life of 18 years. At the time that E places its\ntowboats into service, E is aware that approximately every three to four years E will\nneed to perform scheduled maintenance on the two towboat engines to keep the\nengines in their ordinarily efficient operating condition. This maintenance is\ncompleted while the engines are attached to the towboat and involves the cleaning\nand inspecting of the engines to determine which parts are within acceptable\noperating tolerances and can continue to be used, which parts must be reconditioned\nto be brought back to acceptable tolerances, and which parts must be replaced.\nEngine parts replaced during these procedures are replaced with comparable and\ncommercially available replacement parts. The towboat engines are not rotable\nspare parts. In Year 1, E acquired a new towboat, including its two engines, and\nplaced the towboat into service. In Year 5, E pays amounts to perform scheduled\nmaintenance on both engines in the towboat. Should E be permitted to deduct these\nexpenses as routine maintenance? See Reg. \xc2\xa7 1.263(a)-3(i)(6), Example 9.\n12f. Consider the following: In Year 1, X purchased a store located on a parcel of\n334\n\n\x0cland that contained underground gasoline storage tanks left by prior occupants. The\nparcel of land is the unit of property. The tanks had leaked, causing soil\ncontamination. X was not aware of the contamination at the time of purchase. In\nYear 2, X discovered the contamination and incurred costs to remediate the soil.\nMay X deduct the expenses of soil remediation, or must X capitalize the\nexpenditure? See Reg. 1.263(a)-3(j)(3), Example 1.\n12g. X owns an office building that was constructed with insulation that contained\nasbestos. The health dangers of asbestos were not widely known when the building\nwas constructed. Several years after X places the building into service, X\ndetermined that certain areas of asbestos-containing insulation had begun to\ndeteriorate and could eventually pose a health risk to employees. Therefore, X\ndecided to remove the asbestos-containing insulation from the building and replace\nit with new insulation that was safer to employees, but no more efficient or effective\nthan the asbestos insulation. May X deduct the expenses of removal of the asbestos\nand replacement with safer insulation, or must X capitalize the expenditure? See\nReg. 1.263(a)-3(j)(3), Example 2.\n12h. X acquires a building for use in its business of providing assisted living\nservices. Before and after the purchase, the building functioned as an assisted living\nfacility. However, at the time of the purchase, X was aware that the building was\nin a condition below the standards that it requires for facilities used in its business.\nImmediately after the acquisition and during the following two years, while X\ncontinued to use the building as an assisted living facility, X incurred costs for\nextensive repairs and maintenance, and the acquisition of new property to bring the\nfacility into the high-quality condition for which X\xe2\x80\x99s facilities are known. The work\nincluded repairing damaged drywall; repainting and re-wallpapering; replacing\nflooring materials, windows, and tiling and fixtures in bathrooms; replacing\nwindow treatments, furniture, and cabinets; and repairing or replacing roofing\nmaterials, heating and cooling systems. May X deduct the expenses of bringing the\nfacility into high-quality condition, or must X capitalize the expenditure? See Reg.\n1.263(a)-3(j)(3), Example 5 (i and ii).\n12i. D owns a parcel of land on which it previously operated a manufacturing\nfacility. Assume that the land is the unit of property. During the course of D\xe2\x80\x99s\noperation of the manufacturing facility, the land became contaminated with wastes\nfrom its manufacturing processes. D discontinues manufacturing operations at the\nsite and decides to develop the property for residential housing. In anticipation of\nbuilding residential property, D pays an amount to remediate the contamination\n335\n\n\x0ccaused by D\xe2\x80\x99s manufacturing process. In addition, D pays an amount to regrade the\nland so that it can be used for residential purposes. May D deduct the amounts it\npaid to clean up the waste? What about the amounts it paid to regrade the land? See\nReg. \xc2\xa7 1.263(a)-3(l)(3), Example 4.\n\nII. Deductibility Under \xc2\xa7\xc2\xa7 162 or 212\nAfter determining that an expense is not a capital expenditure, \xc2\xa7 162 (and \xc2\xa7 212),\ncoupled with \xc2\xa7 274 define and delimit the precise scope of expenses of generating\nincome that taxpayer may deduct. Read \xc2\xa7 162(a). How many specific types of trade\nor business expenses does it name? We consider several \xc2\xa7 162 issues.\n\xe2\x80\xa2Read \xc2\xa7 262. What are the consequences of a court concluding that an\nexpenditure is for a personal expense?\nA. Travel Expenses\nRead \xc2\xa7 162(a)(2).\nCommissioner v. Flowers, 326 U.S. 465 (1946)\nMR. JUSTICE MURPHY delivered the opinion of the Court.\nThis case presents a problem as to the meaning and application of the provision of\n\xc2\xa7 [162(a)(2)] of the Internal Revenue Code, [footnote omitted] allowing a\ndeduction for income tax purposes of \xe2\x80\x9ctraveling expenses (including the entire\namount expended for meals and lodging) while away from home in the pursuit of a\ntrade or business.\xe2\x80\x9d\nThe taxpayer, a lawyer, has resided with his family in Jackson, Mississippi, since\n1903. There, he has paid taxes, voted, schooled his children, and established social\nand religious connections. He built a house in Jackson nearly thirty years ago, and\nat all times has maintained it for himself and his family. He has been connected\nwith several law firms in Jackson, one of which he formed and which has borne his\nname since 1922.\nIn 1906, the taxpayer began to represent the predecessor of the Gulf, Mobile &\nOhio Railroad, his present employer. He acted as trial counsel for the railroad\n336\n\n\x0cthroughout Mississippi. From 1918 until 1927, he acted as special counsel for the\nrailroad in Mississippi. He was elected general solicitor in 1927, and continued to\nbe elected to that position each year until 1930, when he was elected general\ncounsel. Thereafter, he was annually elected general counsel until September, 1940,\nwhen the properties of the predecessor company and another railroad were merged\nand he was elected vice-president and general counsel of the newly formed Gulf,\nMobile & Ohio Railroad.\nThe main office of the Gulf, Mobile & Ohio Railroad is in Mobile, Alabama, as\nwas also the main office of its predecessor. When offered the position of general\nsolicitor in 1927, the taxpayer was unwilling to accept it if it required him to move\nfrom Jackson to Mobile. He had established himself in Jackson both professionally\nand personally, and was not desirous of moving away. As a result, an arrangement\nwas made between him and the railroad whereby he could accept the position and\ncontinue to reside in Jackson on condition that he pay his traveling expenses\nbetween Mobile and Jackson and pay his living expenses in both places. This\narrangement permitted the taxpayer to determine for himself the amount of time he\nwould spend in each of the two cities, and was in effect during 1939 and 1940, the\ntaxable years in question.\nThe railroad company provided an office for the taxpayer in Mobile, but not in\nJackson. When he worked in Jackson, his law firm provided him with office space,\nalthough he no longer participated in the firm\xe2\x80\x99s business or shared in its profits. He\nused his own office furniture and fixtures at this office. The railroad, however,\nfurnished telephone service and a typewriter and desk for his secretary. It also paid\nthe secretary\xe2\x80\x99s expenses while in Jackson. Most of the legal business of the railroad\nwas centered in or conducted from Jackson, but this business was handled by local\ncounsel for the railroad. The taxpayer\xe2\x80\x99s participation was advisory only, and was\nno different from his participation in the railroad\xe2\x80\x99s legal business in other areas.\nThe taxpayer\xe2\x80\x99s principal post of business was at the main office in Mobile.\nHowever, during the taxable years of 1939 and 1940, he devoted nearly all of his\ntime to matters relating to the merger of the railroads. Since it was left to him where\nhe would do his work, he spent most of his time in Jackson during this period. In\nconnection with the merger, one of the companies was involved in certain litigation\nin the federal court in Jackson, and the taxpayer participated in that litigation.\nDuring 1939, he spent 203 days in Jackson and 66 in Mobile, making 33 trips\nbetween the two cities. During 1940, he spent 168 days in Jackson and 102 in\n337\n\n\x0cMobile, making 40 trips between the two cities. The railroad paid all of his traveling\nexpenses when he went on business trips to points other than Jackson or Mobile.\nBut it paid none of his expenses in traveling between these two points or while he\nwas at either of them.\nThe taxpayer deducted $900 in his 1939 income tax return and $1,620 in his 1940\nreturn as traveling expenses incurred in making trips from Jackson to Mobile and\nas expenditures for meals and hotel accommodations while in Mobile.115 The\nCommissioner disallowed the deductions, which action was sustained by the Tax\nCourt. But the Fifth Circuit Court of Appeals reversed the Tax Court\xe2\x80\x99s judgment,\nand we granted certiorari because of a conflict between the decision below and that\nreached by the Fourth Circuit Court of Appeals in Barnhill v. Commissioner, 148\nF.2d 913.\nThe portion of \xc2\xa7 [162(a)(2)] authorizing the deduction of \xe2\x80\x9ctraveling expenses\n(including the entire amount expended for meals and lodging) while away from\nhome in the pursuit of a trade or business\xe2\x80\x9d is one of the specific examples given by\nCongress in that section of \xe2\x80\x9cordinary and necessary expenses paid or incurred\nduring the taxable year in carrying on any trade or business.\xe2\x80\x9d It is to be contrasted\nwith the provision of \xc2\xa7 [262(a)] of the Internal Revenue Code, disallowing any\ndeductions for \xe2\x80\x9cpersonal, living, or family expenses.\xe2\x80\x9d ... In pertinent part, [the\napplicable regulation] states that \xe2\x80\x9cTraveling expenses, as ordinarily understood,\ninclude railroad fares and meals and lodging. If the trip is undertaken for other than\nbusiness purposes, the railroad fares are personal expenses, and the meals and\nlodging are living expenses. If the trip is solely on business, the reasonable and\nnecessary traveling expenses, including railroad fares, meals, and lodging, are\nbusiness expenses. ... Only such expenses as are reasonable and necessary in the\nconduct of the business and directly attributable to it may be deducted. ...\nCommuters\xe2\x80\x99 fares are not considered as business expenses, and are not deductible.\xe2\x80\x9d\nThree conditions must thus be satisfied before a traveling expense deduction may\nbe made under \xc2\xa7 [162(a)(2)]:\n(1) The expense must be a reasonable and necessary traveling expense, as that term\nis generally understood. This includes such items as transportation fares and food\nand lodging expenses incurred while traveling.\nNo claim for deduction was made by the taxpayer for the amounts spent in traveling from Mobile\nto Jackson. ...\n115\n\n338\n\n\x0c(2) The expense must be incurred \xe2\x80\x9cwhile away from home.\xe2\x80\x9d\n(3) The expense must be incurred in pursuit of business. This means that there must\nbe a direct connection between the expenditure and the carrying on of the trade or\nbusiness of the taxpayer or of his employer. Moreover, such an expenditure must\nbe necessary or appropriate to the development and pursuit of the business or trade.\nWhether particular expenditures fulfill these three conditions so as to entitle a\ntaxpayer to a deduction is purely a question of fact in most instances. See\nCommissioner v. Heininger, 320 U. S. 467, 475. And the Tax Court\xe2\x80\x99s inferences\nand conclusions on such a factual matter, under established principles, should not\nbe disturbed by an appellate court. Commissioner v. Scottish American Co., 323\nU.S. 119; Dobson v. Commissioner, 320 U. S. 489.\nIn this instance, the Tax Court, without detailed elaboration, concluded that \xe2\x80\x9cThe\nsituation presented in this proceeding is, in principle, no different from that in which\na taxpayer\xe2\x80\x99s place of employment is in one city and, for reasons satisfactory to\nhimself, he resides in another.\xe2\x80\x9d It accordingly disallowed the deductions on the\nground that they represent living and personal expenses, rather than traveling\nexpenses incurred while away from home in the pursuit of business. The court\nbelow accepted the Tax Court\xe2\x80\x99s findings of fact, but reversed its judgment on the\nbasis that it had improperly construed the word \xe2\x80\x9chome\xe2\x80\x9d as used in the second\ncondition precedent to a traveling expense deduction under \xc2\xa7 [162(a)(2)] The Tax\nCourt, it was said, erroneously construed the word to mean the post, station, or place\nof business where the taxpayer was employed \xe2\x80\x93 in this instance, Mobile \xe2\x80\x93 and thus\nerred in concluding that the expenditures in issue were not incurred \xe2\x80\x9cwhile away\nfrom home.\xe2\x80\x9d The Court below felt that the word was to be given no such \xe2\x80\x9cunusual\xe2\x80\x9d\nor \xe2\x80\x9cextraordinary\xe2\x80\x9d meaning in this statute, that it simply meant \xe2\x80\x9cthat place where\none in fact resides\xe2\x80\x9d or \xe2\x80\x9cthe principal place of abode of one who has the intention to\nlive there permanently.\xe2\x80\x9d Since the taxpayer here admittedly had his home, as thus\ndefined, in Jackson, and since the expenses were incurred while he was away from\nJackson, the deduction was permissible.\nThe meaning of the word \xe2\x80\x9chome\xe2\x80\x9d in \xc2\xa7 [162(a)(2)] with reference to a taxpayer\nresiding in one city and working in another has engendered much difficulty and\nlitigation. 4 MERTENS, LAW OF FEDERAL INCOME TAXATION (1942) \xc2\xa7 25.82. The\nTax Court [footnote omitted] and the administrative rulings116 have consistently\n[The pertinent regulation] does not attempt to define the word \xe2\x80\x9chome,\xe2\x80\x9d although the Commissioner\nargues that the statement therein contained to the effect that commuters\xe2\x80\x99 fares are not business\nexpenses, and are not deductible \xe2\x80\x9cnecessarily rests on the premise that home,\xe2\x80\x99 for tax purposes, is at the\n116\n\n339\n\n\x0cdefined it as the equivalent of the taxpayer\xe2\x80\x99s place of business. See Barnhill v.\nCommissioner, supra. On the other hand, the decision below and Wallace v.\nCommissioner, 144 F.2d 407, have flatly rejected that view, and have confined the\nterm to the taxpayer\xe2\x80\x99s actual residence. [citation omitted].\nWe deem it unnecessary here to enter into or to decide this conflict. The Tax Court\xe2\x80\x99s\nopinion, as we read it, was grounded neither solely nor primarily upon that agency\xe2\x80\x99s\nconception of the word \xe2\x80\x9chome.\xe2\x80\x9d Its discussion was directed mainly toward the\nrelation of the expenditures to the railroad\xe2\x80\x99s business, a relationship required by the\nthird condition of the deduction. Thus, even if the Tax Court\xe2\x80\x99s definition of the\nword \xe2\x80\x9chome\xe2\x80\x9d was implicit in its decision, and even if that definition was erroneous,\nits judgment must be sustained here if it properly concluded that the necessary\nrelationship between the expenditures and the railroad\xe2\x80\x99s business was lacking.\nFailure to satisfy any one of the three conditions destroys the traveling expense\ndeduction.\nTurning our attention to the third condition, this case is disposed of quickly. ...\nThe facts demonstrate clearly that the expenses were not incurred in the pursuit of\nthe business of the taxpayer\xe2\x80\x99s employer, the railroad. Jackson was his regular home.\nHad his post of duty been in that city, the cost of maintaining his home there and\nof commuting or driving to work concededly would be nondeductible living and\npersonal expenses lacking the necessary direct relation to the prosecution of the\nbusiness. The character of such expenses is unaltered by the circumstance that the\ntaxpayer\xe2\x80\x99s post of duty was in Mobile, thereby increasing the costs of\ntransportation, food, and lodging. Whether he maintained one abode or two,\nwhether he traveled three blocks or three hundred miles to work, the nature of these\nexpenditures remained the same.\nThe added costs in issue, moreover, were as unnecessary and inappropriate to the\ndevelopment of the railroad\xe2\x80\x99s business as were his personal and living costs in\nJackson. They were incurred solely as the result of the taxpayer\xe2\x80\x99s desire to maintain\na home in Jackson while working in Mobile, a factor irrelevant to the maintenance\nand prosecution of the railroad\xe2\x80\x99s legal business. The railroad did not require him to\ntravel on business from Jackson to Mobile, or to maintain living quarters in both\nlocality of the taxpayer\xe2\x80\x99s business headquarters.\xe2\x80\x9d Other administrative rulings have been more explicit\nin treating the statutory home as the abode at the taxpayer\xe2\x80\x99s regular post of duty. See, e.g., O.D. 1021, 5\nCum. Bull. 174 (1921); I.T. 1264, I-1 Cum. Bull. 122 (1922); I.T. 3314, 1939-2 Cum. Bull. 152; G.C.M.\n23672, 1943 Cum. Bull. 66.\n\n340\n\n\x0ccities. Nor did it compel him, save in one instance, to perform tasks for it in Jackson.\nIt simply asked him to be at his principal post in Mobile as business demanded and\nas his personal convenience was served, allowing him to divide his business time\nbetween Mobile and Jackson as he saw fit. Except for the federal court litigation,\nall of the taxpayer\xe2\x80\x99s work in Jackson would normally have been performed in the\nheadquarters at Mobile. The fact that he traveled frequently between the two cities\nand incurred extra living expenses in Mobile, while doing much of his work in\nJackson, was occasioned solely by his personal propensities. The railroad gained\nnothing from this arrangement except the personal satisfaction of the taxpayer.\nTravel expenses in pursuit of business within the meaning of \xc2\xa7 [162(a)(2)] could\narise only when the railroad\xe2\x80\x99s business forced the taxpayer to travel and to live\ntemporarily at some place other than Mobile, thereby advancing the interests of the\nrailroad. Business trips are to be identified in relation to business demands and the\ntraveler\xe2\x80\x99s business headquarters. The exigencies of business, rather than the\npersonal conveniences and necessities of the traveler, must be the motivating\nfactors. Such was not the case here.\nIt follows that the court below erred in reversing the judgment of the Tax Court.\nReversed.\nMR. JUSTICE JACKSON took no part in the consideration or decision of this case.\nMR. JUSTICE RUTLEDGE, dissenting.\nI think the judgment of the Court of Appeals should be affirmed. When Congress\nused the word \xe2\x80\x9chome\xe2\x80\x9d in \xc2\xa7 [162] of the Code, I do not believe it meant \xe2\x80\x9cbusiness\nheadquarters.\xe2\x80\x9d And, in my opinion, this case presents no other question.\n\xe2\x80\xa6.\nCongress gave the deduction for traveling away from home on business. The\ncommuter\xe2\x80\x99s case, rightly confined, does not fall in this class. One who lives in an\nadjacent suburb or City and by usual modes of commutation can work within a\ndistance permitting the daily journey and return, with time for the day\xe2\x80\x99s work and\na period at home, clearly can be excluded from the deduction on the basis of the\nsection\xe2\x80\x99s terms equally with its obvious purpose. ... If the line may be extended\nsomewhat to cover doubtful cases, it need not be lengthened to infinity or to cover\n341\n\n\x0ccases as far removed from the prevailing connotation of commuter as this one.\nIncluding it pushes \xe2\x80\x9ccommuting\xe2\x80\x9d too far, even for these times of rapid transit.117\nAdministrative construction should have some bounds. It exceeds what are\nlegitimate when it reconstructs the statute to nullify or contradict the plain meaning\nof nontechnical terms not artfully employed. ...\nBy construing \xe2\x80\x9chome\xe2\x80\x9d as \xe2\x80\x9cbusiness headquarters;\xe2\x80\x9d by reading \xe2\x80\x9ctemporarily\xe2\x80\x9d as\n\xe2\x80\x9cvery temporarily\xe2\x80\x9d into \xc2\xa7 [162]; by bringing down \xe2\x80\x9cordinary and necessary\xe2\x80\x9d from\nits first sentence into its second;118 by finding \xe2\x80\x9cinequity\xe2\x80\x9d where Congress has said\nnone exists; by construing \xe2\x80\x9ccommuter\xe2\x80\x9d to cover long distance, irregular travel, and\nby conjuring from the \xe2\x80\x9cstatutory setting\xe2\x80\x9d a meaning at odds with the plain wording\nof the clause, the Government makes over understandable ordinary English into\nhighly technical tax jargon. ...\nNotes and Questions:\n1. Reg. \xc2\xa7 1.162-2 is now the regulation covering \xe2\x80\x9ctraveling expenses.\xe2\x80\x9d Its\nprovisions have not materially changed from those that the Court quoted in\nFlowers.\n2. Can commuting expenses ever meet the third requirement of deductibility, i.e.,\n\xe2\x80\x9ca direct connection between the expenditure and the carrying on of the trade or\nbusiness of the taxpayer or of his employer?\xe2\x80\x9d\n\nConceivably men soon may live in Florida or California and fly daily to work in New York and back.\nPossibly they will be regarded as commuters when that day comes. But, if so, that is not this case and,\nin any event, neither situation was comprehended by Congress when \xc2\xa7 [162] was enacted.\n117\n\n118\n\nThe language is:\n\xe2\x80\x9cAll the ordinary and necessary expenses paid or incurred during the taxable year in carrying\non any trade or business, including a reasonable allowance for salaries or other compensation\nfor personal services actually rendered; traveling expenses (including the entire amount\nexpended for meals and lodging) while away from home in the pursuit of a trade or\nbusiness. . . .\xe2\x80\x9d\n\n\xc2\xa7 [162(a)], Internal Revenue Code.\n\n342\n\n\x0cFlowers and the cases that follow\nrest on an assumption that\ntaxpayers work in one place and\nreside in another. This conception of\ncommuting and work was evolving\nbefore the pandemic. The pandemic\neroded (if not obliterated) this\nbinary conception of work and\nresidence further. A question for the\nyears ahead is how tax law should\nadapt to these changes.\n\n3. Does Justice Rutledge have a point? After\nall, the Court later construed the word \xe2\x80\x9cgift\xe2\x80\x9d\nin its ordinary sense in Duberstein.\n4. Upon application of the Court\xe2\x80\x99s standards,\nwhy will taxpayer\xe2\x80\x99s home usually be the\n\xe2\x80\x9cpost, station, or place of business where the\ntaxpayer [is] employed?\xe2\x80\x9d\n\n5. Robert Rosenspan was a jewelry salesman\nwho worked on a commission basis and paid\nhis own traveling expenses without reimbursement. In 1964, two New York City\njewelry manufacturers employed him. For 300 days during the year he traveled by\nautomobile through an extensive sales territory in the midwest. He stayed at motels\nand ate at restaurants. Five times per year he returned to New York and spent\nseveral days at his employers\xe2\x80\x99 offices. There he performed a variety of services\nessential to his work, i.e., cleaned his sample case, checked orders, discussed\ncustomers\xe2\x80\x99 credit problems, recommended changes in stock, attended annual staff\nmeetings, and the like. He used his brother\xe2\x80\x99s Brooklyn home as a personal\nresidential address. He kept some clothing and other belongings there. He voted\nand filed his income tax returns from that address. On his trips to New York City,\n\xe2\x80\x9cout of a desire not to abuse his welcome at his brother\xe2\x80\x99s home, he stayed more\noften\xe2\x80\x9d at an inn near the John F. Kennedy Airport.\n\xe2\x80\xa2What tax issue(s) do these facts raise? How should they be resolved?\n\xe2\x80\xa2See Rosenspan v. United\nStates, 438 F.2d 905 (2d Cir.),\nReimbursement of Non-deductible Expenditures:\ncert. denied, 404 U.S. 864\nTaxpayer paid his expenses and tried to\n(1971).\ndeduct them. What result if taxpayer\xe2\x80\x99s\nemployer had paid for taxpayer\xe2\x80\x99s train tickets,\n5a. Folkman, an airline pilot,\nhotels, and meals while in Mobile? Would\nwas stationed in San Francisco\n(should) that have solved taxpayer\xe2\x80\x99s problems\n\xe2\x80\x93 or made them worse? See discussion of Brandl\nInternational Airport as an\nv. Commissioner, infra.\nemployee of Pan American\nWorld Airways. He flew\ninfrequently as a pilot with Pan\nAmerican because of his low seniority. His principal work was that of navigator.\nTo maintain his proficiency as a jet pilot, and to earn extra income, Folkman\nenlisted in a military reserve program, which required that he live in Reno, Nevada,\n343\n\n\x0cabout 250 miles from San Francisco. Folkman and his family moved from their\nhome near the San Francisco airport, to Reno. Folkman divided his time between\nflying with Pan American from\nhis San Francisco base and flying\nReimbursement or Other Expense Allowance\nfor the Nevada Air National\nArrangement: An employee may not deduct\nGuard. During an average month\nhis trade or business expenses until 2026.\nFolkman spent 10 to 13 days\n\xc2\xa7 67(g). In 2026, the employee may only\nperforming services for Pan\nclaim that deduction if he itemizes deductions,\nAmerican and four to seven days\nand trade or business deductions of an\nfulfilling his military reserve\nemployee are subject to the 2% floor for\n\xe2\x80\x9cmiscellaneous deductions.\xe2\x80\x9d See \xc2\xa7 67(a). An\nflying obligations. Whether he\nemployee must include any employer\nwas scheduled to fly for the\nreimbursement in his gross income and pay\nNational Guard on a given day,\nincome tax on most or all of it.\nFolkman routinely returned to\nReno immediately after his Pan\nHowever, \xc2\xa7 62(a)(2)(A) permits taxpayer to\nAmerican flights. Folkman spent\nreduce his AGI by trade or business\nmore time in Reno than in San\nexpenditures (i.e., deduct \xe2\x80\x9cabove-the-line\xe2\x80\x9d) if\nFrancisco,\nbut\nderived\nhis employer (or the employer\xe2\x80\x99s agent or a\napproximately 85% of his\nthird party) has a \xe2\x80\x9creimbursement or other\nearnings from his Pan American\nexpense allowance arrangement.\xe2\x80\x9d See also\nemployment.\nReg. \xc2\xa7 1.62-2. The net effect of such\n\xe2\x80\xa2What tax issue(s) do these facts\nemployer reimbursement of employee trade\nraise? How do you think they\nor business expenses is a wash. The\nshould be resolved and why?\narrangement must require substantiation of\n\xe2\x80\xa2See Folkman v. United States,\ndeductible expenditures so that such\n615 F.2d 493 (9th Cir. 1980).\narrangements do not become a means by\nwhich employees can receive compensation\n5b. Taxpayer Brandl was\nwithout paying income tax on it.\nemployed by Strong Electric Co.\nHow is a \xe2\x80\x9creimbursement or other expense\nas\na\ntraveling\ntechnical\nallowance arrangement\xe2\x80\x9d advantageous to\nrepresentative. His duties were to\nboth employer and employee?\nvisit, assist, and sell to Strong\ndealers throughout the United\nStates. Taxpayer travelled a great\ndeal. Strong\xe2\x80\x99s headquarters are in Toledo, Ohio. Taxpayer neither owned nor rented\nan apartment or house in Toledo. When Taxpayer was in Toledo he either stayed at\na motel or with his brother and sister-in-law. When Taxpayer stayed with his\nbrother he paid no rent but did help pay for groceries and household items, and\nworked around the house doing maintenance and remodeling. He usually was away\n344\n\n\x0cfrom Toledo visiting customers from four to six weeks at a time, but on occasion\nhe was away for up to three months. When Taxpayer traveled he stayed in hotels.\nWhen Taxpayer was at Strong headquarters in Toledo he took care of paper work,\nwrote letters to customers he had visited, and helped with general office work.\nDuring the tax year, Taxpayer spent a total of three months in Toledo. Taxpayer\nreceived personal mail at his brother\xe2\x80\x99s home in Toledo, and he had an Ohio driver\xe2\x80\x99s\nlicense. For the tax year in question, Strong paid Taxpayer $8,288.68 for his travel\nexpenses. Taxpayer did not include that amount in income. Taxpayer did not claim\na deduction for traveling expenses while away from home.\n\xe2\x80\xa2Must Taxpayer Brandl include the $8288.68 in his taxable income?\n\xe2\x80\xa2If so, may he deduct that amount as a \xe2\x80\x9ctravel expense\xe2\x80\x9d under \xc2\xa7 162(a)(2)?\n\xe2\x80\xa2See Brandl v. Commissioner, T.C. Memo 1974-160 (1974).\n\nHantzis v. Commissioner, 638 F.2d 248 (1st Cir.), cert. denied, 452 U.S. 962\n(1981)\nLEVIN H. CAMPBELL, Circuit Judge.\nThe Commissioner of Internal Revenue (Commissioner) appeals a decision of the\nUnited States Tax Court that allowed a deduction under \xc2\xa7 162(a)(2) (1976) for\nexpenses incurred by a law student in the course of her summer employment. ...\nIn the fall of 1973 Catharine Hantzis (taxpayer), formerly a candidate for an\nadvanced degree in philosophy at the University of California at Berkeley, entered\nHarvard Law School in Cambridge, Massachusetts, as a full-time student. During\nher second year of law school she sought unsuccessfully to obtain employment for\nthe summer of 1975 with a Boston law firm. She did, however, find a job as a legal\nassistant with a law firm in New York City, where she worked for ten weeks\nbeginning in June 1975. Her husband, then a member of the faculty of Northeastern\nUniversity with a teaching schedule for that summer, remained in Boston and lived\nat the couple\xe2\x80\x99s home there. At the time of the Tax Court\xe2\x80\x99s decision in this case, Mr.\nand Mrs. Hantzis still resided in Boston.\nOn their joint income tax return for 1975, Mr. and Mrs. Hantzis reported the\nearnings from taxpayer\xe2\x80\x99s summer employment ($3,750) and deducted the cost of\ntransportation between Boston and New York, the cost of a small apartment rented\nby Mrs. Hantzis in New York and the cost of her meals in New York ($3,204). The\n345\n\n\x0cdeductions were taken under \xc2\xa7 162(a)(2) \xe2\x80\xa6\n\xe2\x80\xa6 [The case turns on whether Mrs. Hantzis incurred expenses while away from\nhome so that her expenses are deductible under \xc2\xa7 162(a)(2).]\nWe think the critical step in defining \xe2\x80\x9chome\xe2\x80\x9d in these situations is to recognize that\nthe \xe2\x80\x9cwhile away from home\xe2\x80\x9d requirement has to be construed in light of the further\nrequirement that the expense be the result of business exigencies. The traveling\nexpense deduction obviously is not intended to exclude from taxation every\nexpense incurred by a taxpayer who, in the course of business, maintains two\nhomes. Section 162(a)(2) seeks rather \xe2\x80\x9cto mitigate the burden of the taxpayer who,\nbecause of the exigencies of his trade or business, must maintain two places of\nabode and thereby incur additional and duplicate living expenses.\xe2\x80\x9d [citations\nomitted]. Consciously or unconsciously, courts have effectuated this policy in part\nthrough their interpretation of the term \xe2\x80\x9chome\xe2\x80\x9d in \xc2\xa7 162(a)(2). Whether it is held in\na particular decision that a taxpayer\xe2\x80\x99s home is his residence or his principal place\nof business, the ultimate allowance or disallowance of a deduction is a function of\nthe court\xe2\x80\x99s assessment of the reason for a taxpayer\xe2\x80\x99s maintenance of two homes. If\nthe reason is perceived to be personal, the taxpayer\xe2\x80\x99s home will generally be held\nto be his place of employment rather than his residence and the deduction will be\ndenied. [citations omitted]. If the reason is felt to be business exigencies, the\nperson\xe2\x80\x99s home will usually be held to be his residence and the deduction will be\nallowed. See, e.g., Frederick v. United States, 603 F.2d 1292 (8th Cir. 1979);\n[citations omitted]. We understand the concern of the concurrence that such an\noperational interpretation of the term \xe2\x80\x9chome\xe2\x80\x9d is somewhat technical and perhaps\nuntidy, in that it will not always afford bright line answers, but we doubt the ability\nof either the Commissioner or the courts to invent an unyielding formula that will\nmake sense in all cases. The line between personal and business expenses winds\nthrough infinite factual permutations; effectuation of the travel expense provision\nrequires that any principle of decision be flexible and sensitive to statutory policy.\nConstruing in the manner just described the requirement that an expense be incurred\n\xe2\x80\x9cwhile away from home,\xe2\x80\x9d we do not believe this requirement was satisfied in this\ncase. Mrs. Hantzis\xe2\x80\x99 trade or business did not require that she maintain a home in\nBoston as well as one in New York. Though she returned to Boston at various times\nduring the period of her employment in New York, her visits were all for personal\nreasons. It is not contended that she had a business connection in Boston that\nnecessitated her keeping a home there; no professional interest was served by\nmaintenance of the Boston home as would have been the case, for example, if Mrs.\n346\n\n\x0cHantzis had been a lawyer based in Boston with a New York client whom she was\ntemporarily serving. The home in Boston was kept up for reasons involving Mr.\nHantzis, but those reasons cannot substitute for a showing by Mrs. Hantzis that the\nexigencies of her trade or business required her to maintain two homes. 119 Mrs.\nHantzis\xe2\x80\x99 decision to keep two homes must be seen as a choice dictated by personal,\nalbeit wholly reasonable, considerations and not a business or occupational\nnecessity. We therefore hold that her home for purposes of \xc2\xa7 162(a)(2) was New\nYork and that the expenses at issue in this case were not incurred \xe2\x80\x9cwhile away from\nhome.\xe2\x80\x9d120\n\xe2\x80\xa6 We hold merely that for a taxpayer in Mrs. Hantzis\xe2\x80\x99 circumstances to be \xe2\x80\x9caway\nfrom home in the pursuit of a trade or business,\xe2\x80\x9d she must establish the existence\nof some sort of business relation both to the location she claims as \xe2\x80\x9chome\xe2\x80\x9d and to\nthe location of her temporary employment sufficient to support a finding that her\nduplicative expenses are necessitated by business exigencies. This, we believe, is\nthe meaning of the statement in Flowers that \xe2\x80\x9c[b]usiness trips are to be identified\nin relation to business demands and the traveler\xe2\x80\x99s business headquarters.\xe2\x80\x9d 326 U.S.\nat 474 254 (emphasis added). On the uncontested facts before us, Mrs. Hantzis had\nno business relation to Boston; we therefore leave to cases in which the issue is\nsquarely presented the task of elaborating what relation to a place is required under\n\xc2\xa7 162(a)(2) for duplicative living expenses to be deductible.\nReversed.\nIn this respect, Mr. and Mrs. Hantzis\xe2\x80\x99 situation is analogous to cases involving spouses with careers\nin different locations. Each must independently satisfy the requirement that deductions taken for travel\nexpenses incurred in the pursuit of a trade or business arise while he or she is away from home. See\nChwalow v. Commissioner, 470 F.2d 475, 477-78 (3d Cir. 1972) (\xe2\x80\x9cWhere additional expenses are incurred\nbecause, for personal reasons, husband and wife maintain separate domiciles, no deduction is allowed.\xe2\x80\x9d);\nHammond v. Commissioner, 213 F.2d 43, 44 (5th Cir. 1954); Foote v. Commissioner, 67 T.C. 1 (1976); Coerver\nv. Commissioner, 36 T.C. 252 (1961). This is true even though the spouses file a joint return. Chwalow,\nsupra, 470 F.2d at 478.\n119\n\nThe concurrence reaches the same result on essentially the same reasoning, but under what we take\nto be an interpretation of the \xe2\x80\x9cin pursuit of business\xe2\x80\x9d requirement. We differ from our colleague, it\nwould seem, only on the question of which precondition to deductibility best accommodates the\nstatutory concern for \xe2\x80\x9c\xe2\x80\x98the taxpayer who, because of the exigencies of his trade or business, must\nmaintain two places of abode and thereby incur additional and duplicate living expenses.\xe2\x80\x99\xe2\x80\x9d See supra.\nNeither the phrase \xe2\x80\x9caway from home\xe2\x80\x9d nor \xe2\x80\x9cin pursuit of business\xe2\x80\x9d effectuates this concern without\ninterpretation that to some degree removes it from \xe2\x80\x9cthe ordinary meaning of the term.\xe2\x80\x9d (Keeton, J.,\nconcurring). However, of the two approaches, we find that of the concurrence more problematic than\nthat adopted here.\n120\n\n347\n\n\x0cKEETON, District Judge, concurring in the result.\n....\n... I read the [majority] opinion as indicating that in a dual residence case, the\nCommissioner must determine whether the exigencies of the taxpayer\xe2\x80\x99s trade or\nbusiness require her to maintain both residences. If so, the Commissioner must\ndecide that the taxpayer\xe2\x80\x99s principal residence is her \xe2\x80\x9chome\xe2\x80\x9d and must conclude that\nexpenses associated with the secondary residence were incurred \xe2\x80\x9cwhile away from\nhome,\xe2\x80\x9d and are deductible. If not, as in the instant case, the Commissioner must\nfind that the taxpayer\xe2\x80\x99s principal place of business is her \xe2\x80\x9chome\xe2\x80\x9d and must conclude\nthat the expenses in question were not incurred \xe2\x80\x9cwhile away from home.\xe2\x80\x9d The\nconclusory nature of these determinations as to which residence is her \xe2\x80\x9chome\xe2\x80\x9d\nreveals the potentially confusing effect of adopting an extraordinary definition of\n\xe2\x80\x9chome.\xe2\x80\x9d\nA word used in a statute can mean, among the cognoscenti, whatever authoritative\nsources define it to mean. Nevertheless, it is a distinct disadvantage of a body of\nlaw that it can be understood only by those who are expert in its terminology.\nMoreover, needless risks of misunderstanding and confusion arise, not only among\nmembers of the public but also among professionals who must interpret and apply\na statute in their day-to-day work, when a word is given an extraordinary meaning\nthat is contrary to its everyday usage.\nThe result reached by the court can easily be expressed while also giving \xe2\x80\x9chome\xe2\x80\x9d\nits ordinary meaning, and neither Congress nor the Supreme Court has directed that\n\xe2\x80\x9chome\xe2\x80\x9d be given an extraordinary meaning in the present context. See Flowers,\nsupra, Stidger, supra, and Peurifoy, supra. In Rosenspan v. United States, supra,\nJudge Friendly, writing for the court, rejected the Commissioner\xe2\x80\x99s proposed\ndefinition of home as the taxpayer\xe2\x80\x99s business headquarters, concluding that in\n\xc2\xa7 162(a)(2) \xe2\x80\x9c\xe2\x80\x98home\xe2\x80\x99 means \xe2\x80\x98home.\xe2\x80\x99\xe2\x80\x9d Id. at 912.\nWhen Congress uses a non-technical word in a tax statute, presumably it\nwants administrators and courts to read it in the way that ordinary people\nwould understand, and not \xe2\x80\x9cto draw on some unexpressed spirit outside the\nbounds of the normal meaning of words.\xe2\x80\x9d Addison v. Holly Hill Fruit\nProds., Inc., 322 U.S. 607, 617 (1944).\nId. at 911. [citation omitted].\n348\n\n\x0cIn analyzing dual residence cases, the court\xe2\x80\x99s opinion advances compelling reasons\nthat the first step must be to determine whether the taxpayer has business as\nopposed to purely personal reasons for maintaining both residences. This must be\ndone in order to determine whether the expenses of maintaining a second residence\nwere, \xe2\x80\x9cnecessitated by business, as opposed to personal, demands,\xe2\x80\x9d and were in this\nsense incurred by the taxpayer \xe2\x80\x9cwhile away from home in pursuit of trade or\nbusiness.\xe2\x80\x9d Necessarily implicit in this proposition is a more limited corollary that\nis sufficient to decide the present case: When the taxpayer has a business\nrelationship to only one location, no traveling expenses the taxpayer incurs are\n\xe2\x80\x9cnecessitated by business, as opposed to personal demands,\xe2\x80\x9d regardless of how\nmany residences the taxpayer has, where they are located, or which one is \xe2\x80\x9chome.\xe2\x80\x9d\nIn the present case, although the taxpayer argues that her employment required her\nto reside in New York, that contention is insufficient to compel a determination that\nit was the nature of her trade or business that required her to incur the additional\nexpense of maintaining a second residence, the burden that \xc2\xa7 162(a)(2) was\nintended to mitigate. Her expenses associated with maintaining her New York\nresidence arose from personal interests that led her to maintain two residences\nrather than a single residence close to her work.121 While traveling from her\nprincipal residence to a second place of residence closer to her business, even\nthough \xe2\x80\x9caway from home,\xe2\x80\x9d she was not \xe2\x80\x9caway from home in pursuit of business.\xe2\x80\x9d\nThus, the expenses at issue in this case were not incurred by the taxpayer \xe2\x80\x9cwhile\naway from home in pursuit of trade or business.\xe2\x80\x9d\nIn the contrasting case in which a taxpayer has established that both residences were\nmaintained for business reasons, \xc2\xa7 162(a)(2) allows the deduction of expenses\nassociated with travel to, and maintenance of, one of the residences if they are\nincurred for business reasons and that abode is not the taxpayer\xe2\x80\x99s home. A common\nsense meaning of \xe2\x80\x9chome\xe2\x80\x9d works well to achieve the purpose of this provision.\nIn summary, the court announces a sound principle that, in dual residence cases,\ndeductibility of traveling expenses depends upon a showing that both residences\nwere maintained for business reasons. If that principle is understood to be derived\nfrom the language of \xc2\xa7 162(a)(2) taken as a whole, \xe2\x80\x9chome\xe2\x80\x9d retains operative\nFor reasons explained by the court, the temporary nature of her employment does not bring the\ncase within those as to which Congress was mitigating the burden of duplicative expenses when enacting\n\xc2\xa7 162(a)(2).\n121\n\n349\n\n\x0csignificance for determining which of the business-related residences is the one the\nexpense of which can be treated as deductible. In this context, \xe2\x80\x9chome\xe2\x80\x9d should be\ngiven its ordinary meaning to allow a deduction only for expenses relating to an\nabode that is not the taxpayer\xe2\x80\x99s principal place of residence. On the undisputed facts\nin this case, the Tax Court found that Boston was the taxpayer\xe2\x80\x99s \xe2\x80\x9chome\xe2\x80\x9d in the\neveryday sense, i.e., her principal place of residence. Were the issue relevant to\ndisposition of the case, I would uphold the Tax Court\xe2\x80\x99s quite reasonable\ndetermination on the evidence before it. However, because the taxpayer had no\nbusiness reason for maintaining both residences, her deduction for expenses\nassociated with maintaining a second residence closer than her principal residence\nto her place of employment must be disallowed without regard to which of her two\nresidences was her \xe2\x80\x9chome\xe2\x80\x9d under \xc2\xa7 162(a)(2).\nNotes and Questions:\n1. Obviously, the meaning of \xe2\x80\x9chome\xe2\x80\x9d is not to be determined by the ordinary use\nof the term. Right?\n2. Does the court\xe2\x80\x99s opinion conflate the second and third requirements of Flowers?\n3. On which of the Flowers requirements does Judge Keeton rely to deny taxpayers\na deduction?\n4. What was taxpayer\xe2\x80\x99s (insufficient) reason for maintaining a home in Boston?\n5. Taxpayer owned and operated a very successful swimming pool construction\nbusiness in Lynnfield, Massachusetts. He also owned and operated a very\nsuccessful horse breeding and racing business in Lighthouse Point, Florida. From\nNovember through April, he resided in Florida. From May through October, he\nresided in Massachusetts. Taxpayer owned a home in both Florida and\nMassachusetts and traveled between them to tend to his businesses.\n\xe2\x80\xa2Does Taxpayer have two tax homes so that he may deduct the travel\nexpenses associated with neither of them?\n\xe2\x80\xa2What guidance do the opinions in Hantzis offer in answering this question?\n\xe2\x80\xa2See Andrews v. Commissioner, 931 F.2d 132 (1st Cir. 1991) (\xe2\x80\x9cmajor\xe2\x80\x9d post\nof duty; \xe2\x80\x9cminor\xe2\x80\x9d post of duty).\n5a. For the past five years, Taxpayers (Mr. and Mrs. Chwalow) have maintained a\nresidence in Bala Cynwyd, Pennsylvania. Mrs. Chwalow is a teacher in the\n350\n\n\x0cPhiladelphia public school system and specializes in working with deaf children.\nDr. Chwalow is a physicist whose specialty is military optics and electrooptics\nencompassing areas such as night vision, laser range finding, missile guidance,\naerial reconnaissance, etc. Dr. Chwalow works for IBM in Washington, D.C.,\nwhere he rents an apartment. He uses public transportation to get to his job. Mrs.\nChwalow continues to live in Bala Cynwyd, Pennsylvania.\n\xe2\x80\xa2May either Mr. or Mrs. Chwalow deduct meal and lodging expenses as\n\xe2\x80\x9ctravel expenses\xe2\x80\x9d under \xc2\xa7 162(a)(2)?\n\xe2\x80\xa2See Chwalow v. Commissioner, 470 F.2d 475 (3rd Cir. 1972).\n5b. Taxpayer Dews was a coach on the staff of the Atlanta Braves baseball team.\nHe and his wife lived in Albany, Georgia. In the course of over 20 years in\nprofessional baseball, Dews had 37 different assignments, including as a manager\nof farm teams in the Atlanta organization. During one 4-year period, he was a coach\nfor the Atlanta team. He maintained an apartment in Atlanta.\n\xe2\x80\xa2May Dews deduct the expenses of traveling between Albany and Atlanta?\nMay he deduct the expenses of living in Atlanta?\n\xe2\x80\xa2See Dews v. Commissioner, T.C. Memo. 1987-353, available at 1987 WL\n40405.\nUnited States v. Correll, 389 U.S. 299 (1967)\nMR. JUSTICE STEWART delivered the opinion of the Court.\nThe Commissioner of Internal Revenue has long maintained that a taxpayer\ntraveling on business may deduct the cost of his meals only if his trip requires him\nto stop for sleep or rest. The question presented here is the validity of that rule.\nThe respondent in this case was a traveling salesman for a wholesale grocery\ncompany in Tennessee. [footnote omitted] He customarily left home early in the\nmorning, ate breakfast and lunch on the road, and returned home in time for dinner.\nIn his income tax returns for 1960 and 1961, he deducted the cost of his morning\nand noon meals as \xe2\x80\x9ctraveling expenses\xe2\x80\x9d incurred in the pursuit of his business\n\xe2\x80\x9cwhile away from home\xe2\x80\x9d under [I.R.C.] \xc2\xa7 162(a)(2) ... [footnote omitted]. Because\nthe respondent\xe2\x80\x99s daily trips required neither sleep nor rest, the Commissioner\ndisallowed the deductions, ruling that the cost of the respondent\xe2\x80\x99s meals was a\n\xe2\x80\x9cpersonal, living\xe2\x80\x9d expense under \xc2\xa7 262 [footnote omitted], rather than a travel\nexpense under \xc2\xa7 162(a)(2). The respondent paid the tax, sued for a refund in the\n351\n\n\x0cDistrict Court, and there received a favorable jury verdict.122 The Court of Appeals\nfor the Sixth Circuit affirmed, holding that the Commissioner\xe2\x80\x99s sleep or rest rule is\nnot \xe2\x80\x9ca valid regulation under the present statute.\xe2\x80\x9d In order to resolve a conflict\namong the circuits on this recurring question of federal income tax administration,\n[footnote omitted] we granted certiorari.\nUnder \xc2\xa7 162(a)(2), taxpayers \xe2\x80\x9ctraveling ... away from home in the pursuit of trade\nor business\xe2\x80\x9d may deduct the total amount \xe2\x80\x9cexpended for meals and lodging.\xe2\x80\x9d123 As\na result, even the taxpayer who incurs substantial hotel and restaurant expenses\nbecause of the special demands of business travel receives something of a windfall,\nfor at least part of what he spends on meals represents a personal living expense\nthat other taxpayers must bear without receiving any deduction at all.124 Not\nsurprisingly, therefore, Congress did not extend the special benefits of \xc2\xa7 162(a)(2)\nto every conceivable situation involving business travel. It made the total cost of\nmeals and lodging deductible only if incurred in the course of travel that takes the\ntaxpayer \xe2\x80\x9caway from home.\xe2\x80\x9d The problem before us involves the meaning of that\nlimiting phrase.\nAfter denying the Government\xe2\x80\x99s motion for a directed verdict, the District Judge charged the jury\nthat it would have to \xe2\x80\x9cdetermine under all the facts of this case whether or not\xe2\x80\x9d the Commissioner\xe2\x80\x99s\nrule was \xe2\x80\x9can arbitrary regulation as applied to these plaintiffs under the facts in this case.\xe2\x80\x9d He told the\njury to consider whether the meal expenses were \xe2\x80\x9cnecessary for the employee to properly perform the\nduties of his work.\xe2\x80\x9d \xe2\x80\x9cShould he have eaten them at his home, rather than . . . away from home, in order\nto properly carry on this business or to perform adequately his duties as an employee of this produce\ncompany[?]\xe2\x80\x9d \xe2\x80\x9cYou are instructed that the cost of meals while on one-day business trips away from\nhome need not be incurred while on an overnight trip to be deductible, so long as the expense of such\nmeals ... proximately results from the carrying on the particular business involved and has some\nreasonable relation to that business.\xe2\x80\x9d Under these instructions, the jury found for the respondent. The\nDistrict Court denied the Government\xe2\x80\x99s motion for judgment notwithstanding the verdict.\n122\n\nPrior to the enactment in 1921 of what is now \xc2\xa7 162(a)(2), the Commissioner had promulgated a\nregulation allowing a deduction for the cost of meals and lodging away from home, but only to the\nextent that this cost exceeded \xe2\x80\x9cany expenditures ordinarily required for such purposes when at home.\xe2\x80\x9d\nTreas. Reg. 45 (1920 ed.), Art. 292, 4 Cum. Bull. 209 (1921). Despite its logical appeal, the regulation\nproved so difficult to administer that the Treasury Department asked Congress to grant a deduction for\nthe \xe2\x80\x9centire amount\xe2\x80\x9d of such meal and lodging expenditures. See Statement of Dr. T. S. Adams, Tax\nAdviser, Treasury Department, in Hearings on H.R. 8245 before the Senate Committee on Finance,\n67th Cong., 1st Sess., at 50, 234-235 (1921). Accordingly \xc2\xa7 214(a)(1) of the Revenue Act of 1921, c. 136,\n42 Stat. 239, for the first time included that language that later became \xc2\xa7 162(a)(2). ...\n123\n\nBecause \xc2\xa7 262 makes \xe2\x80\x9cpersonal, living, or family expenses\xe2\x80\x9d nondeductible, the taxpayer whose\nbusiness requires no travel cannot ordinarily deduct the cost of the lunch he eats away from home. But\nthe taxpayer who can bring himself within the reach of \xc2\xa7 162(a)(2) may deduct what he spends on his\nnoontime meal although it costs him no more, and relates no more closely to his business, than does\nthe lunch consumed by his less mobile counterpart.\n124\n\n352\n\n\x0cIn resolving that problem, the Commissioner has avoided the wasteful litigation\nand continuing uncertainty that would inevitably accompany any purely case-bycase approach to the question of whether a particular taxpayer was \xe2\x80\x9caway from\nhome\xe2\x80\x9d on a particular day. [footnote omitted] Rather than requiring \xe2\x80\x9cevery mealpurchasing taxpayer to take pot luck in the courts,\xe2\x80\x9d [footnote omitted] the\nCommissioner has consistently construed travel \xe2\x80\x9caway from home\xe2\x80\x9d to exclude all\ntrips requiring neither sleep nor rest,125 regardless of how many cities a given trip\nmay have touched, [footnote omitted] how many miles it may have covered, 126 or\nhow many hours it may have consumed. [footnote omitted] By so interpreting the\nstatutory phrase, the Commissioner has achieved not only ease and certainty of\napplication, but also substantial fairness, for the sleep or rest rule places all one-day\ntravelers on a similar tax footing, rather than discriminating against intracity\ntravelers and commuters, who, of course, cannot deduct the cost of the meals they\neat on the road. See Commissioner v. Flowers, 326 U.S. 465.\nAny rule in this area must make some rather arbitrary distinctions [footnote\nomitted], but at least the sleep or rest rule avoids the obvious inequity of permitting\nthe New Yorker who makes a quick trip to Washington and back, missing neither\nhis breakfast nor his dinner at home, to deduct the cost of his lunch merely because\nhe covers more miles than the salesman who travels locally and must finance all his\nmeals without the help of the Federal Treasury. [footnote omitted] And the\nCommissioner\xe2\x80\x99s rule surely makes more sense than one which would allow the\nrespondent in this case to deduct the cost of his breakfast and lunch simply because\nhe spends a greater percentage of his time at the wheel than the commuter who eats\nbreakfast on his way to work and lunch a block from his office.\nThe Court of Appeals nonetheless found in the \xe2\x80\x9cplain language of the statute\xe2\x80\x9d an\ninsuperable obstacle to the Commissioner\xe2\x80\x99s construction. We disagree. The\nlanguage of the statute \xe2\x80\x93 \xe2\x80\x9cmeals and lodging ... away from home\xe2\x80\x9d \xe2\x80\x93 is obviously\nnot self-defining. [footnote omitted] And to the extent that the words chosen by\nCongress cut in either direction, they tend to support, rather than defeat, the\nCommissioner\xe2\x80\x99s position, for the statute speaks of \xe2\x80\x9cmeals and lodging\xe2\x80\x9d as a unit,\nsuggesting \xe2\x80\x93 at least arguably \xe2\x80\x93 that Congress contemplated a deduction for the cost\nof meals only where the travel in question involves lodging as well. [footnote\nThe Commissioner\xe2\x80\x99s interpretation, first expressed in a 1940 ruling, I.T. 3395, 1910-2 Cum. Bull.\n64, was originally known as the overnight rule. See Commissioner v. Bagley, [374 F.2d 204,] 205.\n125\n\nThe respondent seldom traveled farther than 55 miles from his home, but he ordinarily drove a total\nof 150 to 175 miles daily.\n126\n\n353\n\n\x0comitted] Ordinarily, at least, only the taxpayer who finds it necessary to stop for\nsleep or rest incurs significantly higher living expenses as a direct result of his\nbusiness travel,127 and Congress might well have thought that only taxpayers in that\ncategory should be permitted to deduct their living expenses while on the road.128\n...\nAlternatives to the Commissioner\xe2\x80\x99s sleep or rest rule are, of course, available.\n[footnote omitted] Improvements might be imagined. [footnote omitted] But we do\nnot sit as a committee of revision to perfect the administration of the tax laws.\nCongress has delegated to the Commissioner, not to the courts, the task of\nprescribing \xe2\x80\x9call needful rules and regulations for the enforcement\xe2\x80\x9d of the Internal\nRevenue Code. 26 U.S.C. \xc2\xa7 7805(a). In this area of limitless factual variations, \xe2\x80\x9cit\nis the province of Congress and the Commissioner, not the courts, to make the\nappropriate adjustments.\xe2\x80\x9d Commissioner v. Stidger, 386 U.S. 287, 296. The role of\nthe judiciary in cases of this sort begins and ends with assuring that the\nCommissioner\xe2\x80\x99s regulations fall within his authority to implement the\ncongressional mandate in some reasonable manner. Because the rule challenged\nhere has not been shown deficient on that score, the Court of Appeals should have\nsustained its validity. The judgment is therefore\nReversed.\n\nThe taxpayer must ordinarily \xe2\x80\x9cmaintain a home for his family at his own expense even when he is\nabsent on business,\xe2\x80\x9d Barnhill v. Commissioner, 148 F.2d 913, 917, and if he is required to stop for sleep or\nrest, \xe2\x80\x9ccontinuing costs incurred at a permanent place of abode are duplicated.\xe2\x80\x9d James v. United States, 308\nF.2d 204, 206. The same taxpayer, however, is unlikely to incur substantially increased living expenses\nas a result of business travel, however far he may go, so long as he does not find it necessary to stop for\nlodging. ...\n127\n\nThe court below thought that \xe2\x80\x9c[i]n an era of supersonic travel, the time factor is hardly relevant to\nthe question of whether or not ... meal expenses are related to the taxpayer\xe2\x80\x99s business. ...\xe2\x80\x9d 369 F.2d 87,\n89-90. But that completely misses the point. The benefits of \xc2\xa7 162(a)(2) are limited to business travel\n\xe2\x80\x9caway from home,\xe2\x80\x9d and all meal expenses incurred in the course of such travel are deductible, however\nunrelated they may be to the taxpayer\xe2\x80\x99s income-producing activity. To ask that the definition of \xe2\x80\x9caway\nfrom home\xe2\x80\x9d be responsive to the business necessity of the taxpayer\xe2\x80\x99s meals is to demand the impossible.\n128\n\n354\n\n\x0cMR. JUSTICE MARSHALL took no part in the consideration or decision of this\ncase.\nMR. JUSTICE DOUGLAS, with whom MR. JUSTICE BLACK and MR.\nJUSTICE FORTAS concur, dissenting.\nThe statutory words \xe2\x80\x9cwhile away from home,\xe2\x80\x9d \xc2\xa7 162(a)(2), may not, in my view,\nbe shrunken to \xe2\x80\x9covernight\xe2\x80\x9d by administrative construction or regulations.\n\xe2\x80\x9cOvernight\xe2\x80\x9d injects a time element in testing deductibility, while the statute speaks\nonly in terms of geography. As stated by the Court of Appeals:\n\xe2\x80\x9cIn an era of supersonic travel, the time factor is hardly relevant to the\nquestion of whether or not travel and meal expenses are related to the\ntaxpayer\xe2\x80\x99s business, and cannot be the basis of a valid regulation under the\npresent statute.\xe2\x80\x9d Correll v. United States, 369 F.2d 87, 89-90.\nI would affirm the judgment below.\nNotes and Questions:\n1. Is this an appropriate area for a bright line rule that may unfairly \xe2\x80\x9ccatch\xe2\x80\x9d some\ntaxpayers?\n2. Read the instruction that the federal district court gave to the jury (in a footnote).\nDoes it seem that the standard resembles the standard that the Court later adopted\nfor \xc2\xa7 119?\n3. Under \xc2\xa7 162(a)(2), how strong must the nexus be between the actual meals and\na business purpose? See the Court\xe2\x80\x99s last footnote. Does your answer make the\napproach of the commissioner seem more reasonable?\n4. Did the majority\xe2\x80\x99s statement of the Commissioner\xe2\x80\x99s rule require an \xe2\x80\x9covernight\xe2\x80\x9d\nstay \xe2\x80\x93 as Justice Douglas claimed in his dissent?\n\xe2\x80\xa2The rule was originally an \xe2\x80\x9covernight\xe2\x80\x9d rule. I.T. 3395, 1940-2 C.B. 64. The\nIRS endorsed the \xe2\x80\x9csleep or rest\xe2\x80\x9d rule in Rev. Rul. 61-221, 1961-2 C.B. 34\nfor purposes of deducting the expense of sleeping.\n5. F.M. Williams was a railroad conductor with more than forty years of service\n355\n\n\x0cwith the Atlanta and West Point Railroad and the Western Railway of Alabama.\nEvery other day Williams got up shortly after five in the morning, left his house in\nMontgomery, Alabama, in time to arrive at the railroad station at 6:45 a.m.,\nattended to duties at the station, left Montgomery on the Crescent at 7:40 a.m.,\narrived in Atlanta, Georgia, at 12:15 p.m., took six hours off, returned to duty in\ntime to leave Atlanta at 6:15 p.m. on the Piedmont, pulled in to Montgomery at\n10:15 p.m., left the Piedmont, and reached home about midnight. It is a long, hard\nday. The railroad never ordered Williams to rent a room in Atlanta, nor required\nhim to sleep during the layover period. For years, however, because he felt he\nneeded sleep and rest in Atlanta before his return run, Williams rented a reasonably\npriced room in the Gordon Hotel, a small hotel near the railroad station. At the hotel\nhe had lunch and dinner, rested and slept, bathed and freshened up before boarding\nthe Piedmont. He had the same room for eight years. His superiors knew that he\ncould be reached in Atlanta at the Gordon Hotel; taxpayer was subject to call at all\ntimes. In 1955 Captain Williams incurred expenses of $796 for meals, lodging, and\ntips at the Gordon Hotel during his layover in Atlanta.\n\xe2\x80\xa2Should Williams be permitted to deduct the expenses that he incurred at\nthe Gordon Hotel?\n\xe2\x80\xa2What issues (sub-issues) do these facts raise?\n\xe2\x80\xa2See Williams v. Patterson, 286 F.2d 333 (5th Cir. 1961).\n5a. Taxpayer B was a ferryboat captain. He worked in the Puget Sound area of\nWashington State. During the summer months, he typically worked 18-hour days\nfor seven consecutive days. Then he would have seven consecutive days off. His\nschedule was the same in the winter, except that he would typically captain a ship\nfrom Seattle to Victoria. The return voyage would be six hours later. During the\nsix-hour layover, he would take a nap on a cot provided by his employer. He would\nalso purchase one or two meals.\n\xe2\x80\xa2Should taxpayer B be permitted to deduct the cost of his meals?\n\xe2\x80\xa2See Bissonnette v. Commissioner, 127 T.C. 124 (2006).\n5b. Taxpayers were employees at the Nevada Test Site, a nuclear testing facility.\nLas Vegas, Nevada, the closest habitable community to the Test Site, is 65 miles\nsouth of the Camp Mercury control point, located at the southernmost boundary of\nthe Test Site, and 130 miles from the northernmost boundary of the Test Site.\nBecause of the potential dangers arising out of the activities conducted at the Test\nSite, the government chose this location precisely because of its remoteness from\npopulated areas. All the taxpayers assigned to the Test Site received, in addition to\ntheir regular wages, a per diem allowance for each day they reported for work at\n356\n\n\x0cthe Test Site. The amount of the allowance varied. Employees reporting to Camp\nMercury received $5 per day; those reporting to any forward area received $7.50\nper day. Employees received these allowances without regard to the actual costs\nincurred by them for transportation, meals, or lodging. A private contractor\nmaintained meal and lodging facilities onsite. Employees were responsible for\nprocuring transportation, meals, and occasionally overnight lodging when they had\nto work overtime.\n\xe2\x80\xa2Should Taxpayers be permitted to exclude their per diem allowances? See\nCommissioner v. Kowalski, 434 U.S. 77 (1977), supra.\n\xe2\x80\xa2Disregarding the fact that for employees, meal and lodging expenses would\nbe \xe2\x80\x9cmiscellaneous deductions\xe2\x80\x9d and so suspended until tax year 2026, \xc2\xa7\n67(g) \xe2\x80\x93\n\xe2\x80\xa2Should Taxpayers be permitted to deduct the cost of their travel?\n\xe2\x80\xa2Should Taxpayers be permitted to deduct the cost of their meals?\n\xe2\x80\xa2Should Taxpayers be permitted to deduct the cost of their lodging?\n\xe2\x80\xa2See Coombs v. Commissioner, 608 F.2d 1269 (9th Cir. 1979).\n\nRead the second sentence of the carryout paragraph that ends \xc2\xa7 162(a). It refers to\n\xc2\xa7 162(a)(2). Also read \xc2\xa7 274(m)(3). Then do the CALI Lesson: Basic Federal\nIncome Taxation: Deductions: Traveling Expenses.\nB. Reasonable Salaries\nRead \xc2\xa7 162(a)(1). How would you determine the reasonableness of salaries? What\nconstraints exist outside of the Code that prevent payment of excessive salaries or\nother compensation? What conditions make it more (or less) likely that a taxpayer\nis paying a greater-than-reasonable salary?\n\xe2\x80\xa2Notice that the approach of the Code is to deny a deduction to the one who\npays an excessive salary. Hence, both the recipient of the salary and the\nemployer would pay tax on the amount paid in salary that the employer may\nnot deduct.\n\n357\n\n\x0cExacto Spring Corp. v. Commissioner, 196 F.3d 833 (7th Cir. 1999).\nPOSNER, Chief Judge.\nThis appeal from a judgment by the Tax Court, requires us to interpret and apply\n\xc2\xa7 162(a)(1), which allows a business to deduct from its income its \xe2\x80\x9cordinary and\nnecessary\xe2\x80\x9d business expenses, including a \xe2\x80\x9creasonable allowance for salaries or\nother compensation for personal services actually rendered.\xe2\x80\x9d In 1993 and 1994,\nExacto Spring Corporation, a closely held corporation engaged in the manufacture\nof precision springs, paid its cofounder, chief executive, and principal owner,\nWilliam Heitz, $1.3 and $1.0 million, respectively, in salary. The Internal Revenue\nService thought this amount excessive, that Heitz should not have been paid more\nthan $381,000 in 1993 or $400,000 in 1994, with the difference added to the\ncorporation\xe2\x80\x99s income, and it assessed a deficiency accordingly, which Exacto\nchallenged in the Tax Court. That court found that the maximum reasonable\ncompensation for Heitz would have been $900,000 in the earlier year and $700,000\nin the later one \xe2\x80\x93 figures roughly midway between his actual compensation and the\nIRS\xe2\x80\x99s determination \xe2\x80\x93 and Exacto has appealed.\nIn reaching its conclusion, the Tax Court applied a test that requires the\nconsideration of seven factors, none entitled to any specified weight relative to\nanother. The factors are, in the court\xe2\x80\x99s words, \xe2\x80\x9c(1) the type and extent of the services\nrendered; (2) the scarcity of qualified employees; (3) the qualifications and prior\nearning capacity of the employee; (4) the contributions of the employee to the\nbusiness venture; (5) the net earnings of the employer; (6) the prevailing\ncompensation paid to employees with comparable jobs; and (7) the peculiar\ncharacteristics of the employer\xe2\x80\x99s business.\xe2\x80\x9d It is apparent that this test, though it or\nvariants of it (one of which has the astonishing total of 21 factors, Foos v.\nCommissioner, 41 T.C.M. (CCH) 863, 878-79 (1981)), are encountered in many\ncases, see, e.g. Edwin\xe2\x80\x99s Inc. v. United States, 501 F.2d 675, 677 (7th Cir.1974);\nOwensby & Kritikos, Inc. v. Commissioner, 819 F.2d 1315, 1323 (5th Cir.1987);\nMayson Mfg. Co. v. Commissioner, 178 F.2d 115, 119 (6th Cir.1949); 1 BORIS I.\nBITTKER & LAWRENCE LOKKEN, FEDERAL TAXATION OF INCOME, ESTATES, AND\nGIFTS \xc2\xb6 22.2.2, p. 22-21 (3d ed.1999), leaves much to be desired \xe2\x80\x93 being, like many\nother multi-factor tests, \xe2\x80\x9credundant, incomplete, and unclear.\xe2\x80\x9d Palmer v. City of\nChicago, 806 F.2d 1316, 1318 (7th Cir.1986).\nTo begin with, it is nondirective. No indication is given of how the factors are to be\nweighed in the event they don\xe2\x80\x99t all line up on one side. And many of the factors,\n358\n\n\x0csuch as the type and extent of services rendered, the scarcity of qualified employees,\nand the peculiar characteristics of the employer\xe2\x80\x99s business, are vague.\nSecond, the factors do not bear a clear relation either to each other or to the primary\npurpose of \xc2\xa7 162(a)(1), which is to prevent dividends (or in some cases gifts), which\nare not deductible from corporate income, from being disguised as salary, which is.\nE.g., Rapco, Inc. v. Commissioner, 85 F.3d 950, 954 n. 2 (2d Cir.1996). Suppose\nthat an employee who let us say was, like Heitz, a founder and the chief executive\nofficer and principal owner of the taxpayer rendered no services at all but received\na huge salary. It would be absurd to allow the whole or for that matter any part of\nhis salary to be deducted as an ordinary and necessary business expense even if he\nwere well qualified to be CEO of the company, the company had substantial net\nearnings, CEOs of similar companies were paid a lot, and it was a business in which\nhigh salaries are common. The multi-factor test would not prevent the Tax Court\nfrom allowing a deduction in such a case even though the corporation obviously\nwas seeking to reduce its taxable income by disguising earnings as salary. The court\nwould not allow the deduction, but not because of anything in the multi-factor test;\nrather because it would be apparent that the payment to the employee was not in\nfact for his services to the company. Reg. \xc2\xa7 1.162-7(a); 1 BITTKER & LOKKEN,\nsupra, \xc2\xb6 22.2.1, p. 22-19.\nThird, the seven-factor test invites\nthe Tax Court to set itself up as a\nIrruption: a breaking or bursting in; a violent\nsuperpersonnel department for\nincursion or invasion.\nclosely held corporations, a role\nunsuitable for courts, as we have\nrepeatedly noted in the Title VII context, e.g., Jackson v. E.J. Brach Corp., 176\nF.3d 971, 984 (7th Cir. 1999), and as the Delaware Chancery Court has noted in\nthe more germane context of derivative suits alleging excessive compensation of\ncorporate employees. Gagliardi v. TriFoods Int\xe2\x80\x99l, Inc., 683 A.2d 1049, 1051 (Del.\nCh. 1996). The test \xe2\x80\x93 the irruption of \xe2\x80\x9ccomparable worth\xe2\x80\x9d thinking (see, e.g.,\nAmerican Nurses\xe2\x80\x99 Ass\xe2\x80\x99n v. Illinois, 783 F.2d 716 (7th Cir. 1986)) in a new context\n\xe2\x80\x93 invites the court to decide what the taxpayer\xe2\x80\x99s employees should be paid on the\nbasis of the judges\xe2\x80\x99 own ideas of what jobs are comparable, what relation an\nemployee\xe2\x80\x99s salary should bear to the corporation\xe2\x80\x99s net earnings, what types of\nbusiness should pay abnormally high (or low) salaries, and so forth. The judges of\nthe Tax Court are not equipped by training or experience to determine the salaries\nof corporate officers; no judges are.\n359\n\n\x0cFourth, since the test cannot itself determine the outcome of a dispute because of\nits nondirective character, it invites the making of arbitrary decisions based on\nuncanalized discretion or unprincipled rules of thumb. The Tax Court in this case\nessentially added the IRS\xe2\x80\x99s determination of the maximum that Mr. Heitz should\nhave been paid in 1993 and 1994 to what he was in fact paid, and divided the sum\nby two. It cut the baby in half. One would have to be awfully naive to believe that\nthe seven-factor test generated this pleasing symmetry.\nFifth, because the reaction of the Tax Court to a challenge to the deduction of\nexecutive compensation is unpredictable, corporations run unavoidable legal risks\nin determining a level of compensation that may be indispensable to the success of\ntheir business.\nThe drawbacks of the multi-factor test are well illustrated by its purported\napplication by the Tax Court in this case. With regard to factor (1), the court found\nthat Heitz was \xe2\x80\x9cindispensable to Exacto\xe2\x80\x99s business\xe2\x80\x9d and \xe2\x80\x9cessential to Exacto\xe2\x80\x99s\nsuccess.\xe2\x80\x9d Heitz is not only Exacto\xe2\x80\x99s CEO; he is also the company\xe2\x80\x99s chief salesman\nand marketing man plus the head of its research and development efforts and its\nprincipal inventor. The company\xe2\x80\x99s entire success appears to be due on the one hand\nto the research and development conducted by him and on the other hand to his\nmarketing of these innovations (though he receives some additional compensation\nfor his marketing efforts from a subsidiary of Exacto). The court decided that factor\n(1) favored Exacto.\nLikewise factor (2), for, as the court pointed out, the design of precision springs,\nwhich is Heitz\xe2\x80\x99s specialty, is \xe2\x80\x9can extremely specialized branch of mechanical\nengineering, and there are very few engineers who have made careers specializing\nin this area,\xe2\x80\x9d let alone engineers like Heitz who have \xe2\x80\x9cthe ability to identify and\nattract clients and to develop springs to perform a specific function for that client....\nIt would have been very difficult to replace Mr. Heitz.\xe2\x80\x9d Notice how factors (1) and\n(2) turn out to be nearly identical.\nFactors (3) and (4) also supported Exacto, the court found. \xe2\x80\x9cMr. Heitz is highly\nqualified to run Exacto as a result of his education, training, experience, and\nmotivation. Mr. Heitz has over 40 years of highly successful experience in the field\nof spring design.\xe2\x80\x9d And his \xe2\x80\x9cefforts were of great value to the corporation.\xe2\x80\x9d So\nfactor (4) duplicated (2), and so the first four factors turn out to be really only two.\n\n360\n\n\x0cWith regard to the fifth factor \xe2\x80\x93 the employer\xe2\x80\x99s (Exacto\xe2\x80\x99s) net earnings \xe2\x80\x93 the Tax\nCourt was noncommittal. Exacto had reported a loss in 1993 and very little taxable\nincome in 1994. But it conceded having taken some improper deductions in those\nyears unrelated to Heitz\xe2\x80\x99s salary. After adjusting Exacto\xe2\x80\x99s income to remove these\ndeductions, the court found that Exacto had earned more than $1 million in each of\nthe years at issue net of Heitz\xe2\x80\x99s supposedly inflated salary.\nThe court was noncommital with regard to the sixth factor \xe2\x80\x93 earnings of comparable\nemployees \xe2\x80\x93 as well. The evidence bearing on this factor had been presented by\nexpert witnesses, one on each side, and the court was critical of both. The taxpayer\xe2\x80\x99s\nwitness had arrived at his estimate of Heitz\xe2\x80\x99s maximum reasonable compensation\nin part by aggregating the salaries that Exacto would have had to pay to hire four\npeople each to wear one of Heitz\xe2\x80\x99s \xe2\x80\x9chats,\xe2\x80\x9d as chief executive officer, chief\nmanufacturing executive, chief research and development officer, and chief sales\nand marketing executive. Although the more roles or functions an employee\nperforms the more valuable his services are likely to be, Dexsil Corp. v.\nCommissioner, 147 F.3d 96, 102-03 (2d Cir.1998); Elliotts, Inc. v. Commissioner,\n716 F.2d 1241, 1245-46 (9th Cir.1983), an employee who performs four jobs, each\non a part-time basis, is not necessarily worth as much to a company as four\nemployees each working full time at one of those jobs. It is therefore arbitrary to\nmultiply the normal full-time salary for one of the jobs by four to compute the\nreasonable compensation of the employee who fills all four of them. Anyway\nsalaries are determined not by the method of comparable worth but, like other\nprices, by the market, which is to say by conditions of demand and supply.\nEspecially in the short run, salaries may vary by more than any difference in the\n\xe2\x80\x9cobjective\xe2\x80\x9d characteristics of jobs. An individual who has valuable skills that are in\nparticularly short supply at the moment may command a higher salary than a more\nversatile, better-trained, and more loyal employee whose skills are, however, less\nscarce.\nThe Internal Revenue Service\xe2\x80\x99s expert witness sensibly considered whether Heitz\xe2\x80\x99s\ncompensation was consistent with Exacto\xe2\x80\x99s investors\xe2\x80\x99 earning a reasonable return\n(adjusted for the risk of Exacto\xe2\x80\x99s business), which he calculated to be 13%. But in\nconcluding that Heitz\xe2\x80\x99s compensation had pushed the return below that level, he\nneglected to consider the concessions of improper deductions, which led to\nadjustments to Exacto\xe2\x80\x99s taxable income. The Tax Court determined that with those\nadjustments the investors\xe2\x80\x99 annual return was more than 20% despite Heitz\xe2\x80\x99s large\nsalary. The government argues that the court should not have calculated the\ninvestors\xe2\x80\x99 return on the basis of the concessions of improper deductions, because\n361\n\n\x0cwhen Heitz\xe2\x80\x99s compensation was determined the corporation was unaware that the\ndeductions would be disallowed. In other words, the corporation thought that its\nafter-tax income was larger than it turned out to be. But if the ex ante perspective\nis the proper one, as the government contends, it favors the corporation if when it\nfixed Heitz\xe2\x80\x99s salary it thought there was more money in the till for the investors\nthan has turned out to be the case.\nWhat is puzzling is how disallowing deductions and thus increasing the taxpayer\xe2\x80\x99s\ntax bill could increase the investors\xe2\x80\x99 return. What investors care about is the\ncorporate income available to pay dividends or be reinvested; obviously money\npaid in taxes to the Internal Revenue Service is not available for either purpose. The\nreasonableness of Heitz\xe2\x80\x99s compensation thus depends not on Exacto\xe2\x80\x99s taxable\nincome but on the corporation\xe2\x80\x99s profitability to the investors, which is reduced by\nthe disallowance of deductions \xe2\x80\x93 if a corporation succeeds in taking phantom\ndeductions, shareholders are better off because the corporation\xe2\x80\x99s tax bill is lower.\nBut the government makes nothing of this. Its only objection is to the Tax Court\xe2\x80\x99s\nhaving taken account of adjustments made after Heitz\xe2\x80\x99s salary was fixed. Both\nparties, plus the Tax Court, based their estimates of investors\xe2\x80\x99 returns on the aftertax income shown on Exacto\xe2\x80\x99s tax returns, which jumped after the deductions were\ndisallowed, rather than on Exacto\xe2\x80\x99s real profits, which declined. The approach is\ninconsistent with a realistic assessment of the investors\xe2\x80\x99 rate of return, but as no\none in the case questions it we shall not make an issue of it.\nFinally, under factor (7) (\xe2\x80\x9cpeculiar characteristics\xe2\x80\x9d), the court first and rightly\nbrushed aside the IRS\xe2\x80\x99s argument that the low level of dividends paid by Exacto\n(zero in the two years at issue, but never very high) was evidence that the\ncorporation was paying Heitz dividends in the form of salary. The court pointed out\nthat shareholders may not want dividends. They may prefer the corporation to retain\nits earnings, causing the value of the corporation to rise and thus enabling the\nshareholders to obtain corporate earnings in the form of capital gains taxed at a\nlower rate than ordinary income. The court also noted that while Heitz, as the owner\nof 55% of Exacto\xe2\x80\x99s common stock, obviously was in a position to influence his\nsalary, the corporation\xe2\x80\x99s two other major shareholders, each with 20% of the stock,\nhad approved it. They had not themselves been paid a salary or other compensation,\nand are not relatives of Heitz; they had no financial or other incentive to allow Heitz\nto siphon off dividends in the form of salary.\nHaving run through the seven factors, all of which either favored the taxpayer or\nwere neutral, the court reached a stunning conclusion: \xe2\x80\x9cWe have considered the\n362\n\n\x0cfactors relevant in deciding reasonable compensation for Mr. Heitz. On the basis of\nall the evidence, we hold that reasonable compensation for Mr. Heitz\xe2\x80\x9d was much\nless than Exacto paid him. The court\xe2\x80\x99s only effort at explaining this result when\nExacto had passed the seven-factor test with flying colors was that \xe2\x80\x9cwe have\nbalanced Mr. Heitz\xe2\x80\x99 unique selling and technical ability, his years of experience,\nand the difficulty of replacing Mr. Heitz with the fact that the corporate entity would\nhave shown a reasonable return for the equity holders, after considering petitioners\xe2\x80\x99\nconcessions.\xe2\x80\x9d Id. But \xe2\x80\x9cthe fact that the corporate entity would have shown a\nreasonable return for the equity holders\xe2\x80\x9d after the concessions is on the same side\nof the balance as the other factors; it does not favor the Internal Revenue Service\xe2\x80\x99s\nposition. The government\xe2\x80\x99s lawyer was forced to concede at the argument of the\nappeal that she could not deny the possibility that the Tax Court had pulled its\nfigures for Heitz\xe2\x80\x99s allowable compensation out of a hat.\nThe failure of the Tax Court\xe2\x80\x99s reasoning to support its result would alone require a\nremand. But the problem with the court\xe2\x80\x99s opinion goes deeper. The test it applied\ndoes not provide adequate guidance to a rational decision. We owe no deference to\nthe Tax Court\xe2\x80\x99s statutory interpretations, its relation to us being that of a district\ncourt to a court of appeals, not that of an administrative agency to a court of appeals.\n26 U.S.C. \xc2\xa7 7482(a)(1); [citations omitted]. The federal courts of appeals, whose\ndecisions do of course have weight as authority with us even when they are not our\nown decisions, have been moving toward a much simpler and more purposive test,\nthe \xe2\x80\x9cindependent investor\xe2\x80\x9d test. Dexsil Corp. v. Commissioner, supra; Elliotts, Inc.\nv. Commissioner, supra, 716 F.2d at 1245-48; Rapco, Inc. v. Commissioner, supra,\n85 F.3d at 954-55. We applaud the trend and join it.\nBecause judges tend to downplay the element of judicial creativity in adapting law\nto fresh insights and changed circumstances, the cases we have just cited prefer to\nsay (as in Dexsil and Rapco) that the \xe2\x80\x9cindependent investor\xe2\x80\x9d test is the \xe2\x80\x9clens\xe2\x80\x9d\nthrough which they view the seven (or however many) factors of the orthodox test.\nBut that is a formality. The new test dissolves the old and returns the inquiry to\nbasics. The Internal Revenue Code limits the amount of salary that a corporation\ncan deduct from its income primarily in order to prevent the corporation from\neluding the corporate income tax by paying dividends but calling them salary\nbecause salary is deductible and dividends are not. (Perhaps they should be, to avoid\ndouble taxation of corporate earnings, but that is not the law.) In the case of a\npublicly held company, where the salaries of the highest executives are fixed by a\nboard of directors that those executives do not control, the danger of siphoning\ncorporate earnings to executives in the form of salary is not acute. The danger is\n363\n\n\x0cmuch greater in the case of a closely held corporation, in which ownership and\nmanagement tend to coincide; unfortunately, as the opinion of the Tax Court in this\ncase illustrates, judges are not competent to decide what business executives are\nworth.\nThere is, fortunately, an indirect market test, as recognized by the Internal Revenue\nService\xe2\x80\x99s expert witness. A corporation can be conceptualized as a contract in\nwhich the owner of assets hires a person to manage them. The owner pays the\nmanager a salary and in exchange the manager works to increase the value of the\nassets that have been entrusted to his management; that increase can be expressed\nas a rate of return to the owner\xe2\x80\x99s investment. The higher the rate of return (adjusted\nfor risk) that a manager can generate, the greater the salary he can command. If the\nrate of return is extremely high, it will be difficult to prove that the manager is being\noverpaid, for it will be implausible that if he quit if his salary was cut, and he was\nreplaced by a lower-paid manager, the owner would be better off; it would be killing\nthe goose that lays the golden egg. The Service\xe2\x80\x99s expert believed that investors in\na firm like Exacto would expect a 13% return on their investment. Presumably they\nwould be delighted with more. They would be overjoyed to receive a return more\nthan 50% greater than they expected \xe2\x80\x93 and 20%, the return that the Tax Court found\nthat investors in Exacto had obtained, is more than 50% greater than the benchmark\nreturn of 13%.\nWhen, notwithstanding the CEO\xe2\x80\x99s \xe2\x80\x9cexorbitant\xe2\x80\x9d salary (as it might appear to a judge\nor other modestly paid official), the investors in his company are obtaining a far\nhigher return than they had any reason to expect, his salary is presumptively\nreasonable. We say \xe2\x80\x9cpresumptively\xe2\x80\x9d because we can imagine cases in which the\nreturn, though very high, is not due to the CEO\xe2\x80\x99s exertions. Suppose Exacto had\nbeen an unprofitable company that suddenly learned that its factory was sitting on\nan oil field, and when oil revenues started to pour in its owner raised his salary from\n$50,000 a year to $1.3 million. The presumption of reasonableness would be\nrebutted. There is no suggestion of anything of that sort here and likewise no\nsuggestion that Mr. Heitz was merely the titular chief executive and the company\nwas actually run by someone else, which would be another basis for rebuttal.\nThe government could still have prevailed by showing that while Heitz\xe2\x80\x99s salary\nmay have been no greater than would be reasonable in the circumstances, the\ncompany did not in fact intend to pay him that amount as salary, that his salary\nreally did include a concealed dividend though it need not have. This is material\n(and the \xe2\x80\x9cindependent investor\xe2\x80\x9d test, like the multi-factor test that it replaces, thus\n364\n\n\x0cincomplete, though invaluable) because any business expense to be deductible must\nbe, as we noted earlier, a bona fide expense as well as reasonable in amount. The\nfact that Heitz\xe2\x80\x99s salary was approved by the other owners of the corporation, who\nhad no incentive to disguise a dividend as salary, goes far to rebut any inference of\nbad faith here, which in any event the Tax Court did not draw and the government\ndoes not ask us to draw.\nThe judgment is reversed with directions to enter judgment for the taxpayer.\nReversed.\nNotes and Questions:\n1. Judge Posner is right in describing what is probably still the prevailing standard\nas a multi-factor test \xe2\x80\x93 with all the problems that go with it. See E.L. Kellett, Annot.,\nReasonableness of Compensation Paid to Officers or Employees, so as to Warrant\nDeduction Thereof in Computing Employer\xe2\x80\x99s Income Tax, 10 A.L.R. FED.3d 125.\n2. For what reasons would a taxpayer \xe2\x80\x9cpay,\xe2\x80\x9d i.e., compensate, an employee\nmore than a reasonable amount of salary?\n\xe2\x80\xa2The court observed that a shareholder derivative suit is a \xe2\x80\x9cmore germane\ncontext\xe2\x80\x9d in which to evaluate excessive compensation? Why would this be\ntrue?\n3. In Elliotts, Inc. v. Commissioner, 716 F.2d 1241 (9th Cir. 1983), the Ninth Circuit\nconsidered the hypothetical investor because the \xe2\x80\x9cemployee\xe2\x80\x9d was the sole\nshareholder of the corporation. The court remanded for consideration of factors\nthat should include the reasonableness of a salary and the reasonableness of a\nformula by which a bonus was determined.\n4. In Menard, Inc. v. Commissioner, 560 F.3d 620 (7th Cir. 2009), the Seventh\nCircuit (opinion by Posner) determined that compensation of $7.1M in 1998 was\nnot excessive. There was no indication of shareholder disappointment with their\n18.8% return.\n5. In Mulcahy, Pauritsch, Salvador & Co v. Commissioner, 680 F.3d 867, 872 (7th\nCir. 2012), the Seventh Circuit (opinion by Posner) affirmed the judgment of the\nTax Court that \xe2\x80\x9cconsulting fees\xe2\x80\x9d were disguised dividends that otherwise would\nhave left investors with a 0% return.\n365\n\n\x0c6. Read \xc2\xa7 162(m). Notice that it\nonly applies to publicly held\ncorporations. How effective do you\nthink \xc2\xa7 162(m) is at curtailing\nexcessive compensation? Keep in\nmind that the Tax Cuts and Jobs Act\nreduced the maximum corporate tax\nrate from 35% to 21%. See David I.\nWalker, Expanding and Effectively\nRepealing the Executive Pay\nDeductibility Limitations, TAX\nNOTES 1819 (Sept. 24, 2018).\nC.\nOrdinary and Necessary\nExpenses\n\nWhat\xe2\x80\x99s at stake? A corporation pays its\nshareholders dividends from the after-tax profits\nit has earned over and above its (deductible)\nexpenses. A corporation may not deduct the\namount of dividends that it pays to shareholders.\nShareholders who receive dividends must pay\nincome tax on them. Thus, corporate profits that\na corporation distributes to shareholders are\nsubject to income taxation twice \xe2\x80\x93 once at the\ncorporate level and once at the shareholder\nlevel.\nA corporation may deduct salaries that it pays.\n\xc2\xa7 162(a)(1). Thus, a salary is subject to tax only\nat the employee level.\nWhat is the tax treatment of a gift that a\ncorporation gives to an employee? See\nDuberstein, supra; \xc2\xa7\xc2\xa7 102(c), 274(b).\n\nSection 162(a) allows taxpayer to\ndeduct all ordinary and necessary\nexpenses paid or incurred in\ncarrying on any trade or business, but \xc2\xa7\xc2\xa7 162 and 274 limit trade or business\ndeductions incurred for certain purposes.\n\nSection 212 allows a similar deduction for the ordinary and necessary expenses that\ntaxpayer pays or incurs \xe2\x80\x93\n\xe2\x80\xa2for the production or collection of income,\n\xe2\x80\xa2for the management, conservation, or maintenance of property held for the\nproduction of income, or\n\xe2\x80\xa2in connection with the determination, collection, or refund of any tax.\n\xe2\x80\xa2Section 67(g) suspends \xe2\x80\x9cmiscellaneous deductions\xe2\x80\x9d until 2026. Section\n212 deductions are included in \xe2\x80\x9cmiscellaneous deductions.\xe2\x80\x9d\n\xe2\x80\xa2This will encourage taxpayers to characterize their activities as a\ntrade or business.\nWe consider here a few recurring issues.\n\n366\n\n\x0c1. Personal vs. Trade or Business\nWe have already seen that \xc2\xa7 162(a)(2) implicitly treats taxpayer\xe2\x80\x99s choice of where\nto live as a personal one (Flowers). So is the choice to be marry (Hantzis). Hence,\ntaxpayer may not deduct expenditures associated with these choices. \xc2\xa7 262(a).\nThese are not the only life choices that the Code implicitly treats as \xe2\x80\x9cpersonal.\xe2\x80\x9d\nSmith v. Commissioner, 40 B.T.A. 1038 (1939), aff\xe2\x80\x99d 113 F.2d 114 (2d Cir. 1940).\n....\nOPINION \xe2\x80\x93 OPPER\nRespondent determined a deficiency of $23.62 in petitioner\xe2\x80\x99s 1937 income tax. This\nwas due to the disallowance of a deduction claimed by petitioners, who are husband\nand wife, for sums spent by the wife in employing nursemaids to care for\npetitioners\xe2\x80\x99 young child, the wife, as well as the husband, being employed. ...\nPetitioners would have us apply the \xe2\x80\x98but for\xe2\x80\x99 test. They propose that but for the\nnurses the wife could not leave her child; but for the freedom so secured she could\nnot pursue her gainful labors; and but for them there would be no income and no\ntax. This thought evokes an array of interesting possibilities. The fee to the doctor,\nbut for whose healing service the earner of the family income could not leave his\nsickbed; [footnote omitted] the cost of the laborer\xe2\x80\x99s raiment, for how can the world\nproceed about its business unclothed; the very home which gives us shelter and rest\nand the food which provides energy, might all by an extension of the same\nproposition be construed as necessary to the operation of business and to the\ncreation of income. Yet these are the very essence of those \xe2\x80\x98personal\xe2\x80\x99 expenses the\ndeductibility of which is expressly denied. [citation omitted]\nWe are told that the working wife is a new phenomenon. This is relied on to account\nfor the apparent inconsistency that the expenses in issue are now a commonplace,\nyet have not been the subject of legislation, ruling, or adjudicated controversy. But\nif that is true it becomes all the more necessary to apply accepted principles to the\nnovel facts. We are not prepared to say that the care of children, like similar aspects\nof family and household life, is other than a personal concern. The wife\xe2\x80\x99s services\nas custodian of the home and protector of its children are ordinarily rendered\nwithout monetary compensation. There results no taxable income from the\n367\n\n\x0cperformance of this service and the correlative expenditure is personal and not\nsusceptible of deduction. [citation omitted] Here the wife has chosen to employ\nothers to discharge her domestic function and the services she performs are\nrendered outside the home. They are a source of actual income and taxable as such.\nBut that does not deprive the same work performed by others of its personal\ncharacter nor furnish a reason why its cost should be treated as an offset in the guise\nof a deductible item.\nWe are not unmindful that, as petitioners suggest, certain disbursements normally\npersonal may become deductible by reason of their intimate connection with an\noccupation carried on for profit. In this category fall entertainment [citation\nomitted], and traveling expenses [citation omitted], and the cost of an actor\xe2\x80\x99s\nwardrobe [citation omitted]. The line is not always an easy one to draw nor the test\nsimple to apply. But we think its principle is clear. It may for practical purposes be\nsaid to constitute a distinction between those activities which, as a matter of\ncommon acceptance and universal experience, are \xe2\x80\x98ordinary\xe2\x80\x99 or usual as the direct\naccompaniment of business pursuits, on the one hand; and those which, though they\nmay in some indirect and tenuous degree relate to the circumstances of a profitable\noccupation, are nevertheless personal in their nature, of a character applicable to\nhuman beings generally, and which exist on that plane regardless of the occupation,\nthough not necessarily of the station in life, of the individuals concerned. See Welch\nv. Helvering, 290 U.S. 111.\nIn the latter category, we think, fall payments made to servants or others occupied\nin looking to the personal wants of their employers. [citation omitted]. And we\ninclude in this group nursemaids retained to care for infant children.\nDecision will be entered for the respondent.\n\n368\n\n\x0cNotes and Questions:\n1. The B.T.A. says that the expenses of a nursemaid \xe2\x80\x9care the very essence of those\n\xe2\x80\x98personal expenses the deductibility of which is expressly denied.\xe2\x80\x99\xe2\x80\x9d\n\xe2\x80\xa2What was the personal choice that taxpayer made in this case that made\nthese expenses non-deductible?\n2. We have already noted \xc2\xa7\xc2\xa7 21 and 129. These provisions reverse the result of\nSmith, but not its construction of \xc2\xa7 162.\n\xe2\x80\xa2What do these provisions say about the underlying rationale of Smith,\nparticularly the role of the wife and mother?\nDo the CALI Lesson, Basic Federal Income Taxation: Taxable Income and Tax\nComputation: Dependent Care Credit.\n2. Limitations on Deductibility of Ordinary and Necessary Trade or\nBusiness Expenses\nConsider the source of a limitation on the deductibility of expenses that taxpayer\nincurs to generate income that the following cases consider:\nCommissioner v. Tellier, 383 U.S. 687 (1966).\nMR. JUSTICE STEWART delivered the opinion of the Court.\nThe question presented in this case is whether expenses incurred by a taxpayer in\nthe unsuccessful defense of a criminal prosecution may qualify for deduction from\ntaxable income under \xc2\xa7 162(a), which allows a deduction of \xe2\x80\x9call the ordinary and\nnecessary expenses paid or incurred during the taxable year in carrying on any trade\nor business. ...\xe2\x80\x9d [footnote omitted] The respondent Walter F. Tellier was engaged\nin the business of underwriting the public sale of stock offerings and purchasing\nsecurities for resale to customers. In 1956, he was brought to trial upon a 36-count\nindictment that charged him with violating the fraud section of the Securities Act\nof 1933 [footnote omitted] and the mail fraud statute, [footnote omitted] and with\nconspiring to violate those statutes. [footnote omitted] He was found guilty on all\ncounts, and was sentenced to pay an $18,000 fine and to serve four and a half years\n369\n\n\x0cin prison. The judgment of conviction was affirmed on appeal. [footnote omitted]\nIn his unsuccessful defense of this criminal prosecution, the respondent incurred\nand paid $22,964.20 in legal expenses in 1956. He claimed a deduction for that\namount on his federal income tax return for that year. The Commissioner\ndisallowed the deduction, and was sustained by the Tax Court. The Court of\nAppeals for the Second Circuit reversed in a unanimous en banc decision, and we\ngranted certiorari. We affirm the judgment of the Court of Appeals.\nThere can be no serious question that the payments deducted by the respondent\nwere expenses of his securities business under the decisions of this Court, and the\nCommissioner does not contend otherwise. In United States v. Gilmore, 372 U.S.\n39, we held that \xe2\x80\x9cthe origin and character of the claim with respect to which an\nexpense was incurred, rather than its potential consequences upon the fortunes of\nthe taxpayer, is the controlling basic test of whether the expense was \xe2\x80\x98business\xe2\x80\x99 or\n\xe2\x80\x98personal\xe2\x80\x99\xe2\x80\x9d within the meaning of \xc2\xa7 162(a). Cf. Kornhauser v. United States, 276\nU.S. 145; Deputy v. du Pont, 308 U.S. 488. The criminal charges against the\nrespondent found their source in his business activities as a securities dealer. The\nrespondent\xe2\x80\x99s legal fees, paid in defense against those charges, therefore clearly\nqualify under Gilmore as \xe2\x80\x9cexpenses paid or incurred ... in carrying on any trade or\nbusiness\xe2\x80\x9d within the meaning of \xc2\xa7 162(a).\nThe Commissioner also concedes that the respondent\xe2\x80\x99s legal expenses were\n\xe2\x80\x9cordinary\xe2\x80\x9d and \xe2\x80\x9cnecessary\xe2\x80\x9d expenses within the meaning of \xc2\xa7 162(a). Our decisions\nhave consistently construed the term \xe2\x80\x9cnecessary\xe2\x80\x9d as imposing only the minimal\nrequirement that the expense be \xe2\x80\x9cappropriate and helpful\xe2\x80\x9d for \xe2\x80\x9cthe development of\nthe [taxpayer\xe2\x80\x99s] business.\xe2\x80\x9d Welch v. Helvering, 290 U.S. 111; cf. Kornhauser v.\nUnited States, supra, at 276 U.S. 152; Lilly v. Commissioner, 343 U.S. 90, 93-94;\nCommissioner v. Heininger, 320 U.S. 467, 320 U.S. 471; McCulloch v. Maryland,\n4 Wheat. 316, 17 U.S. 413-415. The principal function of the term \xe2\x80\x9cordinary\xe2\x80\x9d in\n\xc2\xa7 162(a) is to clarify the distinction, often difficult, between those expenses that are\ncurrently deductible and those that are in the nature of capital expenditures, which,\nif deductible at all, must be amortized over the useful life of the asset. Welch v.\nHelvering, supra, at 290 U.S. 113-116. [footnote omitted] The legal expenses\ndeducted by the respondent were not capital expenditures. They were incurred in\nhis defense against charges of past criminal conduct, not in the acquisition of a\ncapital asset. Our decisions establish that counsel fees comparable to those here\ninvolved are ordinary business expenses, even though a \xe2\x80\x9clawsuit affecting the\nsafety of a business may happen once a lifetime.\xe2\x80\x9d Welch v. Helvering, supra, at\n290 U.S. 114. Kornhauser v. United States, supra, at 276 U.S. 152-153; cf. Trust\n370\n\n\x0cof Bingham v. Commissioner, 325 U.S. 365, 376. [footnote omitted]\nIt is therefore clear that the respondent\xe2\x80\x99s legal fees were deductible under \xc2\xa7 162(a)\nif the provisions of that section are to be given their normal effect in this case. The\nCommissioner and the Tax Court determined, however, that, even though the\nexpenditures meet the literal requirements of \xc2\xa7 162(a), their deduction must\nnevertheless be disallowed on the ground of public policy. That view finds\nconsiderable support in other administrative and judicial decisions.129 It finds no\nsupport, however, in any regulation or statute or in any decision of this Court, and\nwe believe no such \xe2\x80\x9cpublic policy\xe2\x80\x9d exception to the plain provisions of \xc2\xa7 162(a) is\nwarranted in the circumstances presented by this case.\nWe start with the proposition that the federal income tax is a tax on net income, not\na sanction against wrongdoing. That principle has been firmly imbedded in the tax\nstatute from the beginning. One familiar facet of the principle is the truism that the\nstatute does not concern itself with the lawfulness of the income that it taxes.\nIncome from a criminal enterprise is taxed at a rate no higher and no lower than\nincome from more conventional sources. \xe2\x80\x9c[T]he fact that a business is unlawful\n[does not] exempt it from paying the taxes that if lawful it would have to pay.\xe2\x80\x9d\nUnited States v. Sullivan, 274 U.S. 259. See James v. United States, 366 U.S. 213.\nWith respect to deductions, the basic rule, with only a few limited and well defined\nexceptions, is the same. During the Senate debate in 1913 on the bill that became\nthe first modern income tax law, amendments were rejected that would have limited\ndeductions for losses to those incurred in a \xe2\x80\x9clegitimate\xe2\x80\x9d or \xe2\x80\x9clawful\xe2\x80\x9d trade or\nbusiness. Senator Williams, who was in charge of the bill, stated on the floor of the\nSenate that\n\xe2\x80\x9c[T]he object of this bill is to tax a man\xe2\x80\x99s net income; that is to say, what he\nhas at the end of the year after deducting from his receipts his expenditures\nSee Sarah Backer, 1 B.T.A. 214; Norvin R. Lindheim, 2 B.T.A. 229; Thomas A. Joseph, 26 T.C. 562;\nBurroughs Bldg. Material Co. v. Commissioner, 47 F.2d 178 (C.A.2d Cir.); Commissioner v. Schwartz,\n232 F.2d 94 (C.A.5th Cir.); Acker v. Commissioner, 258 F.2d 568 (C.A.6th Cir.); Bell v. Commissioner,\n320 F.2d 953 (C.A.8th Cir.); Peckham v. Commissioner, 327 F.2d 855, 856 (C.A.4th Cir.); Port v. United\nStates, 163 F. Supp. 645. See also Note, Business Expenses, Disallowance, and Public Policy: Some\nProblems of Sanctioning with the Internal Revenue Code, 72 YALE L.J. 108; 4 MERTENS, LAW OF\nFEDERAL INCOME TAXATION \xc2\xa7 25.49 ff. Compare Longhorn Portland Cement Co., 3 T.C. 310; G.C.M.\n24377, 1944 Cum. Bull. 93; Lamont, Controversial Aspects of Ordinary and Necessary Business\nExpense, 42 TAXES 808, 833-834.\n129\n\n371\n\n\x0cor losses. It is not to reform men\xe2\x80\x99s moral characters; that is not the object of\nthe bill at all. The tax is not levied for the purpose of restraining people from\nbetting on horse races or upon \xe2\x80\x98futures,\xe2\x80\x99 but the tax is framed for the purpose\nof making a man pay upon his net income, his actual profit during the year.\nThe law does not care where he got it from, so far as the tax is concerned,\nalthough the law may very properly care in another way.\xe2\x80\x9d 50 Cong. Rec.\n3849.130\nThe application of this principle is reflected in several decisions of this Court. As\nrecently as Commissioner v. Sullivan, 356 U.S. 27, we sustained the allowance of\na deduction for rent and wages paid by the operators of a gambling enterprise, even\nthough both the business itself and the specific rent and wage payments there in\nquestion were illegal under state law. In rejecting the Commissioner\xe2\x80\x99s contention\nthat the illegality of the enterprise required disallowance of the deduction, we held\nthat, were we to \xe2\x80\x9cenforce as federal policy the rule espoused by the Commissioner\nin this case, we would come close to making this type of business taxable on the\nbasis of its gross receipts, while all other business would be taxable on the basis of\nnet income. If that choice is to be made, Congress should do it.\xe2\x80\x9d Id. at 356 U.S. 29.\nIn Lilly v. Commissioner, 343 U.S. 90, the Court upheld deductions claimed by\nopticians for amounts paid to doctors who prescribed the eyeglasses that the\nopticians sold, although the Court was careful to disavow \xe2\x80\x9capproval of the business\nethics or public policy involved in the payments. ...\xe2\x80\x9d 343 U.S. at 97. And in\nCommissioner v. Heininger, 320 U.S. 467, a case akin to the one before us, the\nCourt upheld deductions claimed by a dentist for lawyer\xe2\x80\x99s fees and other expenses\nincurred in unsuccessfully defending against an administrative fraud order issued\nby the Postmaster General.\nDeduction of expenses falling within the general definition of \xc2\xa7 162(a) may, to be\nsure, be disallowed by specific legislation, since deductions \xe2\x80\x9care a matter of grace\nand Congress can, of course, disallow them as it chooses.\xe2\x80\x9d Commissioner v.\nSullivan, 356 U.S. at 28.131 The Court has also given effect to a precise and\n130\n\nIn challenging the amendments, Senator Williams also stated:\n\xe2\x80\x9cIn other words, you are going to count the man as having money which he has not got,\nbecause he has lost it in a way that you do not approve of.\xe2\x80\x9d\n\n50 Cong. Rec. 3850.\nSpecific legislation denying deductions for payments that violate public policy is not unknown. E.g.,\nInternal Revenue Code of 1954, \xc2\xa7 162(c) (disallowance of deduction for payments to officials and\nemployees of foreign countries in circumstances where the payments would be illegal if federal laws\n131\n\n372\n\n\x0clongstanding Treasury Regulation prohibiting the deduction of a specified category\nof expenditures; an example is lobbying expenses, whose nondeductibility was\nsupported by considerations not here present. Textile Mills Securities Corp. v.\nCommissioner, 314 U.S. 326; Cammarano v. United States, 358 U.S. 498. But\nwhere Congress has been wholly silent, it is only in extremely limited\ncircumstances that the Court has countenanced exceptions to the general principle\nreflected in the Sullivan, Lilly, and Heininger decisions. Only where the allowance\nof a deduction would \xe2\x80\x9cfrustrate sharply defined national or state policies\nproscribing particular types of conduct\xe2\x80\x9d have we upheld its disallowance.\nCommissioner v. Heininger, 320 U.S. at 473. Further, the \xe2\x80\x9cpolicies frustrated must\nbe national or state policies evidenced by some governmental declaration of them.\xe2\x80\x9d\nLilly v. Commissioner, 343 U.S. at 97. (Emphasis added.) Finally, the \xe2\x80\x9ctest of\nnondeductibility always is the severity and immediacy of the frustration resulting\nfrom allowance of the deduction.\xe2\x80\x9d Tank Truck Rentals v. Commissioner, 356 U.S.\n30, 35. In that case, as in Hoover Motor Express Co. v. United States, 356 U.S. 38,\nwe upheld the disallowance of deductions claimed by taxpayers for fines and\npenalties imposed upon them for violating state penal statutes; to allow a deduction\nin those circumstances would have directly and substantially diluted the actual\npunishment imposed.\nThe present case falls far outside that sharply limited and carefully defined\ncategory. No public policy is offended when a man faced with serious criminal\ncharges employs a lawyer to help in his defense. That is not \xe2\x80\x9cproscribed conduct.\xe2\x80\x9d\nIt is his constitutional right. Chandler v. Fretag, 348 U.S. 3. See Gideon v.\nWainwright, 372 U.S. 335. In an adversary system of criminal justice, it is a basic\nof our public policy that a defendant in a criminal case have counsel to represent\nhim.\n\nwere applicable; cf. Reg. \xc2\xa7 1.162-18); \xc2\xa7 165(d) (deduction for wagering losses limited to extent of\nwagering gains). See also Stabilization Act of 1942, \xc2\xa7 5(a), 56 Stat. 767, 50 U.S.C. App. \xc2\xa7 965(a) (1946\ned.), Defense Production Act of 1950, \xc2\xa7 405(a), 64 Stat. 807, as amended, c. 275, \xc2\xa7 104(i), 65 Stat. 136\n(1951), 50 U.S.C. App. \xc2\xa7 2105(a) (1952 ed.), and Defense Production Act of 1950, \xc2\xa7 405(b), 64 Stat.\n807, 50 U.S.C. App. \xc2\xa7 2105(b) (1952 ed.) (general authority in President to prescribe extent to which\npayments violating price and wage regulations should be disregarded by government agencies, including\nthe Internal Revenue Service; see Rev. Rul. 56-180). Cf. \xc2\xa7 1.162-1(a), which provides that \xe2\x80\x9cPenalty\npayments with respect to Federal taxes, whether on account of negligence, delinquency, or fraud, are\nnot deductible from gross income;\xe2\x80\x9d Joint Committee on Internal Revenue Taxation, Staff Study of\nIncome Tax Treatment of Treble Damage Payments under the Antitrust Laws, Nov. 1, 1965, p. 16\n(proposal that \xc2\xa7 162 be amended to deny deductions for certain fines, penalties, treble damage\npayments, bribes, and kickbacks).\n\n373\n\n\x0cCongress has authorized the imposition of severe punishment upon those found\nguilty of the serious criminal offenses with which the respondent was charged and\nof which he was convicted. But we can find no warrant for attaching to that\npunishment an additional financial burden that Congress has neither expressly nor\nimplicitly directed.132 To deny a deduction for expenses incurred in the\nunsuccessful defense of a criminal prosecution would impose such a burden in a\nmeasure dependent not on the seriousness of the offense or the actual sentence\nimposed by the court, but on the cost of the defense and the defendant\xe2\x80\x99s particular\ntax bracket. We decline to distort the income tax laws to serve a purpose for which\nthey were neither intended nor designed by Congress.\nThe judgment is\nAffirmed.\n\nCf. Paul, The Use of Public Policy by the Commissioner in Disallowing Deductions, 1954 SO. CALIF.\nTAX INST. 715, 730-731: \xe2\x80\x9c... Section 23(a)(1)(A) [the predecessor of \xc2\xa7 162(a)] is not an essay in morality,\ndesigned to encourage virtue and discourage sin. It \xe2\x80\x98was not contrived as an arm of the law to enforce\nState criminal statutes. ...\xe2\x80\x99 Nor was it contrived to implement the various regulatory statutes which\nCongress has from time to time enacted. The provision is more modestly concerned with \xe2\x80\x98commercial\nnet income\xe2\x80\x99 \xe2\x80\x93 a businessman\xe2\x80\x99s net accretion in wealth during the taxable year after due allowance for\nthe operating costs of the business. ... There is no evidence in the Section of an attempt to punish\ntaxpayers ... when the Commissioner feels that a state or federal statute has been flouted. The statute\nhardly operates \xe2\x80\x98in a vacuum\xe2\x80\x99 if it serves its own vital function and leaves other problems to other\nstatutes.\xe2\x80\x9d\n132\n\n374\n\n\x0cNotes and Questions:\nDeductibility of Legal Expenses: In both Woodward, supra, and\nTellier, the Court cited United States v. Gilmore, 372 U.S. 39\n(1963). In Gilmore, taxpayer and his wife cross-claimed for\ndivorce. Taxpayer owned controlling stock interests in three\ncorporations, each of which owned a General Motors\ndealership. He received a substantial income from these\ncorporations. His wife made sensational allegations, and had\nshe prevailed, she could receive more than half the stock\nand/or GM would terminate the corporations\xe2\x80\x99 franchises.\nFearing such consequences of losing, taxpayer spent large sums\nto fight his wife\xe2\x80\x99s allegation and prevailed. Taxpayer sought\nto deduct his legal expenses attributable to resistance of his\nwife\xe2\x80\x99s claims under \xc2\xa7 212. The Commissioner argued that such\nexpenses were personal or family expenses. The court of claims\nallocated 20% of the fees to the divorce and 80% to the\nconservation of property. The CIR argued that deductibility\nunder either \xc2\xa7 162 or \xc2\xa7 212 turned \xe2\x80\x9cnot upon the consequences\nto [taxpayer] of a failure to defeat his wife\xe2\x80\x99s community\nproperty claims, but upon the origin and nature of the claims\nthemselves.\xe2\x80\x9d The Court agreed: \xe2\x80\x9c[T]he characterization as\n\xe2\x80\x98business\xe2\x80\x99 or \xe2\x80\x98personal,\xe2\x80\x99 of the litigation costs of resisting a claim\ndepends on whether or not the claim arises in connection with\nthe taxpayer\xe2\x80\x99s profit-seeking activities. It does not depend on\nthe consequences that might result to a taxpayer\xe2\x80\x99s incomeproducing property from a failure to defeat the claim[.]\xe2\x80\x9d The\nCourt stated its \xe2\x80\x9corigin of the claim\xe2\x80\x9d test thus: \xe2\x80\x9c[T]he origin and\ncharacter of the claim with respect to which an expense was\nincurred, rather than its potential consequences upon the\nfortunes of the taxpayer is the controlling basic test of whether\nthe expense was \xe2\x80\x98business\xe2\x80\x99 or \xe2\x80\x98personal[.]\xe2\x80\x99\xe2\x80\x9d None of taxpayer\xe2\x80\x99s\nlegal expenses were deductible. \xe2\x80\x9cIt is enough to say that \xe2\x80\xa6\nthe wife\xe2\x80\x99s claims stemmed entirely from the marital relationship,\nand not, under any tenable view of things, from incomeproducing activity.\xe2\x80\x9d\n\n1. Why should the\nstandard of\n\xe2\x80\x9cnecessary\xe2\x80\x9d under\n\xc2\xa7 162 be a\nminimal one, i.e.,\nappropriate and\nhelpful? Are there\nforces other than\nthe rules of \xc2\xa7 162\nthat will provide\ncontrols on the\namounts that a\ntaxpayer spends to\nfurther his/her/its\nbusiness?\n\xe2\x80\xa2Recall the\nstatement in Welch\nv. Helvering:\nTaxpayer\n\xe2\x80\x9ccertainly thought\n[payments to\ncreditors of a\nbankrupt\ncorporation were\nnecessary], and we\nshould be slow to\noverride his\njudgment.\xe2\x80\x9d\n\n2. The income tax\nis a tax only on net\nincome. One\nsignificant\nexception to this \xe2\x80\x93\nexplicitly stated in the Code \xe2\x80\x93 is \xc2\xa7 280E. The expenses of carrying on the trade or\nbusiness of trafficking in controlled substances are not deductible.\n\xe2\x80\xa2In Alpenglow Botanicals. LLC v. United States, 894 F.3d 1187, 1199-202\n375\n\n\x0c(CA10 2018), cert. denied, 139 S. Ct. 2745 (2019), the court held that\nCongress could consistent with the Sixteenth Amendment, deny taxpayers\ndeductions for the trade or business expenses of trafficking in marijuana \xe2\x80\x93\neven though the sale of marijuana is lawful in 28 states.\n3. What norms does a refusal to incorporate public policy into the Code further?\n\xe2\x80\xa2A refusal to incorporate public policy into the Code hardly means that there\nis no public policy limitation on deductibility under \xc2\xa7 162. Rather, those\nlimitations must be explicitly stated in the statute itself.\n\xe2\x80\xa2See Court\xe2\x80\x99s discussion of the point and its third footnote.\n\xe2\x80\xa2Note the topics covered in \xc2\xa7\xc2\xa7 162(b, c, e, f, g, k, l, and m).\n4. The term \xe2\x80\x9cordinary\xe2\x80\x9d has a relatively special meaning as used in \xc2\xa7 162. What is\nit?\n5. In Tellier, taxpayer was a criminal. He nevertheless could deduct the \xe2\x80\x9cordinary\nand necessary\xe2\x80\x9d trade or business expenses arising from this character flaw.\n\xe2\x80\xa2Should taxpayer be permitted to deduct the ordinary and necessary\nexpenses associated with mental \xe2\x80\x9cflaws?\xe2\x80\x9d Is Gilliam distinguishable from\nTellier?\nGilliam v. Commissioner, 51 T.C. Memo. 515 (1986), available at 1986 WL\n21482.\nMEMORANDUM FINDINGS OF FACT AND OPINION\nCHABOT, JUDGE:\nFINDINGS OF FACT\n....\n[Taxpayer] Gilliam is, and was at all material periods, a noted artist. His works have\nbeen exhibited in numerous art galleries throughout the United States and Europe\n\xe2\x80\xa6 In addition, Gilliam is, and was at all material periods, a teacher of art. On\noccasion, Gilliam lectured and taught art at various institutions.\nGilliam accepted an invitation to lecture and teach for a week at the Memphis\n376\n\n\x0cAcademy of Arts in Memphis, Tennessee. On Sunday, February 23, 1975, he flew\nto Memphis to fulfill this business obligation.\nGilliam had a history of hospitalizations for mental and emotional disturbances and\ncontinued to be under psychiatric care until the time of his trip to Memphis. In\nDecember 1963, Gilliam was hospitalized in Louisville; Gilliam had anxieties\nabout his work as an artist. For periods of time in both 1965 and 1966, Gilliam\nsuffered from depression and was unable to work. In 1970, Gilliam was again\nhospitalized. In 1973, while Gilliam was a visiting artist at a number of university\ncampuses in California, he found it necessary to consult an airport physician;\nhowever, when he returned to Washington, D.C., Gilliam did not require\nhospitalization.\nBefore his Memphis trip, Gilliam created a 225-foot painting for the Thirty-fourth\nBiennial Exhibition of American Painting at the Corcoran Gallery of Art\n(hereinafter sometimes referred to as \xe2\x80\x98the Exhibition\xe2\x80\x99). The Exhibition opened on\nFriday evening, February 21, 1975. In addition, Gilliam was in the process of\npreparing a giant mural for an outside wall of the Philadelphia Museum of Art for\nthe 1975 Spring Festival in Philadelphia. The budget plans for this mural were due\non Monday, February 24, 1975.\nOn the night before his Memphis trip, Gilliam felt anxious and unable to rest. On\nSunday morning, Gilliam contacted Ranville Clark (hereinafter sometimes referred\nto as \xe2\x80\x98Clark\xe2\x80\x99), a doctor Gilliam had been consulting intermittently over the years,\nand asked Clark to prescribe some medication to relieve his anxiety. Clark arranged\nfor Gilliam to pick up a prescription of the drug Dalmane on the way to the airport.\nGilliam had taken medication frequently during the preceding 10 years. Clark had\nnever before prescribed Dalmane for Gilliam.\nOn Sunday, February 23, 1975, Gilliam got the prescription and at about 3:25 p.m.,\nhe boarded American Airlines flight 395 at Washington National Airport,\nWashington, D.C., bound for Memphis. Gilliam occupied a window seat. He took\nthe Dalmane for the first time shortly after boarding the airplane.\nAbout one and one-half hours after the airplane departed Washington National\nAirport, Gilliam began to act in an irrational manner. He talked of bizarre events\nand had difficulty in speaking. According to some witnesses, he appeared to be\nairsick and held his head. Gilliam began to feel trapped, anxious, disoriented, and\nvery agitated. Gilliam said that the plane was going to crash and that he wanted a\n377\n\n\x0clife raft. Gilliam entered the aisle and, while going from one end of the airplane to\nthe other, he tried to exit from three different doors. Then Gilliam struck Seiji\nNakamura (hereinafter sometimes referred to as \xe2\x80\x98Nakamura\xe2\x80\x99), another passenger,\nseveral times with a telephone receiver. Nakamura was seated toward the rear of\nthe airplane, near one of the exits. Gilliam also threatened the navigator and a\nstewardess, called for help, and cried. As a result of the attack, Nakamura sustained\na one-inch laceration above his left eyebrow which required four sutures. Nakamura\nalso suffered ecchymosis of the left arm and pains in his left wrist. Nakamura was\ntreated for these injuries at Methodist Hospital in Memphis.\nOn arriving in Memphis, Gilliam was arrested by Federal officials. On March 10,\n1975, Gilliam was indicted. He was brought to trial in the United States District\nCourt for the Western District of Tennessee, Western Division, on one count of\nviolation of 49 U.S.C. \xc2\xa7 1472(k) (relating to certain crimes aboard an aircraft in\nflight) and two counts of violation 49 U.S.C. \xc2\xa7 1472(j) (relating to interference with\nflight crew members or flight attendants). Gilliam entered a plea of not guilty to the\ncriminal charges. ... After Gilliam presented all of his evidence, the district court\ngranted Gilliam\xe2\x80\x99s motion for a judgment of acquittal by reason of temporary\ninsanity.\nPetitioners paid $8250 and $8600 for legal fees in 1975 and 1976, respectively, in\nconnection with both the criminal trial and Nakamura\xe2\x80\x99s civil claim. In 1975,\npetitioners also paid $3800 to Nakamura in settlement of the civil claim.\nPetitioners claimed deductions for the amounts paid in 1975 and 1976 on the\nappropriate individual income tax returns. Respondent disallowed the amounts\nclaimed in both years attributable to the incident on the airplane. [footnote omitted].\n***\nGilliam\xe2\x80\x99s trip to Memphis was a trip in furtherance of his trades or businesses.\n\xe2\x80\xa6.\nOPINION\nPetitioners contend that they are entitled to deduct the amounts paid in defense of\nthe criminal prosecution and in settlement of the related civil claim under \xc2\xa7 162.\n[footnote omitted]. Petitioners maintain that the instant case is directly controlled\n378\n\n\x0cby our decision in Dancer v. Commissioner, 73 T.C. 1103 (1980). According to\npetitioners, \xe2\x80\x98[t]he clear holding of Dancer is *** that expenses for litigation arising\nout of an accident which occurs during a business trip are deductible as ordinary\nand necessary business expenses.\xe2\x80\x99 Petitioners also contend that Clark v.\nCommissioner, 30 T.C. 1330 (1958), is to the same effect as Dancer.\nRespondent maintains that Dancer and Clark are distinguishable. Respondent\ncontends that the legal fees paid are not deductible under either \xc2\xa7 162 or \xc2\xa7 212\nbecause the criminal charges against Gilliam were neither directly connected with\nnor proximately resulted from his trade or business and the legal fees were not paid\nfor the production of income. Respondent maintains that \xe2\x80\x98the criminal charges\nwhich arose as a result of *** (the incident on the airplane), could hardly be deemed\n\xe2\x80\x98ordinary,\xe2\x80\x99 given the nature of (Gilliam\xe2\x80\x99s) profession.\xe2\x80\x99 Respondent contends \xe2\x80\x98that\nthe provisions of \xc2\xa7 262 control this situation.\xe2\x80\x99 As to the settlement of the related\ncivil claim, respondent asserts that since Gilliam committed an intentional tort, the\nsettlement of the civil claim constitutes a nondeductible personal expense.\nWe agree with respondent that the expenses are not ordinary expenses of Gilliam\xe2\x80\x99s\ntrade or business.\nSection 162(a) [footnote omitted] allows a deduction for all the ordinary and\nnecessary expenses of carrying on a trade or business. In order for the expense to\nbe deductible by a taxpayer, it must be an ordinary expense, it must be a necessary\nexpense, and it must be an expense of carrying on the taxpayer\xe2\x80\x99s trade or business.\nIf any one of these requirements is not met, the expense is not deductible under\n\xc2\xa7 162(a). Deputy v. du Pont, 308 U.S. 488 (1940); Welch v. Helvering, 290 U.S.\n111 (1933); Kornhauser v. United States, 276 U.S. 145 (1928). In Deputy v. du\nPont, the Supreme Court set forth a guide for application of the statutory\nrequirement that the expense be \xe2\x80\x98ordinary\xe2\x80\x99, as follows (308 U.S. at 494-497):\n[...] Ordinary has the connotation of normal, usual, or customary. To be\nsure, an expense may be ordinary though it happens but once in the\ntaxpayer\xe2\x80\x99s lifetime. Cf. Kornhauser v. United States, supra. Yet the\ntransaction which gives rise to it must be of common or frequent occurrence\nin the type of business involved. Welch v. Helvering, supra, 114. Hence, the\nfact that a particular expense would be an ordinary or common one in the\ncourse of one business and so deductible under [\xc2\xa7 162(a)] does not\nnecessarily make it such in connection with another business. *** As stated\nin Welch v. Helvering, supra, pp. 113-114: \xe2\x80\x98... What is ordinary, though\n379\n\n\x0cthere must always be a strain of constancy within it, is none the less a\nvariable affected by time and place and circumstance.\xe2\x80\x99 22 F. Supp. 589,\n597.\nOne of the extremely relevant circumstances is the nature and scope of the\nparticular business out of which the expense in question accrued. The fact\nthat an obligation to pay has arisen is not sufficient. It is the kind of\ntransaction out of which the obligation arose and its normalcy in the\nparticular business which are crucial and controlling.\nReview of the many decided cases is of little aid since each turns on its\nspecial facts. But the principle is clear. [...] [T]he fact that the payments\nmight have been necessary ... is of no aid. For Congress has not decreed that\nall necessary expenses may be deducted. Though plainly necessary they\ncannot be allowed unless they are also ordinary. Welch v. Helvering, supra.\n... It undoubtedly is ordinary for people in Gilliam\xe2\x80\x99s trades or businesses to travel\n(and to travel by air) in the course of such trades or businesses; however, we do not\nbelieve it is ordinary for people in such trades or businesses to be involved in\naltercations of the sort here involved in the course of any such travel. The travel\nwas not itself the conduct of Gilliam\xe2\x80\x99s trades or businesses. Also, the expenses here\ninvolved are not strictly a cost of Gilliam\xe2\x80\x99s transportation. Finally, it is obvious that\nneither the altercation nor the expenses were undertaken to further Gilliam\xe2\x80\x99s trades\nor businesses.\nWe conclude that Gilliam\xe2\x80\x99s expenses are not ordinary expenses of his trades or\nbusinesses.\nIt is instructive to compare the instant case with Dancer v. Commissioner, supra,\nupon which petitioners rely. In both cases, the taxpayer was traveling on business.\nIn both cases, the expenses in dispute were not the cost of the traveling, but rather\nwere the cost of an untoward incident that occurred in the course of the trip. In both\ncases, the incident did not facilitate the trip or otherwise assist the taxpayer\xe2\x80\x99s trade\nor business. In both cases, the taxpayer was responsible for the incident; in neither\ncase was the taxpayer willful. In Dancer, the taxpayer was driving an automobile;\nhe caused an accident which resulted in injuries to a child. The relevant expenses\nwere the taxpayer\xe2\x80\x99s payments to settle the civil claims arising from the accident. 73\nT.C. at 1105. In the instant case, Gilliam was a passenger in an airplane; he\napparently committed acts which would have been criminal but for his temporary\n380\n\n\x0cinsanity, and he injured a fellow passenger. Gilliam\xe2\x80\x99s expenses were the costs of\nhis successful legal defense, and his payments to settle Nakamura\xe2\x80\x99s civil claim.\nIn Dancer, we stated as follows (73 T.C. at 1108-1109):\nIt is true that the expenditure in the instant case did not further petitioner\xe2\x80\x99s\nbusiness in any economic sense; nor is it, we hope, the type of expenditure\nthat many businesses are called upon to pay. Nevertheless, neither factor\nlessens the direct relationship between the expenditure and the business.\nAutomobile travel by petitioner was an integral part of this business. As\nrising insurance rates suggest, the cost of fuel and routine servicing are not\nthe only costs one can expect in operating a car. As unfortunate as it may\nbe, lapses by drivers seem to be an inseparable incident of driving a car.\nAnderson v. Commissioner (81 F.2d 457 (CA10 1936)). Costs incurred as a\nresult of such an incident are just as much a part of overall business\nexpenses as the cost of fuel. (Emphasis supplied.)\nDancer is distinguishable.\nIn Clark v. Commissioner, supra, also relied on by petitioners, the expenses\nconsisted of payments of (a) legal fees in defense of a criminal prosecution and (b)\namounts to settle a related civil claim. In this regard, the instant case is similar to\nClark. In Clark, however, the taxpayer\xe2\x80\x99s activities that gave rise to the prosecution\nand civil claim were activities directly in the conduct of Clark\xe2\x80\x99s trade or business.\nIn the instant case, Gilliam\xe2\x80\x99s activities were not directly in the conduct of his trades\nor businesses. Rather, the activities merely occurred in the course of transportation\nconnected with Gilliam\xe2\x80\x99s trades or businesses. And, as we noted in Dancer v.\nCommissioner, 73 T.C. at 1106, \xe2\x80\x98in cases like this, where the cost is an adjunct of\nand not a direct cost of transporting an individual, we have not felt obliged to\nroutinely allow the expenditure as a transportation cost deduction.\xe2\x80\x99\nPetitioners also rely on Commissioner v. Tellier, 383 U.S. 687 (1966), in which the\ntaxpayer was allowed to deduct the cost of an unsuccessful criminal defense to\nsecurities fraud charges. The activities that gave rise to the criminal prosecution in\nTellier were activities directly in the conduct of Tellier\xe2\x80\x99s trade or business. Our\nanalysis of the effect of Clark v. Commissioner, applies equally to the effect of\nCommissioner v. Tellier.\nIn sum, Gilliam\xe2\x80\x99s expenses were of a kind similar to those of the taxpayers in Tellier\n381\n\n\x0cand Clark; however the activities giving rise to Gilliam\xe2\x80\x99s expenses were not\nactivities directly in the conduct of his trades or businesses, while Tellier\xe2\x80\x99s and\nClark\xe2\x80\x99s activities were directly in the conduct of their respective trades or\nbusinesses. Gilliam\xe2\x80\x99s expenses were related to his trades or businesses in a manner\nsimilar to those of the taxpayer in Dancer; however Gilliam\xe2\x80\x99s actions giving rise to\nthe expenses were not shown to be ordinary, while Dancer\xe2\x80\x99s were shown to be\nordinary. Tellier, Clark, and Dancer all have similarities to the instant case;\nhowever, Tellier, Clark, and Dancer are distinguishable in important respects. The\nexpenses are not deductible under \xc2\xa7 162(a). [footnote omitted].\nWe hold for respondent.\nNotes and Questions:\n1. Were the expenses incurred by taxpayer \xe2\x80\x9cnecessary?\xe2\x80\x9d\n2. By what means did the court in\nIf not \xe2\x80\x9cordinary\xe2\x80\x9d ...: In Welch, the opposite of\nfact implement a public policy\nan \xe2\x80\x9cordinary\xe2\x80\x9d expense was a capital expense.\nlimitation on taxpayer\xe2\x80\x99s trade or\nWhat is the opposite of \xe2\x80\x9cordinary\xe2\x80\x9d in Gilliam?\nbusiness expense? Why were the\ndeductions that taxpayer claimed\ndenied?\n\xe2\x80\xa2because they were \xe2\x80\x9cextraordinary\xe2\x80\x9d for taxpayer\xe2\x80\x99s trade or business?\n\xe2\x80\xa2If so, are there trades or businesses in which such expenditures\nwould not be extraordinary?\n\xe2\x80\xa2What if airline employees hit taxpayer in order to control him and\nincurred legal expenses and paid tort damages? Should their\nexpenses be deductible? These expenses would be the very type of\nexpenses that Gilliam could not deduct.\n3. Even when taxpayer incurs ordinary and necessary trade or business expenses,\ntaxpayer might not be entitled to deduct them.\nCongress has determined that it is not appropriate for taxpayers to benefit from\nmaking certain types of expenditures or from making expenditures for certain\n\n382\n\n\x0cpurposes. The denial (or limitation133) may extend to the expenditure itself \xe2\x80\x93 not\nmerely to the statutory basis of the deduction \xe2\x80\x93 whether trade or business, or\nsomething else. Some of these provisions are the following:\n\xe2\x80\xa2Section 274(a): A taxpayer may not deduct the expenses of entertainment,\nfacilities for entertainment,134 club dues, or providing an employee a\n\xe2\x80\x9cqualified transportation fringe.\xe2\x80\x9d There are exceptions. See \xc2\xa7 274(e)(4, 5,\n6).\n\xe2\x80\xa2Section 274 does not preclude deduction of 50% of the expense of\nfood and beverage during or at entertainment events if purchased\nseparately, provided their cost is separately stated. Notice 2018-76,\nI.R.B. 2018-195.\n\xe2\x80\xa2Section 274(c): Section 274(c) limits deductions under \xc2\xa7\xc2\xa7 162/212 of\n\xe2\x80\x9ctravel expenses\xe2\x80\x9d for foreign travel if such expenses are not \xe2\x80\x9callocable\xe2\x80\x9d to\ntaxpayer\xe2\x80\x99s trade or business activity engaged in for profit. This \xe2\x80\x9callocation\nlimitation applies if such travel exceeds one week or the time spent pursuing\ntrade or business or profit-making activity is not 75% or more of the total\ntime of such travel.\n\xe2\x80\xa2Section 274(h): Section 274(h) limits deductions as a trade or business\nexpense for expenditures made to attend a convention, seminar, or similar\nmeeting outside of North America. Section 274(h)(2) drastically curtails\ndeductions for such expenditures for attending a convention, seminar, or\nsimilar meeting aboard a cruise ship. Section 274(h)(7) denies deductibility\nof such expense altogether under \xc2\xa7 212.\n\xe2\x80\xa2Section 274(j): Section 274(j) limits deduction for employee achievement\nawards.\n\xe2\x80\xa2Section 274(m): Section 274(m)(1) limits deductions for transportation by\nwater. Section 274(m)(2) denies any deduction for expenses of travel as a\nform of education.\n\nWe have already encountered \xc2\xa7 274(b), which limits deductions under \xc2\xa7 162 or \xc2\xa7 212 for\nexpenditures on gifts to $25.\n133\n\nThis limit on deductions does not extend to expenses for food and beverages and facilities for\nentertainment on the employer\xe2\x80\x99s premises primarily for taxpayer\xe2\x80\x99s employees. \xc2\xa7 274(e)(1).\n134\n\n383\n\n\x0c\xe2\x80\xa2Section 274(n): Section 274(n)(1) restricts the deductibility of food and\nbeverage expenses to 50% of the amount of the\nCCA, Taxpayer Certainty\nexpense.\nand Disaster Tax Relief Act of\n\xe2\x80\xa2Section 274(o): Section 274(o) will, beginning\n2020, \xc2\xa7 210, added \xc2\xa7\nJanuary 1, 2026, deny employer deductions for\n274(n)(2)(D) which provides\nthe expenses of providing meals for its\nthat 100% of the cost of\nconvenience (see \xc2\xa7 119) or for operating an\nbusiness meals furnished in a\neating facility whose benefit is a de minimis\nrestaurant\nis\ndeductible\nfringe for its employees (see \xc2\xa7 132(e)(2)).\nthrough December 31, 2022.\n\xe2\x80\xa2Section 276: Section 276 denies any deduction\nfor expenditures made to benefit directly or\nindirectly a political party or political candidate.\n\xe2\x80\xa2Section 279: Section 279 limits the deduction for interest paid \xe2\x80\x9cby a\ncorporation\xe2\x80\x9d to make a corporate acquisition to $5M.\n\xe2\x80\xa2Section 280A: Section 280A limits deductions for business use of a\ndwelling unit that taxpayer (individual or S corporation) uses as a residence.\nSection 280A(a) provides taxpayer is entitled to no deduction for such use\n\xe2\x80\x9c[e]xcept as otherwise provided in\xe2\x80\x9d \xc2\xa7 280A itself. Section 280A(c) provides\nthose exceptions.\n\xe2\x80\xa2Section 280A(c)(1) permits deductions when taxpayer regularly\nuses a portion of the dwelling \xe2\x80\x9cexclusively\xe2\x80\x9d \xe2\x80\x93\n\xe2\x80\xa2as a principal place of business, including a place that\ntaxpayer uses for administrative or management activities of\ntaxpayer\xe2\x80\x99s trade or business, and there is no other fixed\nlocation where taxpayer conducts substantial management\nor administrative activities,\n\xe2\x80\xa2as a place of business that patients, clients, or customers use\nto meet with taxpayer \xe2\x80\x9cin the normal course of his trade or\nbusiness,\xe2\x80\x9d OR\n\xe2\x80\xa2in connection with taxpayer\xe2\x80\x99s trade or business \xe2\x80\x9cin the case\nof a separate structure which is not attached to the dwelling\nunit.\xe2\x80\x9d\n\xe2\x80\xa2Section 280A(c)(2) permits deductions when taxpayer regularly\nuses space in the dwelling unit to store inventory or product samples\nthat taxpayer sells at retail or wholesale, provided the dwelling unit\nis the only fixed location of taxpayer\xe2\x80\x99s trade or business.\n\xe2\x80\xa2Section 280A(c)(3) permits deductions when they are attributable\nto rental of the dwelling unit.\n\xe2\x80\xa2Section 280A(c)(4) permits deductions attributable to use of a\n384\n\n\x0cportion of the dwelling unit for licensed child or dependent care\nservices.\nSection 280A(c)(5) limits the amount of any deductions attributable to\nbusiness use of the home to the gross income that taxpayer derives from\nsuch use. \xc2\xa7 280A(c)(5)(A). Section 280A(c)(5) and Prop. Reg. \xc2\xa7 1-280A2(i)(5) provide a sequence in which taxpayer may claim deductions\nattributable to the business activity, namely \xe2\x80\x93\n1. deductions attributable to such trade or business and allocable to\nthe portion of the dwelling unit that taxpayer uses that the Code\nwould allow taxpayer even if he did not conduct a trade or business\nin the dwelling unit, e.g., real property taxes, \xc2\xa7 164(a)(1), mortgage\ninterest, \xc2\xa7 163(h)(2)(D).\n2. deductions attributable to such trade or business use that do not\nreduce basis, e.g., utilities, homeowners\xe2\x80\x99 insurance.\n3. basis-reducing deductions, i.e., depreciation.\nIf taxpayer\xe2\x80\x99s deductions exceed his gross income derived from the business\nuse of the dwelling unit that he uses as a home, taxpayer may carry those\ndeductions forward to succeeding years.\n\xe2\x80\xa2Notice that unless taxpayer operates a trade or business in the home\nthat is genuine, in the sense that it is profitable, it is unlikely that\ntaxpayer will ever be able to exploit all the deductions that business\nuse of a home would generate. A taxpayer who does not carry on a\nprofitable trade or business in the home will likely carry forward\nunused deductions forever.\n\xe2\x80\xa2Notice also that the sequence of deductions that \xc2\xa7 280A(c)(5) and\nProp. Reg. \xc2\xa7 1.280A-2(i)(5) mandate requires taxpayer first to \xe2\x80\x9cuse\nup\xe2\x80\x9d the deductions to which he would be entitled even if he did not\nuse his dwelling unit for business activities.\n\xe2\x80\xa2The deductions that might motivate taxpayer to claim\nbusiness use of a home are the ones to which he would not\notherwise be entitled to claim, e.g., a portion of\nhomeowners\xe2\x80\x99 insurance, utilities, other expenses of home\nownership, and (perhaps most importantly) depreciation.\nThose deductions may be effectively out of reach.\n\xe2\x80\xa2Section 280B: Taxpayer must capitalize \xe2\x80\x93 not deduct \xe2\x80\x93 the cost of\ndemolishing any structure.\n385\n\n\x0c\xe2\x80\xa2Section 280E: Taxpayer may not claim a deduction or credit for any\namount paid to carry on the trade or business of trafficking in controlled\nsubstances.\n\xe2\x80\xa2Section 280G: Section 280G(a) denies any deduction for \xe2\x80\x9cany excess\nparachute payment\xe2\x80\x9d (\xe2\x80\x9cgolden parachute payment\xe2\x80\x9d). This is the amount by\nwhich such a parachute payment exceeds a \xe2\x80\x9cbase amount,\xe2\x80\x9d i.e., an\nindividual\xe2\x80\x99s annualized taxable compensation. A \xe2\x80\x9cparachute payment\xe2\x80\x9d is a\npayment made to a person who performs services for the corporation and\nwho is an officer, shareholder, or highly compensated individual when the\npayment is contingent on a change in ownership or control of the\ncorporation of its assets that exceeds three time the base amount. Thus, a\npayment to any of \xe2\x80\x9cdisqualified individuals\xe2\x80\x9d is a \xe2\x80\x9cparachute payment\xe2\x80\x9d only\nif it exceeds three times the \xe2\x80\x9cbase amount.\xe2\x80\x9d But if a payment is a \xe2\x80\x9cparachute\npayment,\xe2\x80\x9d all of the excess of that payment over the base amount is not\ndeductible.\n\nDo the CALI Lesson, Basic Federal Income Taxation: Reasonable Compensation,\nMiscellaneous Business Deductions, and Business Losses\nMoss v. Commissioner, 758 F.2d 211 (7th Cir. 1985)\nPOSNER, Circuit Judge\nThe taxpayers, a lawyer named Moss and his wife, appeal from a decision of the\nTax Court disallowing federal income tax deductions of a little more than $1,000\nin each of two years, representing Moss\xe2\x80\x99s share of his law firm\xe2\x80\x99s lunch expense at\nthe Caf\xc3\xa9 Angelo in Chicago. \xe2\x80\xa6\nMoss was a partner in a small trial firm specializing in defense work, mostly for\none insurance company. Each of the firm\xe2\x80\x99s lawyers carried a tremendous litigation\ncaseload, averaging more than 300 cases, and spent most of every working day in\ncourts in Chicago and its suburbs. The members of the firm met for lunch daily at\nthe Caf\xc3\xa9 Angelo near their office. At lunch the lawyers would discuss their cases\nwith the head of the firm, whose approval was required for most settlements, and\nthey would decide which lawyer would meet which court call that afternoon or the\n386\n\n\x0cnext morning. Lunchtime was chosen for the daily meeting because the courts were\nin recess then. The alternatives were to meet at 7:00 a.m. or 6:00 p.m., and these\nwere less convenient times. There is no suggestion that the lawyers dawdled over\nlunch, or that the Caf\xc3\xa9 Angelo is luxurious.\nThe framework of statutes and regulations for deciding this case is simple, but not\nclear. Section 262 of the Internal Revenue Code disallows, \xe2\x80\x9cexcept as otherwise\nexpressly provided in this chapter,\xe2\x80\x9d the deduction of \xe2\x80\x9cpersonal, family, or living\nexpenses.\xe2\x80\x9d Section 119 excludes from income the value of meals provided by an\nemployer to his employees for his convenience, but only if they are provided on the\nemployer\xe2\x80\x99s premises; and \xc2\xa7 162(a) allows the deduction of \xe2\x80\x98\xe2\x80\x9call the ordinary and\nnecessary expenses paid or incurred during the taxable year in carrying on any trade\nor business, including \xe2\x80\x93 ... (2) traveling expenses (including amounts expended for\nmeals ...) while away from home....\xe2\x80\x99\xe2\x80\x9d Since Moss was not an employee but a partner\nin a partnership not taxed as an entity, since the meals were not served on the\nemployer\xe2\x80\x99s premises, and since he was not away from home (that is, on an\novernight trip away from his place of work, see United States v. Correll, 389 U.S.\n299 (1967)), neither \xc2\xa7 119 nor \xc2\xa7 162(a)(2) applies to this case. The Internal\nRevenue Service concedes, however, that meals are deductible under \xc2\xa7 162(a) when\nthey are ordinary and necessary business expenses (provided the expense is\nsubstantiated with adequate records, see \xc2\xa7 274(d)) even if they are not within the\nexpress permission of any other provision and even though the expense of\ncommuting to and from work, a traveling expense but not one incurred away from\nhome, is not deductible. Reg. \xc2\xa7 1.262-1(b)(5); Fausner v. Commissioner, 413 U.S.\n838 (1973) (per curiam).\nThe problem is that many expenses are simultaneously business expenses in the\nsense that they conduce to the production of business income and personal expenses\nin the sense that they raise personal welfare. This is plain enough with regard to\nlunch; most people would eat lunch even if they didn\xe2\x80\x99t work. Commuting may seem\na pure business expense, but is not; it reflects the choice of where to live, as well as\nwhere to work. Read literally, \xc2\xa7 262 would make irrelevant whether a business\nexpense is also a personal expense; so long as it is ordinary and necessary in the\ntaxpayer\xe2\x80\x99s business, thus bringing \xc2\xa7 162(a) into play, an expense is (the statute\nseems to say) deductible from his income tax. But the statute has not been read\nliterally. There is a natural reluctance, most clearly manifested in the regulation\ndisallowing deduction of the expense of commuting, to lighten the tax burden of\npeople who have the good fortune to interweave work with consumption. To allow\na deduction for commuting would confer a windfall on people who live in the\n387\n\n\x0csuburbs and commute to work in the cities; to allow a deduction for all businessrelated meals would confer a windfall on people who can arrange their work\nschedules so they do some of their work at lunch.\nAlthough an argument can thus be made for disallowing any deduction for business\nmeals, on the theory that people have to eat whether they work or not, the result\nwould be excessive taxation of people who spend more money on business meals\nbecause they are business meals than they would spend on their meals if they were\nnot working. Suppose a theatrical agent takes his clients out to lunch at the\nexpensive restaurants that the clients demand. Of course he can deduct the expense\nof their meals, from which he derives no pleasure or sustenance, but can he also\ndeduct the expense of his own? He can, because he cannot eat more cheaply; he\ncannot munch surreptitiously on a peanut butter and jelly sandwich brought from\nhome while his client is wolfing down tournedos Rossini followed by souffle au\ngrand marnier. No doubt our theatrical agent, unless concerned for his longevity,\nderives personal utility from his fancy meal, but probably less than the price of the\nmeal. He would not pay for it if it were not for the business benefit; he would get\nmore value from using the same money to buy something else; hence the meal\nconfers on him less utility than the cash equivalent would. The law could require\nhim to pay tax on the fair value of the meal to him; this would be (were it not for\ncosts of administration) the economically correct solution. But the government does\nnot attempt this difficult measurement; it once did, but gave up the attempt as not\nworth the cost, see United States v. Correll, supra, 389 U.S. at 301 n. 6. The\ntaxpayer is permitted to deduct the whole price, provided the expense is \xe2\x80\x98\xe2\x80\x9ddifferent\nfrom or in excess of that which would have been made for the taxpayer\xe2\x80\x99s personal\npurposes.\xe2\x80\x99\xe2\x80\x9d Sutter v. Commissioner, 21 T.C. 170, 173 (1953).\nBecause the law allows this generous deduction, which tempts people to have more\n(and costlier) business meals than are necessary, the Internal Revenue Service has\nevery right to insist that the meal be shown to be a real business necessity. This\ncondition is most easily satisfied when a client or customer or supplier or other\noutsider to the business is a guest. Even if Sydney Smith was wrong that \xe2\x80\x98\xe2\x80\x9dsoup\nand fish explain half the emotions of life,\xe2\x80\x99\xe2\x80\x9d it is undeniable that eating together\nfosters camaraderie and makes business dealings friendlier and easier. It thus\nreduces the costs of transacting business, for these costs include the frictions and\nthe failures of communication that are produced by suspicion and mutual\nmisunderstanding, by differences in tastes and manners, and by lack of rapport. A\nmeeting with a client or customer in an office is therefore not a perfect substitute\nfor a lunch with him in a restaurant. But it is different when all the participants in\n388\n\n\x0cthe meal are coworkers, as essentially was the case here (clients occasionally were\ninvited to the firm\xe2\x80\x99s daily luncheon, but Moss has made no attempt to identify the\noccasions). They know each other well already; they don\xe2\x80\x99t need the social\nlubrication that a meal with an outsider provides \xe2\x80\x93 at least don\xe2\x80\x99t need it daily. If a\nlarge firm had a monthly lunch to allow partners to get to know associates, the\nexpense of the meal might well be necessary, and would be allowed by the Internal\nRevenue Service. See Wells v. Commissioner, 36 T.C.M. 1698, 1699 (1977), aff\xe2\x80\x99d\nwithout opinion, 626 F.2d 868 (9th Cir. 1980). But Moss\xe2\x80\x99s firm never had more\nthan eight lawyers (partners and associates), and did not need a daily lunch to\ncement relationships among them.\nIt is all a matter of degree and circumstance (the expense of a testimonial dinner,\nfor example, would be deductible on a morale-building rationale); and particularly\nof frequency. Daily \xe2\x80\x93 for a full year \xe2\x80\x93 is too often, perhaps even for entertainment\nof clients, as implied by Hankenson v. Commissioner, 47 T.C.M. 1567, 1569\n(1984), where the Tax Court held nondeductible the cost of lunches consumed three\nor four days a week, 52 weeks a year, by a doctor who entertained other doctors\nwho he hoped would refer patients to him, and other medical personnel.\nWe may assume it was necessary for Moss\xe2\x80\x99s firm to meet daily to coordinate the\nwork of the firm, and also, as the Tax Court found, that lunch was the most\nconvenient time. But it does not follow that the expense of the lunch was a\nnecessary business expense. The members of the firm had to eat somewhere, and\nthe Caf\xc3\xa9 Angelo was both convenient and not too expensive. They do not claim to\nhave incurred a greater daily lunch expense than they would have incurred if there\nhad been no lunch meetings. Although it saved time to combine lunch with work,\nthe meal itself was not an organic part of the meeting, as in the examples we gave\nearlier where the business objective, to be fully achieved, required sharing a meal.\nThe case might be different if the location of the courts required the firm\xe2\x80\x99s members\nto eat each day either in a disagreeable restaurant, so that they derived less value\nfrom the meal than it cost them to buy it, cf. Sibla v. Commissioner, 611 F.2d 1260,\n1262 (9th Cir. 1980); or in a restaurant too expensive for their personal tastes, so\nthat, again, they would have gotten less value than the cash equivalent. But so far\nas appears, they picked the restaurant they liked most. Although it must be pretty\nmonotonous to eat lunch the same place every working day of the year, not all the\nlawyers attended all the lunch meetings and there was nothing to stop the firm from\nmeeting occasionally at another restaurant proximate to their office in downtown\nChicago; there are hundreds.\n389\n\n\x0cAn argument can be made that the price of lunch at the Caf\xc3\xa9 Angelo included rental\nof the space that the lawyers used for what was a meeting as well as a meal. There\nwas evidence that the firm\xe2\x80\x99s conference room was otherwise occupied throughout\nthe working day, so as a matter of logic Moss might be able to claim a part of the\nprice of lunch as an ordinary and necessary expense for work space. But this is\ncutting things awfully fine; in any event Moss made no effort to apportion his lunch\nexpense in this way.\nAFFIRMED.\n\nNotes and Questions:\n1. What requirement of deductibility under \xc2\xa7 162 did taxpayer Moss fail to meet?\n2. If this firm had only monthly lunches, the court seems to say that the cost of\nsuch lunches might have been deductible. Why should such meals be treated\ndifferently than the daily lunches at Caf\xc3\xa9 Angelo?\n\nDo the CALI Lesson, Basic Federal Income Taxation: Deductions: Trade or\nBusiness Deductions.\n3. Education Expenses\nDo the CALI Lesson, Basic Federal Income Taxation: Deductions: Education\nExpenses.\n\xe2\x80\xa2Read Reg. \xc2\xa7 1.162-5.\n\xe2\x80\xa2Read \xc2\xa7\xc2\xa7 274(m)(2), 274(n).\nA taxpayer may incur expenses for various educational activities, e.g., training, that\nhe may deduct as ordinary and necessary business expenses. Recall that in Welch\nv. Helvering, the Court indicated that investment in one\xe2\x80\x99s basic education is a\nnondeductible investment in human capital. Not surprisingly, then, the regulations\ndraw lines around education undertaken to meet the minimum requirements of a\ntrade or business or to qualify for a new trade or business. Reg. \xc2\xa7 1.162-5\n390\n\n\x0cimplements these distinctions.\nReg. \xc2\xa7 1.162-5(a) states the general rule that expenditures made for education are\ndeductible, even when those expenditures may lead to a degree, if the education \xe2\x80\x93\n\xe2\x80\x9c(1) Maintains or improves skills required by the individual in his\nemployment or other trade or business, or\n(2) Meets the express requirements of the individual\xe2\x80\x99s employer, or the\nrequirements of applicable law or regulations, imposed as a condition to the\nretention by the individual of an established employment relationship status,\nor rate of compensation.\xe2\x80\x9d\nId. However, even expenditures that meet one of these two conditions are\nnevertheless not deductible if \xe2\x80\x93\n\xe2\x80\xa2the expenditures are \xe2\x80\x9cmade by an individual for education which is\nrequired of him in order to meet the minimum educational requirements for\nqualification in his employment or other trade or business. ... The fact that\nan individual is already performing service in an employment status does\nnot establish that he has met the minimum educational requirements for\nqualification in that employment. Once an individual has met the minimum\neducational requirements for qualification in his employment or other trade\nor business (as in effect when he enters the employment or trade or\nbusiness), he shall be treated as continuing to meet those requirements even\nthough they are changed.\xe2\x80\x9d Reg. \xc2\xa7 1.162-5(b)(2)(i). OR\n\xe2\x80\xa2the expenditures are \xe2\x80\x9cmade by an individual for education which is part of\na program of study being pursued by him which will lead to qualifying him\nin a new trade or business.\xe2\x80\x9d Reg. \xc2\xa7 1.162-5(b)(3)(i).\nConsider:\nPere Alegal works for a downtown Memphis law firm. He works under the\nsupervision of attorneys and does the same type of work that the firm\xe2\x80\x99s attorneys\ndo. The firm\xe2\x80\x99s partners advise Alegal that if he does not obtain a law license, he\nwill not be retained. Alegal therefore enrolled in one of the nation\xe2\x80\x99s best-value law\nschools. Pere will continue to work for the firm. Alegal incurs the expenses of\ntuition, books, etc. At the end of the educational program, Alegal passed the bar\nexamination and obtained a license to practice law. Alegal continues to work for\nthe firm and in fact his job functions did not change at all.\n\xe2\x80\xa2If Alegal sought to deduct the expenses of his legal education, could he\n391\n\n\x0cargue that his job functions did not change at all once he obtained his law\nlicense?\n\xe2\x80\xa2Is it relevant that a law license did not cause Alegal to take up a new trade\nor business?\n4. Sections 172135\nThe costs of earning taxable income are offset against that income. Ours is a system\nthat generally taxes only \xe2\x80\x9cnet income.\xe2\x80\x9d The Tax\nCode requires an annual accounting of income and CARES Act, \xc2\xa7 2303 amended \xc2\xa7\ndeductible expenses. A taxpayer\xe2\x80\x99s income may 172 to provide that net losses\nfluctuate between losses and profitability from one incurred in 2018, 2019, and\nyear to the next. This could raise serious problems 2020 could be carried back\nof fairness if losses cannot offset gross income. five years except for losses\nSection 172 permits some netting of business gains incurred by real estate\nand losses between different tax years by permitting investment trusts. This will\ntaxpayer to deduct net operating losses incurred in enable businesses that suffer\none tax year against his taxable income in a net operating losses during the\npandemic to claim refunds of\nsucceeding tax year.\n\xe2\x80\xa2Read \xc2\xa7 172(c). It defines a \xe2\x80\x9cnet operating income taxes paid during the\nloss\xe2\x80\x9d (NOL) to be the excess of deductions prior five years.\nallowed over gross income.\nFarmers may elect not to\n\xe2\x80\xa2Read \xc2\xa7 172(d). Its effect is to limit the apply this 5-year carryback\ndeductions that would \xe2\x80\x9ctake taxpayer\xe2\x80\x99s for losses arising in 2018,\ntaxable income negative\xe2\x80\x9d to essentially trade 2019, and 2020. CAA,\nor business expenses. For individual Covid-Related Tax Relief Act\ntaxpayers, capital losses are deductible only of 2020, \xc2\xa7 282.\nto the extent of capital gains,\n\xc2\xa7 172(d)(2)(A); no deduction is allowed for personal exemptions,\n\xc2\xa7 172(d)(3); nonbusiness deductions are allowed only to the extent of\ntaxpayer\xe2\x80\x99s non-trade or business income, \xc2\xa7 172(d)(4); the \xc2\xa7 199A qualified\nbusiness income deduction is not allowed, \xc2\xa7 172(d)(8).\n\xe2\x80\xa2Section 172(a) permits NOL carryovers and limited carrybacks to reduce\ntaxpayer\xe2\x80\x99s taxable income. Taxpayer may deduct the lesser of \xe2\x80\x93\nThe Tax Cuts and Jobs Act curtailed the immediate availability of NOLs to reduce a taxpayer\xe2\x80\x99s\ntaxable income. Previously, all taxpayers could carry back an NOL two years, and in some cases five\nyears. Also, there was no 80% of taxable income cap on the taxpayer\xe2\x80\x99s NOL deduction.\n135\n\n392\n\n\x0c\xe2\x80\xa2net operating loss carryovers to the taxable year plus net operating\nloss carrybacks\n\xe2\x80\xa2OR\n\xe2\x80\xa280% of taxpayer\xe2\x80\x99s taxable income computed without regard to the\nNOL deduction. \xc2\xa7 172(a).\n\xe2\x80\xa2Unused NOLs carry over indefinitely. \xc2\xa7 172(b)(1)(A)(ii). Taxpayer must\ncarry an NOL to the earliest taxable year to which it can be carried. \xc2\xa7\n170(b)(2).\n\xe2\x80\xa2A taxpayer may carry back an NOL which is a farming loss to each\nof the two years preceding the year in which the loss was incurred.\n\xc2\xa7 170(b)(1)(B)(i). The taxpayer may elect not to carry a farming loss\nback. \xc2\xa7170(b)(1)(B)(iv).136\n\xe2\x80\xa2The effect of allowing a carryback is to get money into the\npockets of the affected taxpayer(s) quickly.\nConsider:\nIn 2021, taxpayer had net losses of $500,000. Taxpayer is neither a farmer nor an\ninsurance company. Determine taxpayer\xe2\x80\x99s taxable income under the rules of \xc2\xa7 172\nif taxpayer\xe2\x80\x99s taxable income would otherwise have been the following amounts for\nthe years in question. Disregard \xc2\xa7 461(l).\n\xe2\x80\xa22020: $100,000\n\xe2\x80\xa22021: ($500,000)\n\xe2\x80\xa22022: $50,000.\n\xe2\x80\xa22023: $75,000.\n\xe2\x80\xa22024: $120,000.\n\xe2\x80\xa22025: $165,000\n\xe2\x80\xa22026: $200,000\n\xe2\x80\xa22027: $100,000\n\xe2\x80\xa22028: $60,000\n\nAn insurance company other than a life insurance company (i.e., property and casualty insurance\ncompanies) must carry an NOL back two years. Its NOLs expire after twenty years. \xc2\xa7 172(b)(1)(C).\n136\n\n393\n\n\x0cD. Special Rules to Encourage Business Activity and Exploitation of\nNatural Resources\n1. Section 199A: \xe2\x80\x9cQualified Business Income\xe2\x80\x9d Deduction\nIn the Tax Cuts and Jobs Act, Congress repealed \xc2\xa7 199, which had provided a\ndeduction for a portion of a taxpayer\xe2\x80\x99s income derived from domestic production\nactivities. In its place, Congress enacted \xc2\xa7 199A.137 Section 199A provides a\ndeduction to certain taxpayers who derive income in a trade or business that they\nown until and through December 31, 2025. \xc2\xa7 199A(i). The availability of the\ndeduction depends on the amount of taxpayer\xe2\x80\x99s trade or business income and, at\nhigher levels of such income, the specific types of those trades or businesses. The\ngist of \xc2\xa7 199A is that non-C-corporation owners of trades or businesses may deduct\n(up to) 20% of their business income \xe2\x80\x93 thereby effectively paying income tax on as\nlittle as 80% of such income. The rules governing availability of the deduction\nbecome more exacting as the amount of a taxpayer\xe2\x80\x99s \xe2\x80\x9ctaxable income\xe2\x80\x9d increases.\nAs usual, definitions and conditions define the scope of a \xc2\xa7 199A deduction.\nSection 199A(a) states that a taxpayer may deduct the lesser of two amounts:\n(1) taxpayer\xe2\x80\x99s \xe2\x80\x9ccombined qualified business income amount\xe2\x80\x9d (CQBIA), or (2) 20%\nof taxpayer\xe2\x80\x99s (taxable income138 minus net capital gain139). \xc2\xa7 199A(a). The\n\xe2\x80\x9ccombined qualified business income amount\xe2\x80\x9d is itself a figure that is 20% of a\nlarger amount. See \xc2\xa7 199A(b)(1 and 2).\n\xe2\x80\xa2The second of the two amounts named by \xc2\xa7 199A(a) is fairly easily\nmeasured. Section 199A measures the first of the two amounts (CQBIA)\nmore granularly. Once measured, \xc2\xa7 199A(a) requires a comparison.\n\xe2\x80\xa2Observation: If a taxpayer has no income from a business that he\nowns, his \xe2\x80\x9ccombined qualified business income amount\xe2\x80\x9d will be $0.\nObviously that amount will be the lesser of two figures. Thus,\nThe TCJA was signed into law on December 22, 2017. On March 23, 2018, Congress amended \xc2\xa7\n199A to provide a deduction from the income of certain agricultural or horticultural cooperatives. See\n\xc2\xa7 199A(g). That deduction is beyond the scope of this introductory discussion.\n137\n\n\xe2\x80\x9cTaxable income\xe2\x80\x9d is gross income minus allowable deductions, \xc2\xa7 63(a), except for the deduction\nthat \xc2\xa7 199A itself allows. \xc2\xa7 199A(e)(1).\n138\n\n\xe2\x80\x9cNet capital gain\xe2\x80\x9d is a taxpayer\xe2\x80\x99s \xe2\x80\x9cnet long-term capital gain\xe2\x80\x9d minus \xe2\x80\x9cnet short-term capital loss.\xe2\x80\x9d \xc2\xa7\n1222(11); see chapter 10, infra. For non-corporate taxpayers and for purposes of \xc2\xa7 199A, \xc2\xa7 1(h)(11)\nincludes within net capital gain dividends paid by domestic corporations, dividends paid by corporations\nincorporated in a country with which the United States has a tax treaty, or dividends paid by foreign\ncorporations whose stock is readily traded in an established securities market in the United States.\n139\n\n394\n\n\x0c\xc2\xa7 199A only helps taxpayers who own a trade or business.\n\xe2\x80\xa2Defining the taxpayer\xe2\x80\x99s \xe2\x80\x9ccombined qualified business income amount\xe2\x80\x9d\nrequires us to dive into the middle of Section 199A and then to work our\nway back up.\n\xe2\x80\xa2Initially, note that a taxpayer\xe2\x80\x99s CQBIA is 20% of the sum of a\ntaxpayer\xe2\x80\x99s \xe2\x80\x9cqualified business income\xe2\x80\x9d subject to conditions\napplicable to each \xe2\x80\x9cqualified trade or business,\xe2\x80\x9d plus 20% of his\n[qualified REIT dividends income plus qualified publicly traded\npartnership income]. \xc2\xa7 199A(b)(1).\nTaxpayers who may avail themselves of this deduction may be sole proprietors or\nowners of \xe2\x80\x9cpass-through\xe2\x80\x9d entities or partnerships. \xe2\x80\x9cPass-through\xe2\x80\x9d entities pay no\nincome tax. Rather their income tax items (items of income, gain, deduction, and\nloss) \xe2\x80\x9cpass through\xe2\x80\x9d to the individual owners of the trade or business.140\n\xe2\x80\xa2Taxpayers who are C corporations, \xc2\xa7 199A(a), may not avail themselves\nof a \xc2\xa7 199A deduction. Performance of services as an \xe2\x80\x9cemployee\xe2\x80\x9d is not a\n\xe2\x80\x9cqualified trade or business,\xe2\x80\x9d 141 \xc2\xa7 199A(d)(1)(B).\nCQBIA and Qualified Business Income. Initially, CQBIA includes 20% of a\ntaxpayer\xe2\x80\x99s \xe2\x80\x9cqualified business income.\xe2\x80\x9d \xe2\x80\x9cQualified business income\xe2\x80\x9d (QBI)142 is\nthe net income taxpayer derives from the conduct of a \xe2\x80\x9cqualified trade or business\xe2\x80\x9d\nto the extent the income tax items are \xe2\x80\x9ceffectively connected with the conduct of a\ntrade or business within the United States ...\xe2\x80\x9d \xc2\xa7 199A(c)(1); \xc2\xa7 199A(c)(3)(A)(i).\nQBI does not include various items of investment income.143 Net losses carry over\nto succeeding years. \xc2\xa7 199A(c)(2).\n\xe2\x80\xa2Section 199A defines \xe2\x80\x9cqualified trade or business\xe2\x80\x9d as any trade or business\nother than a \xe2\x80\x9cspecified service trade or business\xe2\x80\x9d or the trade or business of\nperforming services as an employee. \xc2\xa7 199A(d)(1). BUT: the definition of\n140\n\nSee \xc2\xa7 199A(f)(1)(A)(i) (\xc2\xa7 199A applies at the individual or S corporation shareholder level).\n\nPartners who derive income from a partnership in a capacity other than as a partner or who receive\nguaranteed payments may not avail themselves of a deduction under \xc2\xa7 199A. \xc2\xa7 199A(c)(4).\n141\n\nQBI does not include \xe2\x80\x9cqualified REIT dividends\xe2\x80\x9d or \xe2\x80\x9cqualified publicly trade partnership income.\xe2\x80\x9d\n\xc2\xa7 199A(c)(1). Section 199A(a)(1)(B) names these income items separately and includes them in a\ntaxpayers \xe2\x80\x9ccombined qualified business income amount,\xe2\x80\x9d i.e., CQBIA.\n142\n\nSpecifically, the net amount of QBI does not include capital gains/losses, dividend income, interest\nincome not properly allocable to a trade or business, gains/losses from commodities transactions or\ngains/loss from foreign currency transactions, gains/losses from certain \xe2\x80\x9cnotional\xe2\x80\x9d contracts, amounts\nreceived from annuity contracts not connected with a trade or business properly allocable to one of\nthese items. \xc2\xa7 199A(c)(3)(B).\n143\n\n395\n\n\x0c\xe2\x80\x9cqualified trade or business\xe2\x80\x9d varies, depending on the level of a taxpayer\xe2\x80\x99s\n\xe2\x80\x9ctaxable income.\xe2\x80\x9d\n\xe2\x80\xa2Section 199A articulates these variations by establishing a \xe2\x80\x9cthreshold\namount\xe2\x80\x9d \xe2\x80\x93 which refers to a level of a taxpayer\xe2\x80\x99s \xe2\x80\x9ctaxable income,\xe2\x80\x9d indexed\nfor inflation. See \xc2\xa7 199A(e)(2). Section 199A establishes consequences that\ndepend upon whether taxpayer\xe2\x80\x99s \xe2\x80\x9ctaxable income\xe2\x80\x9d falls below the\n\xe2\x80\x9cthreshold amount,\xe2\x80\x9d falls above the \xe2\x80\x9cthreshold amount\xe2\x80\x9d but within a phaseout range, or falls above the \xe2\x80\x9cthreshold amount\xe2\x80\x9d plus the phase-out range.\nThreshold Income Amounts: Relevance to Specified Trade or Businesses, and\nto CQBIA. Section 199A(e)(2) defines a \xe2\x80\x9cthreshold amount,\xe2\x80\x9d which serves as the\nthreshold at which restrictions on the \xc2\xa7 199A deduction \xe2\x80\x9cphase in.\xe2\x80\x9d The \xe2\x80\x9cthreshold\namount\xe2\x80\x9d is $157,500, indexed for inflation, \xc2\xa7 199A(e)(2)(B), and twice that amount\nfor a joint return. \xc2\xa7 199A(e)(2)(A). The \xe2\x80\x9cthreshold amount\xe2\x80\x9d is relevant for two\npurposes:\n\xe2\x80\xa2(1) Special rules limit that availability of the \xc2\xa7 199A deduction for\ntaxpayers engaged in a \xe2\x80\x9cspecified service trade or business\xe2\x80\x9d (SSTB). A\n\xe2\x80\x9cspecified service trade or business\xe2\x80\x9d is a \xe2\x80\x9ctrade or business involving the\nperformance of services in the fields of\xe2\x80\x9d health, law, accounting, actuarial\nscience, performing arts, consulting, athletics, financial services, brokerage\nservice, and any trade or business where the principal asset is the reputation\nof one or more of its employees or owners, \xc2\xa7 1202(e)(3)(A), crossreferenced and as modified by \xc2\xa7 199A(d)(2) (not including engineering or\narchitecture). Additionally, a \xe2\x80\x9cspecified trade or business\xe2\x80\x9d is any trade or\nbusiness \xe2\x80\x9cwhich involves performance of services that consist of investing,\ntrading, or dealing in securities ..., partnership interests, or commodities ...\xe2\x80\x9d\n\xc2\xa7 199A(d)(2)(B). A taxpayer engaged in an SSTB whose \xe2\x80\x9ctaxable income\xe2\x80\x9d\nis greater than the threshold amount will see the availability of a \xc2\xa7 199A\ndeduction gradually phase out altogether. See \xc2\xa7 199A(d)(1)(A),\n\xc2\xa7 199A(d)(2).\n\xe2\x80\xa2(2) Taxpayers engaged in any trade or business (including an SSTB) that\ngenerates QBI whose \xe2\x80\x9ctaxable income\xe2\x80\x9d is less than the threshold amount\nmay include 20% of that QBI in their CQBIA, irrespective of conditions\napplicable to taxpayers whose \xe2\x80\x9ctaxable income\xe2\x80\x9d is more than the threshold\namount. See \xc2\xa7 199A(d)(3) (SSTB), \xc2\xa7 199A(b)(3)(A) (wage and basis\nrequirements). But: wage and property restrictions \xe2\x80\x9cphase in\xe2\x80\x9d as the\n\xe2\x80\x9ctaxable income\xe2\x80\x9d of the owner of a non-SSTB rises above the threshold\namount by $50,000 (or $100,000 for taxpayers married filing jointly), infra.\n396\n\n\x0cVisualizing \xc2\xa7 199A CQBIA\n\xe2\x80\xa2Work from the bottom up, QBI by QBI.\n\xe2\x80\xa2Deduct CQBIA or 20% of [(taxable income) \xc3\xb7 (NCG)], whichever is less.\n\n\xc2\xa7 199A\ndeduction\n= Lesser of\n20% of QBI\nor\nwage/basis\nfloor\n\nWage/basis floor amount =\nGreater of (50% of W-2\nwages) or (25% of W-2 wages\n+ 2.5% of unadjusted basis)\n\nTI = $207,500 ($415,000 (mfj))\n\nPhase-in of\nW-2/W-2basis\nthreshold\n\nTI = $157,500 ($315,000 (mfj))\n\n\xc2\xa7 199A\ndeduction =\n20% of QBI;\nno\nwage/basis\nfloor\nNo \xc2\xa7 199A\ndeduction\n\n(Taxable Income)\n\xe2\x80\x93 (QBI)\n\n\xe2\x80\xa2Dollar figures are indexed for inflation.\n\n397\n\n\x0cTaxpayer\xe2\x80\x99s CQBIA: A taxpayer\xe2\x80\x99s CQBIA is the sum of \xe2\x80\x93\n\xe2\x80\xa220% of taxpayer\xe2\x80\x99s aggregate amount of qualified REIT dividends 144 and\nqualified publicly-traded partnership income,145 \xc2\xa7 199A(d)(3); PLUS\n\xe2\x80\xa220% of the QBI of each qualified trade or business, but not more than the\ngreater of\n\xe2\x80\xa250% of the W-2 wages taxpayer pays with respect to that trade or\nbusiness,146 OR\n\xe2\x80\xa225% of the W-2 wages taxpayer pays with respect to that trade or\nbusiness plus 2.5% of the unadjusted basis of \xe2\x80\x9cqualified\nproperty.\xe2\x80\x9d147 \xc2\xa7 199A(b)(2)(B).\nThere are three different tax treatments of taxpayer\xe2\x80\x99s QBI \xe2\x80\x93 depending on the level\nof taxpayer\xe2\x80\x99s \xe2\x80\x9ctaxable income.\xe2\x80\x9d\n\xe2\x80\xa2(1) Taxpayers who own a \xe2\x80\x9cqualified trade or business\xe2\x80\x9d that is not a\n\xe2\x80\x9cspecified service trade or business\xe2\x80\x9d may deduct their CQBIA computed\nwithout regard to the W-2 and/or qualified property conditions if the\ntaxpayer\xe2\x80\x99s taxable income does not exceed the indexed threshold amount.\n\xc2\xa7 199A(b)(3)(A).\n\xe2\x80\xa2(2) If taxpayer\xe2\x80\x99s taxable income does exceed the indexed threshold amount\nby less than $50,000 ($100,000 for a taxpayer married filing jointly), and if\ntaxpayer\xe2\x80\x99s QBI determined without regard to the W-2 and qualified\nproperty conditions would be greater than the relevant W-2 wage/property\nbasis limitation, then taxpayer must reduce his QBI by the percentage of\nA \xe2\x80\x9cqualified REIT dividend\xe2\x80\x9d is any dividend from a real estate investment trust that is neither a\ncapital gain dividend nor a \xe2\x80\x9cqualified dividend\xe2\x80\x9d under \xc2\xa7 1(h)(11). \xc2\xa7 199A(e)(3).\n144\n\n\xe2\x80\x9cQualified publicly traded partnership income\xe2\x80\x9d is the net amount of a partner\xe2\x80\x99s allocable share of\nincome tax items from a publicly traded partnership not treated as a corporation, \xc2\xa7 199A(e)(4)(A)\n(referencing \xc2\xa7199A(c)(3 and 4), or gain from the sale of an interest in a publicly traded partnership to\nthe extent it is treated as an amount realized from the sale or exchange of property other than a capital\nasset. \xc2\xa7199A(e)(4)(B).\n145\n\nSpecial rules reduce the CQBIA of a \xe2\x80\x9cqualified trade or business\xe2\x80\x9d that is a patron of a \xe2\x80\x9cspecified\nagricultural or horticultural cooperative.\xe2\x80\x9d See \xc2\xa7 199A(b)(7). These rules prevent double-counting some\nincome for deduction purposes. The details are beyond the scope of this discussion.\n146\n\n\xe2\x80\x9cQualified business property\xe2\x80\x9d is depreciable property that the taxpayer uses in his qualified trade or\nbusiness to produce QBI and holds at the close of the taxable year. \xc2\xa7 199A(b)(6)(A). The depreciation\nperiod must not have ended before the close of the taxable year, \xc2\xa7 199A(b)(6)(A)(iii), but that period is\nextended to the later of the date that is ten years after the property was placed in service or the last day\nof the last full year to which the applicable recovery period would apply. \xc2\xa7 199A(b)(6) (without regard\nto the alternate depreciation system).\n147\n\n398\n\n\x0c$50,000 ($100,000 for taxpayers married filing jointly) by which 20% of\nhis QBI exceeds the otherwise applicable W-2 and qualified property\nconditions. \xc2\xa7 199A(b)(3)(B).\n\xe2\x80\xa2Example: Taxpayer is a sole proprietor. Taxpayer\xe2\x80\x99s filing status is\nmarried filing jointly. Taxpayer has $100K of QBI and $350K of\ntaxable income.148 Taxpayer paid W-2 wages of $10K. Taxpayer\nhas no depreciable property. Taxpayer would be entitled to a $20K\n\xc2\xa7 199A deduction if there were no wage/basis condition. See\n\xc2\xa7\xc2\xa7 199A(b)(2)(A); 199A(b)(3)(B)(iii)(I). Taxpayer\xe2\x80\x99s \xe2\x80\x9ctaxable\nincome\xe2\x80\x9d exceeds the threshold amount by $35K, i.e., [$350K \xe2\x88\x92\n$315K]. The W-2 wage condition is 50% of $10K, i.e., $5K.\n\xc2\xa7\xc2\xa7 199A(b)(2)(B); 199A(b)(3)(B)(iii)(I). Taxpayer\xe2\x80\x99s potential\n\xc2\xa7 199A deduction exceeds the wage condition by $15K, i.e.\n($20,000 \xe2\x88\x92 $5,000). This is the \xe2\x80\x9cexcess amount.\xe2\x80\x9d\n\xc2\xa7 199A(b)(3)(B)(iii). Taxpayer\xe2\x80\x99s \xc2\xa7 199A deduction is reduced from\nits unrestricted potential by the percentage of the \xe2\x80\x9cexcess amount\xe2\x80\x9d\nequal to the same percentage that $35K is of $100K, i.e., 35%. 35%\nof $15K = $5,250. Taxpayer may claim a \xc2\xa7199A deduction of\n$14,750. \xc2\xa7 199A(b)(3)(b)(i, ii).\n\xe2\x80\xa2Example: Same facts except that taxpayer paid $0 in W-2 wages.\nThe W-2 wage limitation is $0. Taxpayer\xe2\x80\x99s potential \xc2\xa7 199A\ndeduction exceeds the wage limitation by $20,000. 35% of $20,000\n= $7,000. Taxpayer may claim a \xc2\xa7 199A deduction of $13,000.\n\xe2\x80\xa2(3) When a taxpayer\xe2\x80\x99s \xe2\x80\x9ctaxable income\xe2\x80\x9d exceeds the \xe2\x80\x9cthreshold amount\xe2\x80\x9d\nplus $50,000 ($100,000 for taxpayers married filing jointly), taxpayer\ncomputes his \xc2\xa7199A deduction by applying the W-2/property basis rules\nnoted above.\nSpecified Service Trade or Business (SSTB): Taxpayers engaged in a \xe2\x80\x9cspecified\nservice trade or business\xe2\x80\x9d may include the income they derive from such a trade or\nbusiness in their CQBIA if their \xe2\x80\x9ctaxable income\xe2\x80\x9d is less than the threshold level.\nThe amount of SSTB income that they may include in the CQBIA decreases to $0\nas their taxable income rises above the threshold. See \xc2\xa7 199A(b)(3)(A),\n\xc2\xa7 199A(d)(3). Thus, there are three levels of \xc2\xa7 199A deductions for a taxpayer\nengaged in an SSTB:\n\xe2\x80\xa2(1) Taxpayers whose \xe2\x80\x9ctaxable income\xe2\x80\x9d is less than the threshold amount\nand are engaged in an SSTB may treat all of their trade or business income\n148\n\nTaxpayer had a lot of itemized deductions.\n\n399\n\n\x0cas QBI without restrictions.\n\xe2\x80\xa2(2) Taxpayers engaged in an SSTB whose \xe2\x80\x9ctaxable income\xe2\x80\x9d is greater than\nthe threshold amount but less than the threshold amount plus $50,000\n($100,000 for taxpayers married filing jointly) may include in their QBI the\n\xe2\x80\x9capplicable percentage\xe2\x80\x9d of all the SSTB income items. The same\n\xe2\x80\x9capplicable percentage\xe2\x80\x9d applies to the wage/basis limitations restrictions\napplicable to CQBIA, infra. The \xe2\x80\x9capplicable percentage\xe2\x80\x9d is 100% minus the\npercentage that taxpayer\xe2\x80\x99s excess \xe2\x80\x9ctaxable income\xe2\x80\x9d is relative to $50,000\n($100,000 for taxpayers married filing jointly). \xc2\xa7 199A(d)(3)(B).\nTaxpayer\xe2\x80\x99s excess \xe2\x80\x9ctaxable income\xe2\x80\x9d is the amount by which taxpayer\xe2\x80\x99s\n\xe2\x80\x9ctaxable income\xe2\x80\x9d exceeds the threshold amount.\n\xe2\x80\xa2Example:149 Taxpayer has taxable income of $200,000, of which\n$125,000 is attributable to an accounting sole proprietorship in\nwhich he pays wages of $40,000 to employees. Taxpayer uses no\ndepreciable property. Taxpayer has an \xe2\x80\x9capplicable percentage\xe2\x80\x9d of\n15%, determined thus:\n1 \xe2\x88\x92 [($200,000 \xe2\x88\x92 $157,500)/$50,000]150\n1 \xe2\x88\x92 $42,500/$50,000\n1 \xe2\x88\x92 0.85\n0.15, or 15%\nIn determining includible QBI, taxpayer takes into account 15% of\n$125,000, i.e., $18,750. In determining the includible W-2 wages,\ntaxpayer takes into account 15% of $40,000, i.e., $6000. Taxpayer\xe2\x80\x99s\nCQBIA deduction is the lesser of151 \xe2\x80\x93\n20% of $18,750, i.e., $3750152 or\n50% of $6000,153 i.e., $3000.\nTaxpayer may take a \xc2\xa7 199A deduction of $3000.\n\xe2\x80\xa2(3) Taxpayers engaged in an SSTB with taxable income greater than the\nThis example is derived from Conference Report on H.R. 1, Tax Cuts and Jobs Act, H. REP. 115-466 (1st\nSess. 2017).\n149\n\n150\n\n\xc2\xa7 1999A(d)(3)(B).\n\n... i.e., the lesser of 20% of QBI or 50% of W-2 wages. Thus, the Code requires a pro-rated\napplication of rules applicable to a non-SSTB taxpayer.\n151\n\n152\n\n\xc2\xa7 199A(d)(3)(A)(ii).\n\n153\n\n\xc2\xa7 199A(d)(3)(A)(ii).\n\n400\n\n\x0cthreshold amount plus $50,000 ($100,000 for taxpayers married filing\njointly) are not entitled to any \xc2\xa7 199A deduction.\nSee generally Robert E. Ward, Tax Cuts and Jobs Act of 2017 \xe2\x80\x93 Individual Tax\nProvisions, TAXES THE TAX MAGAZINE 49, 51-53 (July 2018).\n\n401\n\n\x0cVisualizing Specified Service Trade or Business and \xc2\xa7199A\nDollar figures are indexed for inflation.\nWage/basis floor amount = Greater of\n(50% of W-2 wages) or (25% of W-2\nwages + 2.5% of unadjusted basis)\n\nNo \xc2\xa7 199A deduction\nwhen taxable income\nis greater than\nthreshold\n$207,500 ($415,000 (mfj))\n\xc2\xa7 199A deduction=\nLesser of 20% of SSTB\nor wage/basis floor\n\nDeduction phase out range\n\n$157,500 ($315,000 (mfj))\n\n\xc2\xa7 199A deduction =\n20% of SSTB Income\n\n(Taxable Income) \xe2\x80\x93\n(SSTB Income)\n\nNo \xc2\xa7 199A deduction\n\n402\n\n\x0cQBI is of course included in a taxpayer\xe2\x80\x99s \xe2\x80\x9ctaxable income.\xe2\x80\x9d The difference\nbetween taxpayer\xe2\x80\x99s \xe2\x80\x9ctaxable income\xe2\x80\x9d and \xe2\x80\x9cnet capital gain\xe2\x80\x9d will be less than a\ntaxpayer\xe2\x80\x99s CQBIA when the taxpayer derives a substantial portion of his taxable\nincome from capital gains and \xe2\x80\x9cqualified dividends.\xe2\x80\x9d As a taxpayer\xe2\x80\x99s net capital\ngain increases his CQBIA eventually becomes the greater figure.\n\xe2\x80\xa2Describe a typical taxpayer for whom the CQBIA would be the greater\namount. Describe a typical taxpayer for whom the CQBIA would be the\nlesser amount.\nComment: Section 199A replaced \xc2\xa7 199, a measure designed to encourage all\ntaxpayers, including corporations, to engage in manufacturing trades or businesses\nin the United States. Section 199A, on the other hand, provides benefits only to\n\xe2\x80\x9cpass-through\xe2\x80\x9d entities and sole proprietorships. The justification for this different\ntreatment for corporations lies in the fact that the TCJA reduced the top corporate\ntax rate from 35% to 21%. By defining the limits of the \xc2\xa7 199A deduction through\nreference to W-2 wages and depreciable property used to generate income\neffectively connected with a trade or business within the United States, Congress\nclearly aims to encourage certain forms of economic activity within the United\nStates. Notice that \xc2\xa7 199A is not part of the Code\xe2\x80\x99s methods of determining a\ntaxpayer\xe2\x80\x99s net income. Rather, it provides a reward for doing something that\nCongress wants pass-through entities that own a trade or business to do, i.e.,\ngenerate taxable income from American workers and/or depreciable property\nsituated in the United States. And: the more profit such a taxpayer can derive from\nhis domestic economic activities, the greater his deduction.\nSection 199 was an effort to make U.S. manufacturers more competitive vis-a-vis\nforeign competition. A byproduct of this effort would be that export activity would\nincrease. By rewarding successful businesses, Congress is (likely to be) rewarding\nexporters the most. Congress has pursued similar objectives in other tax legislation,\nbut the World Trade Organization (WTO) found that such legislation violated the\nGeneral Agreement on Tariffs and Trade (GATT). Section 199A may also be\nvulnerable to a challenge before the WTO.154\n\nSection 199 provided a deduction to all taxpayers, including C corporations, engaged in domestic\nproduction activities. The business activity on which \xc2\xa7 199A focuses is different, but the intent to\nstimulate only domestic business activity is apparent.\n154\n\n403\n\n\x0cProblems:\n*In these problems, use the figures that appear in the text of \xc2\xa7 199A, not the figures\nthat have been indexed for inflation.\n1. Mary Taxpayer is married and lives in a medium-sized town with a large\nuniversity. Mary and her husband live only a few blocks from the university. She\nand her husband file their income tax return married filing jointly. Taxpayer and\nhusband both have jobs from which they derive employment income. Their wage\nincome from these jobs is $250,000. They have $50,000 of net capital gain. In\naddition, Mary has a t-shirt silk screening business that she runs out of the couple\xe2\x80\x99s\ngarage. The university has athletic teams that participate in several sports. When\nthere is a home game, thousands of people descend on the town to attend the games.\nMary pays attention to the athletic schedules and designs and produces t-shirts in\nonly a few hours with timely messages. She sells the t-shirts to persons that pass by\nseveral kiosks that she rents. Her gross revenue from t-shirt sales for the tax year is\n$180,000. Deductions for supplies and kiosk rental come to $30,000. She pays two\nemployees a total of $40,000 in wages. She has no \xe2\x80\x9cqualified REIT dividends\xe2\x80\x9d or\n\xe2\x80\x9cqualified publicly-traded partnership income.\xe2\x80\x9d\n1A. How much can Mary and her husband claim as a \xc2\xa7 199A deduction?\n1B. What if Mary and her husband had total taxable wages income from their other\njobs of $100,000, and still had the same capital gain and business income from the\nsale of t-shirts?\n1C. What if Mary and her husband had total taxable income from their other jobs\nof $500,000?\n2. Mike Perch is a baseball player for the Rockville Hellions. He makes a minor\nleague salary and works in the off-season in a brewery where his employer paid\nhim wages. His \xe2\x80\x9ctaxable income\xe2\x80\x9d from these jobs is $50,000. He also made $10,000\nof net capital gain. On the side, he has his own business as a personal trainer \xe2\x80\x9cto\nthe stars.\xe2\x80\x9d He grossed $85,000 as a personal trainer. He paid an assistant, Lopez\nSchaden, an illegal immigrant, $20,000 cash under-the-table. These are all of his\nexpenses. Hence, he netted $65,000 as a personal trainer. Perch lives alone in an\napartment and his tax filing status is single. Perch has no \xe2\x80\x9cqualified REIT\ndividends\xe2\x80\x9d or \xe2\x80\x9cqualified publicly-traded partnership income.\xe2\x80\x9d\n2A. How much can Perch claim for a \xc2\xa7 199A deduction?\n404\n\n\x0c2B. Suppose Perch\xe2\x80\x99s \xe2\x80\x9ctaxable income\xe2\x80\x9d from his wages as a baseball player and\nbrewery worker was $100,000. Furthermore, suppose that Lopez Schaden is not an\nillegal immigrant and that the wages Perch paid him are W-2 wages. How much\ncould Perch claim as a \xc2\xa7 199A deduction?\n2C. Suppose Perch made the major leagues and quit his job at the brewery. His\nsalary jumped to $500,000. He continued his trade or business of being a personal\ntrainer with the same revenue and expenses. How much could Perch claim as a\n\xc2\xa7 199A deduction?\n2. Section 611: The Depletion Deduction\nSection 611(a) provides for a deduction in computing taxable income for depletion.\nThis deduction is available for \xe2\x80\x9cmines, oil and gas wells, other natural deposits, and\ntimber[.]\xe2\x80\x9d155 The depletion allowance deduction resembles the depreciation\ndeduction, infra, in that both deductions are a form of cost recovery of capital\ninvestments. Unlike the depreciation deduction, which is an allowance for the\ngradual consumption of an asset that the taxpayer uses to produce a product (or to\nprovide a service), the depletion allowance deduction is an allowance for the cost\nrecovery of wasting assets that are the product.156 The depletion allowance is part\nof the cost of the thing that the taxpayer sells.\nCongress enacted the depletion allowance deduction as a means for fossil fuel\ncompanies and mine operators to deduct an amount equal to the reduction in value\nof their mineral reserves as they extracted and sold the mineral. \xc2\xa7 611(a). The\ndeduction allows a taxpayer to recover its capital investment so that the investment\nwill not diminish as the minerals are extracted and sold.157 Despite this purpose,\nthere is no requirement that the taxpayer invest any money in the mineral rights,158\n\n155\n\nI.R.C. \xc2\xa7 611(a).\n\n156 Commissioner v. Southwest Exploration Co., 350 U.S. 308, 312 (1956) (depletion allowance \xe2\x80\x9cbased\non the theory that the extraction of minerals gradually exhausts the capital investment in the mineral\ndeposit\xe2\x80\x9d).\n157\n\nId. at 312.\n\n158\n\nId.\n\n405\n\n\x0cand taxpayer does not have to have legal title to take advantage of the deduction.159\nFirst codified in 1913, the depletion allowance deduction was originally limited to\nmines \xe2\x80\x93 and only 5% of the gross value of a mine\xe2\x80\x99s reserves could be deducted in\na year.160 Over time, the depletion allowance deduction has expanded to include\nresources other than those from mining \xe2\x80\x93 such as oil, gas, and timber \xe2\x80\x93 and to allow\nfor deductions greater than 5%.\nAnyone with an \xe2\x80\x9ceconomic interest\xe2\x80\x9d may share161 in the depletion allowance\ndeduction.162 \xe2\x80\x9cAn economic interest is possessed in every case in which the\ntaxpayer has acquired by investment any interest in mineral in place or standing\ntimber and secures, by any form of legal relationship, income derived from the\nextraction of the mineral or severance of the timber, to which he must look for a\nreturn of his capital.\xe2\x80\x9d163 A broad range of economic interests exists whose owners\nmay claim the depletion allowance deduction.\nThere are now two ways to calculate a depletion allowance deduction, and taxpayer\nchooses the one that yields the greater deduction. However, taxpayer may not\nchoose percentage depletion in the case of an interest in timber.164\nCost Depletion: Under cost depletion, taxpayer allocates annually an equal amount\nof basis165 to each recoverable unit.166 Taxpayer may claim the deduction when it\n\n159\n\nId.\n\n5 William H. Byrnes, IV & Christopher M Sove, Mertens Law of Fed. Income Tax\xe2\x80\x99n \xc2\xa7 24:132 (rev.\n2013), available on Westlaw.\n160\n\nSee, e.g., Commissioner v. Southwest Exploration Co., 350 U.S. 308, 309 (1956) (Court granted cert\n\xe2\x80\x9cbecause both the drilling company and the upland owners cannot be entitled to depletion on the same\nincome\xe2\x80\x9d).\n161\n\nSee Palmer v. Bender, 257 U.S. 551, 557 (1933) (conveyance of leased property in exchange for cash\nbonus, future payment, plus 1/8 royalty sufficient to claim depletion allowance deduction, irrespective\nof fact that taxpayer may have retained no legal interest in the mineral content of the land).\n162\n\n163\n\nReg. \xc2\xa7 1.611-1(b)(1).\n\n164\n\nI.R.C. \xc2\xa7 613(a) (percentage method applicable to \xe2\x80\x9cmines, wells, and [certain] other natural deposits\xe2\x80\x9d).\n\nI.R.C. \xc2\xa7 612 (same as adjusted basis in \xc2\xa7 1011 for \xe2\x80\x9cpurpose of determining gain upon sale or other\ndisposition of\xe2\x80\x9d the property).\n165\n\n166\n\nReg. \xc2\xa7 1.611-2(a)(1) (mines, oil and gas wells, and other natural deposits); Reg. \xc2\xa7 1.611-3(b) (timber).\n\n406\n\n\x0csells the unit167 or cuts the timber.168 Depletion allowance deductions \xe2\x80\x93 allowed or\nallowable \xe2\x80\x93 reduce taxpayer\xe2\x80\x99s basis in the property until the basis is $0.169 At that\ntime, taxpayer may shift to percentage depletion, except when taxpayer claims\ndepletion allowance deductions for timber. Recapture of depletion allowance\ndeductions upon sale or exchange of the property is subject to income taxation at\nordinary income rates.170\nPercentage Depletion: Percentage depletion is a deduction based on a specified\npercentage of taxpayer\xe2\x80\x99s gross income from different named activities171 of up to\n50% of the taxable income from the activity.172 The limit is 100% of taxable\nincome from oil and gas properties.173 However, Sections 613(d) and 613A\ndisallow any depletion allowance deduction for oil and gas wells, except for some\nsmall independent producers and royalty owners of domestic oil and gas.174 Their\npercentage depletion allowance deduction is 15%175 of gross income, limited to\n65% of taxable income.176 A percentage depletion allowance deduction is available\neven though taxpayer has no basis remaining in the asset.\nThe percentage depletion method serves to encourage the further development and\nexploitation of certain natural resources. This is important in a time when we\nbelieve that preservation of natural resources should be national policy.177 In recent\nyears, depletion allowance deductions have increased significantly: in 2003, total\ncorporate depletion allowance deductions were nearly $10.2 billion, while in 2012,\n167\n168\n\nReg. \xc2\xa7 1.611-2(a)(1) (mines, oil and gas wells, and other natural deposits).\nReg. \xc2\xa7 1.611-3(b)(1) (timber).\n\nI.R.C. \xc2\xa7 1016(a)(1)(2); Reg. \xc2\xa7 1.611-2(b)(2) (cost depletion for mines, oil and gas wells, and other\nnatural deposits); Reg. \xc2\xa7 1.611-3(c)(1) (timber).\n169\n\n170\n\nI.R.C. \xc2\xa7 1254(a).\n\n171\n\nI.R.C. \xc2\xa7 613(a and b) (the percentages range from 5% to 22%).\n\n172\n\nI.R.C. \xc2\xa7 613(a).\n\n173\n\nId. But see \xc2\xa7\xc2\xa7 613(d), 613A.\n\n174\n\nSee Reg. \xc2\xa7 1.613A-3 (details of exemption for independent producers and royalty owners).\n\n175\n\nI.R.C. \xc2\xa7 613A(c)(1).\n\n176\n\nI.R.C. \xc2\xa7 613A(d)(1).\n\nFor an argument that the depletion deduction provides a tax incentive for companies that extract\nminerals but does little to preserve the environment from which the minerals were extracted, see Wendy\nB. Davis, Elimination of the Depletion Deduction for Fossil Fuels, 26 SEATTLE U. L. REV. 197 (2002).\n177\n\n407\n\n\x0ctotal corporate depletion allowance deductions rose to more than $27.4 billion.178\n\nIII. Depreciation, Amortization, and Cost Recovery\nWe have encountered at several points the principle that taxpayer\xe2\x80\x99s consumption of\nonly a part of a productive asset to generate taxable income entitles taxpayer to a\ndeduction for only that amount of consumption. Such consumption represents a\ntaxpayer\xe2\x80\x99s de-investment and consumption of in the asset and so must result in a\nreduction of basis. We take up here the actual mechanics of some of the Code\xe2\x80\x99s\ndepreciation provisions. The following case provides a good review of depreciation\nprinciples and congressional tinkering with them as a means of pursuing certain\neconomic policies.\nLiddle v. Commissioner, 65 F.3d 329 (3d Cir. 1995)\nMcKEE, Circuit Judge:\nIn this appeal from a decision of the United States Tax Court we are asked to decide\nif a valuable bass viol can be depreciated under the Accelerated Cost Recovery\nSystem when used as a tool of trade by a professional musician even though the\ninstrument actually increased in value while the musician owned it. We determine\nthat, under the facts before us, the taxpayer properly depreciated the instrument and\ntherefore affirm the decision of the Tax Court.\nI.\nBrian Liddle, the taxpayer here, is a very accomplished professional musician.\nSince completing his studies in bass viol at the Curtis Institute of Music in 1978,\nhe has performed with various professional music organizations, including the\nPhiladelphia Orchestra, the Baltimore Symphony, the Pennsylvania ProMusica and\nthe Performance Organization.\nIn 1984, after a season with the Philadelphia Orchestra, he purchased a 17th century\nbass viol made by Francesco Ruggeri (c. 1620-1695), a luthier who was active in\nCremona, Italy. Ruggeri studied stringed instrument construction under Nicolo\nThe IRS now publishes Statistics of Income historical and data tables only online. The relevant tables\nare at http://www.irs.gov/file_source/pub/irs-soi/histab13e.xls (line 66).\n178\n\n408\n\n\x0cAmati, who also instructed Antonio Stradivari. Ruggeri\xe2\x80\x99s other contemporaries\ninclude the craftsmen Guadanini and Guarneri. These artisans were members of a\ngroup of instrument makers known as the Cremonese School.\nLiddle paid $28,000 for the Ruggeri bass, almost as much as he earned in 1987\nworking for the Philadelphia Orchestra. The instrument was then in an excellent\nstate of restoration and had no apparent cracks or other damage. Liddle insured the\ninstrument for its then-appraised value of $38,000. This instrument was his\nprincipal instrument and he used it continuously to earn his living, practicing with\nit at home as much as seven and one-half hours every day, transporting it locally\nand out of town for rehearsals, performances and auditions. Liddle purchased the\nbass because he believed it would serve him throughout his professional career \xe2\x80\x93\nanticipated to be 30 to 40 years.\nDespite the anticipated longevity of this instrument, the rigors of Liddle\xe2\x80\x99s\nprofession soon took their toll upon the bass and it began reflecting the normal wear\nand tear of daily use, including nicks, cracks, and accumulations of resin. At one\npoint, the neck of the instrument began to pull away from the body, cracking the\nwood such that it could not be played until it was repaired. Liddle had the\ninstrument repaired by renown [sic] artisans. However, the repairs did not restore\nthe instrument\xe2\x80\x99s \xe2\x80\x9cvoice\xe2\x80\x9d to its previous quality. At trial, an expert testified for\nLiddle that every bass loses mass from use and from oxidation and ultimately loses\nits tone, and therefore its value as a performance instrument decreases. Moreover,\nas common sense would suggest, basses are more likely to become damaged when\nused as performance instruments than when displayed in a museum. Accordingly,\nprofessional musicians who use valuable instruments as their performance\ninstruments are exposed to financial risks that do not threaten collectors who regard\nsuch instruments as works of art, and treat them accordingly.\nThere is a flourishing market among nonmusicians for Cremonese School\ninstruments such as Mr. Liddle\xe2\x80\x99s bass. Many collectors seek primarily the \xe2\x80\x9clabel\xe2\x80\x9d,\ni.e., the maker\xe2\x80\x99s name on the instrument as verified by the certificate of authenticity.\nAs nonplayers, they do not concern themselves with the physical condition of the\ninstrument; they have their eye only on the market value of the instrument as a\ncollectible. As the quantity of these instruments has declined through loss or\ndestruction over the years, the value of the remaining instruments as collectibles\nhas experienced a corresponding increase.\nEventually, Liddle felt the wear and tear had so deteriorated the tonal quality of his\n409\n\n\x0cRuggeri bass that he could no longer use it as a performance instrument. Rather\nthan selling it, however, he traded it for a Domenico Busan 18th century bass in\nMay of 1991. The Busan bass was appraised at $65,000 on the date of the exchange,\nbut Liddle acquired it not for its superior value, but because of the greater tonal\nquality.\nLiddle and his wife filed a joint tax return for 1987, and claimed a depreciation\ndeduction of $3,170 for the Ruggeri bass under the Accelerated Cost Recovery\nSystem (\xe2\x80\x9cACRS\xe2\x80\x9d), \xc2\xa7 168. [footnote omitted] The Commissioner disallowed the\ndeduction asserting that the \xe2\x80\x9cRuggeri bass in fact will appreciate in value and not\ndepreciate.\xe2\x80\x9d Accordingly, the Commissioner assessed a deficiency of $602 for the\ntax year 1987. The Liddles then filed a petition with the Tax Court challenging the\nCommissioner\xe2\x80\x99s assertion of the deficiency. A closely divided court entered a\ndecision in favor of the Liddles. This appeal followed. [footnote omitted]\nII.\n[The Commissioner conceded that an asset can appreciate in value and still be\nsubject to a depreciation deduction.]\nHere, the Commissioner originally argued that the ACRS deduction under \xc2\xa7 168 is\ninappropriate here because the bass actually appreciated in value. However, the\nCommissioner has apparently abandoned that theory, presumably because an asset\ncan appreciate in market value and still be subject to a depreciation deduction under\ntax law. Fribourg Navigation Co. v. Commissioner, 383 U.S. 272, 277 (1966) (\xe2\x80\x9ctax\nlaw has long recognized the accounting concept that depreciation is a process of\nestimated allocation which does not take account of fluctuations in valuation\nthrough market appreciation.\xe2\x80\x9d); Noyce v. Commissioner, 97 T.C. 670, 1991 WL\n263146 (1991) (taxpayer allowed to deduct depreciation under \xc2\xa7 168 on an airplane\nthat appreciated in economic value from the date of purchase to the time of trial).\nHere, the Commissioner argues that the Liddles can claim the ACRS deduction\nonly if they can establish that the bass has a determinable useful life. Since Mr.\nLiddle\xe2\x80\x99s bass is already over 300 years old, and still increasing in value, the\nCommissioner asserts that the Liddles can not establish a determinable useful life\nand therefore can not take a depreciation deduction. In addition, the Commissioner\nargues that this instrument is a \xe2\x80\x9cwork of art\xe2\x80\x9d which has an indeterminable useful\nlife and is therefore not depreciable.\n... Prior to 1981, \xc2\xa7 167 governed the allowance of depreciation deductions with\n410\n\n\x0crespect to tangible and intangible personality. Section 167 provided, in relevant\npart, as follows:\nSec. 167. DEPRECIATION\n(a) General Rule. \xe2\x80\x93 There shall be allowed as a depreciation deduction a\nreasonable allowance for the exhaustion, wear and tear (including a\nreasonable allowance for obsolescence) \xe2\x80\x93\n(1) of property used in the trade or business, or\n(2) of property held for the production of income.\n26 U.S.C. \xc2\xa7 167(a). The regulations promulgated under \xc2\xa7 167 provided that in order\nto qualify for the depreciation deduction, the taxpayer had to establish that the\nproperty in question had a determinable useful life. Reg. \xc2\xa7 1.167(a)-1(a) and (b).\nThe useful life of an asset was not necessarily the useful life \xe2\x80\x9cinherent in the asset\nbut [was] the period over which the asset may reasonably be expected to be useful\nto the taxpayer in his trade or business....\xe2\x80\x9d Reg. \xc2\xa7 1.167(a)-1(b). Nonetheless, under\n\xc2\xa7 167 and its attendant regulations, a determinable useful life was the sine qua non\nfor claiming the deduction. See, Harrah\xe2\x80\x99s Club v. United States, 661 F.2d 203, 207\n(1981) (\xe2\x80\x9cUnder the regulation on depreciation, a useful life capable of being\nestimated is indispensable for the institution of a system of depreciation.\xe2\x80\x9d).\nUnder \xc2\xa7 167, the principal method for determining the useful life of personalty was\nthe Asset Depreciation Range (\xe2\x80\x9cADR\xe2\x80\x9d) system. Personalty eligible for the ADR\nsystem was grouped into more than 100 classes and a guideline life for each class\nwas determined by the Treasury Department. See Reg. \xc2\xa7 1.167(a)-11. A taxpayer\ncould claim a useful life up to 20% longer or shorter than the ADR guideline life.\nReg.\xc2\xa7 1.167(a)-11(4)(b). The ADR system was optional with the taxpayer. Reg.\n\xc2\xa7 1.167(a)-11(a). For personalty which was not eligible for ADR, and for taxpayers\nwho did not choose to use ADR, the useful life of an asset was determined\naccording to the unique circumstances of the particular asset or by an agreement\nbetween the taxpayer and the Internal Revenue Service. STAFF OF THE JOINT\nCOMMITTEE ON TAXATION, GENERAL EXPLANATION OF THE ECONOMIC RECOVERY\nTAX ACT OF 1981, 97th Cong. ...\nIn 1981, convinced that tax reductions were needed to ensure the continued\neconomic growth of the country, Congress passed the Economic Recovery Tax Act\nof 1981, P. L. 97-34 (\xe2\x80\x9cERTA\xe2\x80\x9d). Id. It was hoped that the ERTA tax reduction\nprogram would \xe2\x80\x9chelp upgrade the nation\xe2\x80\x99s industrial base, stimulate productivity\nand innovation throughout the economy, lower personal tax burdens and restrain\n411\n\n\x0cthe growth of the Federal Government.\xe2\x80\x9d Id. Congress felt that prior law and rules\ngoverning depreciation deductions need to be replaced \xe2\x80\x9cbecause they did not\nprovide the investment stimulus that was felt to be essential for economic\nexpansion.\xe2\x80\x9d Id. Further, Congress believed that the true value of the depreciation\ndeduction had declined over the years because of high inflation rates. Id. As a result,\nCongress believed that a \xe2\x80\x9csubstantial restructuring\xe2\x80\x9d of the depreciation rules would\nstimulate capital formation, increase productivity and improve the country\xe2\x80\x99s\ncompetitiveness in international trade. Id. Congress also felt that the prior rules\nconcerning the determination of a useful life were \xe2\x80\x9ctoo complex\xe2\x80\x9d, \xe2\x80\x9cinherently\nuncertain\xe2\x80\x9d and engendered \xe2\x80\x9cunproductive disagreements between taxpayers and the\nInternal Revenue Service.\xe2\x80\x9d Id. To remedy the situation, Congress decided\nthat a new capital cost recovery system should be structured which deemphasizes the concept of useful life, minimizes the number of elections\nand exceptions and is easier to comply with and to administer.\nId.\nAccordingly, Congress adopted the Accelerated Cost Recovery System (\xe2\x80\x9cACRS\xe2\x80\x9d)\nin ERTA. The entire cost or other basis of eligible property is recovered under\nACRS eliminating the salvage value limitation of prior depreciation law. GENERAL\nEXPLANATION OF THE ECONOMIC RECOVERY TAX ACT OF 1981 at 1450. ACRS was\ncodified in I.R.C. \xc2\xa7 168, which provided, in relevant part, as follows:\nSec. 168. Accelerated cost recovery system\n(a) Allowance of Deduction. \xe2\x80\x93 There shall be allowed as a deduction for\nany taxable year the amount determined under this section with respect to\nrecovery property.\n(b) Amount of Deduction.-(1) In general. \xe2\x80\x93 Except as otherwise provided in this section, the\namount of the deduction allowable by subsection (a) for any taxable\nyear shall be the aggregate amount determined by applying to the\nunadjusted basis of recovery property the applicable percentage\ndetermined in accordance with the following table:\n******\n(c) Recovery Property. \xe2\x80\x93 For purposes of this title \xe2\x80\x93\n(1) Recovery Property Defined. \xe2\x80\x93 Except as provided in subsection\n412\n\n\x0c(e), the term \xe2\x80\x9crecovery property\xe2\x80\x9d means tangible property of a\ncharacter subject to the allowance for depreciation \xe2\x80\x93\n(A) used in a trade or business, or\n(B) held for the production of income.\n26 U.S.C. \xc2\xa7 168. ACRS is mandatory and applied to \xe2\x80\x9crecovery property\xe2\x80\x9d placed in\nservice after 1980 and before 1987.179\nSection 168(c)(2) grouped recovery property into five assigned categories: 3-year\nproperty, 5-year property, 10-year property, 15-year real property and 15-year\npublic utility property. Three year property was defined as \xc2\xa7 1245 property180 with\na class life of 4 years or less. Five year property is all \xc2\xa7 1245 property with a class\nlife of more than 4 years. Ten year property is primarily certain public utility\nproperty, railroad tank cars, coal-utilization property and certain real property\ndescribed in I.R.C. \xc2\xa7 1250(c). Other long-lived public utility property is in the 15year class. \xc2\xa7 168(a)(2)(A), (B) and (C). Basically, 3-year property includes certain\nshort-lived assets such as automobiles and light-duty trucks, and 5-year property\nincluded all other tangible personal property that was not 3-year property. Most\neligible personal property was in the 5-year class.\nThe Commissioner argues that ERTA \xc2\xa7 168 did not eliminate the pre-ERTA \xc2\xa7 167\nrequirement that tangible personalty used in a trade or business must also have a\ndeterminable useful life in order to qualify for the ACRS deduction. She argues that\nthe phrase \xe2\x80\x9cof a character subject to the allowance for depreciation\xe2\x80\x9d demonstrates\nthat the pre-ERTA \xc2\xa7 167 requirement for a determinable useful life is the threshold\ncriterion for claiming the \xc2\xa7 168 ACRS deduction.\nMuch of the difficulty inherent in this case arises from two related problems. First,\nCongress left \xc2\xa7 167 unmodified when it added \xc2\xa7 168; second, \xc2\xa7 168 contains no\nstandards for determining when property is \xe2\x80\x9cof a character subject to the allowance\nfor depreciation.\xe2\x80\x9d In the absence of any express standards, logic and common sense\nwould dictate that the phrase must have a reference point to some other section of\nthe Internal Revenue Code. Section 167(a) would appear to be that section. As\nIn the Tax Reform Act of 1986, P. L. 99-514, Sec. 201, Congress made substantial changes to I.R.C.\n\xc2\xa7 168. In particular, Congress deleted the \xe2\x80\x9crecovery property\xe2\x80\x9d concept from the statute.\n179\n\nSection 1245 property is, inter alia, any personal property which is or has been property of a character\nsubject to allowance for depreciation provided in \xc2\xa7 167. \xc2\xa7 1245(a)(3).\n180\n\n413\n\n\x0cstated above, that section provides that \xe2\x80\x9c[t]here shall be allowed as a depreciation\ndeduction a reasonable allowance for the exhaustion, wear and tear ... of property\nused in a trade or business....\xe2\x80\x9d The Commissioner assumes that all of the\ndepreciation regulations promulgated under \xc2\xa7 167 must, of necessity, be imported\ninto \xc2\xa7 168. That importation would include the necessity that a taxpayer\ndemonstrate that the asset have a demonstrable useful life, and (the argument\ncontinues) satisfy the phrase \xe2\x80\x9ctangible property of a character subject to the\nallowance for depreciation\xe2\x80\x9d in \xc2\xa7 168.\nHowever, we do not believe that Congress intended the wholesale importation of\n\xc2\xa7 167 rules and regulations into \xc2\xa7 168. Such an interpretation would negate one of\nthe major reasons for enacting the Accelerated Cost Recovery System. Rather, we\nbelieve that the phrase \xe2\x80\x9cof a character subject to the allowance for depreciation\xe2\x80\x9d\nrefers only to that portion of \xc2\xa7 167(a) which allows a depreciation deduction for\nassets which are subject to exhaustion and wear and tear. Clearly, property that is\nnot subject to such exhaustion does not depreciate. Thus, we hold that \xe2\x80\x9cproperty of\na character subject to the allowance for depreciation\xe2\x80\x9d refers to property that is\nsubject to exhaustion, wear and tear, and obsolescence. However, it does not follow\nthat Congress intended to make the ACRS deduction subject to the \xc2\xa7 167 useful life\nrules, and thereby breathe continued life into a regulatory scheme that was\nbewildering, and fraught with problems, and required \xe2\x80\x9csubstantial restructuring.\xe2\x80\x9d\nWe previously noted that Congress believed that prior depreciation rules and\nregulations did not provide the investment stimulus necessary for economic\nexpansion. Further, Congress believed that the actual value of the depreciation\ndeduction declined over the years because of inflationary pressures. In addition,\nCongress felt that prior depreciation rules governing the determination of useful\nlives were much too complex and caused unproductive disagreements between\ntaxpayers and the Commissioner. Thus, Congress passed a statute which \xe2\x80\x9cdeemphasizes the concept of useful life.\xe2\x80\x9d GENERAL EXPLANATION OF THE ECONOMIC\nRECOVERY TAX ACT OF 1981 at 1449. Accordingly, we decline the Commissioner\xe2\x80\x99s\ninvitation to interpret \xc2\xa7 168 in such a manner as to re-emphasize a concept which\nCongress has sought to \xe2\x80\x9cde-emphasize.\xe2\x80\x9d\nThe Commissioner argues that de-emphasis of useful life is not synonymous with\nabrogation of useful life. As a general statement, that is true. However, the position\nof the Commissioner, if accepted, would reintroduce unproductive disputes over\nuseful life between taxpayers and the Internal Revenue Service. Indeed, such is the\nplight of Mr. Liddle.\n414\n\n\x0cCongress de-emphasized the \xc2\xa7 167 useful life rules by creating four short periods\nof time over which taxpayers can depreciate tangible personalty used in their trade\nor business. These statutory \xe2\x80\x9crecovery periods ... are generally unrelated to, but\nshorter than, prior law useful lives.\xe2\x80\x9d GENERAL EXPLANATION OF THE ECONOMIC\nRECOVERY TAX ACT OF 1981 at 1450. The four recovery periods are, in effect, the\nstatutorily mandated useful lives of tangible personalty used in a trade or business.\nThe recovery periods serve the primary purpose of ERTA. Once a taxpayer has\nrecovered the cost of the tangible personalty used in a trade or business, i.e., once\nthe taxpayer has written off the asset over the short recovery period, his or her basis\nin that asset will be zero and no further ACRS deduction will be allowed. To avail\nhimself or herself of further ACRS deductions, the taxpayer will have to purchase\na new asset. Thus, because the recovery period is generally shorter than the preERTA useful life of the asset, the taxpayer\xe2\x80\x99s purchase of the new asset will increase\ncapital formation and new investment and, as a result, promote the Congressional\nobjective for continued economic expansion.\nThus, in order for the Liddles to claim an ACRS deduction, they must show that\nthe bass is recovery property as defined in \xc2\xa7 168(c)(1). It is not disputed that it is\ntangible personalty which was placed in service after 1980 and that it was used in\nBrian Liddle\xe2\x80\x99s trade or business. What is disputed is whether the bass is \xe2\x80\x9cproperty\nof a character subject to the allowance for depreciation.\xe2\x80\x9d We hold that that phrase\nmeans that the Liddles must only show that the bass was subject to exhaustion and\nwear and tear. The Tax Court found as a fact that the instrument suffered wear and\ntear during the year in which the deduction was claimed. That finding was not\nclearly erroneous. Accordingly, the Liddles are entitled to claim the ACRS\ndeduction for the tax year in question.\nSimilarly, we are not persuaded by the Commissioner\xe2\x80\x99s \xe2\x80\x9cwork of art\xe2\x80\x9d theory,\nalthough there are similarities between Mr. Liddle\xe2\x80\x99s valuable bass, and a work of\nart. The bass, is highly prized by collectors; and, ironically, it actually increases in\nvalue with age much like a rare painting. Cases that addressed the availability for\ndepreciation deductions under \xc2\xa7 167 clearly establish that works of art and/or\ncollectibles were not depreciable because they lacked a determinable useful life.\nSee Associated Obstetricians and Gynecologists, P.C. v. Commissioner, 762 F.2d\n38 (6th Cir.1985) (works of art displayed on wall in medical office not depreciable);\nHawkins v. Commissioner, 713 F.2d 347 (8th Cir.1983) (art displayed in law office\nnot depreciable); Harrah\xe2\x80\x99s Club v. United States, 661 F.2d 203 (1981) (antique\nautomobiles in museum not depreciable). See also, Rev. Rul. 68-232 (\xe2\x80\x9cdepreciation\n415\n\n\x0cof works of art generally is not allowable because \xe2\x80\x98[a] valuable and treasured art\npiece does not have a determinable useful life.\xe2\x80\x99\xe2\x80\x9c).\n... In Brian Liddle\xe2\x80\x99s professional hands, his bass viol was a tool of his trade, not a\nwork of art. It was as valuable as the sound it could produce, and not for its looks.\nNormal wear and tear from Liddle\xe2\x80\x99s professional demands took a toll upon the\ninstrument\xe2\x80\x99s tonal quality and he, therefore, had every right to avail himself of the\ndepreciation provisions of the Internal Revenue Code as provided by Congress.\nIII.\nAccordingly, for the reasons set forth above, we will affirm the decision of the tax\ncourt.\nNotes and Questions:\n1. Note the court\xe2\x80\x99s account of the evolution of depreciation law. In its first footnote,\nthe court noted that \xe2\x80\x9crecovery property\xe2\x80\x9d is no longer part of \xc2\xa7 168. Section 168 now\napplies to \xe2\x80\x9cany tangible property.\xe2\x80\x9d\n2. The Second Circuit reached a similar result in Simon v. Commissioner, 68 F.3d\n41 (2d Cir. 1995), Nonacq. 1996-29 I.R.B. 4, 1996-2 C.B. 1, 1996 WL 33370246\n(cost recovery allowance for a violin bow).\nNote: Sections 167 and 168\nSection 167 still governs depreciation. It has been supplemented \xe2\x80\x93 to the point that\nit has been replaced \xe2\x80\x93 by \xc2\xa7 168 for tangible property \xe2\x80\x93 but not for intangible\nproperty. The allowable depreciation deduction of \xc2\xa7 167(a) is what is described in\n\xc2\xa7 168 when it is applicable. \xc2\xa7 168(a). When \xc2\xa7 168 is applicable, its application is\nmandatory. \xc2\xa7 168(a) (\xe2\x80\x9cshall be determined\xe2\x80\x9d). Application of \xc2\xa7 168 is much more\nmechanical and predictable than application of \xc2\xa7 167. The Third Circuit described\nthe mechanics of applying \xc2\xa7 167 \xe2\x80\x93 and of course, the greater accuracy that \xc2\xa7 167\n(may have) yielded came at a high administrative cost, both to the taxpayer and to\nthe IRS. The Commissioner\xe2\x80\x99s argument that taxpayer must demonstrate that an\nasset has a \xe2\x80\x9cdeterminable useful life\xe2\x80\x9d in order to claim a deduction for depreciation\nis an accurate statement of the law of \xc2\xa7 167. Applying \xc2\xa7 167 required placing an\n416\n\n\x0casset into an \xe2\x80\x9cAsset Depreciation Range\xe2\x80\x9d (ADR), deriving its useful life,\ndetermining its future \xe2\x80\x9csalvage value,\xe2\x80\x9d and then calculating the actual depreciation\ndeduction according to an allowable method. The court in Liddle described this\nsystem as \xe2\x80\x9cbewildering, and fraught with problems[.]\xe2\x80\x9d While ADRs are no longer\nlaw, they are still used to determine the \xe2\x80\x9cclass life\xe2\x80\x9d of an asset which in turn\ndetermines the type of property that it is \xe2\x80\x93 whether 3-year, 5-year, 7-year, 10-year,\n15-year, or 20-year property. \xc2\xa7 168(e)(1).\nThe late 1970s and early 1980s was a time of slow economic growth and very high\ninflation. The court describes the congressional response, i.e., the Economic\nRecovery Tax Act of 1981 (ERTA). Clearly, Congress \xe2\x80\x93 at the urging of President\nReagan \xe2\x80\x93 was using tax rules as a device to stimulate the economy. Congress\nmodified the system so that property placed in service in 1986 and after would be\nsubject to the \xe2\x80\x9cModified Accelerated Cost Recovery System\xe2\x80\x9d (MACRS). Sufficient\ntime has passed that we do not often have to distinguish between ACRS and\nMACRS; often we simply refer to the current system as ACRS. Notice that \xc2\xa7 168\nuses the phrase \xe2\x80\x9caccelerated cost recovery system\xe2\x80\x9d (ACRS) \xe2\x80\x93 implying that we no\nlonger consider this to be \xe2\x80\x9cdepreciation.\xe2\x80\x9d As we see in the succeeding paragraphs,\ntaxpayers who place property in service to which \xc2\xa7 168 applies may \xe2\x80\x9cwrite it off\xe2\x80\x9d\nmuch faster than they could under the old rules. The Third Circuit in Liddle\nexplained what Congress was trying to accomplish by adopting these rules.\nSection 168(e) requires that we identify the \xe2\x80\x9cclassification of property.\xe2\x80\x9d Certain\nproperty is classified as 3-year property, 5-year property, 7-year property, 10-year\nproperty, 15-year property, and 20-year property. \xc2\xa7 168(e)(3). Property not\notherwise described is first defined according to the old class life rules, \xc2\xa7 168(e)(1),\n\xc2\xa7 168(i)(1), and then placed into one of these classifications. For such properties,\nthe recovery period corresponds to the classification of the property. See \xc2\xa7 168(c).\nIn addition, \xc2\xa7 168(b)(3) names certain properties whose recovery period is\nprescribed in \xc2\xa7 168(c).\n\xe2\x80\xa2You should read through these sub-sections \xe2\x80\x93 particularly \xc2\xa7 168(e)(3),\n\xc2\xa7 168(e)(1), and \xc2\xa7 168(c).\n\xe2\x80\xa2Notice that \xc2\xa7 168(e)(3)(C)(v) provides that property without a class life and\nnot otherwise classified is classified as 7-year property. Section\n168(e)(3)(C)(v) thus serves as a sort of \xe2\x80\x9cdefault\xe2\x80\x9d provision when taxpayers\npurchase items such as bass viols. At the time the Liddles filed their tax\nreturn, the default period was five years.\n417\n\n\x0cSection 168(b)(4) treats salvage value as zero. This eliminates one point of dispute\nbetween taxpayers and the IRS. The basis for depreciation is the adjusted basis\nprovided in \xc2\xa7 1011. \xc2\xa7 167(c)(1).\nSection 168(d) prescribes certain \xe2\x80\x9cconventions.\xe2\x80\x9d We generally treat all property to\nwhich \xc2\xa7 168 applies as if it were placed in service or disposed of at the midpoint of\nthe taxpayer\xe2\x80\x99s taxable year. \xc2\xa7 168(d)(1 and 4(A)) (\xe2\x80\x9chalf-year convention\xe2\x80\x9d). In the\ncase of real property, we treat it as if it were placed in service or disposed of at the\nmidpoint of the month in which it was placed in service or disposed of. \xc2\xa7 168(d)(2)\nand (4)(B) (\xe2\x80\x9cmid-month convention\xe2\x80\x9d). A special rule precludes the abuse of these\nconventions through back-loading. We treat all property to which \xc2\xa7 168 applies as\nif it were placed in service at the midpoint of the quarter in which it was placed in\nservice if more than 40% of the aggregate bases of such property was placed in\nservice during the last quarter of the taxpayer\xe2\x80\x99s tax year. \xc2\xa7 168(d)(3)(A). In making\nthis 40% determination, taxpayer does not count nonresidential real property,\nresidential rental property, a railroad grading or tunnel bore, and property placed in\nservice and disposed of during the same taxable year. \xc2\xa7 168(d)(3)(B).\nSection 168(b) prescribes three cost recovery methods. The straight-line method\napplies to certain property for which the recovery period is relatively long.\n\xc2\xa7 168(b)(3). This of course means that taxpayer divides the item\xe2\x80\x99s basis by the\napplicable recovery period. In the first and last year of ownership, taxpayer applies\nthe applicable convention to determine his \xe2\x80\x9ccost recovery\xe2\x80\x9d deduction. A more rapid\nmethod of cost recovery applies to property whose classification is 15 or 20 years,\ni.e., 150% of declining balance. \xc2\xa7 168(b)(2)(A). This method also applies to\nspecifically named property. \xc2\xa7 168(b)(2)(B and C). A still more rapid method of\ncost recovery applies to 3-year, 5-year, 7-year, and 10-year property, i.e., 200% of\ndeclining balance. \xc2\xa7 168(a).\n\xe2\x80\xa2A taxpayer may irrevocably elect to apply one of the slower methods of\ncost recovery to one or more classes of property. \xc2\xa7 168(b)(2)(C),\n\xc2\xa7 168(b)(3)(D), \xc2\xa7 168(b)(5).\n\xe2\x80\xa2Rather than work through the 150% and 200% of declining balance\nmethods of cost recovery, we are fortunate that the IRS has promulgated\nRev. Proc. 87-57. This revenue procedure has several tables that provide the\nappropriate multiplier year by year for whatever the recovery period for\ncertain property is. The tables incorporate and apply the depreciation\nmethod and the appropriate convention.\n\xe2\x80\xa2Familiarize yourself with these tables.\n418\n\n\x0cSection 168(g)(2) provides an \xe2\x80\x9calternate depreciation system\xe2\x80\x9d which provides for\nstraight-line cost recovery over a longer period than the rules of \xc2\xa7 168 noted thus\nfar. Taxpayer may irrevocably elect to apply the \xe2\x80\x9calternate depreciation system\xe2\x80\x9d to\nall the property in a class placed in service during the taxable year. \xc2\xa7 168(g)(7).\nTaxpayer may make this election separately with respect to each nonresidential real\nproperty or residential rental property. \xc2\xa7 168(g)(7).\n\xe2\x80\xa2A taxpayer might make such an election to avoid paying the alternative\nminimum tax. See \xc2\xa7 56(a)(1).\nAccelerating cost recovery is one policy tool that Congress may use to encourage\ninvestment in certain types of property at certain times. See \xc2\xa7 168(k), infra.\nCongress and the President have increasingly resorted to this tool to stimulate\neconomic growth \xe2\x80\x93 even if not necessary.\nConsider:\n1. Taxpayer purchased a racehorse on January 2, 2019 for $10,000 and \xe2\x80\x9cplaced it\nin service\xe2\x80\x9d immediately. Taxpayer purchased no other property subject to ACRS\nallowances during the year.\n\xe2\x80\xa2What is Taxpayer\xe2\x80\x99s ACRS allowance for 2021?\nTaxpayer sold the horse on December 31, 2021 for $9000.\n\xe2\x80\xa2What is Taxpayer\xe2\x80\x99s adjusted basis in the racehorse?\n\xe2\x80\xa2What is Taxpayer\xe2\x80\x99s taxable gain from this sale?\n2. Taxpayer purchased a \xe2\x80\x9cmotorsports entertainment complex\xe2\x80\x9d on October 1, 2019\nfor $10M. See \xc2\xa7 168(e)(3)(C)(ii). Assume that there is no backloading problem.\n\xe2\x80\xa2What is Taxpayer\xe2\x80\x99s ACRS allowance for 2019?\n\xe2\x80\xa2What is Taxpayer\xe2\x80\x99s ACRS allowance for 2020?\n\xe2\x80\xa2What is Taxpayer\xe2\x80\x99s ACRS allowance for 2021?\n\xe2\x80\xa2What is Taxpayer\xe2\x80\x99s ACRS allowance for 2022?\n\xe2\x80\xa2What is Taxpayer\xe2\x80\x99s ACRS allowance for 2023?\n\xe2\x80\xa2What is Taxpayer\xe2\x80\x99s ACRS allowance for 2024?\n\xe2\x80\xa2What is Taxpayer\xe2\x80\x99s ACRS allowance for 2025?\n\xe2\x80\xa2What is Taxpayer\xe2\x80\x99s ACRS allowance for 2026?\n\n419\n\n\x0cSection 179 and \xc2\xa7 168(k) Bonus Depreciation\nSection 179 permits a taxpayer to treat \xe2\x80\x9cthe cost of any \xc2\xa7 179 property as an expense\nwhich is not chargeable to capital account.\xe2\x80\x9d \xc2\xa7 179(a). The limit of this deduction\nbeginning in tax year 2016 is $1,000,000, \xc2\xa7 179(b)(1), and the limit is indexed for\ninflation, \xc2\xa7 179(b)(6).181 The limit is reduced dollar for dollar by the amount by\nwhich the cost of \xc2\xa7 179 property that taxpayer places into service exceeds\n$2,500,000. \xc2\xa7 179(b)(2). The \xc2\xa7 179 deduction is limited to the amount of taxable\nincome that taxpayer derived from the active conduct of a trade or business\n(computed without regard to any \xc2\xa7 179 deduction) during the taxable year.\n\xc2\xa7 179(b)(3)(A). Taxpayers whose \xc2\xa7 179 deduction is subject to one of these\nlimitations may carry it forward to succeeding years. \xc2\xa7 179(b)(3)(B).\n\xe2\x80\xa2To encourage small business investment during the recent recession,\nCongress dramatically increased the \xc2\xa7 179 limit.\n\xe2\x80\xa2\xc2\xa7 179 property is tangible property to which \xc2\xa7 168 applies or \xc2\xa7 1245\nproperty purchased \xe2\x80\x9cfor use in the active conduct of a trade or business.\xe2\x80\x9d\n\xc2\xa7 179(d)(1). \xc2\xa7 179 property also includes computer software.\n\xc2\xa7 179(d)(1)(A)(ii). The taxpayer may elect to include \xe2\x80\x9cqualified real\nproperty\xe2\x80\x9d in his \xc2\xa7 179 property. \xc2\xa7 179(d)(1)(B)(ii). \xe2\x80\x9cQualified real property\xe2\x80\x9d\nincludes various improvements to existing real property. See \xc2\xa7 179(e),\n\xc2\xa7 168(e)(6).\n\xe2\x80\xa2After taking a \xc2\xa7 179 deduction, taxpayer may apply the rules of \xc2\xa7 168 to\nhis remaining basis.\nAfter the terrorist attacks of September 11, 2001, economic activity in the United\nStates, particularly in New York City, slowed dramatically. One congressional\nresponse was to provide for \xe2\x80\x9ctemporary\xe2\x80\x9d bonus depreciation for \xe2\x80\x9cqualified\nproperty.\xe2\x80\x9d See \xc2\xa7 168(k). The TCJA (2017) dramatically increased the availability\nof bonus depreciation. Section 168(k) calls for a phasing out of the bonus\ndepreciation. For taxpayers who place in service \xe2\x80\x9cqualified property\xe2\x80\x9d their\ndepreciation deduction \xe2\x80\x9cshall include\xe2\x80\x9d the \xe2\x80\x9capplicable percentage\xe2\x80\x9d of their adjusted\nbasis in the year that they place it in service. \xc2\xa7 168(k)(1)(A). They then reduce their\nbasis in the \xe2\x80\x9cqualified property\xe2\x80\x9d for purposes of computing their remaining cost\nrecovery deductions. \xc2\xa7 168(k)(1)(B). Until 2023, the bonus depreciation is 100%.\n\xc2\xa7 168(k)(6)(B)(i). The \xe2\x80\x9capplicable percentage\xe2\x80\x9d decreases by twenty percentage\npoints in each successive tax year, i.e., to 80%, 60%, 40%, 20%, and 0%.\nAs recently as tax year 1992, the limit was $10,000. Obviously \xc2\xa7 179 serves a different purpose than\nit did when it was enacted.\n181\n\n420\n\n\x0c\xc2\xa7 168(k)(6)(A). The bonus depreciation is not phased out completely until 2027.\n\xc2\xa7 168(k)(6)(B). \xe2\x80\x9cQualified property\xe2\x80\x9d is property that has a recovery period of 20\nyears or less. \xc2\xa7 168(k)(2)(A)(i)(I). It can also be computer software property, water\nutility property, qualified film or television production, or a live theatrical\nproduction. \xc2\xa7 168(k)(2)(A)(i).182\nThe original use of the property must begin with the taxpayer. \xc2\xa7 168(k)(2)(A)(ii).\nAlternatively, taxpayer may claim bonus depreciation for the acquisition and\nplacing in service of used property, \xc2\xa7 168(k)(2)(A)(ii) and \xc2\xa7 168(k)(2)(E)(ii)(I), so\nlong as taxpayer did not acquire the used property from a related party or in a\ncarryover basis transaction or by inheritance. \xc2\xa7 168(k)(2)(A)(ii),\n\xc2\xa7 168(k)(2)(E)(ii)(II), \xc2\xa7 179(d)(2 and 3). Taxpayer must place the property in\nservice before 2027. \xc2\xa7 168(k)(2)(iii). Moreover, the benefits that \xc2\xa7\xc2\xa7 179 and 168(k)\nprovide are cumulative \xe2\x80\x93 so a taxpayer may \xe2\x80\x9cwrite off\xe2\x80\x9d very substantial investments\nin productive assets.\nSection 197\nSection 197 permits the amortization of \xe2\x80\x9c\xc2\xa7 197 intangibles.\xe2\x80\x9d \xc2\xa7 197(a). A \xe2\x80\x9c\xc2\xa7 197\nintangible\xe2\x80\x9d includes such intangibles as goodwill, going concern value, intellectual\nproperty, a license or permit granted by a government, etc. \xc2\xa7 197(d)(1). Section 197\npermits ratable amortization over 15 years of the purchase price (as opposed to the\ncost of self-creation) of such intangibles. \xc2\xa7 197(a), \xc2\xa7 197(c)(2).\n\xe2\x80\xa2Congress intended that \xc2\xa7 197 put an end to expensive contests between the\nIRS and taxpayers over whether such items could be amortized at all, and if\nso, the applicable useful life. Now a \xe2\x80\x9cone-size-fits-all\xe2\x80\x9d approach applies to\nall such intangibles.\nSection 195: Start-Up Expenses\nSection 195 provides that no deductions are allowed for start-up expenditures of a\ntrade or business \xe2\x80\x9c[e]xcept as otherwise provided in this section.\xe2\x80\x9d Section\n195(c)(1)(A) defines \xe2\x80\x9cstart-up expenditures\xe2\x80\x9d to be amounts paid or incurred to \xe2\x80\x93\n\xe2\x80\xa2investigate the creation of acquisition of an active trade or business,\nThere are many detailed definitions and conditions to \xc2\xa7 168(k) that are more than we need to\nconsider at this point. You should understand that Congress has used \xe2\x80\x9cbonus\xe2\x80\x9d depreciation as a tool\nof stimulating the economy and that Congress has regularly extended the applicability of \xc2\xa7 168(k).\n182\n\n421\n\n\x0c\xe2\x80\xa2create an active trade or business, or\n\xe2\x80\xa2engage in an activity for profit and for the production of income before the\ndate on which the active trade or business begins.\nSuch expenditures must otherwise be deductible if they were \xe2\x80\x9cpaid or incurred in\nconnection with\xe2\x80\x9d an existing active trade or business. \xc2\xa7 195(c)(1)(B).\nSection 195(b)(1) does permit a taxpayer to elect to deduct the lesser of \xe2\x80\x93\n\xe2\x80\xa2all the start-up expenses of the trade or business, or\n\xe2\x80\xa2$5000, reduced by the amount by which taxpayer\xe2\x80\x99s start-up expenses\nexceed $50,000.\nTaxpayer may amortize the remainder of his start-up expenditures over 180 months\n(15 years). \xc2\xa7 195(b)(1)(B). Similar rules apply to the start-up expenditures of a\npartnership (\xc2\xa7 709) and a corporation (\xc2\xa7 248).\nThere are quite likely to be expenditures other than these \xe2\x80\x9cstart-up expenditures\xe2\x80\x9d\nassociated with the establishment of a trade or business. They are not deductible or\namortizable \xe2\x80\x93 ever. Why do you think that Congress should be so stingy in\npermitting taxpayers to deduct expenditures incurred to start a trade or business?\n\nDo the CALI Lesson, Basic Federal Income Taxation: Deductions: Basic\nDepreciation, ACRS, and MACRS Concepts.\nSection 280F: Mixing Business and Personal\nA taxpayer may make expenditures to purchase items that are helpful in earning\nincome and useful in taxpayer\xe2\x80\x99s personal life as well. An automobile may fit this\ndescription. These points may lead some taxpayers to purchase items that they\nmight not otherwise purchase, or to purchase items that are more expensive than\nthey might otherwise purchase. Congress has addressed these points in \xc2\xa7 280F.\nSection 280F limits deductions associated with the purchase and use of so-called\n\xe2\x80\x9clisted property.\xe2\x80\x9d\nSection 280F(d)(4)(A) defines \xe2\x80\x9clisted property\xe2\x80\x9d to be a passenger automobile, any\nproperty used as a means of transportation, any property generally used for\nentertainment, recreation, or amusement, and any other property that the Secretary\n422\n\n\x0cspecifies.183 Section 280F(d)(3)(A) denies \xe2\x80\x9cemployee\xe2\x80\x9d deductions for use of listed\nproperty unless \xe2\x80\x9csuch use is for the convenience of the employer and required as a\ncondition of employment.\xe2\x80\x9d\nSection 280F provides the following types of limitations on cost recovery and \xc2\xa7 179\nexpensing deductions: an absolute dollar limit on such deductions for listed\nproperty, a percentage limitation on such deductions for listed property, and a\ncombination of a percentage limitation on an absolute dollar limit on such\ndeductions.\n\xe2\x80\xa2Absolute dollar limit on depreciation deductions for listed property:\nSections 280F(a)(1)(A and B) place an absolute limit on the amount of\ndepreciation allowable for any passenger automobile. The amounts are\nindexed for inflation. \xc2\xa7 280F(d)(7). Nevertheless, the allowable amounts\nmight channel a taxpayer\xe2\x80\x99s choice of automobile.184\n\xe2\x80\xa2Read \xc2\xa7\xc2\xa7 280F(a)(1)(A and B). Consider this to be 2018. Taxpayer\nwas a real estate agent and purchased a Mercedes-Benz for $100,000\nto squire clients around from property to property. An automobile is\n5-year property. \xc2\xa7 168(e)(3)(B)(i). Assume that taxpayer uses the\nautomobile only for trade or business purposes. For the first four\nyears (i.e., 2018 to 2021), Taxpayer\xe2\x80\x99s total cost recovery as limited\nby \xc2\xa7 280F(a)(1)(A) is $41,360. Assume that Taxpayer will not be\nable to use \xc2\xa7 179. See \xc2\xa7 280F(d)(1). When would taxpayer have\nrecovered all the cost of the automobile? See \xc2\xa7 280F(a)(1)(B)(ii).\n\xe2\x80\xa2Percentage limitation on depreciation deductions for listed property: If a\ntaxpayer uses property partly for business and partly for personal purposes,\nhe must determine the percentage of total use that is trade or business use.\nSee \xc2\xa7\xc2\xa7 280F(d)(6)(A and B). Only the trade or business use portion of\ndepreciation is deductible if the percentage of total use is more than 50%\nfor trade or business. See \xc2\xa7 280F(b)(3). If the percentage of total use is not\nmore than 50% trade or business, \xc2\xa7 280F(b)(1) provides that the alternative\ndepreciation system of \xc2\xa7 168(g) applies. Sections 168(g) of course\nprescribes less favorable straight-line cost recovery over a longer recovery\nperiod. If taxpayer used an item predominantly for trade or business, elected\nto use an accelerated method of cost recovery, and subsequently made a use\nThe Tax Cuts and Jobs Act deleted \xe2\x80\x9ccomputer and peripheral equipment\xe2\x80\x9d from the list of \xe2\x80\x9clisted\nproperty.\xe2\x80\x9d\n183\n\n184\n\nThe sum of the amounts in \xc2\xa7 280F(a)(1)(A) for 2018 is $41,360.\n\n423\n\n\x0cof it that is not predominantly for trade or business, then taxpayer must\nrecapture the cost recovery that exceeded what would have been allowed\nunder \xc2\xa7 168(g) in prior years. \xc2\xa7 280F(b)(2).\n\xe2\x80\xa2Consider: Taxpayer purchased a Hummer \xe2\x80\x93 which is not a\npassenger automobile. See \xc2\xa7 280F(d)(5)(A). However, it is property\nused for transportation. Assume that a Hummer is 7-year property\nunder \xc2\xa7 168(e)(3)(B) with a class life of 10 years. Taxpayer paid\n$100,000 for the Hummer. Taxpayer used the Hummer 75% for\ntrade or business in both 2019 and 2020. In 2021, Taxpayer used the\nHummer 25% for trade or business. In 2022, and all subsequent\nyears, Taxpayer used the Hummer 75% for trade or business. What\nis Taxpayer\xe2\x80\x99s cost recovery allowance for 2019? \xe2\x80\x93 2020? 2021?\n2022? \xe2\x80\x93 2023? \xe2\x80\x93 2024? \xe2\x80\x93 2025? \xe2\x80\x93 2026? \xe2\x80\x93 2027? \xe2\x80\x93 2028? \xe2\x80\x93 2029?\n\xe2\x80\xa2Perhaps we have discovered another reason to elect cost\nrecovery under the alternative depreciation system of\n\xc2\xa7 168(g).\nIn computing the depreciation deduction for any given year, we assume that\nall of taxpayer\xe2\x80\x99s use of listed property over the recovery period was for trade\nor business purposes. \xc2\xa7 280F(d)(2). Thus, a pro rata reduction of allowable\ncost recovery for less than predominantly business use does not extend the\ncost recovery period.\n\xe2\x80\xa2Combination of a percentage limitation on an absolute dollar limit on cost\nrecovery deductions: In the case of passenger automobiles, the absolute\ndollar limit on cost recovery deductions is applied first. Then limitations\nbased on less-than-predominant trade or business use are applied.\n\xc2\xa7 280F(a)(2).\n\nWrap-Up Questions for Chapter 6\n1. What is the relationship between depreciation and basis? Why does the\nrelationship have to be what it is? Feel free to state your answer in Haig-Simons\nterms.\n2. This chapter has offered three different tax treatments of expenses. What are\nthey? What rationales support each?\n424\n\n\x0c3. We tax net income? What economic distortions would occur if we taxed gross\nreceipts?\n4. What economic distortions occur if we accelerate depreciation allowances? \xe2\x80\x93 if\nwe give deductions to certain activities when they are profitable, for example\n\xc2\xa7 199A?\n5. Do depletion allowances encourage (too much) exploitation of natural\nresources?\n\nWhat have you learned?\nCan you explain or define \xe2\x80\x93\n\xe2\x80\xa2What makes a trade or business expenditure \xe2\x80\x9cnecessary?\xe2\x80\x9d What makes a trade or\nbusiness expenditure (extra) \xe2\x80\x9cordinary?\xe2\x80\x9d\n\xe2\x80\xa2How acquisition costs of an asset should be treated under \xc2\xa7\xc2\xa7 162, 212, and 263?\n\xe2\x80\xa2What is the \xe2\x80\x9corigin of the claim\xe2\x80\x9d rule for determining the deductibility of litigation\nexpenses?\n\xe2\x80\xa2What is the importance of the ordering rule of \xc2\xa7\xc2\xa7 161/261?\n\xe2\x80\xa2What is the difference between deductibility under \xc2\xa7 162 or \xc2\xa7 212 and\ncapitalization under \xc2\xa7 263?\n\xe2\x80\xa2What is the Tax Code\xe2\x80\x99s treatment of business bad debts? What is the Tax Code\xe2\x80\x99s\ntreatment of non-business bad debts?\n\xe2\x80\xa2What is the Tax Code\xe2\x80\x99s treatment of expenditures for repairs? What is the Tax\nCode\xe2\x80\x99s treatment of expenditures for improvements?\n\xe2\x80\xa2What does it mean to be \xe2\x80\x9caway from home\xe2\x80\x9d for purposes of \xc2\xa7 162(a)(2)?\n\xe2\x80\xa2How should a taxpayer determine what is a reasonable salary that he may deduct\nunder \xc2\xa7 162(a)(1)?\n\xe2\x80\xa2Why might a taxpayer prefer to deduct expenses as ordinary and necessary to\ncarrying on a trade or business rather as ordinary and necessary for incomeproducing activities? Distinguish a trade or business from an income-producing\nactivity.\n\xe2\x80\xa2Why are child care expenses not deductible as an ordinary and necessary trade or\nbusiness expense?\n\xe2\x80\xa2What is the source of public policy limitations on deductions under \xc2\xa7 162?\n\xe2\x80\xa2What is the \xe2\x80\x9crole\xe2\x80\x9d of \xc2\xa7\xc2\xa7 261 to 280H of the Code?\n\xe2\x80\xa2What is \xe2\x80\x9ccost recovery?\xe2\x80\x9d\n\xe2\x80\xa2How does rapid cost recovery generate economic growth?\n\xe2\x80\xa2What is \xe2\x80\x9clisted property?\xe2\x80\x9d\n425\n\n\x0cChapter 7: Personal Deductions and the Standard Deduction\nTo say that an expenditure is personal\nis to say that taxpayer may not shift the\ntax burden on the income necessary to\n(gross income)\nmake the expenditure to other\n\xe2\x9e\x94MINUS deductions named in \xc2\xa7 62\ntaxpayers. The choice of where to live\nEQUALS (adjusted gross income (AGI))\nis a personal matter, so taxpayer must\n\xe2\x9e\x94MINUS (standard deduction or itemized\npay income tax on the income\ndeductions)\nnecessary to pay the commuting\nMINUS (deduction for \xe2\x80\x9cqualified business\nexpenses associated with that choice.\nincome\xe2\x80\x9d)\nFlowers. The choice to be married is a\npersonal matter, so taxpayer must pay\nEQUALS (taxable income)\nincome tax on the income necessary to\npay the travel expenses that marriage\nCompute income tax liability from tables\nnecessitates. Hantzis. The choice to\nin \xc2\xa7 1(j) (indexed for inflation)\nhave children is a personal matter, so\nMINUS (credits against tax)\ntaxpayer must pay income tax on the\nincome necessary to pay the expenses\nthat having children necessitates. Smith. In theory the Code might allow deductions\nfor no personal expenditures.\nThe Tax Formula:\n\nHowever, the Code has always permitted deductions from some personal\nexpenditures. The Code allows a taxpayer to reduce her taxable income by a\nstandard deduction, i.e., deduction of a fixed amount that differs among individuals\nonly according to their filing status, and whether they have reached a certain age or\nare blind. \xc2\xa7 63(b)(1), (c), (f).185 If a taxpayer spends more on selected personal items\nthan the standard deduction, taxpayer may elect to itemize them rather than claim\nthe standard deduction. \xc2\xa7 63(e)(1).\nA slightly different consideration is that taxpayers have no choice but to spend some\nof their income for themselves and their families to survive. The Code has allowed\na deduction of a fixed amount for each dependent that the taxpayer supports (i.e.,\nexemptions). \xc2\xa7\xc2\xa7 151, 152. For tax years 2018 through 2025, the Code allows no\n\nCorporations do not benefit from a standard deduction. They incur no \xe2\x80\x9cpersonal\xe2\x80\x9d expenses from\nwhich a deduction from taxable income should be allowed.\n185\n\n426\n\n\x0cdeduction for personal exemptions. \xc2\xa7 151(d)(5). For those years, Congress doubled\nthe standard deduction and doubled (and later trebled) the child tax credit.\nThe Code provides other tools to reduce the tax burden on income necessary to\nmake certain expenditures. Some of these favored expenditures are personal in\nnature. The Code implements policies favoring certain expenditures through \xe2\x80\x93\n\xe2\x80\xa2Exclusions from gross income: We considered the subject of exclusions\nfrom gross income in chapter 3, supra. We observed that Congress has\npursued certain policies concerning certain \xe2\x80\x9caccessions to wealth\xe2\x80\x9d by\nallowing taxpayers simply not to count them in determining the amount of\nincome tax they must pay.\n\xe2\x80\xa2To the taxpayer, an exclusion from gross income saves in income\ntaxes \xe2\x80\x93 and so is worth \xe2\x80\x93 the taxpayer\xe2\x80\x99s marginal tax rate multiplied\nby the amount excluded from gross income.\n\xe2\x80\xa2Deductions that reduce adjusted gross income: In \xc2\xa7\xc2\xa7 161 to 199A\nCongress has defined deductions available both to individual taxpayers and\nto corporate taxpayers. In \xc2\xa7\xc2\xa7 211 to 224 Congress has defined deductions\navailable only to individual taxpayers. In \xc2\xa7\xc2\xa7 241 to 250, Congress has\ndefined deductions available only to corporate taxpayers. In \xc2\xa7 62, Congress\nnamed certain of these deductions that reduce an individual taxpayer\xe2\x80\x99s\n\xe2\x80\x9cadjusted gross income.\xe2\x80\x9d For the individual taxpayer, a deduction named\nin \xc2\xa7 62 has the practical effect of reducing taxpayer\xe2\x80\x99s taxable income.\nSection 62\xe2\x80\x99s deductions are in addition to the standard deduction or\nitemized deductions. Moreover, the amount of some itemized deductions is\ndetermined by taxpayer\xe2\x80\x99s adjusted gross income.\n\xe2\x80\xa2To the taxpayer, a deduction named in \xc2\xa7 62 saves in income taxes\n\xe2\x80\x93 and so is worth \xe2\x80\x93 the taxpayer\xe2\x80\x99s marginal tax rate multiplied by\nthe amount of the deduction.\n\xe2\x80\xa2Standard deduction OR itemized deductions that reduce taxable income:\nIn computing her taxable income, a taxpayer may deduct a standard\ndeduction. Alternatively, a taxpayer may elect to itemize her deductions that\n\xc2\xa7 62 does not name and reduce her taxable income by the total of those\ndeductions. \xc2\xa7 63. Naturally a taxpayer will elect to deduct the amount that\nis greater.\n\xe2\x80\xa2To the taxpayer, a below-the-line deduction saves in income taxes\n\xe2\x80\x93 and so is worth \xe2\x80\x93 the taxpayer\xe2\x80\x99s marginal tax rate multiplied by\nthe amount of the standard deduction or an itemized deduction.\n\xe2\x80\xa2Credits against tax liability: After computing her income tax liability,\ntaxpayer may be entitled to one or more credits against that tax liability. The\n427\n\n\x0camount of a credit reduces dollar-for-dollar taxpayer\xe2\x80\x99s income tax liability.\nThe amount of a credit is usually limited to a percentage of what taxpayer\nspent on the creditable item.\n\xe2\x80\xa2To the taxpayer, a credit saves in income taxes \xe2\x80\x93 and so is worth \xe2\x80\x93\nthe amount of the credit. Notice: A tax credit is worth precisely the\nsame amount as a \xc2\xa7 62 deduction while placing the taxpayer in a tax\nbracket equal to the percentage of the expenditure allowed as a\ncredit.\n\xe2\x80\xa2Example, a 20% credit on dependent care expenses has the\nsame worth to a taxpayer in an imaginary 20% tax bracket\nas a \xc2\xa7 62 deduction of such an expense.\n\xe2\x80\xa2Since the amount of the credit is usually limited to a\npercentage of the named expense, taxpayers whose tax rate\nis higher than that percentage would reduce their income tax\nliability more with an above-the-line deduction. Taxpayers\nwhose tax rate is lower than that percentage reduce their\nincome tax liability more with a credit than with an abovethe-line deduction.\n\xe2\x80\xa2This suggests that Congress can use tax credits as a tool to\nassist lower income taxpayers more than higher income\ntaxpayer without denying a tax benefit altogether to higher\nincome taxpayers. Simply set the percentage of the\ncreditable expense at a point between those tax brackets\nCongress wants to benefit more and those whom Congress\nwants to benefit less.186\n\nTo illustrate: Suppose that taxpayer spends $1000 on a benefit. The expense might be deductible,\nor it might be creditable. In the table, compare the net cost to taxpayers in different tax brackets of the\nbenefit when its cost is deductible or 20% of its cost is creditable. If the Code provides for a deduction,\nwhich taxpayers pay more for the benefit and which taxpayers pay less?\n186\n\n428\n\n\x0c\xe2\x80\xa2Moreover, some credits are \xe2\x80\x9crefundable\xe2\x80\x9d and some are\n\xe2\x80\x9cnonrefundable.\xe2\x80\x9d See table of contents to Code, chapter 1,\nsubchapter A. subparts A and C. A nonrefundable credit can\nreduce a taxpayer\xe2\x80\x99s income tax liability only to $0. A\nrefundable credit can reduce a taxpayer\xe2\x80\x99s income tax liability\nto less than $0. Thus, a refundable credit functions as a\ngovernment benefit program. An example of refundable\ncredit is the earned income credit, \xc2\xa7 32.\n\xe2\x80\xa2Note on the Tax Cuts and Jobs Act: Tax laws may lead taxpayers to structure their\nlives and affairs in certain ways, especially when they expect the law not to change\nsignificantly. A change in existing tax law may require taxpayers to adjust their\nexpectations \xe2\x80\x93 and their expenditure choices. The Tax Cuts and Jobs Act doubled\nthe standard deduction for all taxpayers and suspended several itemized deductions\nuntil 2026.187 Many fewer taxpayers will elect to itemize deductions. Henceforth,\nthe taxable income of taxpayers who previously itemized but no longer can will\nincrease relative to taxpayers with like amounts of adjusted gross income who did\nnot itemize. The tradeoff for this rearrangement of tax burdens is that tax brackets\nTaxpayer\xe2\x80\x99s\nBracket\n\nTax\n\nNet Cost of Benefit with a\nDeduction\n\nNet Cost of Benefit with 20%\nTax Credit\n\n10%\n\n$900\n\n$800\n\n12%\n\n$880\n\n$800\n\n22%\n\n$780\n\n$800\n\n24%\n\n$760\n\n$800\n\n32%\n\n$680\n\n$800\n\n35%\n\n$650\n\n$800\n\n37%\n\n$630\n\n$800\n\nSee \xc2\xa7 163(h)(3)(F)(i) (disallowing deduction for home equity indebtedness; capping interest on new\nacquisition debt to indebtedness of $750,000 ($375,000 for married, filing separate return)); \xc2\xa7 165(h)(5)\n(limiting personal casualty loss deduction to losses incurred in Federally declared disaster); \xc2\xa7 217\n(disallowing deductions of moving expenses, see also \xc2\xa7 132(g)(2)); \xc2\xa7 67(g) (disallowing \xe2\x80\x9cmiscellaneous\ndeductions\xe2\x80\x9d otherwise subject to a 2%-of-AGI floor, which include employee trade or business\nexpenses and the expenses paid or incurred for production of income or to hold property for the\nproduction of income (\xc2\xa7 212)).\n187\n\n429\n\n\x0cwere lowered slightly for all taxpayers; at the high end, there is much less\nprogressivity than previously.188\nTaxpayers who structure their affairs with an eye on the Tax Code will be driven to\nseek accessions to wealth that are excludable \xe2\x80\x93 perhaps an employee benefit \xe2\x80\x93 that\nare listed in \xc2\xa7 62 and so deductible without the need to itemize, or that are creditable\nagainst income tax. Congress will also learn that when it wants to lessen a burden\nof taxpayers who make a named expenditure, it matters more than previously that\nthe tool it uses is not an itemized deduction.\nWith this as background, consider why there should be an allowable deduction of,\nexclusion of, or credit for any personal expenses. We might preliminarily observe\nthat there are four basic purposes:\n1. We want to encourage taxpayers to incur a certain personal expense. We\nchoose to make a \xe2\x80\x9ctax expenditure.\xe2\x80\x9d In this group, we should place charitable\ncontributions, home mortgage interest, and adoption expenses.\n2. We want to provide some relief to those taxpayers whose personal\nexpenditures result \xe2\x80\x93 at best \xe2\x80\x93 from the exercise of choice among unappealing\nalternatives. When discretion among consumption choices is absent, we have\nseen that a court is less likely to find that a taxpayer\xe2\x80\x99s accession to wealth is in\nfact gross income. Cf. Gotcher; Benaglia, supra. Conversely, when taxpayers\nmay spend an accession to wealth any way they choose \xe2\x80\x93 as when they receive\ncash \xe2\x80\x93 they have realized gross income. See Kowalski, supra. However,\ntaxpayers must on occasion make some expenditures that we feel do not result\nfrom meaningful choices. The Code names some occasions when the absence\nof such discretion entitles a taxpayer to deduct (or exclude) an expenditure from\nher gross income. Examples include casualty losses and medical expenses.\n3. We want to enlarge the tax base. Some taxpayer expenses are not necessarily\ntrade or business expenses, but they enhance a taxpayer\xe2\x80\x99s ability to generate\ntaxable income. If they do that, they would also enlarge the tax base. We should\nencourage taxpayers to make such expenditures. In this group, we place the\nCode\xe2\x80\x99s provisions for child care and education.\n\nFor all but the highest income earners, the tax cuts were not \xe2\x80\x9cepic\xe2\x80\x9d or the \xe2\x80\x9cbiggest in history\xe2\x80\x9d as\nthe President claimed.\n188\n\n430\n\n\x0c4. We want taxpayers to save to meet a future expense that they know they will\nhave to pay. The Code encourages such saving by various means, e.g., deferring\nthe income tax on the income taxpayer sets aside to spend later on selected items\nof consumption, not taxing the growth of a fund established to meet future\nconsumption of selected items, shifting (and presumably lightening) the tax\nburden from the growth of a fund that taxpayer established to another taxpayer.\nIn this group, we should place the Code\xe2\x80\x99s provisions for setting money aside\nfor retirement, medical expenses, or educational expenses.\nWe examine some189 of the Code\xe2\x80\x99s provisions providing favorable treatment for\nsome personal expenses.\n\nI. \xe2\x80\x9cTax Expenditures\xe2\x80\x9d\nCongress may use the tax code to encourage190 (at least not to discourage) taxpayers\nto make certain expenditures. In \xc2\xa7 170, Congress allows taxpayers a deduction for\ncharitable contributions. This, coupled with the exemption from income tax that\nmany charities enjoy,191 may provide sufficient incentive for some taxpayers to\nsupport the good work certain charities do.\nIn \xc2\xa7 164, Congress has allowed a deduction for certain taxes that taxpayer has paid\nor accrued. Section 275 specifically disallows a deduction for certain taxes that\ntaxpayer may have paid or accrued. These rules may encourage some taxpayers to\nengage in activities subject to a deductible tax, most notably, owning property.\n\xe2\x80\xa2As noted, in the Tax Cuts and Jobs Act Congress doubled the standard\ndeduction. At the same time, it suspended the deduction for foreign real\nproperty taxes and capped a taxpayer\xe2\x80\x99s total deductions for state and local\ntaxes paid (i.e., \xe2\x80\x9cSALT\xe2\x80\x9d) until 2026 at $10,000. \xc2\xa7 164(b)(6).\nAmong the provisions that we do not cover are \xc2\xa7 163(h)\xe2\x80\x99s allowance of a deduction for home\nmortgage interest and \xc2\xa7\xc2\xa7 221/62(a)(17)\xe2\x80\x99s deduction of $2500 of interest paid on education loans (a \xc2\xa7 62\ndeduction) which is subject to an income phaseout. A deduction of interest paid on home equity\nindebtedness has been suspended until 2026. \xc2\xa7 163(h)(3)(F)(i)(I). The deduction of interest paid on\nacquisition indebtedness has been temporarily limited to the interest paid on $750,000 of indebtedness\nrather than $1,000,000 of indebtedness. \xc2\xa7 163(h)(3)(F)(i)(II).\n189\n\nSee National Federation of Business v. Sebelius, 567 U.S. 519, 567 (2012) (Congress may shape\nindividual decisions through exercise of taxing power).\n190\n\n191\n\nSee \xc2\xa7 501(a).\n\n431\n\n\x0c\xe2\x80\xa2Congress also increased the allowable deduction for cash contributions to\ncharity from 50% of a taxpayer\xe2\x80\x99s contribution base to 60%. \xc2\xa7 170(b)(G).\n\xe2\x80\xa2Can you identify policies that Congress has opted to pursue in these\nchanges?\nThe definitions (read: conditions) of the items for which an expenditure is\ndeductible structure the policy that Congress pursues. Of course, it is the IRS that\nenforces that policy, at least in the first instance.\nWith respect to both charitable contributions and payment of taxes, a taxpayer may\ntry to characterize payments that provide a benefit for the taxpayer as either a\ncharitable contribution or as payment of a tax. For example, a taxpayer might\ncontribute money to a university on the condition that the university grant a\nscholarship to taxpayer\xe2\x80\x99s daughter. Or a taxpayer may pay her share of a\ncondominium-owners\xe2\x80\x99 association\xe2\x80\x99s assessment to remodel the association\xe2\x80\x99s\ncommon areas. In neither case should taxpayer be permitted to claim a deduction.\nInstead the taxpayer has simply \xe2\x80\x9cpurchased something.\xe2\x80\x9d These are easy cases. How\ndo we determine whether taxpayer has merely bought something \xe2\x80\x93 or has made a\ncharitable contribution or paid a tax?\nA. Charitable Contributions\nSection 170(a)(1) permits taxpayers to deduct charitable contributions that they\nmake within a taxable year. Section 170(c) defines a \xe2\x80\x9ccharitable contribution\xe2\x80\x9d to be\na gift \xe2\x80\x9cto or for the use of\xe2\x80\x9d certain types of organizations.\nSuch organizations include any political subdivision of a state, so long as the\n\xe2\x80\x9ccontribution is made for exclusively public purposes.\xe2\x80\x9d \xc2\xa7 170(c)(1). Consider:\nTaxpayers entered into an agreement to purchase certain property contingent on the\nCity Council rezoning it to permit use for a trailer court and shopping center. To\nassure access to the portion intended for a mobile home development, the rezoning\nproposal provided for dedication of a strip of the property for a public road. The\nroad would also provide access or frontage for a public school, a church, and a\nhome for the aged. Taxpayers completed their purchase and made the contemplated\ntransfer to the city. The City Council formally adopted the rezoning ordinance.\n\xe2\x80\xa2Should taxpayers be permitted a charitable deduction for the value of the\nland it donated to the city to be used for a road?\n\xe2\x80\xa2Should the fact that the City of Tucson benefitted from taxpayer\xe2\x80\x99s\n432\n\n\x0cdonation of the land be sufficient to permit taxpayer a deduction,\nirrespective of her motive in making the donation?\n\xe2\x80\xa2Would it matter if the dedication of the land to the City did not in\nfact increase the value of Taxpayers\xe2\x80\x99 property?\n\xe2\x80\xa2See Stubbs v. United States, 428 F.2d 885 (9th Cir. 1970), cert. denied, 400\nU.S. 1009 (1971).\nIf a charitable contribution deduction turns on a weighing of benefits against the\ntaxpayer\xe2\x80\x99s cost, whose benefit should be relevant \xe2\x80\x93 benefit to the public or benefit\nto the taxpayer?\nRolfs v. Commissioner, 668 F.3d 888 (7th Cir. 2012)\nHAMILTON, Circuit Judge.\nTaxpayers Theodore R. Rolfs and his wife Julia Gallagher (collectively, the Rolfs)\npurchased a three-acre lakefront property in the Village of Chenequa, Wisconsin.\nNot satisfied with the house that stood on the property, they decided to demolish it\nand build another. To accomplish the demolition, the Rolfs donated the house to\nthe local fire department to be burned down in a firefighter training exercise. The\nRolfs claimed a $76,000 charitable deduction on their 1998 tax return for the value\nof their donated and destroyed house. The IRS disallowed the deduction, and that\ndecision was upheld by the United States Tax Court. The Rolfs appeal. To support\nthe deduction, the Rolfs needed to show a value for their donation that exceeded\nthe substantial benefit they received in return. The Tax Court found that they had\nnot done so. We agree and therefore affirm.\nCharitable deductions for burning down a house in a training exercise are unusual\nbut not unprecedented. By valuing their gifts as if the houses were given away intact\nand without conditions, taxpayers like the Rolfs have claimed substantial\ndeductions from their taxable income. But this is not a complete or correct way to\nvalue such a gift. When a gift is made with conditions, the conditions must be taken\ninto account in determining the fair market value of the donated property. As we\nexplain below, proper consideration of the economic effect of the condition that the\nhouse be destroyed reduces the fair market value of the gift so much that no net\nvalue is ever likely to be available for a deduction, and certainly not here.\nWhat is the fair market value of a house, severed from the land, and donated on the\n433\n\n\x0ccondition that it soon be burned down? There is no evidence of a functional market\nof willing sellers and buyers of houses to burn. Any valuation must rely on analogy.\nThe Rolfs relied primarily on an appraiser\xe2\x80\x99s before-and-after approach, valuing\ntheir entire property both before and after destruction of the house. The difference\nshowed the value of the house as a house available for unlimited use. The IRS, on\nthe other hand, presented experts who attempted to value the house in light of the\ncondition that it be burned. The closest analogies were the house\xe2\x80\x99s value for salvage\nor removal from the site intact.\nThe Tax Court first found that the Rolfs received a substantial benefit from their\ndonation: demolition services valued by experts and the court at approximately\n$10,000. The court then found that the Rolfs\xe2\x80\x99 before-and-after valuation method\nfailed to account for the condition placed on the gift requiring that the house be\ndestroyed. The court also found that any valuation that did account for the\ndestruction requirement would certainly be less than the value of the returned\nbenefit. We find no error in the court\xe2\x80\x99s factual or legal analysis. The IRS analogies\nprovide reasonable methods for approximating the fair market value of the gift here.\nThe before-and-after method does not.\nI. Legal Background Concerning Charitable Donations Under Section 170(a)\nThe legal principles governing our decision are well established, and the parties\nfocus their dispute on competing valuation methodologies. We briefly review the\nrelevant law, addressing some factual prerequisites along the way.\nThe requirements for a charitable deduction are governed by statute. Taxpayers\nmay deduct from their return the verifiable amount of charitable contributions made\nto qualified organizations. 26 U.S.C. \xc2\xa7 170(a)(1). Everyone agrees that the Village\nof Chenequa and its volunteer fire department are valid recipients of charitable\ncontributions as defined under section 170(c). To qualify for deduction,\ncontributions must also be unrequited \xe2\x80\x93 that is, made with \xe2\x80\x9cno expectation of a\nfinancial return commensurate with the amount of the gift.\xe2\x80\x9d Hernandez v. Comm\xe2\x80\x99r\nof Internal Revenue, 490 U.S. 680, 690 (1989). The IRS and the courts look to the\nobjective features of the transaction, not the subjective motives of the donor, to\ndetermine whether a gift was intended or whether a commensurate return could be\nexpected as part of a quid pro quo exchange. Id. at 690\xe2\x80\x9391.\nThe Treasury regulations implement the details of \xc2\xa7 170, instructing taxpayers how\nto prove a deduction to the IRS and how to value donated property using its fair\n434\n\n\x0cmarket value. Under \xc2\xa7 1.170A\xe2\x80\x931(c) of the regulations, fair market value is to be\ndetermined as of the time of the contribution and under the hypothetical willing\nbuyer/willing seller rule, wherein both parties to the imagined transaction are\nassumed to be aware of relevant facts and free from external compulsion to buy or\nsell. 26 C.F.R. \xc2\xa7 1.170A-1(c). As with the question of the purpose of the claimed\ngift, fair market value requires an objective, economic inquiry and is a question of\nfact.\nWe can assume, as the record suggests, that the Rolfs were subjectively motivated\nat least in part by the hope of deducting the value of the demolished house on their\ntax return. Applying the objective test, however, we treat their donation the same\nas we would if it were motivated entirely by the desire to further the training of\nlocal firefighters. Objectively, the purpose of the transaction was to make a\ncharitable contribution to the fire department for a specific use. ... The Tax Court\nfound ... that when the transaction was properly evaluated, the Rolfs (a) received a\nsubstantial benefit in exchange for the donated property and (b) did not show that\nthe value of the donated property exceeded the value of the benefit they received.\nWe also agree with these findings. There was no net deductible value in this\ndonation in light of the return benefit to the Rolfs.\nA charitable contribution is a \xe2\x80\x9ctransfer of money or property without adequate\nconsideration.\xe2\x80\x9d United States v. American Bar Endowment, 477 U.S. 105, 118\n(1986). A charitable deduction is not automatically disallowed if the donor received\nany consideration in return. Instead, as the Supreme Court observed in American\nBar Endowment, some donations may have a dual purpose, as when a donor\noverpays for admission to a fund-raising dinner, but does in fact expect to enjoy the\nproverbial rubber-chicken dinner and accompanying entertainment. Where \xe2\x80\x9cthe\nsize of the payment is clearly out of proportion to the benefit received,\xe2\x80\x9d taxpayers\ncan deduct the excess, provided that they objectively intended it as a gift. Id. at\n116\xe2\x80\x9318 (...). In practice then, the fair market value of any substantial returned\nbenefit must be subtracted from the fair market value of the donation.\nThis approach differs from that of the Tax Court in Scharf v. Comm\xe2\x80\x99r of Internal\nRevenue, T.C.M. 1973-265, an earlier case that allowed a charitable deduction for\nproperty donated to a fire department to be burned. In Scharf, a building had been\npartially burned and was about to be condemned. The owner donated the building\nto the fire department so it could burn it down the rest of the way. The Tax Court\ncompared the value of the benefit obtained by the donor (land cleared of a ruined\nbuilding) to the value of the public benefit in the form of training for the firefighters,\n435\n\n\x0cand found that the public benefit substantially exceeded the private return benefit.\nThus, the donation was deemed allowable as a legitimate charitable deduction, and\nthe court proceeded to value the donation using the established insurance loss figure\nfor the building. The Scharf court did not actually calculate a dollar value for the\npublic benefit, and if it had tried, it probably would have found the task exceedingly\ndifficult. Although Scharf supports the taxpayers\xe2\x80\x99 claimed deduction here, its focus\non public benefit measured against the benefit realized by the donor is not\nconsistent with the Supreme Court\xe2\x80\x99s later reasoning in American Bar Endowment.\nThe Supreme Court did not rely on amorphous concepts of public benefit at all, but\nfocused instead on the fair market value of the donated property relative to the fair\nmarket value of the benefit returned to the donor. 477 U.S. at 116\xe2\x80\x9318. The Tax\nCourt ruled correctly in this case that the Scharf test \xe2\x80\x9chas no vitality\xe2\x80\x9d after American\nBar Endowment. 135 T.C. at 487.\nWith this background, the decisive legal principle for the Tax Court and for us is\nthe common-sense requirement that the fair market valuation of donated property\nmust take into account conditions on the donation that affect the market value of\nthe donated property. This has long been the law. See Cooley v. Comm\xe2\x80\x99r of Internal\nRevenue, 33 T.C. 223, 225 (1959) (\xe2\x80\x9cproperty otherwise intrinsically more valuable\nwhich is encumbered by some restriction or condition limiting its marketability\nmust be valued in light of such limitation\xe2\x80\x9d). ...\nII. Valuation Methods\nAs this case demonstrates, however, knowing that one must account for a condition\nin a valuation opens up a second tier of questions about exactly how to do so. \xe2\x80\xa6\nIn this case there is no evidence of an actual market for, and thus no real or\nhypothetical willing buyers of, doomed houses as firefighter training sites. ...\nSometimes fire departments ... conduct exercises using donated or abandoned\nproperty, but there is also no record evidence of any fire departments paying for\nsuch property. Without comparators from any established markets, the parties\npresented competing experts who advocated different valuation methods. The\ntaxpayers relied on the conventional real estate market, as if they had given the fire\ndepartment fee ownership of the house. The IRS relied on the salvage market and\nthe market for relocated houses, attempting to account for the conditions proposed\nin the gift.\n\xe2\x80\xa6 [The taxpayers\xe2\x80\x99 expert witness compared the value of the land with the house\n436\n\n\x0con it with the value of the land without the house.] He subtracted the latter from\nthe former to estimate $76,000 as the value of the house alone.\n\xe2\x80\xa6 While this approach might superficially seem like a reasonable way to back into\nan answer for the house\xe2\x80\x99s value apart from the underlying land, the before-and-after\nmethod cannot properly account for the conditions placed on the recipient with a\ngift of this type. The Tax Court properly rejected use of the before-and-after method\nfor valuing a donation of property on the condition that the property be destroyed.\n... The IRS asserted that a comparable market could be sales of houses, perhaps\nhistorically or architecturally important structures, where the buyer intends to have\nthe house moved to her own land. Witness Robert George is a professional house\nmover who has experience throughout Wisconsin lifting houses from their\nfoundations and transporting them to new locations. He concluded that it would\ncost at least $100,000 to move the Rolfs\xe2\x80\x99 house off of their property. Even more\nimportant, he opined that no one would have paid the owners more than nominal\nconsideration to have moved this house. In his expert opinion, the land in the\nsurrounding area was too valuable to warrant moving such a modest house to a lot\nin the neighborhood. George also opined that the salvage value of the component\nmaterials of the house was minimal and would be offset by the labor cost of hauling\nthem away. ... Based on this testimony, the IRS argued that since the house would\nhave had negligible value if sold under the condition that it be separated from the\nland and moved away, the house must also have had negligible value if sold under\nthe condition that it be burned down.\nThe Tax Court found that the parties to the donation understood that the house must\nbe promptly burned down, and the court credited testimony by the fire chief that he\nknew the house could be put to no other use by the department. The court rejected\nthe taxpayers\xe2\x80\x99 before-and-after method as an inaccurate measure of the value of the\nhouse \xe2\x80\x9cas donated\xe2\x80\x9d to the department. The taxpayers\xe2\x80\x99 method measured the value\nof a house that remained a house, on the land, and available for residential use. The\nconditions of the donation, however, required that the house be severed from the\nland and destroyed. The Tax Court, accepting the testimony of the IRS experts,\nconcluded that a house severed from the land had no substantial value, either for\nmoving off-site or for salvage. Moving and salvage were analogous situations that\nthe court found to be reasonable approximations of the actual scenario. We agree\nwith these conclusions, which follow the Cooley principle by taking into account\nthe economic effect of the main condition that the taxpayers put on their donation.\nThe Tax Court correctly required, as a matter of law, that the valuation must\n437\n\n\x0cincorporate any reduction in market value resulting from a restriction on the gift.\n\xe2\x80\xa6 We find no clear error in the factual findings and conclude further that it would\nhave been an error of law to ascribe any weight to the taxpayers\xe2\x80\x99 before-and-after\nvaluation evidence.\n....\n... The taxpayers here gave away only the right to come onto their property and\ndemolish their house, a service for which they otherwise would have paid a\nsubstantial sum. ... The demolition condition placed on the donation of the house\nreduced the fair market value of the house to a negligible amount, well enough\napproximated by its negligible salvage value.\n\xe2\x80\xa6.\n\xe2\x80\xa6 The value of the training exercises to the fire department is not in evidence. The\nfire chief testified in the Tax Court that he could not assign a specific value to the\nsignificant public benefit of the training \xe2\x80\x93 but in any event, we know from American\nBar Endowment that trying to measure the benefit to the charity is not the\nappropriate approach. ...\nThe Tax Court also undertook a fair market valuation of the benefit received by the\ntaxpayers. The expert witnesses for the IRS both agreed with Mr. Rolfs\xe2\x80\x99 own\ntestimony (based on his investigation) that the house would cost upwards of\n$10,000 to demolish. ... We see no error in the Tax Court\xe2\x80\x99s factual determination,\nbased on the available evidence and testimony, that the Rolfs received a benefit\nworth at least $10,000.\nWhen property is donated to a charity on the condition that it be destroyed, that\ncondition must be taken into account when valuing the gift. In light of that\ncondition, the value of the gift did not exceed the fair market value of the benefit\nthat the donating taxpayers received in return. Accordingly, the judgment of the\nTax Court is Affirmed. [footnote omitted]\n\n438\n\n\x0cNotes and Questions:\n1. How does the test of American Bar Endowment as the court articulates it differ\nfrom the test that the Tax Court (evidently) applied in Scharf?\n2. Why should taxpayer be able to claim the fmv of the property as the amount to\nbe deducted when that amount is greater than the adjusted basis of the property?\n\xe2\x80\xa2Shouldn\xe2\x80\x99t taxpayer be limited to a deduction equal to the property\xe2\x80\x99s\nadjusted basis? See \xc2\xa7 170(e)(1)(A).\n3. In 1971, the IRS issued Rev. Rul. 71-447 in which it stated the position that a\nprivate school that does not have a racially non-discriminatory policy as to students\nis not \xe2\x80\x9ccharitable\xe2\x80\x9d within the common-law concepts reflected in \xc2\xa7\xc2\xa7 170 and\n501(c)(3). The IRS relied on this position to revoke the tax-exempt status of two\nprivate schools. The United States Supreme Court upheld this determination:\nThere can thus be no question that the interpretation of \xc2\xa7 170 and\n\xc2\xa7 501(c)(3) announced by the IRS in 1970 was correct. That it may be seen\nas belated does not undermine its soundness. It would be wholly\nincompatible with the concepts underlying tax exemption to grant the\nbenefit of tax-exempt status to racially discriminatory educational entities,\nwhich \xe2\x80\x9cexer[t] a pervasive influence on the entire educational process.\xe2\x80\x9d\n[citation omitted] Whatever may be the rationale for such private schools\xe2\x80\x99\npolicies, and however sincere the rationale may be, racial discrimination in\neducation is contrary to public policy. Racially discriminatory educational\ninstitutions cannot be viewed as conferring a public benefit within the\n\xe2\x80\x9ccharitable\xe2\x80\x9d concept \xe2\x80\xa6 or within the Congressional intent underlying \xc2\xa7 170\nand \xc2\xa7 501(c)(3).\nBob Jones University v. United States, 461 U.S. 574, 595-96 (1983). The schools\xe2\x80\x99\ntax-exempt status was lost. Donors could not claim a charitable contribution\ndeduction for contributing money to it.\n\xe2\x80\xa2This is one area where public policy is a part of income tax law.\n4. A gift \xe2\x80\x9cto\xe2\x80\x9d an organization and a gift \xe2\x80\x9cfor the use of\xe2\x80\x9d an organization are not the\nsame thing. The Supreme Court construed the meaning of the phrase \xe2\x80\x9cto or for the\nuse of\xe2\x80\x9d in \xc2\xa7 170(c) in Davis v. United States, 495 U.S. 472 (1990). Taxpayers\xe2\x80\x99 sons\nwere missionaries for the Church of Jesus Christ of Latter-Day Saints. Taxpayers\ndeposited amounts into the individual accounts of their sons. The Church had\n439\n\n\x0crequested the payments and set their amounts. The Church issued written\nguidelines, instructing that the funds be used exclusively for missionary work. In\naccordance with the guidelines, petitioners\xe2\x80\x99 sons used the money primarily to pay\nfor rent, food, transportation, and personal needs while on their missions. Taxpayers\nclaimed that these amounts were deductible under \xc2\xa7 170. The Supreme Court\ndenied the deductibility of such payments and adopted the IRS\xe2\x80\x99s interpretation of\nthe phrase. \xe2\x80\x9c[W]e conclude that a gift or contribution is \xe2\x80\x98for the use of\xe2\x80\x99 a qualified\norganization when it is held in a legally enforceable trust for the qualified\norganization or in a similar legal arrangement.\xe2\x80\x9d Id. at 485. \xe2\x80\x9c[B]ecause petitioners\ndid not donate the funds in trust for the Church, or in a similarly enforceable legal\narrangement for the benefit of the Church, the funds were not donated \xe2\x80\x98for the use\nof\xe2\x80\x99 the Church for purposes of \xc2\xa7 170.\xe2\x80\x9d Id. at 486. And while \xe2\x80\x9cthe Service\xe2\x80\x99s\ninterpretation does not require that the qualified organization take actual possession\nof the contribution, it nevertheless reflects that the beneficiary [(organization)]\nmust have significant legal rights with respect to the disposition of donated funds.\xe2\x80\x9d\nId. at 483.\n5. There are limits to the amount of a charitable contribution that a taxpayer may\ndeduct. Section 170\'s rules are complex.\n\xe2\x80\xa2An individual has a \xe2\x80\x9ccontribution base,\xe2\x80\x9d i.e., adjusted gross income without\nregard to an NOL carryback. \xc2\xa7 170(b)(1)(H).\n\xe2\x80\xa2A taxpayer may deduct in a taxable year only a certain percentage of her\n\xe2\x80\x9ccontribution base,\xe2\x80\x9d the percentage limit dependent on the type of property\nthat taxpayer contributes, the type of charity to which the contribution is\nmade, and whether the contribution is \xe2\x80\x9cto\xe2\x80\x9d or \xe2\x80\x9cfor the use of\xe2\x80\x9d the\norganization.\n6. Type of property: A charitable contribution may take one of several forms. It\nmay of course take the form of cash. It may also take the form of \xe2\x80\x9cordinary income\xe2\x80\x9d\nproperty. And:\n\xe2\x80\xa2A charitable contribution may be of \xe2\x80\x9ccapital gain property,\xe2\x80\x9d i.e., a \xe2\x80\x9ccapital\nasset the sale of which at its fair market value at the time of the contribution\nwould have resulted in gain which would have been long-term capital gain\xe2\x80\x9d\n(LTCG) because taxpayer held it for more than one year or \xc2\xa7 1231 property.\n\xc2\xa7 170(b)(1)(C)(iv).\n\xe2\x80\xa2The fmv of the property is the amount of the allowable deduction.\nReg. \xc2\xa7 1.170A-1(c)(1). This means that the LTCG on such property\n\n440\n\n\x0cis never taxed \xe2\x80\x93 thus creating a true loophole.192\n\xe2\x80\xa2If the donee\xe2\x80\x99s use of the property is unrelated to the charity\xe2\x80\x99s\npurpose, the charity disposes of the property before the last day of\nthe taxable year without a certification that it made a substantial use\nrelated to its charitable purpose, the charity is a certain type of\nprivate foundation, the property was intellectual property, or the\nproperty is self-created taxidermy property \xe2\x80\x93 then the deduction is\nlimited to the taxpayer\xe2\x80\x99s basis in the property or its fmv, whichever\nis lower. \xc2\xa7 170(e)(1)(B).\n\xe2\x80\xa2A charitable contribution may be of property, the gain on whose sale would\nnot be long-term capital gain.\n\xe2\x80\xa2The taxpayer\xe2\x80\x99s deduction is limited to her adjusted basis in the\nproperty or its fmv, whichever is less. \xc2\xa7 170(e)(1)(A).\n\xe2\x80\xa2If a charitable contribution of property is partly a sale, then the taxpayer\xe2\x80\x99s\nbasis in the property is allocated pro rata according to the amount realized\non the sale portion of the transaction and the fmv of the property.\n\xc2\xa7 170(e)(2); Reg. \xc2\xa7 1.1011-2(b). Taxpayer recognizes gain on the sale\nportion of such a transaction.\n7. Type of charity: Section 170(c) describes five numbered types of charities, and\ntaxpayer may deduct contributions to them. However, \xc2\xa7 170(b) classifies these\ncharities further.\n\xe2\x80\xa2The Code creates so-called \xe2\x80\x9cA\xe2\x80\x9d charities, \xc2\xa7 170(b)(1)(A), and \xe2\x80\x9cB\xe2\x80\x9d\ncharities, \xc2\xa7 170(b)(1)(B).\n\xe2\x80\xa2Generally,193 \xe2\x80\x9cA\xe2\x80\x9d charities include churches, educational organizations,\norganizations that provide medical care, research, or education, university\nendowment funds, governmental units if the gift is for public purposes,\npublicly supported organizations with certain specified purposes, certain\nprivate foundations, and organizations that support certain other tax-exempt\norganizations. \xc2\xa7 170(b)(1)(A).\n\xe2\x80\xa2\xe2\x80\x9cB\xe2\x80\x9d charities are all other charities described in \xc2\xa7 170(c). \xc2\xa7 170(b)(1)(B).\n\nUnlike the exclusion from gross income for interest income derived from state and municipal bonds,\nthe market for \xe2\x80\x9ccapital gain\xe2\x80\x9d property does not drive the price down to reflect the tax benefits of owning\nsuch property.\n192\n\nThis paragraph is a generalization and omits a daunting number of details that a course in non-profit\norganizations might cover. We are not going to summarize rules governing contributions of \xe2\x80\x9cqualified\nconservation easements,\xe2\x80\x9d amounts paid to maintain certain students as members of the taxpayer\xe2\x80\x99s\nhousehold, or other more narrowly-focused rules.\n193\n\n441\n\n\x0cThis generally194 includes veterans\xe2\x80\x99 organizations, fraternal societies,\nnonprofit cemeteries, and certain nonoperating foundations.\n8. The CAA, \xc2\xa7 212, amended \xc2\xa7 170(p) to provide a deduction of up to $300 ($600\nfor taxpayers mfj) for individuals who contribute cash to an \xe2\x80\x9cA\xe2\x80\x9d charity. The\nCARES Act, \xc2\xa7 2204, added \xc2\xa7 62(a)(22) to the Code. It permits a $300 ($600 for\ntaxpayers mfj) \xe2\x80\x9cabove-the-line\xe2\x80\x9d deduction to non-itemizing taxpayers who\ncontribute cash to an \xe2\x80\x9cA\xe2\x80\x9d charity \xe2\x80\x93 except for contributions to a supporting\norganization or to a donor-advised fund.\n9. Deductible contributions to or for CARES Act \xc2\xa7 2205: For 2020, this provision\nthe use of: A taxpayer\xe2\x80\x99s allowable raises to 100% of AGI the deduction limit of an\ncontributions are subject to the individual for cash contributions to an \xe2\x80\x9cA\xe2\x80\x9d\nfollowing limitations:\ncharity; this limit is reduced by the amount of all\nof a taxpayer\xe2\x80\x99s other allowable charitable\n\xe2\x80\xa2For tax years 2018 to 2025,\ncontributions. Excess contributions are carried\ntaxpayer may deduct cash\nover.\ncontributions of up to\n195\n60% of her contribution\nFor corporations, the deduction limit for cash\nbase to \xe2\x80\x9cA\xe2\x80\x9d charities,\ncontributions to an \xe2\x80\x9cA\xe2\x80\x9d charity is increased to\n25% of the taxpayer\xe2\x80\x99s taxable income. This limit\n\xc2\xa7 170(b)(1)(G)(i);\n\xe2\x80\xa2Taxpayer may carry excess is reduced by the amount of all of a\ncash contributions to \xe2\x80\x9cA\xe2\x80\x9d corporation\xe2\x80\x99s other allowable charitable\ncharities to each of the contributions. Excess contributions are carried\nsucceeding five tax years in over.\nsequence,\nCAA \xc2\xa7 213 extended these provision through\n2021.\n\xc2\xa7 170(b)(1)(G)(ii);\notherwise \xe2\x80\x93\n\xe2\x80\xa2Taxpayer may deduct up to 50% of her contribution base to \xe2\x80\x9cA\xe2\x80\x9d charities,\n\xc2\xa7 170(b)(1)(A); otherwise \xe2\x80\x93196\n\xe2\x80\xa2Taxpayer may carry excess contributions to \xe2\x80\x9cA\xe2\x80\x9d charities to each of the\n194\n\nId.\n\nThe limit is otherwise 50%. Tax Cuts and Jobs Act temporarily increased the limit to 60% for cash\ncontributions. Section 170 had suspended temporarily the 50% limit for cash contributions to\norganizations providing relief in named hurricane and wildfire areas. The Tax Cuts and Jobs Act limit\ndoes not depend upon providing relief from particular disasters.\n195\n\nSee Brad Bedingfield & Nancy Dempze, The Disappearing 60% Deduction \xe2\x80\x93 New Charitable Giving Limits\nAre Not as Generous as They Appear, TAXATION OF EXEMPTS 36-41 (Sept.-Oct. 2018) (explaining\ncontribution limit under TCJA).\n196\n\n442\n\n\x0cfive succeeding years in sequence, \xc2\xa7 170(d)(1)(A);\n\xe2\x80\xa2Taxpayer may deduct up to 30% of her contribution base to \xe2\x80\x9cB\xe2\x80\x9d charities,\nor for the use of \xe2\x80\x9cA\xe2\x80\x9d or \xe2\x80\x9cB\xe2\x80\x9d charities, \xc2\xa7 170(b)(1)(B);\n\xe2\x80\xa2Taxpayer may carry excess contributions to \xe2\x80\x9cB\xe2\x80\x9d charities or for the use of\n\xe2\x80\x9cA\xe2\x80\x9d or \xe2\x80\x9cB\xe2\x80\x9d charities to each of the succeeding five tax years in sequence,\n\xc2\xa7\xc2\xa7 170(d)(1)(B), 170(d)(1)(A).\n\xe2\x80\xa2Taxpayer may also deduct up to 30% of her contribution base to\n\xe2\x80\x9cA\xe2\x80\x9d charities of \xe2\x80\x9ccapital gain property,\xe2\x80\x9d \xc2\xa7 170(b)(1)(C)(i);\n\xe2\x80\xa2Taxpayer may carry excess contributions of \xe2\x80\x9ccapital gain property\xe2\x80\x9d\nto \xe2\x80\x9cA\xe2\x80\x9d charities to each of the succeeding five tax years in sequence,\n\xc2\xa7\xc2\xa7 170(b)(1)(C)(ii), 170(d)(1)(A);\n\xe2\x80\xa2Taxpayer may deduct up to 20% of her contribution base to \xe2\x80\x9cB\xe2\x80\x9d charities\nor for the use of \xe2\x80\x9cA\xe2\x80\x9d or \xe2\x80\x9cB\xe2\x80\x9d charities of \xe2\x80\x9ccapital gain property,\n\xc2\xa7 170(b)(1)(D)(i);\n\xe2\x80\xa2Taxpayer may carry excess contributions of \xe2\x80\x9ccapital gain property\xe2\x80\x9d to \xe2\x80\x9cB\xe2\x80\x9d\ncharities or for the use of \xe2\x80\x9cA\xe2\x80\x9d or \xe2\x80\x9cB\xe2\x80\x9d charities to each of the succeeding five\ntax years in sequence, \xc2\xa7\xc2\xa7 170(b)(1)(D)(ii), 170(d)(1)(A).\n\xe2\x80\xa2These limitations are presented in a certain order. Every type of contribution is\nsubject to the limitations imposed on gifts above it \xe2\x80\x93 except for the two cumulative\n30% limits that nevertheless are subject to the overall 50% limit.197\n\xc2\xa7 170(b)(1)(B)(ii), \xc2\xa7 170(b)(1)(C)(i), \xc2\xa7 170(b)(1)(D)(i).\n\nStated differently, the contributions to organizations with a higher rank on the list reduce dollar for\ndollar the limits applicable to contributions to organizations with a lower rank on the list.\n197\n\n443\n\n\x0c\xe2\x80\xa2Example: Taxpayer donates property worth 40% of her contribution base\nto an \xe2\x80\x9cA\xe2\x80\x9d charity. Taxpayer also contributed \xe2\x80\x9ccapital gain property\xe2\x80\x9d with a\nfmv equal to 30% of her contribution base to\n\xe2\x80\x9cA\xe2\x80\x9d charities. This latter contribution is\nBetween January 1, 2018 and\nsubject to the 50% limit on contributions to\nFebruary 17, 2019 (i.e., 60 days\n\xe2\x80\x9cA\xe2\x80\x9d charities. Hence, taxpayer must carry \xe2\x85\x94\nafter enactment of the Taxpayer\nof her \xe2\x80\x9ccapital gain property\xe2\x80\x9d contributions\nCertainty and Disaster Relief Act of\nto the next succeeding tax year as a\n2019, corporations could deduct\ncontribution of \xe2\x80\x9ccapital gain property\xe2\x80\x9d to an\ncash contributions in excess of its\n\xe2\x80\x9cA\xe2\x80\x9d charity.\notherwise allowable charitable\ncontributions up to 100% of its\n\xe2\x80\xa2Moreover, as the sequence of the list\ntaxable income if made to support\nrelief efforts in a \xe2\x80\x9cqualified\nimplies, carryovers may be used only\ndisaster area.\xe2\x80\x9d Taxpayer Certainty\nsubject to the contribution limits of the\nand Disaster Relief Act of 2019,\nsucceeding year. \xc2\xa7 170(d)(1)(A)(i). The\nPub. L. No. 116-92, Div. Q, \xc2\xa7\ncarryforward period is five years.\n204(a). The TCDTR, \xc2\xa7 304(a)\n\xc2\xa7 170(d)(1)(A). Taxpayers must work\nextended this to February 25,\nwithin these rules to manage their charitable\n2021 (i.e., 60 days after enactment\ncontributions efficiently.\nof the Taxpayer Certainty and\nDisaster Relief Act of 2020.\n10. Corporations: A corporation may deduct\nonly 10% of its taxable income as charitable\ncontributions. \xc2\xa7 170(b)(2)(A). A corporation may not circumvent this limitation by\nrecharacterizing a contribution or gift that qualifies as a charitable contribution as\na business expenditure. \xc2\xa7 162(b). A corporation computes its taxable income for\npurposes of calculating this limit without regard to any dividends-received\ndeduction, NOL carryback, \xc2\xa7 199A deduction for qualified pass-through business\nincome, and capital loss carryback. \xc2\xa7 170(b)(2)(C). A corporation may carry over\nan excess contribution to each of the next succeeding five tax years. \xc2\xa7 170(d)(2)(A).\nThe carryover cannot operate to increase an NOL in a succeeding year.\n\xc2\xa7 170(d)(2)(B).\n11. Taxpayer made a $1000 contribution to WKNO-FM, the local public radio\nstation. WKNO-FM is an \xe2\x80\x9cA\xe2\x80\x9d organization. Because Taxpayer gave \xe2\x80\x9cat the $1000\nlevel,\xe2\x80\x9d WKNO-FM presented Taxpayer with an HD radio. WKNO-FM had\npurchased several such radios for its fund-raising drive at a cost of $163 each. The\nfmv of the radio was $200. Taxpayer already owned an HD radio so she put the\nnew one \xe2\x80\x93 still in the box it came in \xe2\x80\x93 in the attic. How much may Taxpayer deduct\nas a charitable contribution?\n444\n\n\x0c\xe2\x80\xa2See Shoshone-First National Bank v. United States, 29 A.F.T.R.2d 72-323,\n72-1 USTC (CCH) \xc2\xb6 9119, 1971 WL 454 (D. Wyo. 1971).\n11a. Playhouse on the Circle will \xe2\x80\x9csell the house\xe2\x80\x9d to any organization willing to\npay $2500 to see a private showing on a Sunday afternoon of the play it is currently\nshowing. A ticket to see the same play on Saturday night \xe2\x80\x93 the immediately\npreceding night \xe2\x80\x93 normally costs $35. Many charities engage Playhouse on the\nCircle to raise funds for their organization. St. Marlboro, an \xe2\x80\x9cA\xe2\x80\x9d organization\nengaged in medical research to determine the consequences of smoking only a few\ncigarettes a day, has \xe2\x80\x9cbought the house\xe2\x80\x9d and is selling tickets for $35/each. If\nTaxpayer purchased four tickets at a total cost of $140, how much should Taxpayer\nbe permitted to deduct as a charitable contribution if Taxpayer throws the tickets\naway because she is not the least bit interested in seeing the play that Playhouse is\ncurrently showing?\n\xe2\x80\xa2See Rev. Rul. 67-246, 1967-2 C.B. 104 (Example 3).\n11b. Taxpayer has $200,000 of\nadjusted gross income. Taxpayer\nmade the following charitable\ncontributions:\n\xe2\x80\xa2$20,000 cash to her church, an \xe2\x80\x9cA\xe2\x80\x9d\ncharity;\n\xe2\x80\xa2\xe2\x80\x9clong-term capital gain property\xe2\x80\x9d\nto her favorite university, an \xe2\x80\x9cA\xe2\x80\x9d\ncharity, ab = $10,000, fmv =\n$80,000;\n\xe2\x80\xa2\xe2\x80\x9clong-term capital gain property\xe2\x80\x9d\nto the sorority of which she was a\nmember during her years in college,\na \xe2\x80\x9cB\xe2\x80\x9d organization, ab = $15,000, fmv = $40,000.\n\nVery wealthy taxpayers: The \xe2\x80\x9cGiving Pledge\xe2\x80\x9d is\na campaign to encourage the world\xe2\x80\x99s\nwealthiest people to give to philanthropic\ncauses. About 187 persons or couples have\nmade the pledge. What problems do \xc2\xa7 170\'s\ncontribution limitations create for persons who\naccumulated vast wealth but whose income is\nno longer what it was? Bill Gates, Warren\nBuffett, Larry Ellison, Michael Bloomberg, Mark\nZuckerberg, Vladimir Potanin, Ted Turner, and\nElon Musk have signed on.\n\nWhat is Taxpayer\xe2\x80\x99s allowable charitable contribution deduction? What charitable\ncontribution carryovers will Taxpayer have?\n\n445\n\n\x0c11c. Taxpayer has $200,000 of adjusted gross income. Taxpayer made no charitable\ncontributions except for the following transaction:\n\xe2\x80\xa2Taxpayer sold to a \xe2\x80\x9cB\xe2\x80\x9d charity some stock that he purchased many years\nago for $10,000. Its current fmv = $50,000. Taxpayer sold the stock to the\ncharity for $10,000.\nWhat are the tax consequences to Taxpayer?\nDo the CALI Lesson, Basic Federal Income Taxation: Deductions: Charitable\nContribution Deductions: Basic Concepts and Computations.\nB. Taxes Paid\nSection 164 names some taxes that are deductible, irrespective of the circumstances\nof the taxpayer. These taxes do not have to be connected with a trade or business,\nor with the production of income. They are deductible simply because taxpayer paid\nthem. Section 275 names certain taxes that are not deductible.\nThere is of course an involuntary element of paying any of the taxes that \xc2\xa7 164\nnames. However, there is also an element of choice involved in the sense that some\ntaxes are simply the cost of owning property \xe2\x80\x93 wherever situated \xe2\x80\x93 or making\nincome in one place rather than another. Moreover, the taxes named support\ngovernments other than the federal government. Hence the taxpayer\xe2\x80\x99s costs of taxes\nassociated with the choices that taxpayer makes are borne at least in part by the\nfederal government.\nFor tax years 2018 to 2025, there is a $10,000 cap on the deduction of real property\ntaxes, personal property taxes, state and local income taxes, and state and local sales\ntaxes. \xc2\xa7 164(b)(6)(B). Moreover, Congress suspended the deduction for foreign real\nproperty taxes. \xc2\xa7 164(b)(6)(A). These limitations do not apply to taxes otherwise\nfully deductible when they are \xe2\x80\x9cpaid or accrued in carrying on a trade or business\nor an\xe2\x80\x9d expense incurred for the production of income. \xc2\xa7 164(b)(6) (carryout \xc2\xb6).\n\xe2\x80\xa2Such caps and limitations on itemized deductions increase the number of\ntaxpayers who do not itemize their deductions.\n\xe2\x80\xa2Blue state workarounds and Reg. \xc2\xa7 1.170A-1(h)(3): In response to the\nTCJA\xe2\x80\x99s $10,000 cap on so-called SALT (state and local tax) deductions,\nsome states (notably, Connecticut, New Jersey, and New York) enacted\n446\n\n\x0cstatutes that provided for credits against state income tax liability for\ncontributions made to certain charities. In response, Treasury has issued\nfinal rules that limit the deductibility of such contributions. See\nContributions in Exchange for State of Local Credits, 84 Fed. Reg. 2751301 (June 13, 2019). Such contributions would of course likely result from\nan expectation of a quid pro quo. So: Reg. \xc2\xa7 1.170A-1(h)(3)(i) disallows a\ncharitable contribution deduction to the extent taxpayer receives or expects\nto receive a state or local tax credit. This provision does not apply if the\ntotal amount of state and local tax credits received or expected to be\nreceived is 15% or less than the taxpayer\xe2\x80\x99s payment or the fair market value\nof property transferred by the taxpayer. Reg. \xc2\xa7 1.170A-1(h)(3)(vi). A\ndeduction is still allowed, so long as the amount of the deduction does not\nexceed the amount of the payment or the fair market value of the property\ntransferred. Reg. \xc2\xa7 1.170A-1(h)(3)(ii).\nSome important points about \xc2\xa7\xc2\xa7 164/275 are the following:\n\xe2\x80\xa2To be deductible, a \xe2\x80\x9cpersonal property tax\xe2\x80\x9d must be an ad valorem tax,\n\xc2\xa7 164(b)(1), i.e., \xe2\x80\x9csubstantially in proportion to the value of the personal\nproperty.\xe2\x80\x9d Reg. \xc2\xa7 1.164-3(c)(1). Hence, payment of a uniform \xe2\x80\x9cwheel tax\xe2\x80\x9d\nimposed on automobiles is not deductible.\n\xe2\x80\xa2A taxpayer may deduct either state and local income taxes or state and\nlocal sales taxes. \xc2\xa7 164(b)(5)(A). For a time, state and local sales taxes were\nnot deductible.\n\xe2\x80\xa2What are the fairness implications of these current and former rules\nfor taxpayers who reside in states that raise most of their revenue\nthrough income taxes, through sales taxes, or through a combination\nof income and sales taxes?\n\xe2\x80\xa2Section 164(c)(1) provides in part: \xe2\x80\x9cTaxes assessed against local benefits\nof a kind tending to increase the value of the property assessed\xe2\x80\x9d are not\ndeductible. Reg. \xc2\xa7 1.164-4(a) provides in part: \xe2\x80\x9cA tax is considered assessed\nagainst local benefits when the property subject to the tax is limited to\nproperty benefited. Special assessments are not deductible, even though an\nincidental benefit may inure to the public welfare. The real property taxes\ndeductible are those levied for the general public welfare by the proper\ntaxing authorities at a like rate against all property in the territory over\nwhich such authorities have jurisdiction.\xe2\x80\x9d\n\xe2\x80\xa2If a property owner may not deduct an assessment for the\nconstruction of, say, sidewalks in her neighborhood, should the\nproperty owner be permitted to add the amount of the assessment to\n447\n\n\x0cher basis in her property?\n\xe2\x80\xa2If real property is sold during a tax year, \xc2\xa7 164(d) requires pro rating the\nreal property tax allocable to seller and buyer according to the number of\ndays each owned the property. The seller is treated as owning the property\nup to the day before the sale. \xc2\xa7 164(d)(1)(A).\n\xe2\x80\xa2How should a seller treat real estate taxes that the seller has already\npaid and for which she received reimbursement from the buyer? See\n\xc2\xa7 1001(b)(1); Reg. \xc2\xa7 1.1001-1(b)(1).\n\xe2\x80\xa2How should a seller treat real estate taxes that are the obligation of\nthe seller but which the purchaser pays, perhaps because they are\nonly due after the date of sale? See \xc2\xa7 1001(b)(2); Reg. \xc2\xa7 1.10011(b)(2).\n\xe2\x80\xa2The last sentence of \xc2\xa7 164(a) provides that taxes paid in connection with\nthe sale or acquisition of property are to be treated as amount realized or\ncost.\n\xe2\x80\xa2If this treatment of such taxes does not (ultimately) alter taxpayer\xe2\x80\x99s\ntaxable income, what difference does it make to deduct a payment\nas opposed to reducing the amount realized or increasing the cost?\n\nDo the CALI Lesson, Basic Federal Income Taxation: Deductions: Deductions for\nTaxes.\nDo the CALI Lesson, Basic Federal Income Taxation: Interest Deductions.\n\nII. Denial of Discretion in Choosing How or What to Consume\nA. Medical and Dental Expenses\nSection 213(a) allows a taxpayer to deduct expenses of medical care \xe2\x80\x9cpaid during\nthe taxable year, not compensated for by insurance or otherwise\xe2\x80\x9d to the extent such\nexpenses exceed 7.5% of the taxpayer\xe2\x80\x99s adjusted gross income. This includes the\nexpenses of prescription drugs or of insulin. \xc2\xa7 213(b). Section 213(d)(1)(A) defines\n\xe2\x80\x9cmedical care\xe2\x80\x9d expenses to include expenditures \xe2\x80\x9cfor the diagnosis, cure,\nmitigation, treatment, or prevention of disease, or for the purpose of affecting any\nstructure or function of the body.\xe2\x80\x9d Medical care expenses also include the expenses\n448\n\n\x0cof transportation \xe2\x80\x9cprimarily for and essential to medical care,\xe2\x80\x9d certain long-term\ncare services, and insurance that covers \xe2\x80\x9cmedical care\xe2\x80\x9d as so defined. \xc2\xa7 213(d)(1).\n\xe2\x80\xa2Why should there be a floor on the deductibility of medical expenses? Why\nshould the determinant of that floor be a taxpayer\xe2\x80\x99s adjusted gross income?\nSee William P. Kratzke, The (Im)Balance of Externalities in EmploymentBased Exclusions from Gross Income, 60 THE TAX LAWYER 1, 24-25\n(2006).\n\xe2\x80\xa2Think: What is the profile of taxpayers most likely to claim a medical\nexpense deduction? See id. What type of medical expenditures are such\ntaxpayers likely to make?\nWe are met once again by the chicken-and-egg question of when taxpayer\xe2\x80\x99s\npersonal circumstances can support a deduction for certain expenditures. Why did\ntaxpayer have little choice in making the expenditure?\nOchs v. Commissioner, 195 F.2d 692 (2d Cir.), cert. denied, 344 U.S. 827 (1952)\nThe question raised by this appeal is whether the taxpayer Samuel Ochs was entitled\nunder \xc2\xa7 [213] of the Internal Revenue Code to deduct the sum of $1,456.50 paid by\nhim for maintaining his two minor children in day school and boarding school as\nmedical expenses incurred for the benefit of his wife. ...\nThe Tax Court made the following findings:\n\xe2\x80\x98During the taxable year petitioner was the husband of Helen H. Ochs. They\nhad two children, Josephine age six and Jeanne age four.\n\xe2\x80\x98On December 10, 1943, a thyroidectomy was performed on petitioner\xe2\x80\x99s\nwife. A histological examination disclosed a papillary carcinoma of the\nthyroid with multiple lymph node metastases, according to the surgeon\xe2\x80\x99s\nreport. During the taxable year the petitioner maintained his two children in\nday school during the first half of the year and in boarding school during\nthe latter half of the year at a cost of $1,456.50. Petitioner deducted this sum\nfrom his income for the year 1946 as a medical expense under \xc2\xa7 [213] ...\n\xe2\x80\x98During the taxable year, as a result of the operation on December 10, 1943,\npetitioner\xe2\x80\x99s wife was unable to speak above a whisper. Efforts of\npetitioner\xe2\x80\x99s wife to speak were painful, required much of her strength, and\n449\n\n\x0cleft her in a highly nervous state. Petitioner was advised by the operating\nsurgeon that his wife suffered from cancer of the throat, a condition which\nwas fatal in many cases. ... Petitioner became alarmed when, by 1946, his\nwife\xe2\x80\x99s voice had failed to improve ... Petitioner and his wife consulted a\nreputable physician and were advised by him that if the children were not\nseparated from petitioner\xe2\x80\x99s wife she would not improve and her nervousness\nand irritation might cause a recurrence of the cancer. Petitioner continued\nto maintain his children in boarding school after the taxable year here\ninvolved until up to the end of five years following the operation of\nDecember 10, 1943, petitioner having been advised that if there was no\nrecurrence of the cancer during that time his wife could be considered as\nhaving recovered from the cancer.\n\xe2\x80\x98During the taxable year petitioner\xe2\x80\x99s income was between $5,000 and\n$6,000. Petitioner\xe2\x80\x99s two children have not attended private school but have\nlived at home and attended public school since a period beginning five years\nafter the operation of December 10, 1943. Petitioner\xe2\x80\x99s purpose in sending\nthe children to boarding school during the year 1946 was to alleviate his\nwife\xe2\x80\x99s pain and suffering in caring for the children by reason of her inability\nto speak above a whisper and to prevent a recurrence of the cancer which\nwas responsible for the condition of her voice. He also thought it would be\ngood for the children to be away from their mother as much as possible\nwhile she was unable to speak to them above a whisper.\n\xe2\x80\x98Petitioner\xe2\x80\x99s wife was employed part of her time in 1946 as a typist and\nstenographer. On account of the impairment which existed in her voice she\nfound it difficult to hold a position and was only able to do part-time work.\nAt the time of the hearing of this proceeding in 1951, she had recovered the\nuse of her voice and seems to have entirely recovered from her throat\ncancer.\xe2\x80\x99\nThe Tax Court said in its opinion that it had no reason to doubt the good faith and\ntruthfulness of the taxpayer ..., but it nevertheless held that the expense of sending\nthe children to school was not deductible as a medical expense under the provisions\nof \xc2\xa7 [213] ...\nIn our opinion the expenses incurred by the taxpayer were non-deductible family\nexpenses within the meaning of \xc2\xa7 [262(a)] of the Code rather than medical\nexpenses. Concededly the line between the two is a difficult one to draw, but this\n450\n\n\x0conly reflects the fact that expenditures made on behalf of some members of a family\nunit frequently benefit others in the family as well. The wife in this case had in the\npast contributed the services \xe2\x80\x93 caring for the children \xe2\x80\x93 for which the husband was\nrequired to pay because, owing to her illness, she could no longer care for them. If,\nfor example, the husband had employed a governess for the children, or a cook, the\nwages he would have paid would not be deductible. Or, if the wife had died, and\nthe children were sent to a boarding school, there would certainly be no basis for\ncontending that such expenses were deductible. The examples given serve to\nillustrate that the expenses here were made necessary by the loss of the wife\xe2\x80\x99s\nservices, and that the only reason for allowing them as a deduction is that the wife\nalso received a benefit. We think it unlikely that Congress intended to transform\nfamily expenses into medical expenses for this reason. The decision of the Tax\nCourt is further supported by its conclusion that the expenditures were to some\nextent at least incurred while the wife was acting as a typist in order to earn money\nfor the family. ...\nThe decision is affirmed.\nFRANK, Circuit Judge (dissenting).\n....\n... The Commissioner argued, successfully in the Tax Court, that, because the\nmoney spent was only indirectly for the sake of the wife\xe2\x80\x99s health and directly for\nthe children\xe2\x80\x99s maintenance, it could not qualify as a \xe2\x80\x98medical expense.\xe2\x80\x99 Much is\nmade of the fact that the children themselves were healthy and normal \xe2\x80\x93 and little\nof the fact that it was their very health and normality which were draining away the\nmother\xe2\x80\x99s strength. The Commissioner seemingly admits that the deduction might\nbe a medical expense if the wife were sent away from her children to a sanitarium\nfor rest and quiet, but asserts that it never can be if, for the very same purpose, the\nchildren are sent away from the mother \xe2\x80\x93 even if a boarding school for the children\nis cheaper than a sanitarium for the wife. I cannot believe that Congress intended\nsuch a meaningless distinction, that it meant to rule out all kinds of therapeutic\ntreatment applied indirectly rather than directly \xe2\x80\x93 even though the indirect treatment\nbe \xe2\x80\x98primarily for the *** alleviation of a physical or mental defect or illness.\xe2\x80\x99\n[footnote omitted]. The cure ought to be the doctor\xe2\x80\x99s business, not the\nCommissioner\xe2\x80\x99s.\n451\n\n\x0cThe only sensible criterion of a \xe2\x80\x98medical expense\xe2\x80\x99 \xe2\x80\x93 and I think this criterion\nsatisfies Congressional caution without destroying what little humanity remains in\nthe Internal Revenue Code \xe2\x80\x93 should be that the taxpayer, in incurring the expense,\nwas guided by a physician\xe2\x80\x99s bona fide advice that such a treatment was necessary\nto the patient\xe2\x80\x99s recovery from, or prevention of, a specific ailment.\n....\nIn the final analysis, the Commissioner, the Tax Court and my colleagues all seem\nto reject Mr. Ochs\xe2\x80\x99 plea because of the nightmarish spectacle of opening the\nfloodgates to cases involving expense for cooks, governesses, baby-sitters,\nnourishing food, clothing, frigidaires, electric dish-washers \xe2\x80\x93 in short, allowances\nas medical expenses for everything \xe2\x80\x98helpful to a convalescent housewife or to one\nwho is nervous or weak from past illness.\xe2\x80\x99 I, for one, trust the Commissioner to\nmake short shrift of most such claims. [footnote omitted] The tests should be:\nWould the taxpayer, considering his income and his living standard, normally spend\nmoney in this way regardless of illness? Has he enjoyed such luxuries or services\nin the past? Did a competent physician prescribe this specific expense as an\nindispensable part of the treatment? Has the taxpayer followed the physician\xe2\x80\x99s\nadvice in most economical way possible? Are the so-called medical expenses over\nand above what the patient would have to pay anyway for his living expenses, i.e.,\nroom, board, etc.? Is the treatment closely geared to a particular condition and not\njust to the patient\xe2\x80\x99s general good health or well-being?\nMy colleagues are particularly worried about family expenses, traditionally\nnondeductible, passing as medical expenses. They would classify the children\xe2\x80\x99s\nschooling here as a family expense, because, they say, it resulted from the loss of\nthe wife\xe2\x80\x99s services. I think they are mistaken. The Tax Court specifically found that\nthe children were sent away so they would not bother the wife, and not because\nthere was no one to take care of them. Och\xe2\x80\x99s expenditures fit into the Congressional\ntest for medical deductions because he was compelled to go to the expense of\nputting the children away primarily for the benefit of his sick wife. Expenses\nincurred solely because of the loss of the patient\xe2\x80\x99s services and not as a part of his\ncure are a different thing altogether. Wendell v. Commissioner, 12 T.C. 161, for\ninstance, disallowed a deduction for the salary of a nurse engaged in caring for a\nhealthy infant whose mother had died in childbirth. The case turned on the simple\nfact that, where there is no patient, there can be no deduction.\nThus, even here, expense attributed solely to the education, at least of the older\n452\n\n\x0cchild, should not be included as a medical expense. See Stringham v.\nCommissioner, supra. Nor should care of the children during that part of the day\nwhen the mother would be away, during the period while she was working parttime. Smith v. Commissioner, 40 B.T.A. 1038, aff\xe2\x80\x99d 2d Cir., 113 F.2d 114. The\nsame goes for any period when the older child would be away at public school\nduring the day. In so far as the costs of this private schooling are thus allocable, I\nwould limit the deductible expense to the care of the children at the times when\nthey would otherwise be around the mother. ...\n...\nNotes and Questions:\n1. Is the rationale offered by the court consistent with the tax rules concerning\nimputed income?\n\xe2\x80\xa2Does the rationale seem a bit reminiscent of the rationale in Smith?\n2. What caused taxpayer to have to incur the expenses on his relatively modest\nincome of sending the children to boarding school?\n\xe2\x80\xa2Would taxpayers have had to bear these expenses if they did not have\nchildren?\n\xe2\x80\xa2Would taxpayers have had to bear these expenses if Mrs. Ochs did not have\nthroat cancer?\n3. How much discretion did taxpayer have in incurring the expenses at issue in\nOchs? If taxpayer had paid for Mrs. Ochs to reside in a sanitarium, that expense\nwould qualify as a medical expense.\n4. Consider: Prior to 1962 Mrs. Gerstacker had a history of emotional-mental\nproblems which had grown gradually worse. In 1962 she ran away from mental\nhospitals twice after voluntarily entering them. Her doctors advised Mr. Gerstacker\nthat successful treatment required their continued control so that Mrs. Gerstacker\ncould not leave and disrupt her therapy. They recommended guardianship\nproceedings and hospitalization in Milwaukee Sanitarium, Wauwatosa, Wisconsin.\nMr. Gerstacker instituted guardianship proceedings. Both Mr. and Mrs. Gerstacker\nemployed attorneys. The court appointed guardians. Mrs. Gerstacker was\nhospitalized from 1962 until the latter part of 1963 when she was released by her\ndoctors for further treatment on an out-patient basis. The guardianship was then\nterminated on the recommendation of her doctors because it was no longer\n453\n\n\x0cnecessary due to improved condition of the patient.\n\xe2\x80\xa2Should the legal expenses for establishing, conducting, and terminating the\nguardianship be deductible as medical expenses? For whose benefit were\nthe expenses incurred?\n\xe2\x80\xa2See Gerstacker v. Commissioner, 414 F.2d 448 (6th Cir. 1969).\nDo the CALI Lesson, Basic Federal Income Taxation: Medical Expense\nDeductions.\nB. Casualty Losses\nRead \xc2\xa7 165(c)(3), \xc2\xa7 165(e), \xc2\xa7 165(h), \xc2\xa7 165(i).\nLosses caused by \xe2\x80\x9cfire, storm, shipwreck, or other casualty, or from theft\xe2\x80\x9d do not\nusually result from personal consumption choices. Hence, a deduction seems\nappropriate. From the beginning, a problem has been to distinguish between a \xe2\x80\x9cbad\nhair day\xe2\x80\x9d and the type of damage that represents such a deprivation of consumption\nchoice that a taxpayer should be permitted to share her burden with other taxpayers.\nConsider:\n\xe2\x80\xa2We drop a plate, and it breaks. It\xe2\x80\x99s called \xe2\x80\x9clife,\xe2\x80\x9d not a casualty.\n\xe2\x80\xa2We willingly assume a risk and complain when something untoward\nhappens. We own a cat and an expensive vase and leave them together in\nthe same room. The cat knocks the vase over, and it breaks. See Dyer v.\nCommissioner, T.C. Memo. 1961-141, 1961 WL 424 (1961) (not a\ncasualty).\n\xe2\x80\xa2We deliberately cause a casualty. An arsonist claims a casualty loss\ndeduction when she burns down her own house. After all, her loss was quite\nliterally caused by \xe2\x80\x9cfire.\xe2\x80\x9d See Blackmun v. Commissioner, 88 T.C. 677, 681\n(1987), aff\xe2\x80\x99d, 867 F.2d 605 (1st Cir. 1988) (violation of public policy).\n\xe2\x80\xa2We engage in a business where a certain amount of breakage is predictable.\nTaxpayer operates a fleet of taxicabs, and a few of them are damaged in\ntraffic accidents.\nThe line between \xe2\x80\x9clife\xe2\x80\x9d and casualty has not proved to be easy to draw \xe2\x80\x93 and one\ndoes not have to search the digests very hard to find contradictory results.\nMoreover, the availability of insurance to protect against financial loss that a\ncasualty causes may lead us to conclude that taxpayers should avail themselves of\n454\n\n\x0csuch protection. The cost of the folly of going uninsured should not be one that\nother taxpayers should bear when the foreseeable and insurable loss materializes.\nThe involuntary conversion rules of \xc2\xa7 1033, see chapter 2, supra, become more\nimportant. This is the position that Congress has taken for tax years 2018 to 2025.\n\xc2\xa7 165(b)(5)(A). For those years, the deduction for personal casualty losses is limited\nto personal casualty losses attributable to a Federally declared disaster.\n\xc2\xa7 165(h)(5)(A).\n\xe2\x80\xa2Calculation of the personal casualty loss deduction.\n\xe2\x80\xa2Section 165(h) limits the losses that an individual may deduct as casualty\nlosses.\n\xe2\x80\xa2Reg. \xc2\xa7 1.165-7(b)(1) limits all casualty losses \xe2\x80\x93 whether trade or business,\ntransactions entered into for profit, or personal \xe2\x80\x93 to the lesser of the\nproperty\xe2\x80\x99s fmv before the casualty reduced by the fmv of the property after\nthe casualty OR the property\xe2\x80\x99s adjusted basis.\n\xe2\x80\xa2If the property is used in a trade or business or held for the\nproduction of income AND it is totally destroyed by the casualty,\nthe allowable loss is limited to the adjusted basis of the property.\n\xe2\x80\xa2What is the theoretical underpinning of these limitations?\n\n455\n\n\x0c\xe2\x80\xa2Section 165(h)(1) limits the deductibility\nof personal loss for each casualty to the Taxpayer Certainty and Disaster\nRelief Act of 2019, Pub. L. No.\namount by which the loss exceeds $100.\n116-92, Div. Q, \xc2\xa7 204(b)\n\xe2\x80\xa2Section 165(h)(3)(A) defines \xe2\x80\x9cpersonal\nincreased the amount that a\ncasualty gain\xe2\x80\x9d to be \xe2\x80\x9crecognized gain from taxpayer who suffers a personal\nany involuntary conversion of property\xe2\x80\x9d casualty loss as the result of a\nresulting from a casualty. Section presidentially-declared disaster\n165(h)(3)(B) defines \xe2\x80\x9cpersonal casualty may deduct. In the case of such\nloss\xe2\x80\x9d to be a casualty loss after reduction disasters, a taxpayer may\nby $100.\ndeduct all losses in excess of\n\xe2\x80\xa2Section 165(h)(2) limits the deductibility $500. This type of personal\nof all personal casualty losses to the casualty loss deduction is\namount by which they exceed personal available irrespective of whether\ncasualty gains and by which this net taxpayer itemizes. Taxpayer\xe2\x80\x99s\namount exceeds 10% of a taxpayer\xe2\x80\x99s standard deduction is increased\nadjusted gross income. Taxpayer may by the amount of such loss. The\nreduce her adjusted gross income by the loss must occur during the\nnet personal casualty loss in making this \xe2\x80\x9cincident period,\xe2\x80\x9d i.e., the period\nspecified by the Federal\n10% determination. \xc2\xa7 165(h)(4)(A).\n\xe2\x80\xa2In the event personal casualty Emergency Management Agency\ngains exceed personal casualty (FEMA), but no later than 30 days\nafter enactment of the statute. \xc2\xa7\nlosses, taxpayer must treat all such\n201(4).\ngains and all such losses as if they\nresulted from the sales or The TCDTR, \xc2\xa7 304(b) extended\nexchanges of capital assets. the availability of this deduction\nto February 25, 2021 (i.e., 60\n\xc2\xa7 165(h)(2)(B).\ndays after enactment of the\n\xe2\x80\xa2For tax years 2018 to 2025, the casualty\nTaxpayer Certainty and Disaster\nloss deduction is limited to losses\nRelief Act of 2020.\nattributable to a Federally declared\ndisaster. Casualty losses other than those\nattributable to a Federally declared disaster do not offset casualty gains\nattributable to a Federally declared disaster. \xc2\xa7 165(h)(5)(B)(i).\n\xe2\x80\xa2In the case of casualties other than those attributable to a Federally\ndeclared disaster, no deduction for loss is allowed. Taxpayer should\nstill net personal casualty losses against personal casualty gains to\nreduce the capital gain she must recognize from the event. The\npersonal casualty gain attributable to a Federally declared disaster is\nnot used in the computation of personal casualty gain attributable to\nother casualties. \xc2\xa7 165(h)(5)(B)(ii).\n456\n\n\x0c\xe2\x80\xa2These rules manifest the importance of insurance \xe2\x80\x93 both in defining\nwhat is a casualty and in compensating for loss from a casualty \xe2\x80\x93\nand of the deferral rule of \xc2\xa7 1033 for involuntary conversions.\n\xe2\x80\xa2A taxpayer suffering a casualty loss in a Federally declared disaster area\nmay elect to claim the casualty loss deduction for the taxable year\nimmediately preceding the taxable year in which the disaster occurred. This\nprovision should help get funds into the hands of the victims of Federally\ndeclared disasters quickly. \xc2\xa7 165(i)(1). The casualty loss is then treated as\nhaving occurred in the year for which the deduction is claimed. \xc2\xa7 165(i)(2).\n\nIII. Creating a More Efficient and Productive Economy\nThere are some deductions that the Code permits that promote a more efficient or\nproductive economy. Under this heading, we might include dependent care\nexpenses incurred so that taxpayer can work. We have already examined such\nexpenditures.\n\xe2\x80\xa2Also under this heading are the expenses of moving to a better \xe2\x80\x93 and\npresumably more valuable \xe2\x80\x93 job. Sections \xc2\xa7\xc2\xa7 82, 217, 62(a)(15), 132(a)(6),\nand 132(g) create a set of rules assuring that a taxpayer pays no income tax\non the income necessary to move to a new or different job. But: the Tax\nCuts and Jobs Act suspended the operation of these provisions for tax years\n2018 to 2025. See \xc2\xa7\xc2\xa7 132(g)(2) and 217(k).\nSections 221 and 62(a)(17) provide a deduction for interest paid on student loans.\nBecause the \xc2\xa7 221 deduction is named in \xc2\xa7 62(a)(17), taxpayer benefits from this\ndeduction even when she claims the standard deduction. The maximum interest\ndeduction is $2500, and the availability of the deduction phases out as taxpayers\xe2\x80\x99\nAGI rises. The phaseout range is indexed for inflation and is $140,000 to $170,000\nfor tax year 2020 for taxpayers married filing jointly (half those amounts for\nunmarried taxpayers). \xc2\xa7 221(b)(2)(B) (Rev. Proc. 2019-44, \xc2\xa7 3.30).\n\xe2\x80\xa2What do you think the profile of the student is for whom this deduction\nwould have the greatest impact?\nThe Code also provides credits that reduce the tax liability of a taxpayer, for\npursuing education \xe2\x80\x93 which should enlarge the tax base.\n\xe2\x80\xa2Section 25A provides two credits for investment in a taxpayer\xe2\x80\x99s, her\nspouse\xe2\x80\x99s, or her dependent\xe2\x80\x99s education.\n\xe2\x80\xa2The American Opportunity Credit provides a credit of up to $2500\n457\n\n\x0cfor an education expenditure of $4000. Taxpayer may claim the\ncredit for each of four consecutive years. \xc2\xa7 25A(b)(2)(A). Taxpayer\nmay not claim the credit if she has completed the first four years of\npost-secondary education. \xc2\xa7 25A(b)(2)(C). Forty percent of the\ncredit is refundable. \xc2\xa7 25A(i).\n\xe2\x80\xa2The Lifetime Learning Credit alternatively, \xc2\xa7 25A(c)(2)(A) (only\nAmerican Opportunity Credit or Lifetime Learning Credit available\non one individual), provides a credit of up to 20% of $10,000 of\neducational expenses. There is no limit to the number of times a\nLifetime Learning Credit can be claimed for an individual.\n\xe2\x80\xa2Both the American Opportunity Tax Credit and the Lifetime\nLearning Credit are subject to income phaseouts. For taxpayers\nmarried filing jointly, the credit is phased out at AGI levels between\n$160,000 and $180,000 (between $80,000 and $90,000 for other\ntaxpayers).\n\xe2\x80\xa2These phaseouts imply that taxpayers with higher incomes do not need\nstrong incentives (or perhaps any incentives) to incur such expenses.\n\xe2\x80\xa2What do you think the profile of the student is for whom these credits\nwould have the greatest impact?\n\nIV. Deferral Until Consumption\nAn \xe2\x80\x9cincome tax\xe2\x80\x9d is a tax on income. A \xe2\x80\x9cconsumption tax\xe2\x80\x9d is a tax on consumption.\nWe have largely regarded the Code as creating an income tax. The Code actually\ncreates a hybrid whereby income that a taxpayer holds in order to spend later on\ncertain items of consumption is not subject to tax \xe2\x80\x93 if at all \xe2\x80\x93 until taxpayer actually\nspends it on those forms of consumption. Taxpayers know that they may one day\nretire and no longer have the income that their employment provided. They know\nthat they may one day need money to pay for health care services. They know that\nthey may one day need money to pay for the education of their children. The Code\nimplicitly encourages taxpayers to set money aside to meet a personal expense they\nknow they will incur later.\nThe Code may permit taxpayers to set money aside in an account and pay income\ntax on that money only when it is withdrawn to spend on consumption. See\n\xc2\xa7\xc2\xa7 219(a), 62(a)(7) (money deposited in individual retirement account (IRA)\ndeductible above-the-line; indexed limitation on deposit and indexed income\nphaseout applicable; taxable upon withdrawal). The Code may permit taxpayer to\n458\n\n\x0cset aside after-tax money, never subject return on the investment of that money to\ntax, and permit withdrawal for taxpayer\xe2\x80\x99s later consumption. See \xc2\xa7 408A (\xe2\x80\x9cRoth\nIRA;\xe2\x80\x9d same deposit limit as \xc2\xa7 219 (\xe2\x80\x9ctraditional IRA\xe2\x80\x9d), with higher indexed income\nphaseout). 198 The Code may permit taxpayer to set aside after-tax money, defer tax\non resulting investment income, and shift the tax burden to another whose tax\nbracket should be lower than taxpayer\xe2\x80\x99s tax bracket. See \xc2\xa7 529 (savings for tuition\nwith state agency or educational institution; no contribution limits; beneficiary\nsubject to income tax as if in receipt of annuity income); \xc2\xa7 530 (Coverdell education\nsavings account; annual contribution limits per beneficiary; contributors subject to\nrelatively high income phaseout; beneficiary taxed on investment income of\naccount; funds can be spent on elementary and secondary education). The Code\nmay permit taxpayer to deduct without having to itemize the amount set aside for\nlater consumption and not subject that amount or investment return to income tax,\neven upon consumption. See \xc2\xa7\xc2\xa7 223, 106(d), 62(a)(19) (health savings accounts;\nexcludable if funded by employer, deductible if funded by taxpayer).\nFinancial institutions are usually very interested in you being interested in at least\nsome of these accounts. Question: Is it better to deduct a current deposit to one of\nthese accounts and pay income tax later or to deposit after-tax income in the account\nand never pay income tax on the investment income? This is one point of distinction\nbetween these patterns, and it is the question you must answer when deciding\nbetween a traditional IRA or a Roth IRA, assuming you may contribute to either\nwithout being subject to an income phaseout. Now for some smoke and mirrors.\nImagine: Taxpayer has $5000 to deposit in an IRA or to deposit in a Roth IRA\nafter paying income tax on it. Taxpayer is a 20% bracket taxpayer. Over the course\nof 30 years, savings will grow by a multiple of six (implying an interest rate\nbetween 6% and 7%, see Table 1 in the notes following Bruun).\n\xe2\x80\xa2Traditional IRA: Taxpayer deposits $5000 in an IRA without paying\nincome tax on it. In 30 years, taxpayer will have $30,000 in her account.\nUpon withdrawal, taxpayer must pay a 20% income tax, i.e., $6000. This\nwill leave taxpayer $24,000.\n\xe2\x80\xa2Roth IRA: Taxpayer must pay income tax of $1000 (i.e., 20% of $5000)\non $5000 and deposit the balance of $4000 in her account. In thirty years,\ntaxpayer will have $24,000 in her account \xe2\x80\x93 the same amount she would\nThere are other devices by which taxpayers and/or their employers can fund a pension. The\nmechanics of these devices will fall into one of these patterns. We defer consideration of them to a\ncourse on pension planning.\n198\n\n459\n\n\x0chave in her account if she had deposited the money in a traditional IRA.\nDoes this mean there is no difference between a traditional IRA and a Roth IRA?\nHardly.\n\xe2\x80\xa2While \xc2\xa7 408A(c)(2) seemingly establishes the same cumulative limit for\ncontributions to a Roth IRA as to a traditional IRA, one difference lies in\nthe fact that deposits in a Roth IRA have already been taxed whereas\ncontributions to a traditional IRA have not. AND: $5000 of pre-tax money\nis not equal in value to $5000 of after-tax money. In fact, the contribution\nlimit for a Roth IRA is higher.\nDoes this mean that we should always prefer a Roth IRA to a traditional IRA?\nHardly.\n\xe2\x80\xa2The income that is spent on consumption in retirement is subject to tax at\nsome point. We assumed that the rate of tax was the same, whether paid\nprior to deposit of money or upon withdrawal.\n\xe2\x80\xa2How likely is that to be true?\n\xe2\x80\xa2Congress periodically changes tax brackets and it most certainly\nwill change tax brackets sometime in the next thirty years.\n\xe2\x80\xa2Furthermore, even without such bracket tinkering, it is unlikely that\nthe income tax bracket of a taxpayer would be the same on dates that\nare thirty years apart. In retirement, most taxpayers have less income\nthan they did in their working years and so are in a lower bracket.\nThe Roth IRA (likely) requires payment of income tax when the\ntaxpayer \xe2\x80\x9cis at the top of her game,\xe2\x80\x9d i.e., when her tax bracket is the\nhighest it will ever be. The pattern is reversed for a traditional IRA,\ni.e., deductible when the deduction is worth more than it will ever\nbe.\n\xe2\x80\xa2Determining the relative merits of a traditional IRA and a Roth IRA\nrequires that we examine the assumptions that we made in this\nexercise very carefully.\n\xe2\x80\xa2One more assumption to question: Who is the taxpayer? In the case\nof education funding accounts (\xc2\xa7\xc2\xa7 529, 530), the student becomes\nthe taxpayer. The taxpayer-depositor may be able to shift the tax\nburden on investment return from herself (presumably high bracket\n\n460\n\n\x0ctaxpayer) to the student (presumably low bracket taxpayer).199\nFinal Note: Limitations on Deductions: Floors, Phaseouts, and Phasedowns\nWe know that deduction floors and income phaseouts or phasedowns can reduce\nthe availability of various income-tax-reducing measures to some taxpayers. The\neffect of these limitations on deductions is to raise the tax bracket of affected\ntaxpayers by an undetermined amount and makes comparison of effective tax rates\nbetween two or more taxpayers extremely difficult.\nSection \xc2\xa7 68 provides an overall phasedown on itemized deductions. This\nphasedown has been suspended for tax years 2018 to 2025. \xc2\xa7 68(f).\n\nWrap-Up Questions for Chapter 7\n1. Describe how \xc2\xa7 170(e)(1)(A), which permits a deduction of the fmv of gifts of\nproperty to charity rather than the adjusted basis of the property, creates a \xe2\x80\x9ctrue\xe2\x80\x9d\nloophole.\n2. Why should state and local property taxes and/or state and local income or sales\ntaxes be deductible? What policies do such deductions pursue? Why should there\nbe a $10,000 limit to the deductibility of the sum of these deductions?\n3. Congress recently increased the floor for medical deductions from 7.5% of AGI\nto 10% of agi. The floor was once 3%. The general trend of this floor has been\nupward. How are these movements in the floor likely to affect who may take the\nmedical expense deduction and how big a deduction they may take?\n4. What is the effect of deferring income tax on the income necessary to purchase\na benefit, e.g., a comfortable retirement?\n5. Should Congress implement its tax policy with greater use of credits against tax\nliability rather than deductions or exclusions from gross income? Why? What about\nphasedowns or phaseouts?\nRecall that in Horst, taxpayer failed in his effort to execute such an inter-generational transfer of tax\nburdens. Taxpayer Horst\xe2\x80\x99s technique of tax-burden-shifting has become a tool to encourage funding\neducation expenses.\n199\n\n461\n\n\x0cWhat have you learned?\nCan you explain or define \xe2\x80\x93\n\xe2\x80\xa2Whose benefit, donor\xe2\x80\x99s or donee\xe2\x80\x99s, is relevant in weighing the costs of a charitable\ncontribution against its benefits?\n\xe2\x80\xa2What is an individual\xe2\x80\x99s contribution base? Why is it relevant?\n\xe2\x80\xa2Whether a taxpayer may deduct both state and local income taxes, and state and\nlocal sales taxes?\n\xe2\x80\xa2Who, in this time of the Affordable Care Act, is most likely to benefit from the\nmedical expense deduction?\n\xe2\x80\xa2How the Code measures a personal casualty loss and the extent to which taxpayer\nmay have to recognize casualty gain until tax year 2026?\n\xe2\x80\xa2How credits for education expenses promote a more productive economy?\n\xe2\x80\xa2How tax credits ameliorate the upside-down effect of deductions and exclusions?\n\n462\n\n\x0cChapter 8: Tax Consequences of Divorce and Intra-Family\nTransactions\nI. Introduction\nThe tax consequences of marriage,\nsupport of a family, and divorce reflect\nhow we choose to apply the basic\nprinciples that we tax income once and\nonly once and that expenditures for\npersonal\nconsumption\nare\nnot\ndeductible. Taxpayer chooses whether to\nhave a spouse or a child, so expenditures\nfor the support of a spouse or a child\npresumably are not deductible. The\nsame is true of expenditures to divorce.\n\nThe Tax Formula:\n(gross income)\nMINUS deductions named in \xc2\xa7 62\nEQUALS (adjusted gross income (AGI))\nMINUS (standard deduction or itemized\ndeductions)\nMINUS (deduction for \xe2\x80\x9cqualified business\nincome\xe2\x80\x9d)\nEQUALS (taxable income)\n\nThe definition of \xe2\x80\x9cmarriage\xe2\x80\x9d is a matter\nCompute income tax liability from tables\nof state law; state law determines who is\nin \xc2\xa7 1(j) (indexed for inflation)\n200\nand who is not married. State law also\n\xe2\x9e\x94MINUS (credits against tax)\ndefines the rights that spouses have with\nrespect to their property and income\nbefore, during, and after the marriage. State law governs adoptions and so is\ndeterminative of who is a \xe2\x80\x9cchild\xe2\x80\x9d of the taxpayer. State (or local) law also governs\nthe placement of foster children. State law defines the obligations that family\nmembers have towards each other \xe2\x80\x93 notably that parents have obligations of support\nfor their children up to a certain age. This may affect whether one person is a\ndependent of a taxpayer.\nWe already know that the filing status \xe2\x80\x9cmarried filing jointly\xe2\x80\x9d implies that married\npersons are in fact one taxpaying unit, whether one or both contribute to its taxable\nincome. The fact that a taxpayer provides financial support to a person other than a\nspouse may give that other person the tax status of \xe2\x80\x9cdependent\xe2\x80\x9d and entitle taxpayer\nto a reduction of his tax liability. Section 151 gives (gave?) taxpayer a deduction of\na fixed exemption amount for each of the taxpayer\xe2\x80\x99s dependents. The Tax Cuts and\nStates may not deny same-sex couples the right to marry. See Obergefell v. Hodges, 576 U.S. 644,\n675-76, (2015) (fundamental liberty as well as Due Process and Equal Protection rights).\n200\n\n463\n\n\x0cJobs Act for tax years 2018 to 2025 fixes the exemption amount at zero.\n\xc2\xa7 151(d)(5)(A). However, for the same years \xc2\xa7 24 provides credits for dependents\nother than spouses. We learn shortly that whether one is a dependent of taxpayer\nusually turns on the existence of a family relationship. Moreover, \xc2\xa7 32 conditions\none level of the earned income credit on taxpayer having one more qualifying\nchildren.\nWe consider here the tax ramifications of marriage and family \xe2\x80\x93 before, during, and\nafter.\n\nII. Before Marriage\nThe Code treats a married couple as one taxpayer \xe2\x80\x93 although spouses may elect to\nbe taxed separately. Until they are married, they remain separate taxpayers \xe2\x80\x93\nalthough one might be a dependent of the other. Aside from contractual\nundertakings, the law does not require one to support the other. Taxpayers may\nenter certain transactions with each other in contemplation of marriage, but\npresumptively such transactions are arm\xe2\x80\x99s-length transactions.\nFarid-es-Sultaneh v. Commissioner, 160 F.2d 812 (2d Cir. 1947)\nCHASE, Circuit Judge.\nThe problem presented by this petition is to fix the cost basis to be used by the\npetitioner in determining the taxable gain on a sale she made in 1938 of shares of\ncorporate stock. She contends that it is the adjusted value of the shares at the date\nshe acquired them because her acquisition was by purchase. The Commissioner\xe2\x80\x99s\nposition is that she must use the adjusted cost basis of her transferor because her\nacquisition was by gift. The Tax Court agreed with the Commissioner and\nredetermined the deficiency accordingly.\n....\nThe petitioner is an American citizen who filed her income tax return for the\ncalendar year 1938 ... and ... reported sales during that year of 12,000 shares of the\ncommon stock of the S.S. Kresge Company at varying prices per share, for the total\nsum of $230,802.36 which admittedly was in excess of their cost to her. ...\n464\n\n\x0cIn December 1923 when the petitioner, then unmarried, and S.S. Kresge, then\nmarried, were contemplating their future marriage, he delivered to her 700 shares\nof the common stock of the S.S. Kresge Company which then had a fair market\nvalue of $290 per share. The shares ... were to be held by the petitioner \xe2\x80\x9cfor her\nbenefit and protection in the event that the said Kresge should die prior to the\ncontemplated marriage between the petitioner and said Kresge.\xe2\x80\x9d The latter was\ndivorced from his wife on January 9, 1924, and on or about January 23, 1924 he\ndelivered to the petitioner 1800 additional common shares of S.S. Kresge Company\nwhich were also ... to be held by the petitioner for the same purposes as were the\nfirst 700 shares he had delivered to her. On April 24, 1924, and when the petitioner\nstill retained the possession of the stock so delivered to her, she and Mr. Kresge\nexecuted a written ante-nuptial agreement wherein she acknowledged the receipt of\nthe shares \xe2\x80\x9cas a gift made by the said Sebastian S. Kresge, pursuant to this\nindenture, and as an ante-nuptial settlement, and in consideration of said gift and\nsaid ante-nuptial settlement, in consideration of the promise of said Sebastian S.\nKresge to marry her, and in further consideration of the consummation of said\npromised marriage\xe2\x80\x9d she released all dower and other marital rights, including the\nright to her support to which she otherwise would have been entitled as a matter of\nlaw when she became his wife. They were married in New York immediately after\nthe ante-nuptial agreement was executed and continued to be husband and wife\nuntil the petitioner obtained a final decree of absolute divorce from him on, or\nabout, May 18, 1928. No alimony was claimed by, or awarded to, her.\nThe stock so obtained by the petitioner from Mr. Kresge had a fair market value of\n$315 per share on April 24, 1924, and of $330 per share on, or about May 6, 1924,\nwhen it was transferred to her on the books of the corporation. She held all of it for\nabout three years, but how much she continued to hold thereafter is not disclosed\nexcept as that may be shown by her sales in 1938. Meanwhile her holdings had\nbeen increased by a stock dividend of 50%, declared on April 1, 1925; one of 10 to\n1 declared on January 19, 1926; and one of 50%, declared on March 1, 1929. Her\nadjusted basis for the stock she sold in 1938 was $10.66\xe2\x85\x94 per share computed on\nthe basis of the fair market value of the shares which she obtained from Mr. Kresge\nat the time of her acquisition. His adjusted basis for the shares she sold in 1938\nwould have been $0.159091.\nWhen the petitioner and Mr. Kresge were married he was 57 years old with a life\nexpectancy of 16\xc2\xbd years. She was then 32 years of age with a life expectancy of\n33\xc2\xbe years. He was then worth approximately $375,000,000 and owned real estate\nof the approximate value of $100,000,000.\n465\n\n\x0cThe Commissioner determined the deficiency on the ground that the petitioner\xe2\x80\x99s\nstock obtained as above stated was acquired by gift within the meaning of that word\nas used in \xc2\xa7 [102] and, as the transfer to her was after December 31, 1920, used as\nthe basis for determining the gain on her sale of it the basis it would have had in the\nhands of the donor. This was correct if the just mentioned statute is applicable, and\nthe Tax Court held it was on the authority of Wemyss v. Commissioner, 324 U.S.\n303, and Merrill v. Fahs, 324 U.S. 308.\nThe issue here presented cannot, however, be adequately dealt with quite so\nsummarily. The Wemyss case determined the taxability to the transferor as a gift,\nunder [the Federal Gift Tax] ... of property transferred in trust for the benefit of the\nprospective wife of the transferor pursuant to the terms of an ante-nuptial\nagreement. It was held that the transfer, being solely in consideration of her promise\nof marriage, and to compensate her for loss of trust income which would cease upon\nher marriage, was not for an adequate and full consideration in money or money\xe2\x80\x99s\nworth ... [and] was not one at arm\xe2\x80\x99s length made in the ordinary course of business.\nBut we find nothing in this decision to show that a transfer, taxable as a gift under\nthe gift tax, is ipso facto to be treated as a gift in construing the income tax law.\nIn Merrill v. Fahs, supra, it was pointed out that the estate and gift tax statutes are\nin pari materia and are to be so construed. Estate of Sanford v. Commissioner, 308\nU.S. 39, 44. The estate tax provisions in the Revenue Act of 1916 required the\ninclusion in a decedent\xe2\x80\x99s gross estate of transfers made in contemplation of death,\nor intended to take effect in possession and enjoyment at or after death except when\na transfer was the result of \xe2\x80\x9ca bona fide sale for a fair consideration in money or\nmoney\xe2\x80\x99s worth.\xe2\x80\x9d [citation omitted]. The first gift tax became effective in 1924, and\nprovided inter alia, that where an exchange or sale of property was for less than a\nfair consideration in money or money\xe2\x80\x99s worth the excess should be taxed as a gift.\n[citation omitted]. While both taxing statutes thus provided, it was held that a\nrelease of dower rights was a fair consideration in money or money\xe2\x80\x99s worth.\nFerguson v. Dickson, 3 Cir., 300 F. 961, cert. denied, 266 U.S. 628; McCaughn v.\nCarver, 3 Cir., 19 F.2d 126. Following that, Congress in 1926 replaced the words\n\xe2\x80\x9cfair consideration\xe2\x80\x9d in the 1924 Act limiting the deductibility of claims against an\nestate with the words \xe2\x80\x9cadequate and full consideration in money or money\xe2\x80\x99s worth\xe2\x80\x9d\nand in 1932 the gift tax statute as enacted limited consideration in the same way.\nRev. Act 1932, \xc2\xa7 503. Although Congress in 1932 also expressly provided that the\nrelease of marital rights should not be treated as a consideration in money or\nmoney\xe2\x80\x99s worth in administering the estate tax law, Rev. Act of 1932, \xc2\xa7 804, 26\nU.S.C.A. ..., and failed to include such a provision in the gift tax statute, it was held\n466\n\n\x0cthat the gift tax law should be construed to the same effect. Merrill v. Fahs, supra.\nWe find in this decision no indication, however, that the term \xe2\x80\x9cgift\xe2\x80\x9d as used in the\nincome tax statute should be construed to include a transfer which, if made when\nthe gift tax were effective, would be taxable to the transferor as a gift merely\nbecause of the special provisions in the gift tax statute defining and restricting\nconsideration for gift tax purposes. A fortiori, it would seem that limitations found\nin the estate tax law upon according the usual legal effect to proof that a transfer\nwas made for a fair consideration should not be imported into the income tax law\nexcept by action of Congress.\nIn our opinion the income tax provisions are not to be construed as though they\nwere in pari materia with either the estate tax law or the gift tax statutes. They are\naimed at the gathering of revenue by taking for public use given percentages of\nwhat the statute fixes as net taxable income. Capital gains and losses are, to the\nrequired or permitted extent, factors in determining net taxable income. What is\nknown as the basis for computing gain or loss on transfers of property is established\nby statute in those instances when the resulting gain or loss is recognized for income\ntax purposes and the basis for succeeding sales or exchanges will, theoretically at\nleast, level off tax-wise any hills and valleys in the consideration passing either way\non previous sales or exchanges. When Congress provided that gifts should not be\ntreated as taxable income to the donee there was, without any correlative provisions\nfixing the basis of the gift to the donee, a loophole which enabled the donee to make\na subsequent transfer of the property and take as the basis for computing gain or\nloss its value when the gift was made. Thus it was possible to exclude from taxation\nany increment in value during the donor\xe2\x80\x99s holding and the donee might take\nadvantage of any shrinkage in such increment after the acquisition by gift in\ncomputing gain or loss upon a subsequent sale or exchange. It was to close this\nloophole that Congress provided that the donee should take the donor\xe2\x80\x99s basis when\nproperty was transferred by gift. Report of Ways and Means Committee (No. 350,\nP. 9, 67th Cong., 1st Sess.). This change in the statute affected only the statutory\nnet taxable income. The altered statute prevented a transfer by gift from creating\nany change in the basis of the property in computing gain or loss on any future\ntransfer. In any individual instance the change in the statute would but postpone\ntaxation and presumably would have little effect on the total volume of income tax\nrevenue derived over a long period of time and from many taxpayers. Because of\nthis we think that a transfer which should be classed as a gift under the gift tax law\nis not necessarily to be treated as a gift income-tax-wise. Though such a\nconsideration as this petitioner gave for the shares of stock she acquired from Mr.\n467\n\n\x0cKresge might not have relieved him from liability for a gift tax, had the present gift\ntax then been in effect, it was nevertheless a fair consideration which prevented her\ntaking the shares as a gift under the income tax law since it precluded the existence\nof a donative intent.\nAlthough the transfers of the stock made both in December 1923, and in the\nfollowing January by Mr. Kresge to this taxpayer are called a gift in the ante-nuptial\nagreement later executed and were to be for the protection of his prospective bride\nif he died before the marriage was consummated, the \xe2\x80\x9cgift\xe2\x80\x9d was contingent upon\nhis death before such marriage, an event that did not occur. Consequently, it would\nappear that no absolute gift was made before the ante-nuptial contract was executed\nand that she took title to the stock under its terms, viz: in consideration for her\npromise to marry him coupled with her promise to relinquish all rights in and to his\nproperty which she would otherwise acquire by the marriage. Her inchoate interest\nin the property of her affianced husband greatly exceeded the value of the stock\ntransferred to her. It was a fair consideration under ordinary legal concepts of that\nterm for the transfers of the stock by him. Ferguson v. Dickson, supra; McCaughn\nv. Carver, supra. She performed the contract under the terms of which the stock\nwas transferred to her and held the shares not as a donee but as a purchaser for a\nfair consideration.\n....\nDecision reversed.\n\nEstate and Gift Tax: The estate and gift taxes\nare in pari materia with each other. Neither is\nin pari materia with the income tax. What does\nthis mean?\n\nCLARK, Circuit Judge (dissenting)\n(omitted).\nNotes and Questions:\n1. Did the Commissioner lose out on taxing any transactions in 1923 and 1924?\nWhich ones?\n\xe2\x80\xa2Remember: the exchange of property whose value has appreciated or\ndepreciated to pay for something is a recognition event. Why?\n\xe2\x80\xa2What did the parties buy and sell in this case?\n2. What did taxpayer give as consideration in this case? How much did she pay for\nthe consideration that she gave? When was the money that she used to pay for it\n468\n\n\x0csubject to income tax?\n\xe2\x80\xa2How is this contrary to the sale-of-blood cases \xe2\x80\x93 where the amount realized\nis taxed in full?\nS.S. Kresge: Who was S.S. Kresge? What did\nhe do to make stock in his corporation go up so\nmuch in value?\n\n3. If there had been no antenuptial agreement, would the\ncourt\xe2\x80\x99s holding have been the\nsame?\n\xe2\x80\xa2What if the parties had married and then executed a post-nuptial agreement\nwith the same terms as the ante-nuptial agreement?\n\nIII. During Marriage\nA. Tax Consequences of Support Obligations\nConsider this variation of Cidis v. White, 71 Misc. 2d 481, 336 N.Y.S.2d 362 (Dist.\nCt. Nassau Cty., 1972): Dependent daughter without her parents\xe2\x80\x99 knowledge made\nan appointment with Dr. White to be fitted for contact lenses. Dr. White ordered\nthe contact lenses, and they were of no use to anyone except for daughter Cidis.\nDaughter Cidis was a minor, and her contracts were voidable under state law. Father\nCidis elected to void the contract. Dr. White sued for quasi-contract and restitution.\n\xe2\x80\xa2Assume that Father Cidis has an obligation to provide Daughter Cidis with\n\xe2\x80\x9cnecessaries.\xe2\x80\x9d\n\xe2\x80\xa2Should Father Cidis be liable for the fmv of the contact lenses \xe2\x80\x93 not on the\ntheory that there was an admittedly voidable contract, but because Dr. White\nprovided his daughter with a \xe2\x80\x9cnecessary?\xe2\x80\x9d\n\xe2\x80\xa2Are contact lenses one of life\xe2\x80\x99s \xe2\x80\x9cnecessaries\xe2\x80\x9d if Daughter Cidis\ndoes not see very well?\n\xe2\x80\xa2Would it matter that contact lenses are cheaper than spectacles?\n\xe2\x80\xa2If contact lenses are a \xe2\x80\x9cnecessary\xe2\x80\x9d and Dr. White delivered the contact\nlenses to Daughter Cidis, but neither Father Cidis nor Daughter Cidis would\npay for them, does Father Cidis have gross income? Why or why not?\nB. Filing Status\nWe know that the \xe2\x80\x9cfiling status\xe2\x80\x9d of a taxpayer determines the tax rate applicable to\nincrements of taxable income. We also know that there are such things as a\n469\n\n\x0c\xe2\x80\x9cmarriage bonus\xe2\x80\x9d and a \xe2\x80\x9cmarriage penalty\xe2\x80\x9d \xe2\x80\x93 depending on the relative pre-marital\nincome levels of the spouses. We have already considered the relative burdens of\neach of the filing statuses. Now we briefly consider the rules that place a taxpayer\nin one filing status or another.\nMarried Filing Jointly and Married Filing Separately: Section 1(a) provides that\nmarried persons who file a single tax return and certain surviving spouses must pay\nan income tax at the tax brackets specified. For income tax purposes, state law\ndetermines whether two persons are married.\n\xe2\x80\xa2Section 7703 states various rules concerning application of tax rules to\nmarriage and separation. Read it.\n\xe2\x80\xa2What is the rule established by \xc2\xa7 7703(a)(1)?\n\xe2\x80\xa2What is the rule established by \xc2\xa7 7703(a)(2)?\n\xe2\x80\xa2What is the rule established by \xc2\xa7 7703(b)?\n\xe2\x80\xa2Section 2(a) defines \xe2\x80\x9csurviving spouse.\xe2\x80\x9d Read it.\nSection 1(d) provides that married persons who do not file a single tax return jointly\n(i.e., they are \xe2\x80\x9cmarried filing separately\xe2\x80\x9d) must pay an income tax at the tax brackets\nspecified.\nHead of Household: Section 1(b) provides that a \xe2\x80\x9chead of household\xe2\x80\x9d must pay an\nincome tax at the tax brackets specified.\n\xe2\x80\xa2Section 2(b) defines \xe2\x80\x9chead of household.\xe2\x80\x9d Read it.\n\xe2\x80\xa2Can a married person be a \xe2\x80\x9chead of household?\xe2\x80\x9d\n\xe2\x80\xa2Can a surviving spouse be a \xe2\x80\x9chead of household?\xe2\x80\x9d\nUnmarried Individuals: Section 1(c) provides that every unmarried individual \xe2\x80\x93\nother than a surviving spouse or head of household \xe2\x80\x93 must pay an income tax at the\ntax brackets specified.\nDo the CALI Lesson, Basic Federal Income Taxation: Taxable Income and Tax\nComputation: Filing Status.\n\n470\n\n\x0cC. Dependents\nSection 152 defines \xe2\x80\x9cdependent.\xe2\x80\x9d\n\xe2\x80\xa2A \xe2\x80\x9cdependent\xe2\x80\x9d must be either a \xe2\x80\x9cqualifying child\xe2\x80\x9d or a \xe2\x80\x9cqualifying\nrelative.\xe2\x80\x9d \xc2\xa7 152(a).\n\xe2\x80\xa2A dependent must be a citizen, national, resident of the United States, or\nresident of a country contiguous with the United States. \xc2\xa7 152(b)(3)(A).\nThis limitation does not apply to an adopted child who has the same\nprincipal place of abode as a taxpayer and is a member of the taxpayer\xe2\x80\x99s\nhousehold, provided that the taxpayer is a citizen or national of the United\nStates. \xc2\xa7 152(b)(3)(B).\n\xe2\x80\xa2A dependent may not claim another as a dependent. \xc2\xa7 152(b)(1).\n\xe2\x80\xa2A spouse who files a joint return cannot be the dependent of another\ntaxpayer. \xc2\xa7 152(b)(2).\nSection 151(a) provides that a taxpayer who is an \xe2\x80\x9cindividual\xe2\x80\x9d is entitled to a\ndeduction of an \xe2\x80\x9cexemption amount\xe2\x80\x9d for each \xe2\x80\x9cdependent,\xe2\x80\x9d \xc2\xa7 151(c). In addition, a\ntaxpayer who files \xe2\x80\x9cmarried filing jointly\xe2\x80\x9d may claim a deduction of the exemption\namount for both himself and his spouse. Reg. \xc2\xa7 1.151-1(b) (third sentence, two\nexemptions allowed). A taxpayer who is married but does not file a joint return may\nclaim a deduction of the exemption amount for a spouse who has no gross income\nand is not the dependent of another taxpayer, \xc2\xa7 151(b). The \xe2\x80\x9cexemption amount\xe2\x80\x9d is\na fixed amount per dependent, see \xc2\xa7 151(d)(1), indexed for inflation, \xc2\xa7 151(d)(4).\nA taxpayer may not deduct an \xe2\x80\x9cexemption amount\xe2\x80\x9d for any person for whom a\ndependency deduction is allowable to another taxpayer, \xc2\xa7 151(d)(2).\nFor tax years 2018 to 2025, the exemption amount is zero. \xc2\xa7 151(d)(5)(A). The\ndeduction has been replaced with a doubled child tax credit (to $2000) available to\ntaxpayers at higher income levels, a refundable tax credit of up to $1400 for\ntaxpayers unable to take full advantage of the child tax credit, and a $500 tax credit\nfor each \xe2\x80\x9cqualifying relative.\xe2\x80\x9d \xc2\xa7 24(h)(2, 5, 4). Under the temporary rules, the\ndefinition of \xe2\x80\x9cqualifying child\xe2\x80\x9d and \xe2\x80\x9cqualifying relative\xe2\x80\x9d remain important.\nQualifying Child: A \xe2\x80\x9cqualifying child\xe2\x80\x9d is an individual who meets certain\nrequirements of relationship, place of abode, age, support, and filing status.\n\xc2\xa7 152(c)(1).\n\xe2\x80\xa2Relationship: A \xe2\x80\x9cqualifying child\xe2\x80\x9d can be \xe2\x80\x93\n\xe2\x80\xa2a child of the taxpayer, \xc2\xa7 152(c)(1), i.e., son, daughter, stepson,\nstepdaughter, or a foster child placed by an authorized placement\n471\n\n\x0cagency or under court order (\xc2\xa7152(f)(1)(A and C)) or a descendant\nof such an individual, \xc2\xa7 152(c)(2)(A). Taxpayer\xe2\x80\x99s legal adoption of\na son, daughter, stepson, or stepdaughter renders a person a child of\nthe taxpayer by blood. \xc2\xa7 152(f)(1)(B); OR\n\xe2\x80\xa2a brother, sister, stepbrother, or stepsister or a descendant of any\nsuch relative. \xc2\xa7 152(c)(2)(B). This includes a half-brother or halfsister. \xc2\xa7 152(f)(4).\n\xe2\x80\xa2Abode: A \xe2\x80\x9cqualifying child\xe2\x80\x9d must have \xe2\x80\x9cthe same principal place of abode\nas the taxpayer for more than one-half\xe2\x80\x9d of the year. \xc2\xa7 152(c)(1)(B).\n\xe2\x80\xa2There are special rules when the \xe2\x80\x9cqualifying child\xe2\x80\x9d is the child of\ndivorced parents. If the \xe2\x80\x9cqualifying child\xe2\x80\x9d receives over one-half of\nhis support during the year from his parents (including as a parent\xe2\x80\x99s\ncontribution the contribution of a new spouse, \xc2\xa7 152(e)(6)) who\neither \xe2\x80\x93\n\xe2\x80\xa2are divorced, \xc2\xa7 152(e)(1)(A)(i),\n\xe2\x80\xa2are separated under a written separation agreement,\n\xc2\xa7 152(e)(1)(A)(ii), or\n\xe2\x80\xa2live apart for all the last six months of the calendar year,\n\xc2\xa7 152(e)(1)(A)(iii),\n\xe2\x80\xa2and the child is in the custody of one or both the parents for more\nthan one-half of the calendar year, then the custodial parent (i.e., the\nparent having custody for the greater portion of the calendar year,\n\xc2\xa7 152(e)(4)(A)), may claim the child as a dependent, unless\n\xe2\x80\xa2The custodial parent executes a Form 8332 by which the\ncustodial parent declares that he will not claim the child as a\ndependent, \xc2\xa7 152(e)(2)(A), and\n\xe2\x80\xa2The noncustodial parent attaches Form 8332 to his tax\nreturn. \xc2\xa7 152(e)(2)(B).\n\xe2\x80\xa2These special rules for divorced parents do not apply to any case\nwhere the child received over one-half of his support under a socalled \xe2\x80\x9cmultiple support agreement.\xe2\x80\x9d \xc2\xa7 152(e)(5).\n\xe2\x80\xa2Age: A \xe2\x80\x9cqualifying child\xe2\x80\x9d must be younger than the taxpayer\n(\xc2\xa7 152(c)(3)(A)) and \xe2\x80\x93\n\xe2\x80\xa2not yet 19 years old, \xc2\xa7 152(c)(3)(i), unless\n\xe2\x80\xa2the individual is permanently and totally disabled at any\ntime during the year, \xc2\xa7 152(c)(3)(B), or\n\xe2\x80\xa2the child is a student who is not yet 24 years old,\n472\n\n\x0c\xc2\xa7 152(c)(3)(A)(ii). A \xe2\x80\x9cstudent\xe2\x80\x9d who is an individual who is\na full-time student at an educational institution or is pursuing\na full-time course of institutional on-farm training.\n\xc2\xa7 152(f)(2).\n\xe2\x80\xa2Support: A \xe2\x80\x9cqualifying child\xe2\x80\x9d is one who did not provide more than onehalf of his own support. \xc2\xa7 152(c)(1)(D). Scholarships are not taken into\naccount. \xc2\xa7 152(f)(5).\n\xe2\x80\xa2Filing status: A \xe2\x80\x9cqualifying child\xe2\x80\x9d may not file a joint return other than to\nclaim a refund with his spouse. \xc2\xa7 152(c)(1)(E).\nIt can happen that two or more persons can claim the same \xe2\x80\x9cqualifying child\xe2\x80\x9d as a\ndependent. In such a case, the \xe2\x80\x9cqualifying child\xe2\x80\x9d is treated as the \xe2\x80\x9cqualifying child\xe2\x80\x9d\nof \xe2\x80\x93\n\xe2\x80\xa2a parent, \xc2\xa7 152(c)(4)(A)(i):\n\xe2\x80\xa2If more than one parent can claim the \xe2\x80\x9cqualifying child\xe2\x80\x9d and the\nparents do not file a joint return, \xc2\xa7 152(c)(4)(B), the child is the\n\xe2\x80\x9cqualifying child\xe2\x80\x9d of \xe2\x80\x93\n\xe2\x80\xa2the parent with whom the child resided the longest during\nthe taxable year, \xc2\xa7 152(c)(4)(B)(i), or\n\xe2\x80\xa2if the child resided with each parent an equal amount of\ntime, the parent with the highest adjusted gross income.\n\xc2\xa7 152(c)(4)(B)(ii).\n\xe2\x80\xa2In the event the child is a \xe2\x80\x9cqualifying child\xe2\x80\x9d with respect to a parent\nbut no parent claims the \xe2\x80\x9cqualifying child,\xe2\x80\x9d another taxpayer may\nclaim the child as a dependent if that taxpayer\xe2\x80\x99s adjusted gross\nincome is higher than the highest adjusted gross income of a parent.\n\xc2\xa7 152(c)(4)(C).\n\xe2\x80\xa2If the child is not a \xe2\x80\x9cqualifying\xe2\x80\x9d child as to a parent, the taxpayer with the\nhighest adjusted gross income for whom the individual is a \xe2\x80\x9cqualifying\nchild\xe2\x80\x9d may claim the child as a dependent. \xc2\xa7 152(c)(4)(A)(ii).\nN.B.: Section 151 allowed (allows?) a deduction of an \xe2\x80\x9cexemption amount\xe2\x80\x9d for\neach of taxpayer\xe2\x80\x99s \xe2\x80\x9cdependents.\xe2\x80\x9d \xc2\xa7 151(a, b, and c). As noted, the \xe2\x80\x9cexemption\namount\xe2\x80\x9d for tax years 2018 to 2025 is zero. Instead, taxpayers may be entitled to a\n\xe2\x80\x9cchild tax credit\xe2\x80\x9d of $2000. \xc2\xa7 24(h)(2). Prior to enactment of the Tax Cuts and Jobs\nAct, the credit was $1000. The conditions of the \xe2\x80\x9cchild tax credit\xe2\x80\x9d are not a perfect\n473\n\n\x0cfit with \xc2\xa7 151(c) (dependent deduction) and \xc2\xa7 152(c) (qualifying child). The \xe2\x80\x9cchild\ntax credit\xe2\x80\x9d is only available until the child turns 17, \xc2\xa7 24(a)(1), not 19 (24 in the\ncase of a student). Moreover, the credit is not available for a child who is a resident\nof a country contiguous to the United States. \xc2\xa7 24(c)(2). However, a \xe2\x80\x9cqualifying\nchild\xe2\x80\x9d who is 17 or older may still be a dependent for which taxpayer is entitled to\na $500 tax credit. \xc2\xa7 24(h)(4)(A). The \xe2\x80\x9cchild tax credit\xe2\x80\x9d is non-refundable. \xc2\xa7 26(a).\nThe \xe2\x80\x9cchild tax credit\xe2\x80\x9d is subject to an income phaseout when a taxpayer\xe2\x80\x99s modified\nadjusted gross income exceeds $400,000 for taxpayers married filing jointly or\n$200,000 for other taxpayers. \xc2\xa7 24(h)(3), \xc2\xa7 24(b)(1) (credit reduced by 5% of\nexcess). Prior to enactment of the TCJA, the phaseout began at $110,000 for\ntaxpayers married filing jointly and at $75,000 for unmarried taxpayers. \xc2\xa7 24(b)(2).\nFor taxpayers whose tax liability is\nreduced to $0 and so cannot avail\nthemselves of the full \xe2\x80\x9cchild tax credit,\xe2\x80\x9d \xc2\xa7\n24(d) creates \xe2\x80\x9can additional child tax\ncredit\xe2\x80\x9d (ACTC). The ACTC is refundable\nto the extent a taxpayer could not use the\nfull $2000 \xe2\x80\x9cchild tax credit.\xe2\x80\x9d The TCJA\ncaps the credit at $1400 (indexed for\ninflation) per qualifying child. \xc2\xa7 24(h)(5).\nThe ACTC is only available to a taxpayer\nwith earned income. The refundable\namount is equal to 15% of the amount by\nwhich taxpayer\xe2\x80\x99s earned income exceeds\n$2500 or by which taxpayer\xe2\x80\x99s social\nsecurity taxes exceed taxpayer\xe2\x80\x99s earned\nincome credit if taxpayer has 3 or more\nqualifying children \xe2\x80\x93 WHICHEVER is\ngreater. \xc2\xa7 24(h)(5), \xc2\xa7 24(d)(1)(B). The\namount of the ACTC is subject to the\nadditional condition that the \xe2\x80\x9cchild tax\ncredit\xe2\x80\x9d plus the ACTC cannot exceed\n$2000. \xc2\xa7 24(d)(1)(A).\n\nARPA, \xc2\xa7 9611, 26 U.S.C. 24(i): For tax\nyear 2021, the child tax credit is increased\nfrom $2000 per qualifying child to $3000\nand to $3600 per qualifying child who has\nnot attained the age of 6. The credit is\nmade refundable. Furthermore, the credit\nis available until the child turns 18. The\nSecretary may make periodic payments to\ntaxpayers of this credit. The credit is\nsubject to a phase-out.\nThe amount of the \xe2\x80\x9cadditional child tax\ncredit\xe2\x80\x9d is dependent on the amount by\nwhich taxpayer\xe2\x80\x99s earned income exceeds\n$3000. Because the pandemic caused\nwidespread job loss, taxpayers may opt\nto use their 2019 earned income to\ndetermine the amount of this credit for tax\nyear 2020. CAA \xc2\xa7 211.\nFor purposes of the Earned Income Credit,\nARPA, \xc2\xa7 9626 extends this election\nforward to 2021.\n\nQualifying Relative: A \xe2\x80\x9cqualifying relative\xe2\x80\x9d is an individual who meets certain\nrequirements of relationship, gross income, support, and status.\n\xe2\x80\xa2Relationship: A \xe2\x80\x9cqualifying relative\xe2\x80\x9d with respect to the taxpayer may be\n\xe2\x80\x93\n474\n\n\x0c\xe2\x80\xa2a child or descendant of a child, \xc2\xa7 152(d)(2)(A), i.e., son, daughter,\nstepson, stepdaughter, or a foster child placed by an authorized\nplacement agency or under court order (\xc2\xa7152(f)(1)(A and C)) or a\ndescendant of such an individual, \xc2\xa7 152(c)(2)(A). Taxpayer\xe2\x80\x99s legal\nadoption of a son, daughter, stepson, or stepdaughter renders such a\nperson a child of the taxpayer by blood. \xc2\xa7 152(f)(1)(B);\n\xe2\x80\xa2a brother, sister, stepbrother, or stepsister. \xc2\xa7 152(d)(2)(B). This\nincludes a half-brother or half-sister. \xc2\xa7 152(f)(4);\n\xe2\x80\xa2a father or mother or ancestor of a father or mother; \xc2\xa7 152(d)(2)(C);\n\xe2\x80\xa2a stepfather or stepmother, \xc2\xa7 152(d)(2)(D);\n\xe2\x80\xa2a son or daughter of a brother or sister (i.e., nephew or niece),\n\xc2\xa7 152(d)(2)(E);\n\xe2\x80\xa2a brother or sister of the father or mother (i.e., uncle or aunt),\n\xc2\xa7 152(d)(2)(F);\n\xe2\x80\xa2a son-in-law, daughter-in-law, father-in-law, mother-in-law,\nbrother-in-law, or sister-in-law, \xc2\xa7 152(d)(2)(G);\n\xe2\x80\xa2an individual, other than one who was at any time during the\ntaxable year a spouse, who for the taxable year has the same\nprincipal place of abode as the taxpayer and is a member of the\ntaxpayer\xe2\x80\x99s household. \xc2\xa7 152(d)(2)(H).\n\xe2\x80\xa2An individual is not a member of taxpayer\xe2\x80\x99s household if at\nany time during the taxable year the relationship between the\nindividual and the taxpayer is in violation of local law.\n\xc2\xa7 152(f)(3).\n\xe2\x80\xa2Gross Income: The gross income of a \xe2\x80\x9cqualifying relative\xe2\x80\x9d may not be\nequal to or more than the exemption amount.201 \xc2\xa7 152(d)(1)(B).\n\xe2\x80\xa2The gross income of a permanently and totally disabled individual\ndoes not include income attributable to services rendered at a\ncharitable institution that provides special instruction or training\ndesigned to alleviate the disability, \xc2\xa7 152(d)(4)(B), and the\nindividual\xe2\x80\x99s principal reason for his presence there is the availability\nFor tax years 2018 to 2025, the personal exemption amount is zero. \xc2\xa7 151(d)(5)(A). However, for\npurposes of determining dependency, the personal exemption amount is not taken into account. \xc2\xa7\n151(d)(5)(B). For tax year 2020, the personal exemption amount is $4300. Rev. Proc. 2019-44, \xc2\xa7 3.25.\nThe same exemption amount will apply in determining eligibility for the $500 credit for a dependent\nother than a \xe2\x80\x9cqualifying child,\xe2\x80\x9d \xc2\xa7 24(h)(4)(A), and in determining whether a taxpayer is a \xe2\x80\x9chead of\nhousehold.\xe2\x80\x9d \xc2\xa7 2(b)(1)(A)(ii). See generally I.R.S. Notice 2018-70, 2018-38 I.R.B. 441 (\xe2\x80\x9cGuidance on\nQualifying Relative and the Exemption Amount\xe2\x80\x9d).\n201\n\n475\n\n\x0cof medical care and the income arises only from activities at the\ninstitution incident to such medical care, \xc2\xa7 152(d)(4)(A).\n\xc2\xa7 152(d)(4).\n\xe2\x80\xa2Support: Taxpayer must provide over one-half of the individual\xe2\x80\x99s support\nfor\nthe\ncalendar\nyear.\n\xc2\xa7 152(d)(1)(C).\nCARES Act, \xc2\xa7 2201, 26 U.S.C. \xc2\xa7 6428: This\n\xe2\x80\xa2An alimony or separate\nsection provides for a refundable credit for\nmaintenance payment is not\n2020 of $1200 for individuals, $2400 for\ncounted as payment for support of\njoint returns, and $500 for each qualifying\nchild (see accompanying text). These credits\na dependent. \xc2\xa7 152(d)(5)(A).\nphase out at the rate of 5% of taxpayers\xe2\x80\x99\n\xe2\x80\xa2Multiple Support Agreements: If\nagi that exceeds $150,000 (married filing\nthere is no taxpayer who\njointly), $112,500 (head of household),\ncontributed over one-half of an\nand $75,000 (single individual). Section\nindividual\xe2\x80\x99s support,\n6428(f) provides that the Secretary is to\n\xc2\xa7 152(d)(3)(A),\nrefund or credit these amounts \xe2\x80\x9cas rapidly\n\xe2\x80\xa2a taxpayer for whom the\nas possible.\xe2\x80\x9d\nindividual would otherwise have\nIn the CAA, the Covid-Related Tax Relief\nbeen a \xe2\x80\x9cqualifying individual,\xe2\x80\x9d\nAct of 2020, \xc2\xa7 272 added \xc2\xa7 6428A to the\n\xc2\xa7 152(d)(3)(B), and\nCode, which provides an additional\n\xe2\x80\xa2who contributed more than 10%\nrefundable credit of $600 for individuals\nof the individual\xe2\x80\x99s support,\nand $1200 for joint returns plus a $600\n\xc2\xa7 152(d)(3)(C),\ncredit for each of taxpayer\xe2\x80\x99s \xe2\x80\x9cqualifying\n\xe2\x80\xa2may claim the individual as a\nchildren.\xe2\x80\x9d These credits are subject to the\ndependent provided that all others\nsame phase out as the CARES Act credit.\nwho contributed more than 10%\nARPA, \xc2\xa7 9601, 26 U.S.C. \xc2\xa7 6428B: This\nof the individual\xe2\x80\x99s support file a\nsection provides for a refundable credit for\ndeclaration that they will not\n2021 of $1400 for individuals, $2800 for\nclaim the individual as a\njoint returns, and $1400 for each\ndependent, \xc2\xa7 152(d)(3)(D).\ndependent, i.e., qualifying child or\n\xe2\x80\xa2The rules governing treatment of\nqualifying relative, 26 U.S.C. \xc2\xa7 6428B(e)(1)\nan individual whose parents are\n(\xe2\x80\x9cdependent\xe2\x80\x9d as defined in \xc2\xa7 152)). These\ndivorced that govern the\namounts phase out as taxpayer\xe2\x80\x99s agi rises\nindividual\xe2\x80\x99s abode apply as well\nto $80,000 for individuals, $160,000 for\nto determinations between the\ntaxpayers married filing jointly, and\nparents with respect to support.\n$120,000 for taxpayers filing as head of\n\xc2\xa7 152(e)(1).\nhousehold.\n\n476\n\n\x0c\xe2\x80\xa2Status: A \xe2\x80\x9cqualifying relative\xe2\x80\x9d may not be a \xe2\x80\x9cqualifying child\xe2\x80\x9d of the\ntaxpayer or of any other taxpayer. \xc2\xa7 152(d)(1)(D).\nN.B.: The exemption amount for tax years 2018 to 2025 is zero. The TCJA creates\na $500 tax credit for dependents other than those qualifying for the \xe2\x80\x9cchild tax\ncredit.\xe2\x80\x9d \xc2\xa7 24(h)(4)(A).\nComment: We have seen the near elimination of any marriage penalty. We have\nseen the exemption amount reduced to zero. We note that the Tax Cuts and Jobs\nAct doubled the standard deduction. But the effect of this doubling is mitigated by\nthe suspension of many deductions, capping the SALT deductions at $10,000, and\ndenying a deduction for personal exemptions.\nConsider the change in emphasis that the doubled \xe2\x80\x9cchild tax credit\xe2\x80\x9d brings about.\nThe indexed exemption amount for 2017 was $4050. A taxpayer in the 10% tax\nbracket saved $405 per exemption. The same taxpayer who benefits from a $2000\n\xe2\x80\x9cchild tax credit\xe2\x80\x9d would have to have a deduction of $20,000 to obtain the same\nlevel of saving. For a 12% taxpayer, the same figures are $486 and $16,666.67.\nFor a 22% bracket taxpayer, the figures are $891 and $9090. What do these\nnumbers say about the use of credits rather than deductions?\nDo you see a discernible trend in Congress\xe2\x80\x99s attitude about families with children?\nRemember, Smith and Ochs are still good law.\n\n477\n\n\x0cD. Intra-Family Transactions\nIn various sections, the Tax Code creates presumptions that the members of a\nfamily share a common interest and addresses that presumption.202\n\xe2\x80\xa2We may choose to ignore every tax aspect of a transaction between family\nmembers. In many respects, \xc2\xa7 1041 (discussed infra) has this effect.\n\xe2\x80\xa2We may curtail the tax advantages of transactions where close relationships\ncould lead to abuse.\n\xe2\x80\xa2Read \xc2\xa7\xc2\xa7 267(a)(1), 267(b)(1), 267(c)(2), 267(c)(4), 267(d),203 and 1041.\nConsider:\n1. Taxpayer owned Greenacre. Taxpayer\xe2\x80\x99s adjusted basis in Greenacre was\n$25,000. Taxpayer sold Greenacre to his grandson for $15,000, its fmv.\n\xe2\x80\xa2How much loss may Taxpayer deduct under \xc2\xa7 165(a and c(2))? See\n\xc2\xa7\xc2\xa7 267(a)(1), 267(b)(1), 267(c)(4).\n\xe2\x80\xa2What is grandson\xe2\x80\x99s basis in Greenacre?\n\xe2\x80\xa2Now suppose that Grandson sold Greenacre to Clive for \xe2\x80\x93\n\xe2\x80\xa2$10,000. How much loss could Grandson deduct?\n\xe2\x80\xa2$20,000. How much gain (loss?) must Grandson report? See\n\xc2\xa7 267(d).\n\xe2\x80\xa2$30,000. How much gain must Grandson report? See \xc2\xa7 267(d).\n2. Have we seen this pattern of gain and loss recognition before?\n3. Would your answers be different if Taxpayer had sold Greenacre to his uncle?\n\xe2\x80\x93 grandmother? \xe2\x80\x93 nephew?\n4. Would your answers be different if Taxpayer had sold Greenacre to his husband?\nSee \xc2\xa7 1041.\n\n202\n\nWe defer discussion of some of these presumptions to more advanced courses. See \xc2\xa7 318.\n\nThese selected parts of \xc2\xa7 267 apply to transactions between family members. Be aware that the\nscope of \xc2\xa7 267 is broader than merely transactions involving family members. We defer discussion of\nthese other transactions to later tax courses.\n203\n\n478\n\n\x0cIV. After Marriage: Tax Consequences of Divorce\nDivorce renders spouses separate taxpayers with interests that should (at some\npoint) no longer be presumed to be the same. Various rights and obligations may\nensue, and their origins might be \xe2\x80\x93\n\xe2\x80\xa2a legal duty,\n\xe2\x80\xa2ownership of property, or\n\xe2\x80\xa2an agreement.\nA. Alimony and Property Settlement\nThe \xe2\x80\x9claw\xe2\x80\x9d imposes various duties upon persons. The source of a duty may be a\nrelationship. For example, a parent may have a duty to provide \xe2\x80\x9cnecessaries\xe2\x80\x9d for\nhis minor child.\n\xe2\x80\xa2If a parent fails in that duty and a third person steps up and pays money to\nfulfill that duty, must the parent recognize gross income?\n\xe2\x80\xa2If a family member has a duty to another that requires some payment of\nmoney to fulfill, should such payment give rise to a deduction?\n\xe2\x80\xa2What answers do cases such as Flowers, Hantzis, Smith, and Ochs\nimply?\n\xe2\x80\xa2Consider \xe2\x80\x93\nGould v. Gould, 245 U.S. 151 (1917)\nMR. JUSTICE McREYNOLDS delivered the opinion of the Court.\nA decree of the Supreme Court for New York County entered in 1909 forever\nseparated the parties to this proceeding, then and now citizens of the United States,\nfrom bed and board, and further ordered that plaintiff in error pay to Katherine C.\nGould during her life the sum of $3000 every month for her support and\nmaintenance. The question presented is whether such monthly payments during the\nyears 1913 and 1914 constituted parts of Mrs. Gould\xe2\x80\x99s income within the\nintendment of the act of Congress approved October 3, 1913, 38 Stat. 114, 166, and\nwere subject as such to the tax prescribed therein. The court below answered in the\nnegative, and we think it reached the proper conclusion.\n....\n479\n\n\x0cIn Audubon v. Shufeldt, 181 U.S. 575, 577-578, we said:\n\xe2\x80\x9cAlimony does not arise from any business transaction, but from the relation\nof marriage. It is not founded on a contract, express or implied, but on the\nnatural and legal duty of the husband to support the wife. The general\nobligation to support is made specific by the decree of the court of\nappropriate jurisdiction. ... Permanent alimony is regarded rather as a\nportion of the husband\xe2\x80\x99s estate to which the wife is equitably entitled than\nas strictly a debt; alimony from time to time may be regarded as a portion\nof his current income or earnings. ...\xe2\x80\x9d\nThe net income of the divorced husband subject to taxation was not decreased by\npayment of alimony under the court\xe2\x80\x99s order, and, on the other hand, the sum\nreceived by the wife on account thereof cannot be regarded as income arising or\naccruing to her within the enactment.\nThe judgment of the court below is\nAffirmed.\nNotes and Questions:\n1. What basis of the obligation to pay alimony does the Court recognize?\n2. The holding in Gould was the rule until World War II. At that time, tax brackets\nincreased to such a level that many men came out below $0 when they paid alimony\nand the income tax on the alimony. Congress acted. It made alimony a \xc2\xa7 62\ndeduction to the payor and gross income to the payee. This permitted (encouraged)\ndivorcing spouses to characterize any payment as alimony. The source of their\nobligation became agreement or court order. The parties could enlarge the pie they\nhad to split by arranging to have the ex-spouse in the lower tax bracket be liable for\nincome tax on the alimony.\n3. This has all changed. In the Tax Cuts and Jobs Act, Congress repealed all the\nalimony provisions of the Code for any divorce or separation instrument executed\nafter December 31, 2018. As of tax year 2019, we revert to the rule of Gould v.\nGould.\n480\n\n\x0c4. Property settlement: A property settlement divides marital property \xe2\x80\x93 assets as\nwell as debts. Presumably, the spouses purchased assets with after-tax dollars and\nso its allocation to one spouse or the other should not be the occasion for another\nlayer of income tax.\nB. Payments to Ex-Spouses to Surrender Rights\nWe might suppose that the event of divorce should vest (or re-vest) each ex-spouse\nwith property rights that can be bought and sold \xe2\x80\x93 with all the tax consequences\nthat should naturally flow from such transactions.\n\xe2\x80\xa2Should the event of divorce cause us to treat rights that can only exist\nbetween spouses as property that can be bought and sold in commercial\ntransactions? How should we value such rights?204\n\xe2\x80\xa2The United States Supreme Court addressed these questions in United\nStates v. Davis, 370 U.S. 65 (1962).\nNote on United States v. Davis, 370 U.S. 65 (1962) and \xc2\xa7 1041\nIn United States v. Davis, H transferred pursuant to a property settlement\nappreciated stock (basis = $74,775.37, fmv = $82,250) to W in exchange for W\xe2\x80\x99s\nsurrender of all claims against H, including dower and all rights of testacy and\nintestacy under Delaware state law. The Government argued that the transfer was\nmade in exchange for an independent legal obligation. Taxpayer H argued that the\ntransfer was comparable to a nontaxable division of property between two coowners. The Court concluded that Delaware state law did not make W a co-owner\nof the stock \xe2\x80\x93 as might occur in community property states. Instead, H exchanged\nstock for W\xe2\x80\x99s surrender of claims against him. In the absence of any method to\nvalue what W surrendered, the Court \xe2\x80\x93 by assuming that the parties engaged in an\neven exchange \xe2\x80\x93 treated H as realizing the fmv of the stock. Since that was more\nthan his basis in the stock, the Court agreed that H\xe2\x80\x99s taxable gain was the fmv of\nthe stock minus his basis. As for W, the Court held that she acquired a basis in the\nstock she received equal to the amount H realized.\n\xe2\x80\xa2The Court treated inchoate rights that can only exist in marriage as if they\nwere property that can be bought and sold. The Court treated the parties the\nsame way we would expect courts to treat strangers who exchanged\n204\n\nFarid-es-Sultaneh examined some of these same questions in the pre-marriage context.\n\n481\n\n\x0cproperties. H exchanged appreciated property to pay for something; that is\na recognition event.\n\xe2\x80\xa2Giving W a tax basis equal to the fmv of what H surrendered is no more\ncorrect here than it was in Farid-es-Sultaneh.\n\xe2\x80\xa2Congress responded to Davis.\n\xe2\x80\xa2Read \xc2\xa7 1041. The division of\nproperty between divorcing\nSection 1041: Does \xc2\xa7 1041 create\nspouses is now a nonopportunities to save divorcing\nrecognition event.\nspouses income taxes? What if the\n\xe2\x80\xa2How would the result in Davis\ntax brackets of the divorcing\nhave been different if \xc2\xa7 1041\nspouses are not going to be the\nwere the law at the time the\nsame?\ncase was decided?\n\xe2\x80\xa2In what ways does \xc2\xa7 1041\ndiffer from \xc2\xa7 1015?\n\xe2\x80\xa2Is the rule of \xc2\xa7 1041 better than the holding of Davis?\nC. Child Support\nChild support payments are made to fulfill a parental obligation. Both parents have\nthis obligation. Fulfillment of this obligation does not create any right to a\ndeduction, but only to a dependent deduction (a tax credit for tax years 2018 to\n2025) of the exemption amount. The same is true after dissolution of the marriage.\nThe Code has some special rules for allocation of the dependent deduction (tax\ncredit) in its definitions of \xe2\x80\x9cqualifying child\xe2\x80\x9d and \xe2\x80\x9cqualifying relative,\xe2\x80\x9d supra.\nFurthermore, receipt of child support payments is not gross income to the payee.\nA parent has an obligation to support his minor children. If someone else fulfills\nthat obligation, it seems that the parent has realized gross income. Change the facts:\ninstead of a person with no parental obligation making payments, it is a person with\na parental obligation who fails to make payments (an all-too-frequent occurrence).\nThe former spouse is left to make up the difference.\n\n482\n\n\x0cRev. Rul. 93-27, 1993-1 C.B. 32\nISSUE\nIs a taxpayer entitled to a nonbusiness bad debt deduction under \xc2\xa7 166(a)(1) of the\nCode for the amount of the taxpayer\xe2\x80\x99s own payment in support of the taxpayer\xe2\x80\x99s\nchildren caused by an arrearage in court-ordered child support payments owed by\na former spouse?\nFACTS\nThe taxpayer, A, was divorced in 1989 from B and was granted custody of their\ntwo minor children. Pursuant to a property settlement and support agreement that\nwas incorporated into the divorce decree, B agreed to pay to A $500 per month for\nchild support. During 1991, B failed to pay $5,000 of this obligation. Because of\nB\xe2\x80\x99s arrearage, A had to spend $5,000 of A\xe2\x80\x99s own funds in support of A\xe2\x80\x99s children.\nLAW AND ANALYSIS\nSection 166(a)(1) of the Code allows as a deduction any debt that becomes\nworthless within the taxable year.\nSection 166(b) of the Code provides that for purposes of \xc2\xa7 166(a), the amount of\nthe deduction for any worthless debt is the adjusted basis provided in \xc2\xa7 1011 for\ndetermining the loss from the sale or other disposition of property.\nSection 1011 of the Code generally provides that the adjusted basis for determining\nthe gain or loss from the sale or other disposition of property, whenever acquired,\nis the basis as determined under \xc2\xa7 1012.\nSection 1012 of the Code provides that the basis of property is the cost of the\nproperty.\nIn Swenson v. Commissioner, 43 T.C. 897 (1965), the taxpayer claimed a bad debt\ndeduction under \xc2\xa7 166(a)(1) of the Code for an uncollectible arrearage in child\nsupport payments from a former spouse. The Tax Court denied the deduction on\nthe ground that \xc2\xa7 166(b) precluded any deduction because the taxpayer had no basis\nin the debt created by the child support obligation. The taxpayer had argued that\n483\n\n\x0cher basis consisted of the expenditures for child support she was forced to make\nfrom her own funds as a result of the father\xe2\x80\x99s failure to make his required payments.\nThe court pointed out, however, that the father\xe2\x80\x99s obligation to make the payments\nhad been imposed by the divorce court and was not contingent on the taxpayer\xe2\x80\x99s\nsupport expenditures. It stated that those expenditures neither created the arrearage\nnor constituted its cost to the taxpayer. Swenson, at 899.\nThe Tax Court has followed the decision in Swenson on similar facts in Perry v.\nCommissioner, 92 T.C. 470 (1989); Meyer v. Commissioner, T.C.M. 1984-487;\nPierson v. Commissioner, T.C.M. 1984-452; and Diez-Arguellos v. Commissioner,\nT.C.M. 1984-356.\nIn the present case, as in those above, B\xe2\x80\x99s obligation to make the child support\npayments to A was imposed directly by the court. A\xe2\x80\x99s own child support\nexpenditures did not create or affect B\xe2\x80\x99s obligation to A under the divorce decree.\nAccordingly, A did not have any basis in B\xe2\x80\x99s obligation to pay child support, and\nA may not claim a bad debt deduction under \xc2\xa7 166(a)(1) of the Code with regard to\nan arrearage in those payments.\n....\nHOLDING\nA taxpayer is not entitled to a bad debt deduction under \xc2\xa7 166(a)(1) of the Code for\nthe amount of the taxpayer\xe2\x80\x99s own payment in support of the taxpayer\xe2\x80\x99s children\ncaused by an arrearage in court-ordered child support payments owed by a former\nspouse.\nNotes and Questions:\n1. A problem for \xe2\x80\x9cA\xe2\x80\x9d is that she wants a deduction but no other taxpayer realizes\nan equal amount of gross income.\n\xe2\x80\xa2If the Commissioner determined that B should include $5000 in his gross\nincome, should a court uphold the Commissioner\xe2\x80\x99s position?\n2. Should the failure of one ex-spouse to make child support payments to the other\nex-spouse be a matter for the IRS? One suspects that IRS involvement might lead\nto fewer child support arrearages.\n484\n\n\x0cWrap-Up Questions for Chapter 8\n1. The basis of the Davis case was that taxpayer\xe2\x80\x99s wife\xe2\x80\x99s interest partook \xe2\x80\x9cmore of\na personal liability of the husband than a property interest of the wife.\xe2\x80\x9d Hence,\ntaxpayer merely fulfilled his obligation by giving up appreciated property \xe2\x80\x93 a\nrecognition event. Was Congress right to reverse the holding?\n2. Mr. Davis would have benefited from \xc2\xa7 1041. Exactly how does \xc2\xa7 1041 affect\nMrs. Davis\xe2\x80\x99s basis in her inchoate marital rights?\n3. What should happen if H and W jointly own all the stock of a corporation that\nowns a McDonald\xe2\x80\x99s franchise. They divorce. McDonald\xe2\x80\x99s does not allow divorced\nspouses to own jointly a franchise. As part of their property settlement, H and W\nagree that the corporation will redeem W\xe2\x80\x99s stock. For this, W must pay tax on the\ngain. In reaching this agreement, the parties carefully considered its tax\nconsequences. Specifically, a large chunk of cash would go to W, and she would\npay income tax at the capital gains rate \xe2\x80\x93 much lower than the tax rate on ordinary\nincome. W decides not to pay the tax on the gain and to argue in court that the\ncorporation, a third party, was paying the property settlement obligation of H.\nHence, he should be subject to income tax on dividend income, which was taxable\nat ordinary income rates. What result? See Arnes v. United States, 981 F.2d 456 (9th\nCir. 1992) and Commissioner v. Arnes, 102 T.C. 522 (1994). What is the effect of\nReg. \xc2\xa7 1.1041-2(c)?\n4. Section 23 provides a capped dollar-for-dollar tax credit for various adoption\nexpenses that is subject to an income phaseout at relatively high levels of AGI.\nSection 137 provides an exclusion from gross income for an employee who benefits\nfrom his employer\xe2\x80\x99s adoption assistance program. In the Tax Cuts and Jobs Act,\nCongress doubled the child tax credit for tax years 2018 to 2025 from $1000 to\n$2000 and changed the deductible exemption amount for dependents other than\nqualifying children from (what would have been) $4150 (in 2018) to a flat $500 tax\ncredit. From what you have learned of tax policies towards various personal choices\nin preceding chapters, what trends do you see in provisions such as these?\n\n485\n\n\x0cWhat have you learned?\nCan you explain or define \xe2\x80\x93\n\xe2\x80\xa2What it means for the federal income tax and the federal gift tax to be not in pari\nmateria?\n\xe2\x80\xa2How \xc2\xa7 267 treats losses in transactions between related persons?\n\xe2\x80\xa2What the rule of \xc2\xa7 1041 is? How does it differ from the rule of \xc2\xa7 1015?\n\xe2\x80\xa2In what ways property settlements, alimony, and child support differ conceptually?\n\n486\n\n\x0cChapter 9: Timing of Income and Deductions: Annual Accounting\nand Accounting Principles\nI. Annual Accounting\nAfter Glenshaw Glass (chapter 2,\nThe Tax Formula:\nsupra), we know that one element of\n\xe2\x80\x9cgross income\xe2\x80\x9d that taxpayer must\n\xe2\x9e\x94 (gross income)\nrecognize is taxpayer\xe2\x80\x99s dominion and\nMINUS deductions named in \xc2\xa7 62\ncontrol of it. After Cottage Savings &\nEQUALS (adjusted gross income (AGI))\nLoan (chapter 2, supra), we know that\n\xe2\x9e\x94MINUS (standard deduction or itemized\na realization requirement applies to\ndeductions)\ndeductible losses as well as to income.\nMINUS (deduction for \xe2\x80\x9cqualified business\nIt is not always obvious just exactly\nincome\xe2\x80\x9d)\nwhen taxpayer has dominion and\nEQUALS (taxable income)\ncontrol over income or has realized a\ndeductible\nCompute income tax liability from tables\nloss. Consider some problematic\nin \xc2\xa7 1(j) (indexed for inflation)\nscenarios:\n\xe2\x9e\x94MINUS (credits against tax)\n\xe2\x80\xa2Taxpayer receives money, has\n\xe2\x80\x9cdominion and control\xe2\x80\x9d over it,\nand would normally count it as\n\xe2\x80\x9cgross income\xe2\x80\x9d \xe2\x80\x93 but learns in\na subsequent year that she must give at least some of the money back.\n\xe2\x80\xa2Taxpayer has \xe2\x80\x9cdominion and control\xe2\x80\x9d over money but knows that she\nmight have to return it if certain contingencies occur. For example, a court\nhas determined that taxpayer is entitled to money and has received it, but\nthe judgment on which her receipt of money was based has been appealed.\nIf taxpayer loses the appeal, she will have to return the money. In the\nmeantime, taxpayer may spend the money any way she chooses.\n\xe2\x80\xa2Taxpayer has entered into a contract that calls for various acts of\nperformance to occur over more than one year, perhaps many years. The\ntaxpayer pays expenses in some years and receives payments in some years.\nHowever, in any given year, there is no transactional matching of\nexpenditures and receipts. In some years, expenses are very high; in other\nyears receipts are very high. When taxpayer does receive money, she may\nspend it any way she chooses.\n487\n\n\x0cThe Internal Revenue Code requires taxpayers to compute their taxable income\nannually. See \xc2\xa7 441. This can prove to be quite inconvenient for a taxpayer \xe2\x80\x93 and\neven a bit misleading, as in the third scenario above, i.e., where taxpayer enters into\na contract calling for performance over a period of several years. We examine here\nsome basic rules that have evolved to govern income timing questions.\nClaim of Right doctrine: Taxpayer must include in her\ngross income an item when she has a \xe2\x80\x9cclaim of right\xe2\x80\x9d\nto it. In North American Oil Consolidated v. Burnet,\n286 U.S. 417, 424 (1932), the Supreme Court stated\nthe doctrine thus:\nIf a taxpayer receives earnings under a claim\nof right and without restriction as to its\ndisposition, he has received income which he is\nrequired to return, even though it may still be\nclaimed that he is not entitled to retain the\nmoney, and even though he may still be\nadjudged liable to restore its equivalent.\n\nBurnet v. Sanford &\nBrooks, 282 U.S. 359\n(1931)\nMR. JUSTICE STONE\ndelivered the opinion of\nthe Court.\n\nIn this case, certiorari was\ngranted, 281 U.S. 707, to\nreview a judgment of the\ncourt of appeals for the\nFourth Circuit, reversing\nan order of the Board of Tax Appeals, which had sustained the action of the\nCommissioner of Internal Revenue in making a deficiency assessment against\nrespondent for income and profits taxes for the year 1920.\nFrom 1913 to 1915, inclusive, respondent, a Delaware corporation engaged in\nbusiness for profit, was acting for the Atlantic Dredging Company in carrying out\na contract for dredging the Delaware River, entered into by that company with the\nUnited States. In making its income tax returns for the years 1913 to 1916,\nrespondent added to gross income for each year the payments made under the\ncontract that year, and deducted its expenses paid that year in performing the\ncontract. The total expenses exceeded the payments received by $176,271.88. The\ntax returns for 1913, 1915, and 1916 showed net losses. That for 1914 showed net\nincome.\nIn 1915, work under the contract was abandoned, and in 1916 suit was brought in\nthe Court of Claims to recover for a breach of warranty of the character of the\nmaterial to be dredged. Judgment for the claimant was affirmed by this Court in\n1920. United States v. Atlantic Dredging Co., 253 U.S. 1. It held that the recovery\nwas upon the contract, and was \xe2\x80\x9ccompensatory of the cost of the work, of which\n488\n\n\x0cthe government got the benefit.\xe2\x80\x9d From the total recovery, petitioner received in that\nyear the sum of $192,577.59, which included the $176,271.88 by which its\nexpenses under the contract had exceeded receipts from it, and accrued interest\namounting to $16,305.71. Respondent having failed to include these amounts as\ngross income in its tax returns for 1920, the Commissioner made the deficiency\nassessment here involved, based on the addition of both items to gross income for\nthat year.\nThe court of appeals ruled that only the item of interest was properly included,\nholding, erroneously, as the government contends, that the item of $176,271.88 was\na return of losses suffered by respondent in earlier years, and hence was wrongly\nassessed as income. Notwithstanding this conclusion, its judgment of reversal and\nthe consequent elimination of this item from gross income for 1920 were made\ncontingent upon the filing by respondent of amended returns for the years 1913 to\n1916, from which were to be omitted the deductions of the related items of expenses\npaid in those years. Respondent insists that, as the Sixteenth Amendment and the\nRevenue Act of 1918, which was in force in 1920, plainly contemplate a tax only\non net income or profits, any application of the statute which operates to impose a\ntax with respect to the present transaction, from which respondent received no\nprofit, cannot be upheld.\nIf respondent\xe2\x80\x99s contention that only gain or profit may be taxed under the Sixteenth\nAmendment be accepted without qualification, see Eisner v. Macomber, 252 U.S.\n189; Doyle v. Mitchell Brothers Co., 247 U.S. 179, the question remains whether\nthe gain or profit which is the subject of the tax may be ascertained, as here, on the\nbasis of fixed accounting periods, or whether, as is pressed upon us, it can only be\nnet profit ascertained on the basis of particular transactions of the taxpayer when\nthey are brought to a conclusion.\nAll the revenue acts which have been enacted since the adoption of the Sixteenth\nAmendment have uniformly assessed the tax on the basis of annual returns showing\nthe net result of all the taxpayer\xe2\x80\x99s transactions during a fixed accounting period,\neither the calendar year or, at the option of the taxpayer, the particular fiscal year\nwhich he may adopt. Under ... the Revenue Act of 1918, 40 Stat. 1057, respondent\nwas subject to tax upon its annual net income, arrived at by deducting from gross\nincome for each taxable year all the ordinary and necessary expenses paid during\nthat year in carrying on any trade or business, interest and taxes paid, and losses\nsustained, during the year. ... [G]ross income \xe2\x80\x9cincludes ... income derived from ...\nbusiness ... or the transaction of any business carried on for gain or profit, or gains\n489\n\n\x0cor profits and income derived from any source whatever.\xe2\x80\x9d The amount of all such\nitems is required to be included in the gross income for the taxable year in which\nreceived by the taxpayer, unless they may be properly accounted for on the accrual\nbasis under \xc2\xa7 212(b). See United States v. Anderson, 269 U.S. 422; Aluminum\nCastings Co. v. Rotzahn, 282 U.S. 92.\nThat the recovery made by respondent in 1920 was gross income for that year\nwithin the meaning of these sections cannot, we think, be doubted. The money\nreceived was derived from a contract entered into in the course of respondent\xe2\x80\x99s\nbusiness operations for profit. While it equalled, and in a loose sense was a return\nof, expenditures made in performing the contract, still, as the Board of Tax Appeals\nfound, the expenditures were made in defraying the expenses incurred in the\nprosecution of the work under the contract, for the purpose of earning profits. They\nwere not capital investments, the cost of which, if converted, must first be restored\nfrom the proceeds before there is a capital gain taxable as income. See Doyle v.\nMitchell Brothers Co., supra, 247 U.S. at 185.\nThat such receipts from the conduct of a business enterprise are to be included in\nthe taxpayer\xe2\x80\x99s return as a part of gross income, regardless of whether the particular\ntransaction results in net profit, sufficiently appears from the quoted words of\n\xc2\xa7 213(a) and from the character of the deductions allowed. Only by including these\nitems of gross income in the 1920 return would it have been possible to ascertain\nrespondent\xe2\x80\x99s net income for the period covered by the return, which is what the\nstatute taxes. The excess of gross income over deductions did not any the less\nconstitute net income for the taxable period because respondent, in an earlier\nperiod, suffered net losses in the conduct of its business which were in some\nmeasure attributable to expenditures made to produce the net income of the later\nperiod.\n....\nBut respondent insists that, if the sum which it recovered is the income defined by\nthe statute, still it is not income, taxation of which without apportionment is\npermitted by the Sixteenth Amendment, since the particular transaction from which\nit was derived did not result in any net gain or profit. But we do not think the\namendment is to be so narrowly construed. A taxpayer may be in receipt of net\nincome in one year and not in another. The net result of the two years, if combined\nin a single taxable period, might still be a loss, but it has never been supposed that\nthat fact would relieve him from a tax on the first, or that it affords any reason for\n490\n\n\x0cpostponing the assessment of the tax until the end of a lifetime, or for some other\nindefinite period, to ascertain more precisely whether the final outcome of the\nperiod, or of a given transaction, will be a gain or a loss.\nThe Sixteenth Amendment was adopted to enable the government to raise revenue\nby taxation. It is the essence of any system of taxation that it should produce\nrevenue ascertainable, and payable to the government, at regular intervals. Only by\nsuch a system is it practicable to produce a regular flow of income and apply\nmethods of accounting, assessment, and collection capable of practical operation.\nIt is not suggested that there has ever been any general scheme for taxing income\non any other basis. \xe2\x80\xa6 While, conceivably, a different system might be devised by\nwhich the tax could be assessed, wholly or in part, on the basis of the finally\nascertained results of particular transactions, Congress is not required by the\namendment to adopt such a system in preference to the more familiar method, even\nif it were practicable. It would not necessarily obviate the kind of inequalities of\nwhich respondent complains. If losses from particular transactions were to be set\noff against gains in others, there would still be the practical necessity of computing\nthe tax on the basis of annual or other fixed taxable periods, which might result in\nthe taxpayer\xe2\x80\x99s being required to pay a tax on income in one period exceeded by net\nlosses in another.\nUnder the statutes and regulations in force in 1920, two methods were provided by\nwhich, to a limited extent, the expenses of a transaction incurred in one year might\nbe offset by the amounts actually received from it in another. One was by returns\non the accrual basis ..., which provides that a taxpayer keeping accounts upon any\nbasis other than that of actual receipts and disbursements, unless such basis does\nnot clearly reflect its income, may, subject to regulations of the Commissioner,\nmake its return upon the basis upon which its books are kept. See United States v.\nAnderson, and Aluminum Castings Co. v. Routzahn, supra. The other was under\nTreasury Regulations (Article 121 of Reg. 33 of Jan. 2, 1918 ... providing that, in\nreporting the income derived from certain long-term contracts, the taxpayer might\neither report all of the receipts and all of the expenditures made on account of a\nparticular contract in the year in which the work was completed or report in each\nyear the percentage of the estimated profit corresponding to the percentage of the\ntotal estimated expenditures which was made in that year.\n... [R]espondent [does not] assert, that it ever filed returns in compliance either with\nthese regulations ... or otherwise attempted to avail itself of their provisions; nor,\non this record, do any facts appear tending to support the burden, resting on the\n491\n\n\x0ctaxpayer, of establishing that the Commissioner erred in failing to apply them. See\nNiles Bement Pond Co. v. United States, 281 U.S. 357, 361.\nThe assessment was properly made under the statutes. Relief from their alleged\nburdensome operation, which may not be secured under these provisions, can be\nafforded only by legislation, not by the courts.\nReversed.\nNotes and Questions:\n1. The corporate income tax rate in 1913, 1914, and 1915 was 1%. The rate was\n2% in 1916. The rate was 10% in 1920 with a $2000 exemption.\n2. The Court held out the possibility that taxpayer might keep accounts on the\naccrual basis or on a percentage-of-completion basis\nCARES Act, \xc2\xa7 2303 amended\nin the case of long-term contracts. What do you think\n\xc2\xa7 172 to provide that net\nthese methods are? Would one or the other of these\nlosses incurred in 2018, 2019,\nmethods have been better for taxpayer? Why?\nand 2020 could be carried\nback five years except for\n3. The Code of course now has one more\nlosses incurred by real estate\nmechanism by which a transaction in one year may\ninvestment trusts. This will\noffset a transaction in another: the net operating loss\nenable businesses that suffer\n(\xc2\xa7 172). Taxpayers may carry trade or business\nnet operating losses during\nlosses forward indefinitely. See chapter 6, supra.\nthe pandemic to claim refunds\nof income taxes paid during\n4. Interesting questions involving the impact of\nthe prior five years.\nannual accounting on taxpayers arise when tax rates\nFarmers may elect not to\nchange. Tax rates often change because of war \xe2\x80\x93\napply this 5-year carryback\nthey increase because of the war and decrease after\nfor losses arising in 2018,\nthe war.\n2019, and 2020. CAA,\nCovid-Related Tax Relief Act\nof 2020, \xc2\xa7 282.\n\n492\n\n\x0cUnited States v. Lewis, 340 U.S. 590 (1951)\nMR. JUSTICE BLACK delivered the opinion of the Court.\nRespondent Lewis brought this action in the Court of Claims seeking a refund of\nan alleged overpayment of his 1944 income tax. The facts found by the Court of\nClaims are: in his 1944 income tax return, respondent reported about $22,000 which\nhe had received that year as an employee\xe2\x80\x99s bonus. As a result of subsequent\nlitigation in a state court, however, it was decided that respondent\xe2\x80\x99s bonus had been\nimproperly computed; under compulsion of the state court\xe2\x80\x99s judgment, he returned\napproximately $11,000 to his employer. Until payment of the judgment in 1946,\nrespondent had at all times claimed and used the full $22,000 unconditionally as\nhis own, in the good faith though \xe2\x80\x9cmistaken\xe2\x80\x9d belief that he was entitled to the whole\nbonus.\nOn the foregoing facts, the Government\xe2\x80\x99s position is that respondent\xe2\x80\x99s 1944 tax\nshould not be recomputed, but that respondent should have deducted the $11,000\nas a loss in his 1946 tax return. See G.C.M. 16730, XV-1 CUM. BULL. 179 (1936).\nThe Court of Claims, however, relying on its own case, Greenwald v. United States,\n57 F. Supp. 569, held that the excess bonus received \xe2\x80\x9cunder a mistake of fact\xe2\x80\x9d was\nnot income in 1944, and ordered a refund based on a recalculation of that year\xe2\x80\x99s\ntax. We granted certiorari because this holding conflicted with many decisions of\nthe courts of appeals, see, e.g., Haberkorn v. United States, 173 F.2d 587, and with\nprinciples announced in North American Oil Consolidated v. Burnet, 286 U.S. 417.\nIn the North American Oil case, we said: \xe2\x80\x9cIf a taxpayer receives earnings under a\nclaim of right and without restriction as to its disposition, he has received income\nwhich he is required to return, even though it may still be claimed that he is not\nentitled to retain the money, and even though he may still be adjudged liable to\nrestore its equivalent.\xe2\x80\x9d 286 U.S. at 424. Nothing in this language permits an\nexception merely because a taxpayer is \xe2\x80\x9cmistaken\xe2\x80\x9d as to the validity of his claim.\n...\nIncome taxes must be paid on income received (or accrued) during an annual\naccounting period. Cf. I.R.C. \xc2\xa7\xc2\xa7 41, 42, and see Burnet v. Sanford & Brooks Co.,\n282 U.S. 359, 363. The \xe2\x80\x9cclaim of right\xe2\x80\x9d interpretation of the tax laws has long been\nused to give finality to that period, and is now deeply rooted in the federal tax\nsystem. See cases collected in 2 MERTENS, LAW OF FEDERAL INCOME TAXATION,\n\xc2\xa7 12.103. We see no reason why the Court should depart from this well settled\n493\n\n\x0cinterpretation merely because it results in an advantage or disadvantage to a\ntaxpayer. [footnote omitted]\nReversed.\nMR. JUSTICE DOUGLAS, dissenting. \xe2\x80\xa6.\nNotes and Questions:\n1. Marginal tax brackets decreased a little after the end of WWII. Hence, taxpayer\xe2\x80\x99s\ndeduction in 1946 did not save as much in income tax as the same amount of income\nin 1944 cost him.\n2. Congress has enacted \xc2\xa7 1341 to mitigate the effect of the Lewis rule. When\n\xc2\xa7 1341 applies, taxpayer is required to pay a tax in the year of repayment that is the\nlesser of \xe2\x80\x93\n\xe2\x80\xa2tax liability computed in that year with the repayment treated as a\ndeduction, or\n\xe2\x80\xa2tax liability computed by applying a credit equal in amount to the increase\nin tax liability caused by payment of income tax in the year of inclusion in\ngross income.\n3. Notice that \xc2\xa7 1341 does not reopen taxpayer\xe2\x80\x99s tax return from the earlier tax\nyear, thereby maintaining the integrity of the principle of annual accounting.\n4. Read \xc2\xa7 1341. Note carefully the conditions of its applicability, or the following\ntwo CALI lessons will be more difficult than they need to be.\nDo the CALI Lesson, Basic Federal Income Taxation: Gross Income: Claim of\nRight Doctrine.\nDo the CALI Lesson, Basic Federal Income Taxation: Taxable Income and Tax\nComputation: Claim of Right Mitigation Doctrine.\n5. We might consider Lewis to be a case of \xe2\x80\x9cincome first/deduction later.\xe2\x80\x9d What if\nwe reverse that: \xe2\x80\x9cdeduction first/income later?\xe2\x80\x9d\n494\n\n\x0cRosen v. Commissioner, 71 T.C. 226 (1978), aff\xe2\x80\x99d, 611 F.2d 942 (CA1. Cl.\n1980)\nRaum\nThe Commissioner determined deficiencies in petitioners\xe2\x80\x99 Federal income tax as\nfollows:\nYear\n\xe2\x80\xa6.\n1974\n\nDeficiency\n30,191.42\n\n....\nPrior to December 20, 1972, petitioners [Sidney W. Rosen and Lorraine S. Rosen,\nhusband and wife] were the owners of the land and buildings located on the\nsoutheasterly corner of High Street and Walnut Street, Fall River, Mass.\n(hereinafter the property). The property consisted of approximately 8,010 square\nfeet of land on which was situated a three-story frame house containing five\napartments and a two-car garage.\xe2\x80\xa6\n\xe2\x80\xa6.\nOn June 20, 1973, the petitioners made a gift of the property, less a small portion\nretained for themselves, to the Union Hospital, Fall River, Mass. (the hospital). The\nvalue of the property transferred to the hospital by the petitioners, at the date of\ntransfer, was $48,000, and the petitioners claimed and were allowed a charitable\ncontribution deduction of that amount in respect of the gift of the property.\n[footnote omitted].\nThe transfer by the petitioners to the hospital was made without any restrictions as\nto the use of the property and without imposing any obligation of any nature on the\nhospital. In 1974, the hospital found itself in financial difficulty and was unable to\nmake use of the property. In addition, the building forming part of the property had\nremained vacant since its receipt by the hospital, and substantial damage had been\ndone to the building by the weather and vandals. The building had deteriorated to\nthe point where the board of trustees of the hospital felt it was becoming a liability\nand, accordingly, they voted on August 27, 1974, to transfer the property back to\nthe petitioners without consideration. [footnote omitted]. The hospital was under\nno obligation, legal or otherwise, to return the property to the petitioners.\n495\n\n\x0cThe parties have stipulated that the value of the property, at the time it was\ntransferred to the petitioners by the hospital, was $25,000.\xe2\x80\xa6\nThe Commissioner determined that petitioners must include in gross income, on\naccount of the return of the property to them by \xe2\x80\xa6 the hospital \xe2\x80\xa6 $25,000 in \xe2\x80\xa6\n1974 \xe2\x80\xa6 The petitioners claim, however, that they need include no amounts in their\ngross income in respect of the return of the property by either the city or the\nhospital. The Commissioner has not challenged the bona fides of any of the\ntransactions, and the only question is whether petitioners must include in their gross\nincome, in the year[] of the retransfer[] from the city and the hospital, the fair\nmarket value of the property returned. We hold that they are required to do so.\nIt has long been established that the receipt of money or property which might not\notherwise be regarded as income may nevertheless constitute income within the\nmeaning of the statute (\xc2\xa7 61 ...) if it represents the repayment, restoration, or return\nof an item which the taxpayer had deducted in an earlier year. The general concept\nhas often been referred to as the \xe2\x80\x9ctax benefit rule.\xe2\x80\x9d205\nThe tax benefit rule has widespread applicability to a variety of different receipts.\nSee 1 J. Mertens, Law of Federal Income Taxation, \xc2\xa7\xc2\xa7 7.34-7.37(2) (1974 rev.).\nFamiliar examples appear in cases involving the recovery of a bad debt which had\nbeen deducted on the returns of a prior year, e.g., Askin & Marine Co. v.\nCommissioner, 66 F.2d 776 (2d Cir.); Putnam Nat. Bank v. Commissioner, 50 F.2d\n158 (5th Cir.); and in cases where excises or other taxes paid and deducted from\ngross income in a prior year are refunded in a later year, e.g., Rothensies v. Electric\nBattery Co., 329 U.S. 296, 298; Estate of Block v. Commissioner, 39 B.T.A. 338,\naffirmed sub nom. Union Trust Co. v. Commissioner, 111 F.2d 60 (7th Cir.),\ncertiorari denied 311 U.S. 658. ... Moreover, the so-called tax benefit rule has been\nexplicitly recognized in \xc2\xa7 111(a) of the Code which places limitations on the\namounts to be included in gross income in specified types of restorations. Thus, it\nThe rationale for the rule was set forth in Estate of Block v. Commissioner, 39 B.T.A. 338, 341, affirmed\nsub nom. Union Trust Co. v. Commissioner, 111 F.2d 60 (7th Cir.), certiorari denied 311 U.S. 658:\n205\n\n\xe2\x80\x9cIncome tax liability must be determined for annual periods on the basis of facts as they existed\nin each period. When recovery or some other event which is inconsistent with what has been\ndone in the past occurs, adjustment must be made in reporting income for the year in which\nthe change occurs.\xe2\x80\x9d\nSee also Alice Phelan Sullivan Corp. v. Commissioner, 381 F.2d 399, 402 n. 2 (Ct. Cl.).\n\n496\n\n\x0cprovides that gross income does not include the recovery of a \xe2\x80\x9cbad debt, prior tax,\nor delinquency amount\xe2\x80\x9d to the extent of the \xe2\x80\x9crecovery exclusion\xe2\x80\x9d which is in\nsubstance defined ... to mean the amount on account of which the item in question\ndid not result in a reduction of taxes in the earlier year. [footnote omitted].\nThere can be no serious challenge to the broad sweep of the tax benefit rule, and in\nconsidering its applicability here, we even find precedent for applying the rule in a\ncase involving property once the subject of a charitable contribution deduction that\nis subsequently returned to the donor. In Alice Phelan Sullivan Corp. v. United\nStates, 381 F.2d 399 (Ct.Cl.), there were returned to the taxpayer two parcels of\nreal estate each of which it had previously donated and claimed as a charitable\ncontribution deduction in a prior year. Each of the original gifts had been made\nsubject to the condition that the property be used for a religious or educational\npurpose, and when the donee later determined not to use the gift, it was reconveyed\nto the taxpayer. The Court of Claims held not only that the recoupment properly\nwas classified as income but also that the amount of reportable income was not\nlimited by the more favorable tax rates which were in effect at the time of the\noriginal gifts, provided only that the taxpayer had taken full benefit of the\ndeductions available in the earlier years. [citation omitted] [footnote omitted].\nPetitioners do not challenge the correctness of the result in Alice Phelan Sullivan\nCorp., but rather seek to distinguish it. They correctly point out that in Alice Phelan\nSullivan Corp., the subject property was returned to the taxpayer pursuant to a\ncondition in the original gift that the property would be returned if it ceased to be\nused either for a religious or for an educational purpose. Here, by contrast, both of\nthe petitioners\xe2\x80\x99 gifts were unconditional, and neither the city nor the hospital was\nunder any obligation whatsoever to transfer the property back to the petitioners.\nFrom this petitioners argue that the property was returned to them by way of a \xe2\x80\x9cgift\xe2\x80\x9d\nfrom the city and the hospital excludable from income under \xc2\xa7 102(a), [footnote\nomitted] and that the tax benefit rule does not apply to receipts subject to \xc2\xa7 102(a).\nWe do not agree with the factual predicate to this argument.\nAs a factual matter, we cannot accept the contention that petitioners received \xe2\x80\x9cgifts\xe2\x80\x9d\nas the concept was defined in Commissioner v. Duberstein, 363 U.S. 278, 285-286,\nwhen the property was reconveyed to them. We think it clear that [the] charitable\ndonee [did not] transfer[] the property back to petitioners out of any detached or\ndisinterested generosity; [footnote omitted] [it] made the transfer[] because [it]\nfound the property to be burdensome and because [it] desired to \xe2\x80\x9cundo\xe2\x80\x9d the original\ngift transactions by returning the property to the part[y] who had originally made\n497\n\n\x0cthe gifts to them. [footnote omitted] It would strain our credulity to conclude that\n\xe2\x80\xa6 the hospital would have transferred the property to petitioners without\nconsideration if [it] had originally purchased it from petitioner[]or had obtained it\nfrom some other source. The reconveyance[] to petitioner[] [was] not [a]\nnontaxable \xe2\x80\x9cgift[]\xe2\x80\x9d within the criteria set forth in Duberstein. We therefore need\nnot reach petitioners\xe2\x80\x99 argument that \xc2\xa7 102(a) precludes application of the tax benefit\nrule to these transactions. [footnote omitted]\nPetitioners also contend that there has been no \xe2\x80\x9crecovery\xe2\x80\x9d within the meaning of\nthe tax benefit rule because there has been no receipt of \xe2\x80\x9camounts in respect of\xe2\x80\x9d the\npreviously deducted charitable gifts.206 Petitioners cite the absence of a legal\nobligation to return the property and urge us to conclude that the reconveyances\nwere totally separate and independent transactions from the original gifts. We are\nunconvinced.\nWe agree with the limited proposition that the tax benefit rule requires a sufficient\nfactual nexus between the event producing the tax benefit and the event constituting\nthe recovery to justify viewing the latter event together with the former. See\nDobson v. Commissioner, 320 U.S. 489, 502; Farr v. Commissioner, 11 T.C. 552,\n567, affirmed sub nom. Sloane v. Commissioner, 188 F.2d 254 (6th Cir.); 1 J.\nMertens, Law of Federal Income Taxation, \xc2\xa7 7.37, at p. 125. See also Allen v. Trust\nCo. of Georgia, 180 F.2d 527 (5th Cir.); Continental Illinois National Bank v.\nCommissioner, 69 T.C. 357, 364-372. However, we have found that the purpose\nof the reconveyance[] was a desire by the donee[] to reverse the original gift\ntransaction[], and that the reconveyance[] without consideration would not have\nbeen made to petitioner[] were it not for the fact that [it was] the original donor[]\nof the property. The recover[y was] far from the coincidental happenstance[] that\npetitioner[] would have us believe. This is especially true in light of the relatively\nshort time period[] between the original gifts and the reconveyances.\nNor can we agree, at least in cases where the return of property is not a \xe2\x80\x9cgift,\xe2\x80\x9d that\na legal obligation on the part of the transferor to return the property is always a sine\nqua non for application of the tax benefit rule. We think it sufficient that the\ntransferor specifically intend the transfer to be a repayment, restoration, or return\nof property formerly belonging to the transferee that was the subject of a previous\ntransaction producing a tax benefit, and that the transferee accept it for such\npurpose. See Bear Mill Manufacturing Co. v. Commissioner, 15 T.C. 703, 706-708;\n206\n\nSee \xc2\xa7 1.111-1(a)(2), Income Tax Regs.\n\n498\n\n\x0cExcelsior Printing Co. v. Commissioner, 16 B.T.A. 886, 887-888.207 This was the\ncase in respect of the reconveyance[] by \xe2\x80\xa6 the hospital \xe2\x80\x93 [it was] intended merely\nto reverse previous charitable donations. Under these circumstances, we see no\nreason to allow a windfall tax benefit based upon [the] charitable contribution[]\ndeduction[], particularly when, in the end, petitioners owned the very same property\nthey tried to give away. Cf. Farr v. Commissioner, 11 T.C. at 567. The purposes\nof the tax benefit rule [footnote omitted] served by requiring inclusion in gross\nincome of the fair market value of the property at the times it was returned to\npetitioners.\n\xe2\x80\xa6 The Commissioner agrees that the amount to be included is to be measured by\nthe $25,000 stipulated value rather than [$48,000] which he had previously\ndetermined in his deficiency notice. \xe2\x80\xa6\n...208\nDecision will be entered under Rule 155.\nNotes and Questions:\n1. Congress has not created a legislative counterpart to \xc2\xa7 1341.\n2. Read \xc2\xa7 111.\n3. In Alice Phelan Sullivan (discussed by the court), taxpayer made gifts of\nproperty on condition that the property be used for religious or educational purposes\nin 1939 and 1940 when taxpayer\xe2\x80\x99s marginal tax brackets were 18% and 24%\nIn Bear Mill Manufacturing Co. v. Commissioner, 15 T.C. 703, and Excelsior Printing Co. v. Commissioner, 16\nB.T.A. 886, it was held that there was a taxable recovery of a previously deducted bad debt when a third\nparty, not a party to the loan transaction, and not otherwise legally obligated to repay the debt, made a\ntransfer of property to the creditor with the intention that the debt be satisfied, and the creditor accepted\nit for the purpose the transferor intended. It should be noted that in both cases we found that the\ntransferor did not intend to make a gift to the creditor.\n207\n\nWe do not consider the possible contention that proper application of the tax benefit rule would\nrequire a complete reversal of the deduction in the earlier year by including in income of the later year\nthe full amount previously deducted upon complete restoration of the identical property which gave\nrise to the deduction. Cf. Alice Phelan Sullivan Corp. v. Commissioner, 381 F.2d 399, 402 (Ct.Cl.). \xe2\x80\xa6\n208\n\n499\n\n\x0crespectively. The donee returned the property in 1957 when taxpayer\xe2\x80\x99s marginal\ntax bracket was 52%. The court applied the rule that we account for our income\ntaxes annually. Taxpayer had to recognize the retransfer of the property as income\nto be taxed at 52%\n4. Consider: In year 1, taxpayer\xe2\x80\x99s total itemized deductions were $18,000. A\nportion of the itemized deductions was for her contribution of a parcel of land to\nher church, fmv = $7000, \xe2\x80\x9cso long as used for church purposes.\xe2\x80\x9d Taxpayer filed\nsingle. The standard deduction in year 1 for single persons was $12,000. In year 4,\nthe church decided not to use the land for church purposes and returned it to\ntaxpayer. Its fmv was still $7000.\n\xe2\x80\xa2How much income must taxpayer include in her year 4 tax return?\n4a. Same as #4, but the fmv of the land in year 1 was only $4000? Her total\nitemized deductions were $18,000, including $4000 for the land she contributed\nto her church.\n\xe2\x80\xa2How much income must taxpayer include in her year 4 tax return?\n4b. Same as #4, but the fmv of the land was $3000 and taxpayer\xe2\x80\x99s total itemized\ndeductions, including her charitable contribution, were $11,000.\n\xe2\x80\xa2How much income must taxpayer include in his year 4 tax return?\n\nII. Deferral Mechanisms\nThe Code provides various mechanisms by which taxpayer may defer recognition\nof particular identifiable income.\nA. Realization\nWe have already observed that the realization element of gross income gives\ntaxpayer some discretion to defer recognition of income \xe2\x80\x93 and, as in Cottage\nSavings & Loan, to accelerate the recognition of losses.\n\n500\n\n\x0cB. Installment Method and Other Pro-rating of Basis\nThere are occasions when taxpayer realizes gain on a transaction, but does not\nreceive any cash with which to pay the income tax due on the gain. Perhaps a\npurchaser does not have cash and cannot procure a bank loan. Taxpayer agrees to\npermit the purchaser to make installment payments in subsequent years plus interest\npayments on the declining balance (\xc2\xa7 163(b)). Section 453 requires such a taxpayer\nto defer recognition of \xe2\x80\x9cincome\xe2\x80\x9d209 until receipt of installment payments. \xc2\xa7 453(a).\nTaxpayer may elect out of the installment method of reporting income. \xc2\xa7 453(d)(1).\n\xe2\x80\xa2The installment method applies to an \xe2\x80\x9cinstallment sale.\xe2\x80\x9d An \xe2\x80\x9cinstallment\nsale\xe2\x80\x9d is one where at least one payment is to be received after the close of\nthe taxable year of disposition of the property. \xc2\xa7 453(b)(1).\n\xe2\x80\xa2However, the installment method does not apply to a \xe2\x80\x9cdealer\ndisposition\xe2\x80\x9d or to sales of \xe2\x80\x9cinventory.\xe2\x80\x9d \xc2\xa7 453(b)(2).\n\xe2\x80\xa2Moreover, the installment method does not apply to a disposition\nof property in which the seller will have the wherewithal to pay the\nincome tax due on gain. Section 453 does not apply to a disposition\nof stock or securities traded on an established securities market.\n\xc2\xa7 453(k)(2)(A). Such property is so liquid that it is its own source of\ncash.\n\xe2\x80\xa2Section 453 does not apply to a disposition of personal property\nunder a revolving credit plan. \xc2\xa7 453(k)(1).\n\xe2\x80\xa2The \xe2\x80\x9cinstallment\xe2\x80\x9d method is a \xe2\x80\x9cmethod under which the income recognized\nfor any taxable year from a disposition is that proportion of the payments\nreceived in that year which the gross profits (realized or to be realized when\npayment is completed) bears to the total contract price.\xe2\x80\x9d \xc2\xa7 453(c).\n\xe2\x80\xa2Multiply every payment received by the following ratio:\n(Gross profit)/(Contract Price)\n\xe2\x80\xa2Include the product in gross income in the year of payment of the\ninstallment.\n\xe2\x80\xa2There are some important definitions in the regulations. See Reg.\n\xc2\xa7 15A.453-1(b).\n\xe2\x80\xa2\xe2\x80\x9cGross profit\xe2\x80\x9d is the \xe2\x80\x9cselling price\xe2\x80\x9d less adjusted basis. Reg.\n\xc2\xa715A.453-1(b)(2)(v).\n209\n\nThe installment method does not apply to recognition of losses.\n\n501\n\n\x0c\xe2\x80\xa2\xe2\x80\x9cSelling price\xe2\x80\x9d is the gross selling price without reduction\n\xe2\x80\x9cto reflect any existing mortgage or other encumbrance on\nthe property ...\xe2\x80\x9d Reg. \xc2\xa7 15A.453-1(b)(2)(ii).\n\xe2\x80\xa2The \xe2\x80\x9ccontract price\xe2\x80\x9d is the total \xe2\x80\x9cselling price\xe2\x80\x9d \xe2\x80\x93\n\xe2\x80\xa2reduced by the debt that the buyer assumes\n\xe2\x80\xa2so long as the debt does not exceed the seller\xe2\x80\x99s basis\nin the property. Reg. \xc2\xa7 15A.453-1(b)(2)(iii).\n\xe2\x80\xa2If the debt does exceed the seller\xe2\x80\x99s basis, the\ncontract price is reduced by the seller\xe2\x80\x99s basis,\nnot by the amount of the debt. AND:\n\xe2\x80\xa2The amount by which the debt exceeds basis\nis treated as a payment. Reg. \xc2\xa7 15A.4531(b)(3)(i) (11th sentence).\n\xe2\x80\xa2When the debt assumed by the purchaser exceeds\nthe seller\xe2\x80\x99s basis, what percentage of every payment\nwill seller have to include in her gross income?\n\xe2\x80\xa2You can see that the effect of the installment method is to pro-rate both the\nrecovery of basis and recognition of gain.\n\xe2\x80\xa2It may prove necessary to keep a running score of unrecovered\nbasis and of yet-to-be realized profit.\n\xe2\x80\xa2Section 453B(a) provides that the disposition of an installment obligation\nis a recognition event to the one who disposed of it. That person would\ndetermine her basis in the obligation disposed of and subtract that amount\nfrom the amount she realizes to determine gain or loss.\nDo the CALI Lesson, Basic Federal Income Taxation: Timing: Fundamentals of\nInstallment Sales.\n\xe2\x80\xa2Do not worry about question 19 on wrap-around mortgages. It is discussed\nin Regs. \xc2\xa7\xc2\xa7 15A.453-1(b)(3)(ii) and 15A.453-1(b)(5) Examples 5 and 6.\nThe installment method of \xc2\xa7 453 enables a taxpayer to defer recognition of gain\nuntil she has the wherewithal to pay the tax. However, when taxpayer enters into\ntransactions with related persons solely with a purpose to defer payment of income\ntax, the Code denies the benefits of the installment method.\n\xe2\x80\xa2Consider: Father (a high bracket taxpayer) sells daughter (a low bracket\ntaxpayer) Blackacre. Father\xe2\x80\x99s basis in Blackacre is $20,000. The selling\nprice is $100,000. Daughter is to make annual payments of $10,000 plus\n502\n\n\x0cinterest on the declining balance. Daughter makes no payments and one\nweek later, sells Blackacre to a third party for $100,000 cash.\n\xe2\x80\xa2Notice: daughter has no gain/loss to recognize. She has $100,000\ncash in hand with which to fulfill her obligation to pay father\n$10,000 per year for the next nine years.\n\xe2\x80\xa2Father has essentially sold Blackacre at a substantial gain. A person\nrelated to him holds the cash from the sale. Father spreads\nrecognition of gain over the ensuing ten years.\nSection 453(e) addresses so-called \xe2\x80\x9csecond dispositions by related persons.\xe2\x80\x9d\n\xe2\x80\xa2Section 453(e)(1) requires taxpayer to treat the amount realized in the\n\xe2\x80\x9csecond disposition\xe2\x80\x9d (i.e., sale by daughter in the example) as received by\nthe person making the \xe2\x80\x9cfirst disposition\xe2\x80\x9d (i.e., father in the example).\n\xe2\x80\xa2Thus in our example, father would be treated as realizing $100,000\nupon daughter\xe2\x80\x99s sale of Blackacre.\n\xe2\x80\xa2This rule applies only to a disposition made within two years after the first\ndisposition. \xc2\xa7 453(e)(2). However, the running of this two-year period is\nsuspended in the event the risk of loss to the transferee is substantially\ndiminished by the possibility of certain transactions.210\n\xe2\x80\xa2A person is \xe2\x80\x9crelated\xe2\x80\x9d if she bears a relationship to the transferor described\nin either \xc2\xa7 318(a) or \xc2\xa7 267(b). \xc2\xa7 453(f)(1).\n\xe2\x80\xa2Section 453(e)(3) limits the amount realized by the transferor making the\nfirst disposition to\nthe lesser of \xe2\x80\x93\n\xe2\x80\xa2the amount realized in the second disposition, OR\n\xe2\x80\xa2the total contract price for the first disposition\nMINUS\nthe aggregate amount of payments received with respect to the first\ndisposition, plus the aggregate amount treated as received under\n\xc2\xa7 453(e).\nSection 453(e)(2)(B) names certain interests or transactions that would substantially diminish a risk\nof loss, i.e., the holding of a put with respect to the property (or similar property), the holding by another\nperson of a right to acquire the property, or a short sale or any other transaction.\n210\n\n503\n\n\x0c\xe2\x80\xa2Installment payments received after the second disposition are not treated\nas payments with respect to the first disposition to the extent that such\npayments are less than the amount treated as received on the second\ndisposition. Additional payments are treated as payments with respect to the\nfirst disposition. \xc2\xa7 453(e)(5).\n\xe2\x80\xa2Example: Same facts as above. Daughter sells Blackacre in year 1\nfor $80,000. Father is treated as realizing $80,000. Daughter makes\npayments under the installment contract. The first eight payments\nare not treated as payments with respect to the first disposition.\nFather will pay no income tax for receiving these payments. The last\ntwo payments will produce taxable income for father as before.\nC. Contingent Payments\nSuppose that taxpayer sells stock to another. Taxpayer\xe2\x80\x99s basis in the stock is\n$20,000. The price at which taxpayer sells the stock is $10,000 plus 10% of the\ndividends paid by the corporation, payable every year.\n\xe2\x80\xa2Suppose the same facts except that the selling price is $10,000 plus 10%\nof the dividends paid by the corporation for the next 20 years.\n\xe2\x80\xa2Suppose the same facts except that the selling price is $10,000 plus 10%\nof the dividends paid by the corporation up to a maximum of $25,000.\nNotice that on the day the parties enter the contract, the amount that the seller will\nultimately realize cannot be known. What is the best way to handle the problem?\nBurnet v. Logan, 283 U.S. 404 (1931)\nMR. JUSTICE McREYNOLDS delivered the opinion of the Court.\n....\nPrior to March, 1913, and until March 11, 1916, respondent, Mrs. Logan, owned\n250 of the 4,000 capital shares issued by the Andrews & Hitchcock Iron Company.\nIt held 12 percent of the stock of the Mahoning Ore & Steel Company, an operating\nconcern. In 1895, the latter corporation procured a lease for 97 years upon the\n\xe2\x80\x9cMahoning\xe2\x80\x9d mine, and since then has regularly taken therefrom large, but varying,\n504\n\n\x0cquantities of iron ore \xe2\x80\x93 in 1913, 1,515,428 tons; in 1914, 1,212,287 tons; in 1915,\n2,311,940 tons; in 1919, 1,217,167 tons; in 1921, 303,020 tons; in 1923, 3,029,865\ntons. The lease contract did not require production of either maximum or minimum\ntonnage or any definite payments. Through an agreement of stockholders (steel\nmanufacturers), the Mahoning Company is obligated to apportion extracted ore\namong them according to their holdings.\nOn March 11, 1916, the owners of all the shares in Andrews & Hitchcock Company\nsold them to Youngstown Sheet & Tube Company, which thus acquired, among\nother things, 12 percent of the Mahoning Company\xe2\x80\x99s stock and the right to receive\nthe same percentage of ore thereafter taken from the leased mine.\nFor the shares so acquired, the Youngstown Company paid the holders $2,200,000\nin money, and agreed to pay annually thereafter for distribution among them 60\ncents for each ton of ore apportioned to it. Of this cash, Mrs. Logan received\n250/4000 \xe2\x80\x93 $137,500, and she became entitled to the same fraction of any annual\npayment thereafter made by the purchaser under the terms of sale.\n....\nDuring 1917, 1918, 1919, and 1920, the Youngstown Company paid large sums\nunder the agreement. Out of these respondent received on account of her 250 shares\n$9,900 in 1917; $11,250 in 1918; $8,995.50 in 1919; $5,444.30 in 1920 \xe2\x80\x93\n$35,589.80. ...\nReports of income for 1918, 1919, and 1920 were made by Mrs. Logan upon the\nbasis of cash receipts and disbursements. They included no part of what she had\nobtained from annual payments by the Youngstown Company. She maintains that,\nuntil the total amount actually received by her from the sale of her shares equals\ntheir value on March 1, 1913, no taxable income will arise from the transaction. ...\nOn March 1, 1913,211 the value of the 250 shares then held by Mrs. Logan exceeded\n[Before there was an income tax, there was no need to determine what the basis of property was.\nFurthermore, it would be unfair to assess an income tax on a taxpayer based upon gain that occurred\nprior to the effective date of the income tax. The Revenue Act of 1916 provided that for \xe2\x80\x9cpurposes of\nascertaining the gain from the sale or other disposition of property ... acquired before March 1, 1913,\nthe fair market price or value of such property as of March 1, 1913 shall be the basis for determining\nthe amount of such gain derived.\xe2\x80\x9d Revenue Act of 1916, ch. 463, \xc2\xa72(c), 39 Stat. 756, 758 (1916). Thus\nwhen the Court refers to the value of Mrs. Logan\xe2\x80\x99s shares, it is also referencing the shares\xe2\x80\x99 basis.]\n211\n\n505\n\n\x0c$173,089.80 \xe2\x80\x93 the total of all sums actually received by her prior to 1921 from their\nsale ($137,500 cash in 1916, plus four annual payments amounting to $35,589.80).\nThat value also exceeded original cost of the shares. ...\nThe Commissioner ruled that the obligation of the Youngstown Company to pay\n60 cents per ton has a fair market value of $1,942,111.46 on March 11, 1916; that\nthis value should be treated as so much cash, and the sale of the stock regarded as\na closed transaction with no profit in 1916. He also used this valuation as the basis\nfor apportioning subsequent annual receipts between income and return of capital.\nHis calculations, based upon estimates and assumptions, are too intricate for brief\nstatement. [footnote omitted] He made deficiency assessments according to the\nview just stated, and the Board of Tax Appeals approved the result.\nThe circuit court of appeals held that, in the circumstances, it was impossible to\ndetermine with fair certainty the market value of the agreement by the Youngstown\nCompany to pay 60 cents per ton. Also that respondent was entitled to the return\nof her capital \xe2\x80\x93 the value of 250 shares on March 1, 1913, and the assessed value\nof the interest derived from her mother \xe2\x80\x93 before she could be charged with any\ntaxable income. As this had not in fact been returned, there was no taxable income.\nWe agree with the result reached by the circuit court of appeals.\nThe 1916 transaction was a sale of stock, not an exchange of property. We are not\ndealing with royalties or deductions from gross income because of depletion of\nmining property. Nor does the situation demand that an effort be made to place\naccording to the best available data some approximate value upon the contract for\nfuture payments. ... As annual payments on account of extracted ore come in, they\ncan be readily apportioned first as return of capital and later as profit. The liability\nfor income tax ultimately can be fairly determined without resort to mere estimates,\nassumptions, and speculation.\nWhen the profit, if any, is actually realized, the taxpayer will be required to respond.\nThe consideration for the sale was $2,200,000 in cash and the promise of future\nmoney payments wholly contingent upon facts and circumstances not possible to\nforetell with anything like fair certainty. The promise was in no proper sense\nequivalent to cash. It had no ascertainable fair market value. The transaction was\nnot a closed one. Respondent might never recoup her capital investment from\npayments only conditionally promised. Prior to 1921, all receipts from the sale of\nher shares amounted to less than their value on March 1, 1913. She properly\n506\n\n\x0cdemanded the return of her capital investment before assessment of any taxable\nprofit based on conjecture.\n....\nThe judgments below are\nAffirmed.\nNotes and Questions:\n1. \xe2\x80\x9cAs annual payments on account of extracted ore come in, they can be readily\napportioned first as return of capital and later as profit.\xe2\x80\x9d\n\xe2\x80\xa2The rule of Logan is \xe2\x80\x9cbasis first.\xe2\x80\x9d You might imagine that the IRS will\ntake a dim view of this \xe2\x80\x9copen transaction\xe2\x80\x9d reporting method because it\npermits a taxpayer maximum deferral of recognition of gain.\n\xe2\x80\xa2Reg. \xc2\xa7 15A.453-1(a) provides that \xe2\x80\x9cincome from a sale of real property or\na casual sale of personal property, where any payment is to be received\xe2\x80\x9d in\na tax year after the year of sale is to be reported on the installment method\n\xe2\x80\x93 unless the taxpayer elects otherwise.\n2. The sale in Logan was a \xe2\x80\x9ccontingent payment sale,\xe2\x80\x9d i.e., \xe2\x80\x9ca sale or other\ndisposition of property in which the aggregate selling price cannot be determined\nby the close of that taxable year in which such sale or other disposition occurs.\xe2\x80\x9d\nReg. \xc2\xa7 15A.453-1(c)(1).\n3. The regulations classify contingent payment sales as one of three types when\ntaxpayer has not elected out of the installment method: (1) those where a maximum\nprice is determinable; (2) those where a maximum price is not determinable but\nwhere the time over which payments will be received is determinable, and (3) those\nwhere neither a maximum price nor definite payment term is determinable. Reg.\n\xc2\xa7 15A.453-1(c)(1) (last \xc2\xb6).\n3a. Stated maximum selling price. A sale contract has a \xe2\x80\x9cstated maximum selling\nprice\xe2\x80\x9d if the maximum amount of sales proceeds can be determined as of the end\nof the tax year in which the sale is made. Reg. \xc2\xa7 15A.453-1(c)(2)(i)(A). Assume\nthat all contract contingencies are met. Treat the \xe2\x80\x9cstated maximum selling price\xe2\x80\x9d as\nthe \xe2\x80\x9cselling price.\xe2\x80\x9d Id. The \xe2\x80\x9cgross profit ratio\xe2\x80\x9d is adjusted in the year a maximum\n507\n\n\x0cselling price is reduced, effective for the tax year of change and for all subsequent\npayments. Id.\n\xe2\x80\xa2So: if we suppose a sale of stock in which taxpayer has a $20,000 basis for\n$10,000 plus 10% of the dividends paid by the corporation up to a maximum\nof $25,000, we apply the installment method to the sale and consider the\n\xe2\x80\x9cselling price\xe2\x80\x9d to be $35,000. That is also the \xe2\x80\x9ccontract price.\xe2\x80\x9d ($35,000 \xe2\x88\x92\n$20,000)/$35,000 = 15/35 (i.e., 3/7). 3/7 of every payment will be taxable\nincome, and 4/7 of every payment will be recovery of basis.\n3b. Determinable time over which payments will be received: When the maximum\nselling price is not determinable, but the time over which payments will be received\nis determinable, taxpayer allocates the basis to be recovered in equal annual\nincrements. Reg. \xc2\xa7 15A.453-1(c)(3)(i).212 If the recoverable basis in a tax year is\ngreater than the payments received, no loss is allowed unless this occurs in the final\npayment year. Id. When no loss is allowed, the unrecovered basis is carried to the\nnext succeeding tax year. Id.\n\xe2\x80\xa2So: if we suppose a sale of stock in which taxpayer has a $20,000 basis for\n$10,000 plus 10% of the dividends paid by the corporation for the next\ntwenty years, we allocate basis equally over twenty years. Taxpayer would\nrecognize every year\xe2\x80\x99s payments received minus $1000.\n3c. Neither payments nor time over which payments will be received is\ndeterminable: An agreement that specifies neither the amount of payments nor the\ntime over which payments will be received is subject to \xe2\x80\x9cclose scrutiny\xe2\x80\x9d to assure\nthat the agreement is not one requiring payment of rentals or royalties. Reg.\n\xc2\xa7 15A.453-1(c)(4). If the arrangement is not one calling for payment of rentals or\nroyalties, the seller recovers basis over 15 years. Id. If the recoverable basis in a tax\nyear is greater than the payment received, no loss is allowed. Id. Disallowed loss is\nallocated over the remainder of the 15-year term. Id. Unrecovered basis at the end\nof the 15-year term is carried forward from year to year until the basis is recovered\nor the obligation has become worthless. Id. The IRS may shorten the recovery\nperiod if necessary to avoid substantial and inappropriate deferral of basis recovery.\nId. The IRS may also require backloading within the 15-year period recovery of\nbasis if necessary to avoid substantial and inappropriate acceleration of recovery.\nId.\n\xe2\x80\xa2So: suppose that taxpayer sells stock to another. Taxpayer\xe2\x80\x99s basis in the\nIf the sales agreement incorporates an arithmetic component that is not equal for all taxable years,\nbasis is to be allocated in accordance with that arithmetic component. Reg. \xc2\xa7 15A.453-1(c)(3)(i).\n212\n\n508\n\n\x0cstock is $20,000. The price at which taxpayer sells the stock is $10,000 plus\n10% of the dividends paid by the corporation, payable every year. Taxpayer\nmay recover basis of $1333 for each of the next fifteen years.\n4. Election out: If a taxpayer elects out of the installment method, taxpayer must\nrecognize gain on the sale in accordance with the taxpayer\xe2\x80\x99s method of accounting.\nReg. \xc2\xa7 15A.453-1(d)(2)(i). An installment obligation is property and subject to\nvaluation. Id. A cash method taxpayer realizes the fmv of the obligation which\ncannot be less than the fmv of the property sold. Reg. \xc2\xa7 15A.453-1(d)(2)(ii). An\naccrual method taxpayer realizes the total amount payable under the installment\nobligation. Id.\nsFinancial accounting and the \xe2\x80\x9cGenerally\nAccepted Accounting Principles\xe2\x80\x9d (GAAP):\nTaxpayers routinely keep track of their income\nand expenses for more reasons than making an\nannual accounting to the IRS. They may want to\nprocure a loan from a bank. The bank will want\ntaxpayer to provide it with reason to believe\nthat she can repay the loan. Or taxpayer may\nwant to sell her business. A prospective buyer\nwill want taxpayer to provide some indication\nof what income she can expect, what assets the\nbusiness owns, the fmv of those assets, etc. We\nexpect the rules of accounting that taxpayer\nfollows to provide an accurate picture of her\nbusiness in the context for which information is\nprovided. Those rules are not always the same\nas they are for determining the income on\nwhich taxpayer must pay income tax. The\nGAAP establishes rules for the accounting\nprofession to follow. There are occasions when\ntaxpayer may wish to utilize these accounting\nrules when determining her tax liability. In this\nchapter and elsewhere, notice the occasions\nwhen we require (or permit) deviation from\nGAAP\xe2\x80\x99s rules and why.\n\n\xe2\x80\xa2Taxpayer must treat as the amount\nrealized in the year of sale the fair\nmarket value of the installment\nobligation.\nReg. \xc2\xa7 15A.4531(d)(2)(iii). \xe2\x80\x9cOnly in those rare and\nextraordinary cases involving sales\nfor a contingent payment obligation\nin which the fair market value of the\nobligation \xe2\x80\xa6 cannot reasonably be\nascertained will the taxpayer be\nentitled to assert that the transaction\nis \xe2\x80\x98open.\xe2\x80\x99\xe2\x80\x9d Id.\nDo the CALI Lesson, Basic\nFederal Income Taxation: Timing\nInstallment Sales: Second\nDispositions by Related Parties and\nContingent Payments\n\nIII. Basic Accounting Rules\n\nTaxpayer must account for her\nincome annually. Here we consider\nhow taxpayer accounts for it. Section 446(a) provides that: \xe2\x80\x9cTaxable income shall\nbe computed under the method of accounting on the basis of which the taxpayer\n509\n\n\x0cregularly computes his income in keeping his books.\xe2\x80\x9d There are some caveats to\nthis facially permissive statement.\nSection 446(b) establishes the standard that taxpayer\xe2\x80\x99s method of accounting must\n\xe2\x80\x9cclearly reflect income.\xe2\x80\x9d Section 446(c) establishes \xe2\x80\x9cpermissible methods\xe2\x80\x9d of\naccounting. We will consider the two most important of them: \xe2\x80\x9ccash receipts and\ndisbursements method\xe2\x80\x9d and \xe2\x80\x9caccrual method.\xe2\x80\x9d The regulations define these\nphrases. Reg. \xc2\xa7 1.446-1(c)(1)(i and ii) provide in part:\n(i) Cash receipts and disbursements method. \xe2\x80\x93 Generally, under the cash\nreceipts and disbursements method in the computation of taxable income,\nall items which constitute gross income (whether in the form of cash,\nproperty, or services) are to be included for the taxable year in which\nactually made. ...\n(ii) Accrual method. \xe2\x80\x93 (A) Generally, under an accrual method, income is\nto be included for the taxable year when all the events have occurred that\nfix the right to receive the income and the amount of the income can be\ndetermined with reasonable accuracy. Under such a method, a liability is\nincurred, and generally is\ntaken into account for\nRule of Thumb (and no more than that):\nFederal\nincome\ntax\nCash method: \xe2\x80\x9cfollow the money.\xe2\x80\x9d Income is not\npurposes, in the taxable\nincome unless taxpayer has received money,\nyear in which all the\nproperty, or services. When taxpayer has\nevents have occurred that\nreceived money, property, or services, it is\nestablish the fact of the\nincome \xe2\x80\x93 even if taxpayer may not yet have\nliability, the amount of the\nactually \xe2\x80\x9cearned\xe2\x80\x9d it. The same is true of\nliability\ncan\nbe\ndeductions. Taxpayer is not entitled to a\ndetermined\nwith\ndeduction unless she has actually paid the\nreasonable accuracy, and\ndeductible expense.\neconomic\nperformance\nAccrual method: follow the obligation. Taxpayer\nhas occurred with respect\nmust recognize income when she is entitled to\nto the liability. ...\nreceive it \xe2\x80\x93 even if taxpayer has not actually\nreceived payment. Similarly, taxpayer is entitled\nIn the next subsections of the text,\nto a deduction when she is obligated to pay an\nwe consider a few of the\nexpense \xe2\x80\x93 even if taxpayer has not actually\npaid the expense. Section 461(h) also requires\nprinciples that these accounting\nthat \xe2\x80\x9ceconomic performance\xe2\x80\x9d occur before\nmethods incorporate.\ntaxpayer may claim a deduction.\n510\n\n\x0cSection 446(d) provides that a \xe2\x80\x9ctaxpayer engaged in more than one trade or business\nmay, in computing taxable income, use a different method of accounting for each\ntrade or business.\xe2\x80\x9d However \xe2\x80\x93\n\xe2\x80\xa2A C corporation or a partnership with a C corporation partner whose\naverage gross receipts for the last 3-taxable year period exceeds $25M may\nnot use the cash receipts and disbursements method of accounting.\n\xc2\xa7\xc2\xa7 448(a)(1 and 2), 448(b)(3), 448(c)(1).\n\xe2\x80\xa2A tax shelter may not use the cash receipts and disbursements method of\naccounting. \xc2\xa7 448(a)(3).\n\xe2\x80\xa2A taxpayer who uses an inventory must use the accrual method \xe2\x80\x9cwith\nregard to purchases and sales[.]\xe2\x80\x9d Reg. \xc2\xa7 1.446-1(c)(2)(ii).\nA. Cash Method\nThe virtue of the cash method is that it is simple. Its main shortcoming is that it\ndoes not always present an accurate picture of the taxpayer\xe2\x80\x99s economic well-being.\nIt can also be subject to manipulation. If a taxpayer does not want to pay income\ntax on income, all taxpayer must do is defer its receipt. If a taxpayer wants to\nincrease her deductions, taxpayer simply prepays deductible expenses \xe2\x80\x93 perhaps\nyears in advance.\n\xe2\x80\xa2Section 461(g) addresses prepayment of interest. Read \xc2\xa7 461(g). What\nproblem does it address and how does it address it? What is a \xe2\x80\x9cpoint?\xe2\x80\x9d\n\xe2\x80\xa2Don\xe2\x80\x99t forget that \xc2\xa7 263 (capitalization) covers intangibles that will help to\nproduce income past the end of the current tax year. See Reg. \xc2\xa7 1.263(a)4(c)(1) (list of intangibles \xe2\x80\x93 includes insurance contract and lease).\nVarious rules address the receipt of income under the cash method.\n1. Cash Equivalent\nReceipt of a \xe2\x80\x9ccash equivalent\xe2\x80\x9d is the receipt of cash. A check is considered the\nequivalent of cash. So is a credit card charge. On the payment side, payment by\ncheck is made when taxpayer delivers it in the manner that taxpayer normally does,\ne.g., by mail. Payment by credit card is made when the charge is incurred.\nIn an important case, the United States Court of Appeals for the Fifth Circuit\nconsidered whether a promissory note or contract right is a \xe2\x80\x9ccash equivalent\xe2\x80\x9d and\n511\n\n\x0csaid:\nA promissory note, negotiable in form, is not necessarily the equivalent of\ncash. Such an instrument may have been issued by a maker of doubtful\nsolvency or for other reasons such paper might be denied a ready acceptance\nin the market place. We think the converse of this principle ought to be\napplicable. We are convinced that if a promise to pay of a [(1)] solvent\nobligor is [(2)] unconditional and assignable, [(3)] not subject to set-offs,\nand [(4)] is of a kind that is frequently transferred to lenders or investors at\na discount not substantially greater than the generally prevailing premium\nfor the use of money, such promise is the equivalent of cash and taxable in\nlike manner as cash would have been taxable had it been received by the\ntaxpayer rather than the obligation.\nCowden v. Commissioner, 289 F.2d 20, 24 (5th Cir. 1961). A \xe2\x80\x9cpromissory note\xe2\x80\x9d is\ntreated as \xe2\x80\x9cproperty\xe2\x80\x9d and so its receipt is income to the extent of its fmv. What are\nthe factors that make receipt of a promissory note \xe2\x80\x9cgross income?\xe2\x80\x9d\nOn the other hand, giving a promissory note is not the equivalent of payment and\ndoes not entitle the maker to a deduction, even if the recipient of the note must\ninclude the fmv of the note in her gross income. See Don E. Williams Co. v.\nCommissioner, 429 U.S. 569, 579 (1977). \xe2\x80\x9cThe promissory note, even when\npayable on demand and fully secured, is still, as its name implies, only a promise\nto pay, and does not represent the paying out or reduction of assets. A check, on the\nother hand, is a direction to the bank for immediate payment, is a medium of\nexchange, and has come to be treated for federal tax purposes as a conditional\npayment of cash.\xe2\x80\x9d Id. at 582-83.\n2. Constructive Receipt\nReg. \xc2\xa7 1.451-2(a) provides in part:\nConstructive receipts of income. \xe2\x80\x93 (a) General rule. \xe2\x80\x93 Income although\nnot actually reduced to a taxpayer\xe2\x80\x99s possession is constructively received\nby him in the taxable year during which it is credited to his account, set\napart for him, or otherwise made available so that he may draw upon it at\nany time, or so that he could have drawn upon it during the taxable year if\nnotice of intention to withdraw had been given. However, income is not\n512\n\n\x0cconstructively received if the taxpayer\xe2\x80\x99s control of its receipt is subject to\nsubstantial limitations or restrictions. ...\nConsider:\nTaxpayer Paul Hornung played in the NFL championship game on December 31,\n1961. The game was in Green Bay, Wisconsin and ended at 4:30 p.m. The editors\nof Sport Magazine named him the most valuable player of the game and informed\nhim of this fact. Taxpayer would be given a Corvette automobile, but the editors\nhad neither title nor keys to the automobile at that time. They would present them\nto taxpayer at a luncheon in New York City on January 3, 1962. Sport Magazine\ncould have presented Mr. Hornung with keys and title on December 31, 1961 \xe2\x80\x93 but\nthe automobile was in New York.\n\xe2\x80\xa2Did taxpayer constructively receive the automobile in 1961? See Hornung\nv. Commissioner, 47 T.C. 428 (1967) (acq.).\nTaxpayer is a prisoner. The Champion Transportation Services Inc. Profit Sharing\nand 401(k) Plan mailed a cashier\xe2\x80\x99s check for $25,000 to his personal residence in\n1997. A \xe2\x80\x9chouse-sitter\xe2\x80\x9d lived at the residence during the taxpayer\xe2\x80\x99s period of\nincarceration. Taxpayer had access to a telephone. Taxpayer was released in 1998\nand cashed the check at that time.\n\xe2\x80\xa2Did taxpayer constructively receive $25,000 in 1997? See Roberts v.\nCommissioner, T.C. Memo. 2002-281, 2002 WL 31618544.\n3. Economic Benefit\nA cash method taxpayer must include in her gross income the value of an\n\xe2\x80\x9ceconomic benefit.\xe2\x80\x9d\nUnder the economic-benefit theory, an individual on the cash receipts and\ndisbursements method of accounting is currently taxable on the economic\nand financial benefit derived from the absolute right to income in the form\nof a fund which has been irrevocably set aside for him in trust and is beyond\nthe reach of the payor\'s debtors [sic creditors].\nPulsifer v. Commissioner, 64 T.C. 245, 246 (1975) (taxpayer realized economic\nbenefit even though winners of Irish Sweepstakes unable to claim prize held in\nBank of Ireland until they reached age of 21 or legal representative applied for the\nfunds).\n513\n\n\x0cRev. Rul. 60-31, 1960-1 C.B. 174\nSECTION 451. \xe2\x80\x93 GENERAL RULE FOR TAXABLE YEAR OF INCLUSION,\n26 CFR 1.451-1: General rule for taxable year of inclusion\nDiscussion of the application of the doctrine of constructive receipt to certain\ndeferred compensation arrangements.\nAdvice has been requested regarding the taxable year of inclusion in gross income\nof a taxpayer, using the cash receipts and disbursements method of accounting, of\ncompensation for services received under the circumstances described below.\n(1) On January 1, 1958, the taxpayer and corporation X executed an employment\ncontract under which the taxpayer is to be employed by the corporation in an\nexecutive capacity for a period of five years. Under the contract, the taxpayer is\nentitled to a stated annual salary and to additional compensation of 10x dollars for\neach year. The additional compensation will be credited to a bookkeeping reserve\naccount and will be deferred, accumulated, and paid in annual installments equal to\none-fifth of the amount in the reserve as of the close of the year immediately\npreceding the year of first payment. The payments are to begin only upon (a)\ntermination of the taxpayer\xe2\x80\x99s employment by the corporation; (b) the taxpayer\xe2\x80\x99s\nbecoming a part-time employee of the corporation; or (c) the taxpayer\xe2\x80\x99s becoming\npartially or totally incapacitated. Under the terms of the agreement, corporation X\nis under a merely contractual obligation to make the payments when due, and the\nparties did not intend that the amounts in the reserve be held by the corporation in\ntrust for the taxpayer.\nThe contract further provides that if the taxpayer should fail or refuse to perform\nhis duties, the corporation will be relieved of any obligation to make further credits\nto the reserve (but not of the obligation to distribute amounts previously\ncontributed); but, if the taxpayer should become incapacitated from performing his\nduties, then credits to the reserve will continue for one year from the date of the\nincapacity, but not beyond the expiration of the five-year term of the contract. There\nis no specific provision in the contract for forfeiture by the taxpayer of his right to\ndistribution from the reserve; and, in the event he should die prior to his receipt in\nfull of the balance in the account, the remaining balance is distributable to his\npersonal representative at the rate of one-fifth per year for five years, beginning\nthree months after his death.\n514\n\n\x0c(2) ...\n....\n(3) On October 1, 1957, the taxpayer, an author, and corporation Y, a publisher,\nexecuted an agreement under which the taxpayer granted to the publisher the\nexclusive right to print, publish and sell a book he had written. This agreement\nprovides that the publisher will (1) pay the author specified royalties based on the\nactual cash received from the sale of the published work, (2) render semiannual\nstatements of the sales, and (3) at the time of rendering each statement make\nsettlement for the amount due. On the same day, another agreement was signed by\nthe same parties, mutually agreeing that, in consideration of, and notwithstanding\nany contrary provisions contained in the first contract, the publisher shall not pay\nthe taxpayer more than 100x dollars in any one calendar year. Under this\nsupplemental contract, sums in excess of 100x dollars accruing in any one calendar\nyear are to be carried over by the publisher into succeeding accounting periods; and\nthe publisher shall not be required either to pay interest to the taxpayer on any such\nexcess sums or to segregate any such sums in any manner.\n(4) In June 1957, the taxpayer, a football player, entered into a two-year standard\nplayer\xe2\x80\x99s contract with a football club in which he agreed to play football and engage\nin activities related to football during the two-year term only for the club. In\naddition to a specified salary for the two-year term, it was mutually agreed that as\nan inducement for signing the contract the taxpayer would be paid a bonus of 150x\ndollars. The taxpayer could have demanded and received payment of this bonus at\nthe time of signing the contract, but at his suggestion there was added to the\nstandard contract form a paragraph providing substantially as follows:\nThe player shall receive the sum of 150x dollars upon signing of this\ncontract, contingent upon the payment of this 150x dollars to an escrow\nagent designated by him. The escrow agreement shall be subject to approval\nby the legal representatives of the player, the Club, and the escrow agent.\nPursuant to this added provision, an escrow agreement was executed on June 25,\n1957, in which the club agreed to pay 150x dollars on that date to the Y bank, as\nescrow and the escrow agent agreed to pay this amount, plus interest, to the\ntaxpayer in installments over a period of five years. The escrow agreement also\nprovides that the account established by the escrow agent is to bear the taxpayer\xe2\x80\x99s\nname; that payments from such account may be made only in accordance with the\n515\n\n\x0cterms of the agreement; that the agreement is binding upon the parties thereto and\ntheir successors or assigns; and that in the event of the taxpayer\xe2\x80\x99s death during the\nescrow period the balance due will become part of his estate.\n(5) The taxpayer, a boxer, entered into an agreement with a boxing club to fight a\nparticular opponent at a specified time and place. The place of the fight agreed to\nwas decided upon because of the insistence of the taxpayer that it be held there. The\nagreement was on the standard form of contract required by the state athletic\ncommission and provided, in part, that for his performance taxpayer was to receive\n16x% of the gross receipts derived from the match. Simultaneously, the same\nparties executed a separate agreement providing for payment of the taxpayer\xe2\x80\x99s share\nof the receipts from the match as follows: 25% thereof not later than two weeks\nafter the bout, and 25% thereof during each of the three years following the year of\nthe bout in equal semiannual installments. Such deferments are not customary in\nprize fighting contracts, and the supplemental agreement was executed at the\ndemand of the taxpayer. ...\n....\nAs previously stated, the individual concerned in each of the situations described\nabove, employs the cash receipts and disbursements method of accounting. Under\nthat method, ... he is required to include the compensation concerned in gross\nincome only for the taxable year in which it is actually or constructively received.\nConsequently, the question for resolution is whether in each of the situations\ndescribed the income in question was constructively received in a taxable year prior\nto the taxable year of actual receipt.\nA mere promise to pay, not represented by notes or secured in any way, is not\nregarded as a receipt of income within the intendment of the cash receipts and\ndisbursements method. [citations omitted]. See Zittle v. Commissioner, 12 B.T.A.\n675, in which, holding a salary to be taxable when received, the Board said:\n\xe2\x80\x98Taxpayers on a receipts and disbursements basis are required to report only income\nactually received no matter how binding any contracts they may have to receive\nmore.\xe2\x80\x99\nThis should not be construed to mean that under the cash receipts and disbursements\nmethod income may be taxed only when realized in cash. For, under that method a\ntaxpayer is required to include in income that which is received in cash or cash\nequivalent. Henritze v. Commissioner, 41 B.T.A. 505. And, as stated in the above\n516\n\n\x0cquoted provisions of the regulations, the \xe2\x80\x98receipt\xe2\x80\x99 contemplated by the cash method\nmay be actual or constructive.\n....\n... [U]nder the doctrine of constructive receipt, a taxpayer may not deliberately turn\nhis back upon income and thereby select the year for which he will report it.\n[citation omitted]. Nor may a taxpayer, by a private agreement, postpone receipt\nof income from one taxable year to another. [citation omitted].\nHowever, the statute cannot be administered by speculating whether the payor\nwould have been willing to agree to an earlier payment. See, for example, Amend\nv. Commissioner, 13 T.C. 178, acq., C.B. 1950-1, and Gullett v. Commissioner, 31\nB.T.A. 1067, in which the court, citing a number of authorities for its holding,\nstated:\nIt is clear that the doctrine of constructive receipt is to be sparingly used;\nthat amounts due from a corporation but unpaid, are not to be included in\nthe income of an individual reporting his income on a cash receipts basis\nunless it appears that the money was available to him, that the corporation\nwas able and ready to pay him, that his right to receive was not restricted,\nand that his failure to receive resulted from exercise of his own choice.\nConsequently, it seems clear that in each case involving a deferral of compensation\na determination of whether the doctrine of constructive receipt is applicable must\nbe made upon the basis of the specific factual situation involved.\nApplying the foregoing criteria to the situations described above, the following\nconclusions have been reached:\n(1) The additional compensation to be received by the taxpayer under the\nemployment contract concerned will be includible in his gross income only\nin the taxable years in which the taxpayer actually receives installment\npayments in cash or other property previously credited to his account. To\nhold otherwise would be contrary to the provisions of the regulations and\nthe court decisions mentioned above,\n\n517\n\n\x0c(2) ...\nIn arriving at this conclusion ..., consideration has been given to section\n1.402(b)-1 of the Income Tax Regulations and to Revenue Ruling 57-37,\nC.B. 1957-1, 18, as modified by Revenue Ruling 57-528, C.B. 1957-2, 263.\nSection 1.402(b)-1(a)(1) provides in part, with an exception not here\nrelevant, that any contribution made by an employer on behalf of an\nemployee to a trust during a taxable year of the employer which ends within\nor with a taxable year of the trust for which the trust is not exempt under\n\xc2\xa7 501(a) of the Code, shall be included in income of the employee for his\ntaxable year during which the contribution is made if his interest in the\ncontribution is nonforfeitable at the time the contribution is made. Revenue\nRuling 57-37, as modified by Revenue Ruling 57-528, held, inter alia, that\ncertain contributions conveying fully vested and nonforfeitable interests\nmade by an employer into separate independently controlled trusts for the\npurpose of furnishing unemployment and other benefits to its eligible\nemployees constituted additional compensation to the employees\nincludible, under \xc2\xa7 402(b) of the Code and \xc2\xa7 1.402(b)-1(a)(1) of the\nregulations, in their income for the taxable year in which such contributions\nwere made. These Revenue Rulings are distinguishable from case[] \xe2\x80\x98(1)\xe2\x80\x99 ...\nin that, under all the facts and circumstances of these cases, no trusts for the\nbenefit of the taxpayers were created and no contributions are to be made\nthereto. Consequently, \xc2\xa7 402(b) of the Code and \xc2\xa7 1.402(b)-1(a)(1) of the\nregulations are inapplicable.\n(3) Here the principal agreement provided that the royalties were payable\nsubstantially as earned, and this agreement was supplemented by a further\nconcurrent agreement which made the royalties payable over a period of\nyears. This supplemental agreement, however, was made before the\nroyalties were earned; in fact, in [sic] was made on the same day as the\nprincipal agreement and the two agreements were a part of the same\ntransaction. Thus, for all practical purposes, the arrangement from the\nbeginning is similar to that in (1) above. Therefore, it is also held that the\nauthor concerned will be required to include the royalties in his gross\nincome only in the taxable years in which they are actually received in cash\nor other property.\n(4) In arriving at a determination as to the includibility of the 150x dollars\nconcerned in the gross income of the football player, under the\n518\n\n\x0ccircumstances described, in addition to the authorities cited above,\nconsideration also has been given to ... the decision in Sproull v.\nCommissioner, 16 T.C. 244.\n....\nIn Sproull v. Commissioner, 16 T.C. 244, aff\xe2\x80\x99d, 194 Fed.(2d) 541, the petitioner\xe2\x80\x99s\nemployer in 1945 transferred in trust for the petitioner the amount of $10,500. The\ntrustee was directed to pay out of principal to the petitioner the sum of $5,250 in\n1945 and the balance, including income, in 1947. In the event of the petitioner\xe2\x80\x99s\nprior death, the amounts were to be paid to his administrator, executor, or heirs.\nThe petitioner contended that the Commissioner erred in including the sum of\n$10,500 in his taxable income for 1945. In this connection, the court stated:\n*** it is undoubtedly true that the amount which the Commissioner has\nincluded in petitioner\xe2\x80\x99s income for 1945 was used in that year for his benefit\n*** in setting up the trust of which petitioner, or, in the event of his death\nthen his estate, was the sole beneficiary ***.\nThe question then becomes *** was \xe2\x80\x98any economic or financial benefit\nconferred on the employee as compensation\xe2\x80\x99 in the taxable year. If so, it\nwas taxable to him in that year. This question we must answer in the\naffirmative. The employer\xe2\x80\x99s part of the transaction terminated in 1945. It\nwas then that the amount of the compensation was fixed at $10,500 and\nirrevocably paid out for petitioner\xe2\x80\x99s sole benefit. ***.\xe2\x80\x99\nApplying the principles stated in the Sproull decision to the facts here, it is\nconcluded that the 150x-dollar bonus is includible in the gross income of the\nfootball player concerned in 1957, the year in which the club unconditionally paid\nsuch amount to the escrow agent.\n(5) In this case, the taxpayer and the boxing club, as well as the opponent\nwhom taxpayer had agreed to meet, are each acting in his or its own right,\nthe proposed match is a joint venture by all of these participants, and the\ntaxpayer is not an employee of the boxing club. The taxpayer\xe2\x80\x99s share of the\ngross receipts from the match belong to him and never belonged to the\nboxing club. Thus, the taxpayer acquired all of the benefits of his share of\nthe receipts except the right of immediate physical possession; and,\nalthough the club retained physical possession, it was by virtue of an\n519\n\n\x0carrangement with the taxpayer who, in substance and effect, authorized the\nboxing club to take possession and hold for him. The receipts, therefore,\nwere income to the taxpayer at the time they were paid to and retained by\nthe boxing club by his agreement and, in substance, at his direction, and are\nincludible in his gross income in the taxable year in which so paid to the\nclub. See the Sproull case, supra, and Lucas v. Earl, 281 U.S. 111.\n....\n\n520\n\n\x0cNotes and Questions:\n1. A \xe2\x80\x9cmere promise to pay\xe2\x80\x9d is not included in gross income. It should be apparent\nthat at least some of the taxpayers that the Revenue Ruling described planned or\ncould have planned the timing of their receipt of money in such a way as to\nreduce their tax liability.\n\xe2\x80\xa2Taxpayers in cases 4 and 5 were Section 83: The transfer of property in\npresumably subject to income exchange for services is the subject of \xc2\xa7 83.\ntax earlier than they might have Section 83(a) states the commonsense rule that\nwished. How would you a service provider realizes gross income equal\nrestructure the bargains that they to the fmv of property transferred to her or to\nentered to defer the income tax anyone else minus any amount paid for the\nproperty. However, this rule does not apply \xe2\x80\x93\ndue?\nunless the service provider elects otherwise,\n\xe2\x80\xa2Would such a restructuring \xc2\xa7 83(b) \xe2\x80\x93 until the recipient can transfer the\ncreate other risks?\nproperty and her ownership of it is not subject\nto a substantial risk of forfeiture. \xc2\xa7 83(a) (last\n2. Read the excerpt from Pulsifer again sentence). Conditioning a right to property on\ncarefully. Is there not considerable the performance of substantial future services\noverlap between constructive receipt constitutes a \xe2\x80\x9csubstantial risk of forfeiture.\xe2\x80\x9d\nand economic benefit?\n\xc2\xa7 83(c)(1). Property is not transferable if it is\nsubject to a \xe2\x80\x9csubstantial risk of forfeiture.\xe2\x80\x9d\n3. Read \xc2\xa7 83(a to h). Consider a variant \xc2\xa7 83(c)(2). If the service provider elects to\nof the facts of Example 1 of Reg. \xc2\xa7 1.83- include the fmv of property in her taxable\n1(f). On November 1, 201Y, X income without regard to any restriction, she\nCorporation sells to E, an employee, 100 will have basis equal to the amount on which\nshares of X Corporation stock for she paid income tax and a holding period that\n$10/share. At the time of such sale the commences with the transfer of the property.\nfmv of the X Corporation stock is Reg. \xc2\xa7\xc2\xa7 1.83-4(a, b). But: should the risk of\n$100/share. Under the terms of the sale, forfeiture materialize, taxpayer is not entitled\nto a deduction \xe2\x80\x9cin respect of such forfeiture.\xe2\x80\x9d\nE must perform substantial services for\n\xc2\xa7 83(b)(1) (last sentence). The person for whom\nX Corporation until November 1, 202Y\nservices were performed is entitled to a\nor resell the stock to X Corporation for deduction under \xc2\xa7 162 in the year taxpayer\n$10/share. The stock is non-transferable. includes the amount in her gross income. \xc2\xa7 83(h).\n\xe2\x80\xa2Advise E of her liability for\nincome tax and of options\navailable to her.\n\xe2\x80\xa2Advise X Corporation of the deductibility of what it is providing to E.\n\xe2\x80\xa2What are the potential risks and rewards of this compensation\narrangement?\n521\n\n\x0c4. Congress added \xc2\xa7 83(i) when it enacted the Tax Cut and Jobs Act. This section\nprovides employees of closely-held corporate employers an election to defer\ninclusion in gross income the fmv of employer stock that is not readily tradable on\nan established securities exchange and cannot be sold to the corporation when the\nemployee\xe2\x80\x99s rights are first transferable or not subject to a substantial risk of\nforfeiture. \xc2\xa7 83(i)(2)(B). Section 83 (i) addresses the hardship that can befall\nemployees who must otherwise include in their gross income the value of stock\nwhen it vests, even if the employee cannot realize on the stock by selling it to pay\nwhat may be a substantial tax burden. The fmv of the stock may be high relative to\nthe employee\xe2\x80\x99s normal salary. H.R. REP. NO. 115-409, at 339 (2017). The employee\nmust own the stock \xe2\x80\x9cin connection with the exercise of an option\xe2\x80\x9d or in \xe2\x80\x9csettlement\nof a restricted stock unit\xe2\x80\x9d that was given as compensation for services.\n\xc2\xa7 83(i)(2)(A). \xe2\x80\x9cA restricted stock unit (\xe2\x80\x98\xe2\x80\x98RSU\xe2\x80\x99\xe2\x80\x99) is a term used for an arrangement\nunder which an employee has the right to receive at a specified time in the future\nan amount determined by reference to the value of one or more shares of employer\nstock.\xe2\x80\x9d H.R. REP. NO. 115-409, at 338 (2017).\nThe election enables employees of closely held corporations to obtain parity with\nemployees of other employers whose stock is more liquid. They can elect to defer\ninclusion in their gross income the fmv of stock obtained under these circumstances\nuntil the earliest of: the date the stock becomes transferable (including to the\nemployer), the day the employee becomes an owner, officer, or highlycompensated employee, the date the stock becomes readily tradeable on an\nestablished securities exchange, the date five years after the stock becomes\ntransferable or not subject to a substantial risk of forfeiture, or the day the employee\nrevokes the election. \xc2\xa7 83(i)(1)(B).\nThere are other rules and safeguards to this treatment. A fuller consideration of\n\xc2\xa7 83(i), its uses, and implications can be deferred to a course on employee benefits.\n\nDo the CALI Lesson, Basic Federal Income Taxation: Gross Income: Receipt of\nProperty as Compensation.\n\n522\n\n\x0cB. Accrual Method\nIn United States v. Anderson, 269 U.S. 422, 441 (1926), the United States Supreme\nCourt stated that a taxpayer using the accrual method of accounting must claim a\ndeduction when \xe2\x80\x9call the events [have occurred] which fix the amount of the\n[liability] and determine the liability of the taxpayer to pay it.\xe2\x80\x9d Under the accrual\nmethod, the timing of income or deductions does not turn upon actual receipt or\npayment of money, as it does under the cash method. Its focus is on sufficiently\nfixed rights and obligations concerning payments. The accrual method more\naccurately portrays the financial state of the taxpayer than the cash method.\nThe regulations provide an \xe2\x80\x9call events test\xe2\x80\x9d for deductions and another \xe2\x80\x9call events\ntest\xe2\x80\x9d for recognition of gross income. Not surprisingly, the regulations are stingier\nabout permitting deductions than requiring recognition of gross income.\nDeductions: Reg. \xc2\xa7 1.461-1(a)(2) provides in part:\nUnder an accrual method of accounting, a liability ... is incurred, and\ngenerally is taken into account for Federal income tax purposes, in the\ntaxable year in which all the events have occurred that establish the fact of\nthe liability, the amount of the liability can be determined with reasonable\naccuracy, and economic performance has occurred with respect to the\nliability.\nSee \xc2\xa7 461(h)(4). Section 461(h) defines \xe2\x80\x9ceconomic performance.\xe2\x80\x9d Section 461(h)\nsets forth various events that constitute \xe2\x80\x9ceconomic performance\xe2\x80\x9d in different\ncircumstances. Generally, \xe2\x80\x9ceconomic performance\xe2\x80\x9d is actual performance of an\nobligation by or for the taxpayer, or making a payment. It is not enough that\ntaxpayer owes or is owed performance or payment.\nIncome: Reg. \xc2\xa7 1.451-1(a) provides in part:\nUnder an accrual method of accounting, income is includible in gross\nincome when all the events have occurred which fix the right to receive such\nincome and the amount thereof can be determined with reasonable accuracy.\n... Where an amount of income is properly accrued on the basis of a\nreasonable estimate and the exact amount is subsequently determined, the\ndifference, if any, shall be taken into account for the taxable year in which\nsuch determination is made. ... If a taxpayer ascertains that an item should\n523\n\n\x0chave been included in gross income in a prior taxable year, he should, if\nwithin the period of limitation, file an amended return and pay any\nadditional tax due. Similarly, if a taxpayer ascertains that an item was\nimproperly included in gross income in a prior taxable year, he should, if\nwithin the period of limitation, file claim for credit or refund of any\noverpayment of tax arising therefrom.\nAn important condition that the Supreme Court permitted the Commissioner to\nincorporate into the accrual method of recognizing income is that taxpayer\xe2\x80\x99s receipt\nof cash in exchange for its promise to render services to members of a club who\nmight need them at some undetermined future time gave rise to gross income upon\nreceipt of the cash, American Automobile Assoc. v. United States, 367 U.S. 687\n(1961), irrespective of what Generally Accepted Accounting Principles (GAAP)\nmight otherwise prescribe. Id. at 693. Taxpayer argued that it should be permitted\nto recognize a pro rated amount of income monthly. See also Automobile Club of\nMichigan v. Commissioner, 353 U.S. 180 (1957).\nWhile the Commissioner prevailed on the question of whether an accrual method\ntaxpayer must include advance payments in its gross income in the year of receipt,\nthe IRS offered an accommodation in Rev. Proc. 2004-23, 2004-1 C.B. 991\nwhereby accrual method taxpayers who receive an advance payment could\n(i) include the advance payment in gross income for the year of receipt \xe2\x80\xa6\nto the extent recognized in revenues in its applicable financial statement \xe2\x80\xa6\nfor that taxable year, and\n(ii) include the remaining amount of the advance payment in gross income\nin accordance with \xc2\xa7 5.02(1)(a)(ii) of this revenue procedure[ in the next\nsucceeding taxable year.]\nIn the Tax Cuts and Jobs Act, Congress added \xc2\xa7\xc2\xa7 451(b) and 451(c). These\nprovisions essentially codified these paragraphs of Rev. Proc. 2004-23. Section\n451(b) provides that for taxpayers who compute their taxable income on the accrual\nmethod they must treat an item of income as meeting the all-events test no later\nthan when it is taken into account as revenue in \xe2\x80\x9can applicable financial statement\xe2\x80\x9d\nor another financial statement that the Secretary of the Treasury prescribes.\n\xc2\xa7 451(b)(1)(A). Section 451(b)(3) provides a ranked list of documents that\nconstitute an \xe2\x80\x9capplicable financial statement\xe2\x80\x9d (AFR):\n524\n\n\x0c1. a financial statement certified to be prepared in accordance with\ngenerally accepted accounting principles and filed with the Securities\nExchange Commission (Form 10-K or annual statement to shareholders).\nIf taxpayer has no such financial statement, then \xe2\x80\x93\n2. a financial statement certified to be prepared in accordance with\ngenerally accepted accounting principles and used for credit purposes, to\nreport to shareholders, partners, other proprietors, or to beneficiaries, or for\nany other substantial nontax purpose. If taxpayer has no such financial\nstatement, then \xe2\x80\x93\n3. a financial statement made on the basis of international financial\nreporting standards and filed with an agency of a foreign government that\nis equivalent to the United States SEC which has reporting standards no less\nstringent than those of the SEC. If taxpayer has no such financial statement,\nthen \xe2\x80\x93\n4. a financial statement filed with any other regulatory or governmental\nbody that the Secretary of the Treasury names.\nSection 451(c) makes taxpayer\xe2\x80\x99s deferral of advance cash payments elective\n(\xc2\xa7 451(c)(1)(B)), but only to the extent that it is not included in taxpayer\xe2\x80\x99s income\nin its AFR to the next taxable year following receipt. \xc2\xa7 451(c)(1)(B)(ii). See\nShannon R. Jemiolo, Ian Redpath, & Thomas Vogel. How the TCJA Changed the\nIncome Recognition Rules, TAX NOTES, Apr. 19, 2021, at 369.\nRev. Proc. 2004-34 illustrated the rule with examples, some of which are included\nhere. Cumulatively, they inform us how these rules work.\nRev. Proc. 2004-34, 2004-1 C.B. 991.\n\xe2\x80\xa6.\nExample 1. On November 1, 2004, A, in the business of giving dancing lessons,\nreceives an advance payment for a 1-year contract commencing on that date and\nproviding for up to 48 individual, 1-hour lessons. A provides eight lessons in 2004\nand another 35 lessons in 2005. In its ... financial statement, A recognizes 1\xe2\x88\x956 of the\npayment in revenues for 2004, and 5\xe2\x88\x956 of the payment in revenues for 2005. A uses\nthe Deferral Method. For federal income tax purposes, A must include 1/6 of the\npayment in gross income for 2004, and the remaining 5\xe2\x88\x956 of the payment in gross\nincome for 2005.\n525\n\n\x0cExample 2. Assume the same facts as in Example 1, except that the advance\npayment is received for a 2-year contract under which up to 96 lessons are provided.\nA provides eight lessons in 2004, 48 lessons in 2005, and 40 lessons in 2006. In its\n... financial statement, A recognizes 1\xe2\x88\x9512 of the payment in revenues for 2004, 6\xe2\x88\x9512\nof the payment in revenues for 2005, and 5\xe2\x88\x9512 of the payment in gross revenues for\n2006. For federal income tax purposes, A must include 1\xe2\x88\x9512 of the payment in gross\nincome for 2004, and the remaining 11\xe2\x88\x9512 of the payment in gross income for 2005.\n....\nExample 4. On July 1, 2004, C, in the business of selling and repairing television\nsets, receives an advance payment for a 2-year contract under which C agrees to\nrepair or replace, or authorizes a representative to repair or replace, certain parts in\nthe customer\xe2\x80\x99s television set if those parts fail to function properly. In its ...\nfinancial statement, C recognizes 1\xe2\x88\x954 of the payment in revenues for 2004, 1\xe2\x88\x952 of\nthe payment in revenues for 2005, and 1\xe2\x88\x954 of the payment in revenues for 2006. C\nuses the Deferral Method. For federal income tax purposes, C must include 1\xe2\x88\x954 of\nthe payment in gross income for 2004 and the remaining 3\xe2\x88\x954 of the payment in gross\nincome for 2005.\nExample 5. On December 2, 2004, D, in the business of selling and repairing\ntelevision sets, sells for $200 a television set with a 90-day warranty on parts and\nlabor (for which D, rather than the manufacturer, is the obligor). D regularly sells\ntelevisions sets without the warranty for $188. In its applicable financial statement,\nD allocates $188 of the sales price to the television set and $12 to the 90-day\nwarranty, recognizes 1\xe2\x88\x953 of the amount allocable to the warranty ($4) in revenues\nfor 2004, and recognizes the remaining 2\xe2\x88\x953 of the amount allocable to the warranty\n($8) in revenues for 2005. D uses the Deferral Method. For federal income tax\npurposes, D must include the $4 allocable to the warranty in gross income for 2004\nand the remaining $8 allocable to the warranty in gross income for 2005.\nExample 6. E, in the business of photographic processing, receives advance\npayments for mailers and certificates that oblige E to process photographic film,\nprints, or other photographic materials returned in the mailer or with the certificate.\nE tracks each of the mailers and certificates with unique identifying numbers. On\nJuly 20, 2004, E receives payments for 2 mailers. One of the mailers is submitted\nand processed on September 1, 2004, and the other is submitted and processed on\nFebruary 1, 2006. In its ... financial statement, E recognizes the payment for the\nSeptember 1, 2004, processing in revenues for 2004 and the payment for the\n526\n\n\x0cFebruary 1, 2006, processing in revenues for 2006. E uses the Deferral Method. For\nfederal income tax purposes, E must include the payment for the September 1,\n2004, processing in gross income for 2004 and the payment for the February 1,\n2006, processing in gross income for 2005.\n....\nExample 12. On December 1, 2004, I, in the business of operating a chain of\n\xe2\x80\x9cshopping club\xe2\x80\x9d retail stores, receives advance payments for membership fees.\nUpon payment of the fee, a member is allowed access for a 1-year period to I\xe2\x80\x99s\nstores, which offer discounted merchandise and services. In its ... financial\nstatement, I recognizes 1\xe2\x88\x9512 of the payment in revenues for 2004 and 11\xe2\x88\x9512 of the\npayment in revenues for 2005. I uses the Deferral Method. For federal income tax\npurposes, I must include 1\xe2\x88\x9512 of the payment in gross income for 2004, and the\nremaining 11\xe2\x88\x9512 of the payment in gross income for 2005.\nExample 13. In 2004, J, in the business of operating tours, receives payments from\ncustomers for a 10-day cruise that will take place in April 2005. Under the\nagreement, J charters a cruise ship, hires a crew and a tour guide, and arranges for\nentertainment and shore trips for the customers. In its ... financial statement, J\nrecognizes the payments in revenues for 2005. J uses the Deferral Method. For\nfederal income tax purposes, J must include the payments in gross income for 2005.\n....\nNotes and Questions:\n1. When must an accrual method taxpayer include receipt of cash in her gross\nincome when the time of performance is uncertain?\n2. Why was taxpayer in Example 13 able to defer recognition of income for tax\npurposes, but taxpayers in the other examples were not?\n\xe2\x80\xa2In Artnell v. Commissioner, 400 F.2d 981 (7th Cir. 1968), the owner of the\nChicago White Sox, an accrual method taxpayer, sold tickets in late fall of\none year for games scheduled to be played the following spring and\nsummer, the season ending in the first week of October. Baseball fans paid\nfor tickets at that time. [Only recently, has there been much late October\nbaseball in Chicago.] In its financial statement, taxpayer recognizes the\n527\n\n\x0cpayments in revenue for the following spring and summer. Taxpayer sought\nto defer recognition of this ticket income until the following year. What\nresult?\n\nDo the CALI Lesson, Basic Federal Income Taxation: Timing: Cash and Accrual\nMethods of Accounting.\nC. Inventory\nA taxpayer\xe2\x80\x99s accounting method must clearly reflect income. \xc2\xa7 446(b). A taxpayer\nwho sells from inventory who uses the cash method can too easily manipulate the\ncost of the goods that she sells. Hence the regulations require that such taxpayers\nmatch the cost of goods sold with the actual sale of the goods. Reg. \xc2\xa7 1.4461(c)(2)(i) provides:\nIn any case in which it is necessary to use an inventory the accrual method\nof accounting must be used with regard to purchases and sales unless\notherwise authorized ...\nReg. \xc2\xa7 1.61-3(a) provides the following with respect to gross income derived from\n\xe2\x80\x9cmerchandising:\xe2\x80\x9d\nIn general: In a manufacturing, merchandising, or mining business, \xe2\x80\x9cgross\nincome\xe2\x80\x9d means the total sales, less the cost of goods sold ...\nReg. \xc2\xa7 1.471-1(a) provides in part:\nIn order to reflect taxable income correctly, inventories at the beginning and\nend of each taxable year are necessary in every case in which the\nproduction, purchase, or sale of merchandise is an income-producing factor.\n\n528\n\n\x0cThe formula for determining gross income for sales from inventory is the following:\nGR MINUS COGS EQUALS GI\nor\nGR \xe2\x88\x92 COGS = GI\nGR = gross revenue\nCOGS = cost of goods sold\nGI = gross income.\nThe formula for determining COGS is the\nfollowing:\nOI PLUS P MINUS CI = COGS\nor\nOI + P \xe2\x88\x92 CI = COGS\nOI = opening inventory\nP = purchases of or additions to inventory\nCI = closing inventory.\n\nInventory Accounting for Small\nBusinesses: In the TCJA, Congress\nexpanded the class of taxpayers who\ndo not have to engage in the\ninventory accounting described here.\nA taxpayer whose average annual\ngross receipts for the 3-taxable-year\nperiod ending with the taxable year\npreceding the taxable year does not\nexceed $25M (\xc2\xa7 448(c)(1)) indexed\nfor inflation (\xc2\xa7 448(c)(4)), may\nemploy a method that treats inventory\nas non-incidental materials or supplies\nOR that conforms to the taxpayer\xe2\x80\x99s\nmethod of accounting reflected in an\napplicable financial statement or to\ntaxpayer\xe2\x80\x99s books and records\n\xe2\x80\x9cprepared in accordance with the\ntaxpayer\xe2\x80\x99s accounting procedures.\xe2\x80\x9d\n\xc2\xa7 471(c)(1)(B). The costs of nonincidental materials and supplies are\n\xe2\x80\x9cdeductible in the taxable year in\nwhich the materials and supplies are\nfirst used in the taxpayer\xe2\x80\x99s operations\nor are consumed in taxpayer\xe2\x80\x99s\noperations. Reg. \xc2\xa7 1.162-3(a)(1).\n\nThe Code presumes that taxpayer makes sales\nfrom the first of the items that she purchased\nand placed in inventory, i.e., \xe2\x80\x9cfirst-in-firstout\xe2\x80\x9d or FIFO. Cf. Reg. \xc2\xa7 1.472-1(a) (taxpayer \xe2\x80\x9cmay\xe2\x80\x9d elect LIFO). However,\ntaxpayer may elect to treat sales as made from the last inventory items purchased,\ni.e., \xe2\x80\x9clast-in-first-out\xe2\x80\x9d of LIFO. Id.\nSimple illustration:\n1. Assume taxpayer is not a \xe2\x80\x9csmall business.\xe2\x80\x9d On December 31, 2019, taxpayer\nopened a retail store for business and spent $10,000 to acquire 2000 toolboxes at\n$5 each. During 2020, taxpayer paid $6000 to acquire 1000 more toolboxes at $6\neach. Taxpayer sold 2500 toolboxes for $10 each.\n529\n\n\x0c\xe2\x80\xa2Taxpayer\xe2\x80\x99s gross revenue was $25,000, i.e., 2500 x $10.\n\xe2\x80\xa2Taxpayer\xe2\x80\x99s opening inventory was $10,000. Taxpayer\xe2\x80\x99s purchases were\n$6000.\n\xe2\x80\xa2At the end of the year, taxpayer had 500 toolboxes remaining in inventory.\n\xe2\x80\xa2If we use the FIFO method, we presume that taxpayer sold the toolboxes\nthat she already had at the beginning the year plus the ones she purchased\nearliest in the year. Hence taxpayer presumptively sold the 2000 toolboxes\nthat she had on hand at the first of the year plus 500 more that she purchased.\nCOGS = $10,000 + $6000 \xe2\x88\x92 $3,000 = $13,000\nGI = $25,000 \xe2\x88\x92 $13,000 = $12,000.\n\xe2\x80\xa2The value of the opening inventory of 500 toolboxes at the beginning of\nthe next year is $3000, i.e., 500 x $6.\n2. Now suppose that taxpayer has adopted the LIFO method.\n\xe2\x80\xa2Taxpayer\xe2\x80\x99s gross revenue remains $25,000.\n\xe2\x80\xa2Taxpayer\xe2\x80\x99s opening inventory remains $10,000, and taxpayer\xe2\x80\x99s purchases\nremain $6000.\n\xe2\x80\xa2At the end of the year, taxpayer still has 500 toolboxes on hand.\n\xe2\x80\xa2Under the LIFO method, we presume that taxpayer sold the toolboxes that\nshe purchased last in time. Thus, we presume that taxpayer sold (in order)\nthe 1000 toolboxes that she purchased during the years plus 1500 that she\nhad on hand at the first of the year.\nCOGS = $10,000 + $6000 \xe2\x88\x92 $2500 = $13,500.\nGI = $25,000 \xe2\x88\x92 $13,500 = $11,500.\n\xe2\x80\xa2The value of the opening inventory of 500 toolboxes at the beginning the\nnext year is $2500.\nTaxpayer\xe2\x80\x99s gross income was less when the price of inventory increased during the\nyear using the LIFO method rather than the FIFO method.\nReg. \xc2\xa7 1.471-2(c) permits a FIFO-method taxpayer to elect to value inventory at\ncost or market, whichever is lower.\n3. Same facts as number 1, except that the fmv of toolboxes fell to $4 by the end\nof the year. $4 is less than $6, so taxpayer will value the toolboxes in inventory at\n530\n\n\x0c$4 rather than $6.\n\xe2\x80\xa2Taxpayer\xe2\x80\x99s closing inventory = 500 x $4 = $2000.\n\xe2\x80\xa2Now:\nCOGS = $10,000 + $6000 \xe2\x88\x92 $2000 = $14,000\nGI = $25,000 \xe2\x88\x92 $13,000 = $11,000.\nIf taxpayer anticipates a loss on inventory before it is sold, she might elect cost or\nmarket valuation of inventory, whichever is lower.\n\nWrap-Up Questions for Chapter 9\n1. Why do you think that Congress has never enacted a counterpart to \xc2\xa7 1341 and\nimposed a tax rate on recovery of tax benefit items equal to the rate applicable at\nthe time of the deduction?\n2. Taxpayer has $5000 of before-tax income to save in an IRA. Taxpayer\nanticipates that her tax bracket will never change. Will taxpayer come out ahead\nwith a Roth IRA or a traditional IRA? What if taxpayer anticipates that her tax\nbracket will be lower in retirement years than in working (and saving) years?\n3. How would you structure a retirement plan using Revenue Ruling 60-31 to defer\nincome tax for taxpayers, yet make the payments as secure as possible?\n\nWhat have you learned?\nCan you explain or define \xe2\x80\x93\n\xe2\x80\xa2What is the claim of right doctrine?\n\xe2\x80\xa2What is the rule of Lewis? What is the rule of \xc2\xa7 1341?\n\xe2\x80\xa2What is the rule of Rosen? What is the rule of \xc2\xa7 111?\n\xe2\x80\xa2What is the installment method? When is it applicable? How does it work?\n\xe2\x80\xa2What is the cash method of accounting? What is a cash equivalent, constructive\nreceipt, or economic benefit?\n\xe2\x80\xa2What is the significance of a cash method taxpayer receiving a \xe2\x80\x9cmere promise to\npay?\xe2\x80\x9d\n\xe2\x80\xa2What is the accrual method of accounting? What is the all events test for income?\nWhat is the all events test for deductions? What is economic performance?\n\xe2\x80\xa2Why would some taxpayers who sell merchandise from inventory prefer to\ncompute their gross income under the LIFO method?\n531\n\n\x0cChapter 10: Character of Income and Computation of Tax\nRecall that there are three principles of income taxation that the Code implements.\nSee chapter 1. The first of these\nprinciples is that \xe2\x80\x9c[w]e tax income of a\nThe Tax Formula:\nparticular taxpayer once and only\nonce.\xe2\x80\x9d Section 63(a) defines \xe2\x80\x9ctaxable\n(gross income)\nincome.\xe2\x80\x9d In this chapter, we refine the\nMINUS deductions named in \xc2\xa7 62\nnotion of taxing all income once by\nEQUALS (adjusted gross income (AGI))\nadding this caveat: for a non-corporate\nMINUS (standard deduction or itemized\ndeductions)\ntaxpayer, not all income is taxed the\nMINUS (deduction for \xe2\x80\x9cqualified business\nsame. \xe2\x80\x9cTaxable income\xe2\x80\x9d has a\nincome\xe2\x80\x9d)\n\xe2\x80\x9ccharacter\xe2\x80\x9d that determines the tax\nburden to which it is subject. Under\nEQUALS (taxable income)\n\xc2\xa7 1(h), an individual\xe2\x80\x99s tax liability is\nthe sum of the taxes imposed at\n\xe2\x9e\x94Compute income tax liability from\ndifferent rates on income of different\ntables in \xc2\xa7 1(j) (indexed for inflation)\ncharacters.\nMINUS (credits against tax)\nWe have seen that the Code states rules\nwhose effect is to match income and\nexpenses over time. See, e.g., Idaho Power, Encyclopaedia Britannica, supra. The\nCode also requires taxpayers \xe2\x80\x93 with only quite limited exceptions \xe2\x80\x93 to match\nincome, gains, losses, and expenses with respect to character. See, e.g., \xc2\xa7 1211(b).\nTaxpayers who perceive these points may try to manipulate the character of income\nand associated expenses, and the Code addresses these efforts. Naturally, a taxpayer\nprefers gains to be subject to a lower rate of tax, and deductions to be taken against\nincome subject to a higher rate of tax.\nWe consider here incomes of the following characters: capital gain \xe2\x80\x93 both longterm and short-term, depreciation recapture, \xc2\xa7 1231 gain, dividends, and passive.\nWhat remains is \xe2\x80\x9cordinary income.\xe2\x80\x9d See \xc2\xa7 64. \xe2\x80\x9cTaxable income\xe2\x80\x9d is subject to the\ntax rates of \xc2\xa7 1(a to e), except for tax years 2018 to 2025 when it is subject to the\ntax rates of \xc2\xa7 1(j)(2)(A to E). Income with certain characters is subject to lower\nmaximum rates. We usually refer to the \xe2\x80\x9ctaxable income\xe2\x80\x9d subject to the rates of\n\xc2\xa7 1(a to e) or to \xc2\xa7 1(j)(2)(A to E) as \xe2\x80\x9cordinary income,\xe2\x80\x9d as opposed to income whose\ncharacter is such that it is subject to tax at lower \xe2\x80\x9cmaximum\xe2\x80\x9d rates.\n532\n\n\x0cI. Capital Gain\nSection \xc2\xa7 61(a)(3) includes within the scope of \xe2\x80\x9cgross income\xe2\x80\x9d \xe2\x80\x9cgains derived from\ndealings in property.\xe2\x80\x9d Section 1001(a) informed us that taxpayer measures such\ngains (and losses) by subtracting \xe2\x80\x9cadjusted basis\xe2\x80\x9d from \xe2\x80\x9camount realized.\xe2\x80\x9d\nIndividual taxpayers\xe2\x80\x99 gains from the sale or exchange of \xe2\x80\x9ccapital assets\xe2\x80\x9d might be\nsubject to maximum tax rates lower than those otherwise applicable to \xe2\x80\x9ctaxable\nincome.\xe2\x80\x9d Hence it is important to know what is a \xe2\x80\x9ccapital asset.\xe2\x80\x9d\nA. \xe2\x80\x9cCapital Asset:\xe2\x80\x9d Property Held by the Taxpayer\nRead \xc2\xa7 1221(a). Notice the structure of the definition, i.e., all property except ...\nDo not the first two lines of this section imply that \xe2\x80\x9ccapital asset\xe2\x80\x9d is a broad\nconcept? Is there a common theme to the exceptions \xe2\x80\x93 at least to some of them?\nIn Corn Products Refining Co. v. Commissioner, 350 U.S. 46 (1955), taxpayer was\na manufacturer of products made from corn. Its profitability was vulnerable to price\nincreases for corn. To protect itself against price increases and potential shortages,\ntaxpayer \xe2\x80\x9ctook a long position in corn futures[213]\xe2\x80\x9d at harvest time when prices were\n\xe2\x80\x9cfavorable.\xe2\x80\x9d Id. at 48. If no shortage appeared when taxpayer needed corn, it would\ntake delivery on as much corn as it needed and sell the unneeded futures. If there\nwere a shortage, it would sell the futures only as it was able to purchase corn on the\nspot market. In this manner, taxpayer protected itself against seasonal increases in\nthe price of corn. Taxpayer evidently purchased futures to cover (much) more than\nthe corn it would eventually need. See id. at 49 n.5. Taxpayer\xe2\x80\x99s gains far exceeded\nits losses, and taxpayer treated these sales as sales of capital assets. This would\nsubject its gains to tax rates lower than the tax rate on its ordinary income.214 At the\ntime, the Code did not expressly exclude transactions of this nature from property\nconstituting a capital asset. The Commissioner argued that taxpayer\xe2\x80\x99s transactions\nin corn futures were hedges that protected taxpayer from price increases of a\ncommodity that was \xe2\x80\x9c\xe2\x80\x98integral to its manufacturing business[,]\xe2\x80\x99\xe2\x80\x9d id. at 51, and not\ncapital assets. The Tax Court agreed with the Commissioner as did the United\nStates Court of Appeals for the Second Circuit. The United States Supreme Court\n213\n\nA \xe2\x80\x9cfuture\xe2\x80\x9d entitles the holder to purchase the commodity in the future for a fixed price.\n\nAt the time, corporate taxpayers enjoyed long term capital gain tax rates lower than the tax rates on\ntheir other income.\n214\n\n533\n\n\x0caffirmed. The Court said:\nCongress intended that profits and losses arising from the everyday\noperation of a business be considered as ordinary income or loss rather than\ncapital gain or loss. The [Code\xe2\x80\x99s] preferential treatment [of capital gains]\napplies to transactions in property which are not the normal source of\nbusiness income.\nId. at 52. Congress later amended \xc2\xa7 1221 by adding what is now \xc2\xa7 1221(a)(7). A\n\xe2\x80\x9ccapital asset\xe2\x80\x9d does not include \xe2\x80\x9cany hedging transaction which is clearly identified\nas such before the close of the day on which it was acquired, originated, or entered\ninto ...\xe2\x80\x9d\n\xe2\x80\xa2The statutory embodiment of the Corn Products rule creates the\npresumption that a hedge is a capital asset transaction unless the taxpayer\nidentifies it as an \xe2\x80\x9cordinary income transaction\xe2\x80\x9d at the time taxpayer enters\nthe transaction.\nWe might surmise that a major point of Corn Products is that a transaction that is\na \xe2\x80\x9csurrogate\xe2\x80\x9d for a \xe2\x80\x9cnon-capital\xe2\x80\x9d transaction is in fact a non-capital transaction.\nIn Arkansas Best Corp. v. Commissioner, 485 U.S. 212 (1988), taxpayer was a\ndiversified holding company that purchased approximately 65% of the stock of a\nDallas bank. The bank needed more capital and so over the course of five years,\ntaxpayer tripled its investment in the bank without increasing its percentage-ofownership interest. During that time, the financial health of the bank declined\nsignificantly. Taxpayer sold the bulk of its stock, retaining only a 14.7% interest. It\nclaimed an ordinary loss on the sale of this stock, arguing that its ownership of the\nstock was for business purposes rather than investment purposes. The\nCommissioner argued that the loss was a capital loss. Taxpayer argued that Corn\nProducts supported the position that property purchased with a business motive was\nnot a capital asset. The Tax Court agreed with this analysis. The United States\nCourt of Appeals for the Eighth Circuit reversed, finding that the bank stock was\nclearly a capital asset. The Supreme Court affirmed. The Court refused to define\n\xe2\x80\x9ccapital asset\xe2\x80\x9d so as to exclude all assets purchased for a business purpose. \xe2\x80\x9cThe\nbroad definition of the term \xe2\x80\x98capital asset\xe2\x80\x99 explicitly makes irrelevant any\nconsideration of the property\xe2\x80\x99s connection with the taxpayer\xe2\x80\x99s business ...\xe2\x80\x9d Id. at\n217. The Court held that the list of exceptions to \xc2\xa7 1221\'s broad definition of\n\xe2\x80\x9ccapital asset\xe2\x80\x9d is exclusive. Id. at 217-18. Instead of defining \xe2\x80\x9ccapital asset\xe2\x80\x9d\nnarrowly as in Corn Products, the Court can broadly construe the inventory\n534\n\n\x0cexception. Id. at 220. The corn futures in Corn Products were surrogates for\ninventory.\n\xe2\x80\xa2Thus, \xe2\x80\x9ccapital asset\xe2\x80\x9d is indeed \xe2\x80\x9call property\xe2\x80\x9d except for the items \xe2\x80\x93 broadly\ndefined \xe2\x80\x93 specifically named in \xc2\xa7 1221(a).\n\xe2\x80\xa2Read \xc2\xa7 1221(a)\xe2\x80\x99s list of exceptions to \xe2\x80\x9ccapital assets\xe2\x80\x9d again. Is (are) there\na general theme(s) to these exceptions?\n\xe2\x80\xa2Read again the excerpt from Corn Products, above.\n\xe2\x80\xa2The phrase \xe2\x80\x9ccapital asset\xe2\x80\x9d includes personal use property. Thus, if a\ntaxpayer sells his personal automobile for a gain, the gain is subject to tax\nas capital gain.\nDo the CALI Lesson, Basic Federal Income Taxation: Property Transactions:\nCapital Asset Identification.\nB. Section 1222: Definitions of Terms Relating to Capital Gains and\nLosses: Long Term and Short Term Gains and Losses\nRead \xc2\xa7 1222. You will see that the Code distinguishes between sales or exchanges\nof capital assets held for one year or less, and sales or exchanges of capital assets\nheld for more than one year.215 Sections 1222(1, 2, 3 and 4) inform us that every\nsingle sale or exchange of a capital asset gives rise to one of the following:\n\xe2\x80\xa2short-term capital gain (STCG);\n\xe2\x80\xa2short-term capital loss (STCL);\n\xe2\x80\xa2long-term capital gain (LTCG);\n\xe2\x80\xa2long-term capital loss (LTCL).\nSections 1222(5, 6, 7, and 8) direct us to net all short-term transactions and to net\nall long-term transactions.\n\xe2\x80\xa2net short-term capital gain (NSTCG) = STCG \xe2\x88\x92 STCL, but not less than\nzero;\n\xe2\x80\xa2net short-term capital loss (NSTCL) = STCL \xe2\x88\x92 STCG, but not less than\nzero;\n\xe2\x80\xa2net long-term capital gain (NLTCG) = LTCG \xe2\x88\x92 LTCL, but not less than\nzero;\n\n215\n\nOne year is not more than one year.\n\n535\n\n\x0c\xe2\x80\xa2net long-term capital loss (NLTCL) = LTCL \xe2\x88\x92 LTCG, but not less than\nzero.\nNotice the precise phrasing of \xc2\xa7\xc2\xa7 1222(9, 10, and 11). The definitions of these\nphrases are in \xc2\xa7 1222, but other code sections assign specific tax consequences to\nthem. Section 1222(11) defines \xe2\x80\x9cnet capital gain\xe2\x80\x9d (NCG) to be\nNLTCG \xe2\x88\x92 NSTCL\nSection 1222(10) defines \xe2\x80\x9cnet capital loss\xe2\x80\x9d to be the excess of capital losses over\nthe amount of capital loss deductions allowed by \xc2\xa71211. A corporation disregards\nSTCL are disregarded in computing its \xe2\x80\x9cnet capital loss.\xe2\x80\x9d\nSection 1222(9) defines \xe2\x80\x9ccapital gain net income\xe2\x80\x9d to be all capital gain, no matter\nits character, minus all capital loss, no matter its character.\nNotice that the definitions of \xc2\xa7 1222 implement, at least initially, a matching\nprinciple to gains and losses. Short-term losses offset only short-term gains. Longterm losses offset only long-term gains.\nNet capital gain: the effect of mismatching\nNLTCG and NSTCL: Reductions in taxable income,\nwhether by exclusion or deduction, \xe2\x80\x9cwork\xe2\x80\x9d only as\nhard as taxpayer\xe2\x80\x99s marginal bracket to reduce his\ntax liability. Since NSTCG does not figure into a\ntaxpayer\xe2\x80\x99s \xe2\x80\x9cnet capital gain,\xe2\x80\x9d it is subject to tax at\ntaxpayer\xe2\x80\x99s highest marginal rate on \xe2\x80\x9ctaxable\nincome,\xe2\x80\x9d i.e., \xe2\x80\x9cordinary income.\xe2\x80\x9d However, NSTCL\nreduces income that would otherwise be taxed at\na rate lower than taxpayer\xe2\x80\x99s ordinary income rate.\nHence, such losses \xe2\x80\x9cwork\xe2\x80\x9d no harder than\ntaxpayer\xe2\x80\x99s marginal rate on his \xe2\x80\x9cnet capital gain\xe2\x80\x9d\nat reducing his tax liability \xe2\x80\x93 not as hard as\ntaxpayer\xe2\x80\x99s marginal rate on his ordinary income.\n\n536\n\nIn determining NCG, net shortterm capital loss offsets net longterm capital gain. Section 1222\ndoes not allow any other\nmismatching. (Section 1211(b)\nallows some limited\nmismatching.) The matching\nprinciple is very important to\nindividual taxpayers because\nonly the LTCG that remains after\nallowable offsets (LTCL and\nNSTCL) is subject to tax at\nreduced maximum rates; other\nincome is subject to tax at\notherwise higher \xe2\x80\x9cordinary\nincome\xe2\x80\x9d rates.\n\n\x0cDo the CALI Lesson, Basic Federal Income Taxation: Property Transactions:\nCapital Gain Mechanics (For questions on \xe2\x80\x9ccapital gain net income,\xe2\x80\x9d see\n\xc2\xa7 1222(9)).\nC. Deductibility of Capital Losses and Capital Loss Carryforwards\nSection 1211(b) provides that a taxpayer other than a corporation 216 may claim\ncapital losses \xe2\x80\x93 without regard to whether they are long-term or short-term \xe2\x80\x93 only\nto the extent of capital gains plus the lesser of $3000 or the excess of such losses\nover gains. This is one of very few places where the Code permits a taxpayer to\nmismatch what might be NLTCL against income subject to ordinary income rates,\nwhether STCG or otherwise.\nIn the event taxpayer incurred losses greater than those allowed by \xc2\xa7 1211(b), i.e.,\na \xe2\x80\x9cnet capital loss,\xe2\x80\x9d \xc2\xa7 1222(10), taxpayer may carry them forward until he dies.\n\xc2\xa7 1212(b). Section 1212(b) treats a capital loss-carryover as if it were one of the\ntransactions described in \xc2\xa7\xc2\xa7 1222(2 or 4) (i.e., STCL or LTCL) in the next\nsucceeding year.\n\xe2\x80\xa2The Code establishes some \xe2\x80\x9cif \xe2\x80\xa6 then\xe2\x80\x9d rules that apply after adding a\n(hypothetical) STCG equal to the lesser of taxpayer\xe2\x80\x99s \xc2\xa7 1211(b) deduction\nor taxpayer\xe2\x80\x99s \xe2\x80\x9cadjusted taxable income.\xe2\x80\x9d \xc2\xa7 1212(b)(2)(A).217\n\xe2\x80\xa2If the \xe2\x80\x9cnet capital loss\xe2\x80\x9d results from both NLTCL and NSTCL, then\ntaxpayer first reduces the NSTCL by the amount of his \xc2\xa7 1211(b)\ndeduction, and then reduces the NLTCL by the balance (if any) of\nhis \xc2\xa7 1211(b) deduction. Taxpayer separately carries forward the\nremaining NSTCL and NLTCL.\n\xe2\x80\xa2If NSTCL > NLTCG, then taxpayer carries forward the \xe2\x80\x9cnet capital\nloss\xe2\x80\x9d as a STCL transaction. \xc2\xa7 1212(b)(1)(A) and \xc2\xa7 1212(b)(2)(A).\n\xe2\x80\xa2If NLTCL > NSTCG, then taxpayer carries forward the \xe2\x80\x9cnet capital\nloss\xe2\x80\x9d as a LTCL transaction. \xc2\xa7\xc2\xa7 1212(b)(1)(B) and 1212(b)(2)(A).\nExample 1: Taxpayer has $100,000 of \xe2\x80\x9ctaxable income\xe2\x80\x9d derived from wages. For\nA corporation may claim losses from the sale or exchange of capital assets only to the extent of its\ncapital gains. \xc2\xa7 1211(a).\n216\n\n\xe2\x80\x9cAdjusted taxable income\xe2\x80\x9d equals: (taxable income) + (\xc2\xa7 1211(b) deduction) + (personal exemption\ndeductions) \xe2\x88\x92 ((deductions allowed) \xe2\x88\x92 (gross income) [but not less than $0]). \xc2\xa7 1212(b)(2)(B).\n217\n\n537\n\n\x0cthe tax year, taxpayer also has $5000 of NSTCL and $4000 of NLTCL. What is\ntaxpayer\xe2\x80\x99s \xc2\xa7 1211(b) deduction, and what is taxpayer\xe2\x80\x99s \xc2\xa7 1212(b) capital loss\ncarryover?\n\xe2\x80\xa2Taxpayer\xe2\x80\x99s capital losses (i.e., $9000) exceed his capital gains (i.e., $0) by\n$9000. Taxpayer\xe2\x80\x99s \xc2\xa7 1211(b) deduction is $3000. He may deduct $3000\nagainst his \xe2\x80\x9ctaxable income\xe2\x80\x9d derived from wages. Taxpayer\xe2\x80\x99s has a \xe2\x80\x9cnet\ncapital loss\xe2\x80\x9d (\xc2\xa7 1222(10)), which is $6000.\n\xe2\x80\xa2We calculate taxpayer\xe2\x80\x99s capital loss carryovers by first adding $3000 (the\namount of taxpayer\xe2\x80\x99s \xc2\xa7 1211(b) deduction) of STCG to his NSTCL.218\nTaxpayer\xe2\x80\x99s NSTCL becomes $2000; taxpayer\xe2\x80\x99s NLTCL is $4000.\nTaxpayer will carry these amounts forward. In the succeeding year,\ntaxpayer will include $2000 as a STCL and include $4000 as a LTCL.\nExample 2. Taxpayer has $100,000 of \xe2\x80\x9ctaxable income\xe2\x80\x9d derived from wages. For\nthe year, taxpayer also has $8000 of NSTCL and $2000 of NLTCG.\n\xe2\x80\xa2Taxpayer\xe2\x80\x99s capital losses exceed his capital gains by $6000. Taxpayer\xe2\x80\x99s\n\xc2\xa7 1211(b) deduction is $3000. Taxpayer\xe2\x80\x99s has a \xe2\x80\x9cnet capital loss\xe2\x80\x9d of $3000.\n\xe2\x80\xa2We calculate taxpayer\xe2\x80\x99s capital loss carryover by first adding $3000 of\nSTCG to his NSTCL.219 Taxpayer\xe2\x80\x99s NSTCL becomes $5000. Subtract\n$2000 from $5000. \xc2\xa7 1212(b)(1)(A). Taxpayer will carry this amount\nforward. In the succeeding year, taxpayer will include $3000 as a STCL.\nExample 3. Taxpayer has $100,000 of \xe2\x80\x9ctaxable income\xe2\x80\x9d derived from wages. For\nthe year, taxpayer also has $11,000 of NSTCG and $18,000 of NLTCL.\n\xe2\x80\xa2Taxpayer\xe2\x80\x99s capital losses exceed his capital gains by $7000. Taxpayer\xe2\x80\x99s\n\xc2\xa7 1211(b) deduction is $3000. Taxpayer has a \xe2\x80\x9cnet capital loss\xe2\x80\x9d of $4000.\n\xe2\x80\xa2We calculate taxpayer\xe2\x80\x99s capital loss carryover by first adding $3000 to his\nNSTCG. Taxpayer\xe2\x80\x99s NSTCG becomes $14,000. Subtract $14,000 from\n$18,000. Taxpayer will carry forward $4000 as a LTCL to the succeeding\nyear. \xc2\xa7 1212(b)(1)(B).\nMatching the character of gains and losses: Aside from \xc2\xa7\xc2\xa7 1211 and 1212, the\nCode strictly implements a matching regime with respect to ordinary gains and\nlosses, and capital gains and losses. A taxpayer who regularly earns substantial\namounts of ordinary income and incurs very large investment losses can use those\n\n218\n\n\xe2\x88\x92 $5000 + $3000 = \xe2\x88\x92 $2000.\n\n219\n\n\xe2\x88\x92 $8000 + $3000 = \xe2\x88\x92 $5000.\n\n538\n\n\x0closses only at the rate prescribed by \xc2\xa7 1211(b) in the absence of investment gains.220\nDo the CALI Lesson, Basic Federal Income Taxation: Property Transactions:\nCapital Loss Mechanics.\nDividends: For many years, dividend income that\nindividual taxpayers received was taxed as\nordinary income. Corporations pay dividends from\nthe profits that remain after they pay income tax on\ntheir profits. Corporations may not deduct dividends\nthat they pay to shareholders \xe2\x80\x93 so the dividend\nincome that a shareholder receives is subject to two\nlevels of income tax. This double tax has been\nsubject to criticism from the beginning. Nevertheless,\nit is constitutional. A legislative compromise between\nremoving one level of tax and retaining the rules\ntaxing dividends as ordinary income is \xc2\xa7 1(h)(11).\n\xe2\x80\x9cQualified dividend income\xe2\x80\x9d is taxed at the\nfavorable rates applicable to \xe2\x80\x9cadjusted net capital\ngain,\xe2\x80\x9d infra. \xe2\x80\x9cQualified dividend income\xe2\x80\x9d includes\ndividends paid by domestic corporations and by\n\xe2\x80\x9cqualified foreign corporations.\xe2\x80\x9d \xc2\xa7 1(h)(11)(B)(i). A\n\xe2\x80\x9cqualified foreign corporation\xe2\x80\x9d is one incorporated\nin a possession of the United States or in a country\nthat is eligible for certain tax-treaty benefits, or one\nwhose stock \xe2\x80\x9cis readily tradable on an established\nsecurities market in the United States.\xe2\x80\x9d \xc2\xa7 1(h)(11)(C).\n\nD. Computation of Tax\nWe already know that \xc2\xa7 1\nimposes income taxes on\nindividuals.221 Section 1(h)\ncreates income \xe2\x80\x9cbaskets\xe2\x80\x9d and\nsubjects these baskets to\ndifferent rates of income tax.\nOnce an income \xe2\x80\x9cbasket\xe2\x80\x9d has\nbeen subject to its rate of tax,\nthe principle that we tax income\nonce applies, i.e., no income\nwill be subject to income tax in\nmore than one basket.\nSection 1(h)(1)(A) isolates\nordinary income\xe2\x80\x9d222 and for tax\nyears 2018 to 2025 subjects it to\nthe progressive tax brackets of\n\xc2\xa7 1(j).223 Section 1(h) refers to\n\xe2\x80\x9cnet capital gain,\xe2\x80\x9d a phrase that\n\n220\n\nFor a spectacular application of this principle, see United States v. Generes, 405 U.S. 93 (1972).\n\n221\n\nSection 11 imposes income taxes on corporations.\n\n\xe2\x80\x9cOrdinary income\xe2\x80\x9d is the income subject to the highest rates imposed on individual taxpayers. It\nincludes gains from the sale or exchanges of non-capital and non-\xc2\xa7 1231 assets, offset by allowable\nlosses on the sales of the same assets. \xc2\xa7\xc2\xa7 64, 65.\n222\n\n223\n\n... as modified in \xc2\xa7 1(i) and as indexed for inflation, id.\n\n539\n\n\x0c\xc2\xa7 1222 defines, i.e., NLTCG\n\xe2\x80\x93 NSTCL. Section 1(h)\nmodifies this definition to\nproduce\n\xe2\x80\x9cadjusted\nnet\ncapital gain,\xe2\x80\x9d as noted in the\ntext box on dividends. The\nimportance of defining\n\xe2\x80\x9cadjusted net capital gain\xe2\x80\x9d\nin \xc2\xa7 1(h) rather than adding\nanother sub-section to\n\xc2\xa7 1222 is that it applies only\nto individuals224 \xe2\x80\x93 not to\ncorporations. Also, capital\nloss carryovers do not offset\ndividends\nincluded\nin\nadjusted net capital gain.\n\nTaxing Ordinary Income, \xe2\x80\x9cNet Capital Gain,\xe2\x80\x9d and\n\xe2\x80\x9cAdjusted Net Capital Gain:\xe2\x80\x9d Not all \xe2\x80\x9cnet capital\ngain\xe2\x80\x9d income is taxed alike, but no \xe2\x80\x9cnet capital gain\xe2\x80\x9d\nincome is taxed at a rate higher than the rate\napplicable to a taxpayer\xe2\x80\x99s taxable ordinary income.\nSection 1(h) distinguishes between \xe2\x80\x9cnet capital gain\xe2\x80\x9d\nand \xe2\x80\x9cadjusted net capital gain.\xe2\x80\x9d Section 1(h)(3)\ndefines the phrase \xe2\x80\x9cadjusted net capital gain\xe2\x80\x9d to be\n\xe2\x80\x9cnet capital gain\xe2\x80\x9d MINUS \xe2\x80\x9cunrecaptured \xc2\xa7 1250\ngain,\xe2\x80\x9d MINUS \xe2\x80\x9c28-percent rate gain,\xe2\x80\x9d PLUS\n\xe2\x80\x9cqualified dividend income.\xe2\x80\x9d The definition of\n\xe2\x80\x9cadjusted net capital gain\xe2\x80\x9d assures that \xe2\x80\x9cqualified\ndividend income\xe2\x80\x9d will be taxed at rates applicable to\n\xe2\x80\x9cadjusted net capital gain.\xe2\x80\x9d Those rates for\nindividuals, trusts, and estates\xe2\x80\x9d are 0%, 15%, 20%.\n\nThe definition of \xe2\x80\x9cadjusted net capital gain\xe2\x80\x9d excludes\nSections 1(h)(1)(B, C, and\n\xe2\x80\x9cunrecaptured \xc2\xa7 1250 gain\xe2\x80\x9d and \xe2\x80\x9c28-percent rate\nD) define the next three\ngain.\xe2\x80\x9d Such items are nevertheless elements of \xe2\x80\x9cnet\n\xe2\x80\x9cbaskets\xe2\x80\x9d of income, all of\ncapital gain.\xe2\x80\x9d They are taxed separately and\nwhich contain taxpayer\xe2\x80\x99s\ndifferently from \xe2\x80\x9cadjusted net capital gain.\xe2\x80\x9d If\n\xe2\x80\x9cadjusted net capital gain\xe2\x80\x9d\ntaxpayer\xe2\x80\x99s ordinary income rate is lower than the rate\nincome. (See accompanying\notherwise applicable to these forms of capital gain,\ntext box). For tax years 2018\nthe lower ordinary income rate applies. Hence, the\nto 2025, each basket is\nmaximum tax rate on unrecaptured \xc2\xa7 1250 gain is\ndefined with reference to the\n25%, \xc2\xa7 1(h)(1)(E), and the maximum tax rate on 28%amount of a taxpayer\xe2\x80\x99s\nrate gain is 28%, \xc2\xa7 1(h)(1)(F).\n\xe2\x80\x9ctaxable income.\xe2\x80\x9d225 The\nincome in each of these\nthree baskets is subject to an increasing rate of tax as taxpayer\xe2\x80\x99s \xe2\x80\x9ctaxable income\xe2\x80\x9d\nincreases. Such amounts are indexed for inflation. \xc2\xa7 1(j)(5)(C). For tax year 2018,\nthe \xe2\x80\x9cmaximum zero rate amount\xe2\x80\x9d226 for taxpayers married filing jointly is $77,200\nof taxable income, for heads of household it is $51,700, and for single persons or\n224\n\n... and estates and trusts.\n\nIn other years, the tax rate on \xe2\x80\x9cadjusted net capital gain\xe2\x80\x9d has depended on taxpayer\xe2\x80\x99s marginal tax\nbracket otherwise applicable to all his \xe2\x80\x9ctaxable income.\xe2\x80\x9d\n225\n\nI.e., the amount of a taxpayer\xe2\x80\x99s \xe2\x80\x9ctaxable income\xe2\x80\x9d below which he pays a tax of 0% on his \xe2\x80\x9cadjusted\nnet capital gain\xe2\x80\x9d income.\n226\n\n540\n\n\x0cmarried taxpayers filing separately, it is\n$38,600 (i.e., half of $77,200).\n\xc2\xa7 1(j)(5)(B)(i). For tax year 2018, the\n\xe2\x80\x9cmaximum 15% rate amount\xe2\x80\x9d227 for\ntaxpayers married filing jointly is\n$479,000, for heads of household it is\n$452,400, and for single persons and\nmarried taxpayers filing separately, it is\n$239,500 (half of $479,000). \xc2\xa7 1(j)(B)(ii).\nFor taxpayers with \xe2\x80\x9ctaxable income\xe2\x80\x9d in excess of those amounts, the tax rate\napplicable to their \xe2\x80\x9cadjusted net capital gain\xe2\x80\x9d is 20%. In addition, (relatively228)\nhigh income earners must pay a medicare tax of 3.8% on their net investment\nincome.229 \xc2\xa7 1411.\n\nUnrecaptured \xc2\xa7 1250 gain:\n\xe2\x80\x9cUnrecaptured \xc2\xa7 1250 gain\xe2\x80\x9d is the\nincome attributable to recapture of\ndepreciation (infra) that taxpayer has\nclaimed on real property. It will be\nincluded in taxpayer\xe2\x80\x99s net \xc2\xa7 1231\ngain.\n\nThe next \xe2\x80\x9cbasket\xe2\x80\x9d is \xe2\x80\x9cunrecaptured \xc2\xa7 1250 gain.\xe2\x80\x9d Section 1(h)(1)(E) subjects\nunrecaptured depreciation on real property up to the amount of net \xc2\xa7 1231 gain\n(infra) to a maximum rate of 25%.\nThe last basket is \xe2\x80\x9c28-percent rate gain.\xe2\x80\x9d Section 1(h)(1)(F) subjects \xe2\x80\x9c28-percent\nrate gain\xe2\x80\x9d property to a maximum rate of (surprise) 28%. \xc2\xa7 1(h)(1)(E).\nTaxpayer\xe2\x80\x99s tax liability is the sum of the taxes imposed on these income baskets.\n\nII. Sections 1245 and 1250: Depreciation Recapture\nThe basis of an allowance for depreciation is the notion that during a tax year a\ntaxpayer consumes a portion, but only a portion, of an asset that enables him to\ngenerate income over a period longer than one year. The Code treats that bit of\n\xe2\x80\x9cconsumption\xe2\x80\x9d the same as any other consumption that enables a taxpayer to\ngenerate income, i.e., a deduction from ordinary income. See \xc2\xa7\xc2\xa7 162, 212. Such an\nallowance requires an equal reduction in taxpayer\xe2\x80\x99s basis in the asset. See\nI.e., the amount of a taxpayer\xe2\x80\x99s \xe2\x80\x9ctaxable income\xe2\x80\x9d below which he pays a tax of 15% on his \xe2\x80\x9cadjusted\nnet capital gain\xe2\x80\x9d income.\n227\n\nI.e., those taxpayers whose modified adjusted gross income exceeds $250,000 in the case of taxpayers\nmarried filing jointly, half that amount in the case of married taxpayers filing separately, and $200,000\nin the case of all other taxpayers \xe2\x80\x93 to the extent of the excess. \xc2\xa7 1411(b).\n228\n\n229\n\n\xe2\x80\xa6 unless a taxpayer\xe2\x80\x99s modified AGI (as defined) less a threshold amount is less.\n\n541\n\n\x0c\xc2\xa7 1016(a)(2).\nWe learn shortly that the Code\ntreats gain upon the sale of most\nassets subject to depreciation \xe2\x80\x93\nand therefore not capital assets,\n\xc2\xa7 1222(a)(2) \xe2\x80\x93 that taxpayer has\nheld for more than one year as\nLTCG. This would mean that\nwhatever gain taxpayer realizes\nthat is attributable to basis\nreductions resulting from\ndeductions for depreciation would\nbe subject to a lower rate of tax\nthan the income against which\ntaxpayer claimed those\ndeductions.230 The Code addresses\nthis mismatch of character of\nincome and deductions through\n\xe2\x80\x9cdepreciation recapture\xe2\x80\x9d\nprovisions, i.e., \xc2\xa7\xc2\xa7 1245231 and\n1250.232\n\nA. Section 1245\n\nMismatch of NSTCL and different types of\nLTCG: Different types of LTCG combine to\nmake up an individual taxpayer\xe2\x80\x99s \xe2\x80\x9cnet capital\ngain,\xe2\x80\x9d and these types are not all subject to\nthe same tax rates. LTCG that becomes \xe2\x80\x9c28%\nrate gain\xe2\x80\x9d or \xe2\x80\x9cunrecaptured \xc2\xa7 1250 gain\xe2\x80\x9d are\nsubject to special capital gain rates. \xe2\x80\x9c28percent rate gain\xe2\x80\x9d is the net of LONG-TERM\ncollectibles gains and losses PLUS \xc2\xa7 1202\ngain, i.e., currently $0. \xc2\xa7\xc2\xa7 1202(a)(4), 1(h)(4).\nA \xe2\x80\x9ccollectible\xe2\x80\x9d is essentially any work of art,\nrug or antique, metal or gem, stamps or\ncertain coins, an alcoholic beverage, and\nanything else that the Secretary of the\nTreasury designates. \xc2\xa7 408(m)(2).\nNSTCL reduces first LTCG of the same type,\ne.g., collectible losses first offset collectible\ngains. Then in sequence, NSTCL plus a LTCL\ncarryover reduce LTCG that would otherwise\nbe subject to successively lower rates of tax,\ni.e., first reduce \xe2\x80\x9cnet capital gain\xe2\x80\x9d subject to a\ntax rate of 28%, then reduce \xe2\x80\x9cnet capital\ngain\xe2\x80\x9d subject to a tax rate of 25%, and then\nreduce \xe2\x80\x9cnet capital gain\xe2\x80\x9d subject to a tax rate\nof 20%, 15%, or 0%. See \xc2\xa7\xc2\xa7 1(h)(4)(B)(ii),\n1(h)(6)(A)(ii).\n\nSection 1245 provides that a taxpayer realizes ordinary income upon a\ndisposition233 of \xe2\x80\x9csection 1245 property\xe2\x80\x9d to be measured by subtracting its adjusted\n\n230\n\nTaxpayers could engage in such systematic mismatching prior to 1962.\n\n231\n\nCongress enacted \xc2\xa7 1245 in 1962. Revenue Act of 1962, P.L. 87-834, \xc2\xa7 13(a).\n\n232\n\nCongress enacted \xc2\xa7 1250 in 1964. Revenue Act of 1964, P.L. 88-272, \xc2\xa7 231(a).\n\n\xe2\x80\x9cDisposition\xe2\x80\x9d is a broader term than \xe2\x80\x9csale\xe2\x80\x9d or \xe2\x80\x9cexchange.\xe2\x80\x9d A corporation that distributes property\nto a shareholder has not sold or exchanged it, but has disposed of it. Such a disposition triggers a tax\non the gain computed as if the corporation had sold the property to the shareholder. \xc2\xa7 311(b). Some\nor all the gain might be depreciation recapture.\n233\n\n542\n\n\x0cbasis from the lesser of the property\xe2\x80\x99s \xe2\x80\x9crecomputed basis\xe2\x80\x9d or the amount realized.234\n\xc2\xa7 1245(a)(1).\n\xe2\x80\xa2A property\xe2\x80\x99s \xe2\x80\x9crecomputed basis\xe2\x80\x9d is its adjusted basis plus all \xe2\x80\x9cadjustments\nreflected in such adjusted basis on account of deductions (whether in respect\nof the same or other property) allowed or allowable to the taxpayer or to\nany other person for depreciation or amortization.\xe2\x80\x9d \xc2\xa7 1245(a)(2)(A).\n\xe2\x80\xa2Taxpayer may establish \xe2\x80\x9cby adequate records or other sufficient\nevidence\xe2\x80\x9d that the amount allowed for depreciation or amortization\nwas less than the amount allowable. \xc2\xa7 1245(a)(2)(B).\n\xe2\x80\xa2Deductions allowed by provisions other than \xc2\xa7 167 and \xc2\xa7 168 \xe2\x80\x93\nnotably expensing provisions that reduce taxpayer\xe2\x80\x99s basis in the\nproperty \xe2\x80\x93 are also considered to be \xe2\x80\x9camortization,\xe2\x80\x9d\n\xc2\xa7 1245(a)(2)(C), and so become a part of the property\xe2\x80\x99s\n\xe2\x80\x9crecomputed basis.\xe2\x80\x9d\n\xe2\x80\x9cSection 1245 property\xe2\x80\x9d is property that is subject to an allowance for depreciation\nunder \xc2\xa7 167 (which of course includes \xc2\xa7 168) and is \xe2\x80\x93\n\xe2\x80\xa2personal property, \xc2\xa7 1245(a)(3)(A),\n\xe2\x80\xa2other tangible property \xe2\x80\x93 not including a building or structural components\n\xe2\x80\x93 that was used as an \xe2\x80\x9cintegral part of manufacturing, production, or\nextraction or of furnishing transportation, communications, electrical\nenergy, gas, water, or sewage disposal services,\xe2\x80\x9d \xc2\xa7 1245(a)(3)(B)(i), that\nconstituted a research facility in connection with these activities,\n\xc2\xa7 1245(a)(3)(B)(ii), or that constituted a facility used in connection with\nsuch activities for the bulk storage of fungible commodities,\n\xc2\xa7 1245(a)(3)(B)(iii),\n\xe2\x80\xa2real property subject to depreciation and whose basis reflects the benefit of\ncertain special or rapid depreciation provisions, \xc2\xa7 1245(a)(3)(C),\n\xe2\x80\xa2a \xe2\x80\x9csingle purpose agricultural or horticultural structure,\xe2\x80\x9d \xc2\xa7 1245(a)(3)(D),\n\xe2\x80\xa2a \xe2\x80\x9cstorage facility (not including a building or its structural components)\nused in connection with the distribution of petroleum\xe2\x80\x9d products,\n\xc2\xa7 1245(a)(3)(E), or\n\xe2\x80\xa2a \xe2\x80\x9crailroad grading or tunnel bore,\xe2\x80\x9d \xc2\xa7 1245(a)(3)(F).\n\nActually, if the disposition is other than by sale, exchange, or involuntary conversion, gain taxable\nas ordinary income is measured by subtracting adjusted basis from the lesser of recomputed basis or\nthe fmv of the property, not the amount realized. \xc2\xa7 1245(a)(1).\n234\n\n543\n\n\x0cExample:\n\xe2\x80\xa2Taxpayer is a professional violinist who plays the violin for the local symphony\norchestra. She purchased a violin bow for $100,000 in May 2019. Treat a violin\nbow as 7-year property. In January 2021, she sold the bow for $110,000, its fmv.\nWhat is the taxable gain on which taxpayer must pay tax and what is the character\nof that gain?\n\xe2\x80\xa2Taxpayer will deduct a cost recovery allowance under \xc2\xa7 168. She will\napply the half-year convention to both the year in which she placed the bow\nin service and the year of sale. \xc2\xa7 168(d)(4).\n\xe2\x80\xa2Go to the tables at the front of your Code. In 2019, she will deduct\n14.29% of $100,000, or $14,290. In 2020 she will deduct 24.49% of\n$100,000, or $24,490. In 2021, she will deduct half of 17.49% of\n$100,000, or $8745.\n\xe2\x80\xa2Taxpayer\xe2\x80\x99s remaining basis in the violin bow is $52,475.\n\xe2\x80\xa2Taxpayer\xe2\x80\x99s \xe2\x80\x9crecomputed basis\xe2\x80\x9d is $100,000. It is less than the fmv\nof the bow. Hence, taxpayer has depreciation recapture income of\n$47,525. This is ordinary income. The balance of taxpayer\xe2\x80\x99s gain\n(i.e., $10,000) is \xc2\xa7 1231 gain, infra, which will be subject to tax as\nif it were long term capital gain.\n\xe2\x80\xa2Suppose that taxpayer sold the violin bow for its fmv of $90,000.\n\xe2\x80\xa2Now the fmv of the bow is less than taxpayer\xe2\x80\x99s recomputed basis.\n\xe2\x80\xa2Hence, taxpayer\xe2\x80\x99s depreciation recapture income is $37,525. This income\nis subject to tax as ordinary income.\nSection 1245 provides specific rules governing certain dispositions.\n\xe2\x80\xa2Section 1245 does not apply to a disposition by gift. \xc2\xa7 1245(b)(1). Instead,\nthe donee takes the donor\xe2\x80\x99s basis for purposes of determining gain \xe2\x80\x93 and\nincludes recapture income in his income upon disposition of the gifted\nproperty.\n\xe2\x80\xa2Section 1245 does not apply to a transfer at death. \xc2\xa7 1245(b)(2). Since there\nis a basis step-up on property acquired from a decedent, \xc2\xa7 1014(a),\ndepreciation recapture is not subject to tax at all upon such a disposition.\n\xe2\x80\xa2In certain tax-free dispositions of property between a subsidiary and its\nparent corporation, shareholders and a corporation, and partners and a\npartnership \xe2\x80\x93 there is no recognition of depreciation recapture. \xc2\xa7 1245(b)(3).\nInstead, the recipient \xe2\x80\x93 who takes a carryover basis \xe2\x80\x93 will recognize\ndepreciation recapture income upon disposition of the property.\n\xe2\x80\xa2In a tax-deferred like-kind exchange (\xc2\xa7 1031) or involuntary conversion\n544\n\n\x0c(\xc2\xa7 1033), depreciation recapture is subject to tax only to the extent the\nacquisition of property not qualifying for tax-deferred treatment is subject\nto tax plus the fmv of non-section 1245 property acquired. \xc2\xa7 1245(b)(4).\nInstead gain on the disposition of the replacement property attributable to\ndepreciation allowances on both the original and the replacement properties\nis depreciation recapture income.\n\xe2\x80\xa2Section 1245 does not apply to a tax-deferred distribution of partnership\nproperty to a partner. \xc2\xa7 1245(b)(5)(A). The partner will recognize\ndepreciation recapture income upon his disposition of the property (subject\nto some very technical adjustments).\n\xe2\x80\xa2Section 1245 does not apply to a disposition to a tax-exempt organization,\n\xc2\xa7 1245(b)(3), unless the organization immediately uses the property in a\ntrade or business unrelated to its exemption, \xc2\xa7 1245(b)(6)(A). If the taxexempt organization later ceases to use the property for a purpose related to\nits exemption, it is treated as having made a disposition on the date of such\ncessation. \xc2\xa7 1245(b)(6)(B).\n\xe2\x80\xa2Special amortization rules apply to reforestation expenditures. \xc2\xa7 194. An\n84-month amortization period applies. \xc2\xa7 194(a)(1). Ten years after\nacquiring the \xe2\x80\x9camortizable basis\xe2\x80\x9d for incurring reforestation expenditures,\ngain on the disposition of such assets is no longer considered to be\ndepreciation recapture. \xc2\xa7 1245(b)(7).\n\xe2\x80\xa2If taxpayer disposes of more than one amortizable section 197 intangible\nin one or more related transactions, all section 197 intangibles are\nconsidered to be one section 1245 property. \xc2\xa7 1245(b)(8)(A). However, this\nrule does not apply to a section 197 intangible whose fmv is less than its\nadjusted basis. \xc2\xa7 1245(b)(8)(B).\nSection 1245(d) provides that \xc2\xa7 1245 applies \xe2\x80\x9cnotwithstanding any other provision\nof this subtitle.\xe2\x80\x9d This means that except to the extent \xc2\xa7 1245 itself excepts its own\napplicability, depreciation recapture will be carved out of the gain on any\ndisposition of depreciable or amortizable property and be subject to tax as ordinary\nincome. This important provision limits taxpayer opportunity to mismatch the\ncharacter of income against which he claims deductions with the character of\nsubsequent resulting gain.\n\n545\n\n\x0cB. Section 1250\nSection 1250 treats as ordinary income, \xc2\xa7 1250(a)(1)(A), the recapture of so-called\n\xe2\x80\x9cadditional depreciation,\xe2\x80\x9d i.e., the excess of depreciation adjustments over straightline adjustments on \xe2\x80\x9csection 1250 property\xe2\x80\x9d held for more than one year.\n\xc2\xa7 1250(b)(1). Section 1250 property is real property to which \xc2\xa7 1245 does not\napply. Since \xc2\xa7 168 allowances on real property are all now straight-line, the\napplicability of \xc2\xa7 1250 is limited.\nNevertheless, depreciation allowances on real property are recaptured for\nindividual taxpayers to an extent through the (complicated) interplay of \xc2\xa7 1(h)(6)\n(supra) and \xc2\xa7 1231 (infra).\nThe recapture of cost recovery on real property is subject to income tax at a\nmaximum rate of 25%. Such favorable tax treatment of recapture income for real\nproperty relative to the tax treatment of recapture income for personal property is\nsubject to criticism for causing economic distortions and inequity. See Richard L.\nSchmalbeck & Jay Soled, Reforming Real Estate Depreciation Recapture, TAX\nNOTES, Feb. 16, 2015, at 887.\n\nIII. Section 1231: Some Limited Mismatching\nDuring World War II, the nation moved to a war economy. The Government seized\nmany of the nation\xe2\x80\x99s productive assets to convert them to production of items\ncritical to the war effort. The Fifth Amendment to the Constitution of course\nrequires that the owners of such properties be justly compensated. The owners of\nbusinesses often did not wish to sell their assets to the Government and then to pay\nincome tax (at wartime rates) on the taxable gains they were forced to recognize.\nCongress responded by enacting \xc2\xa7 1231 \xe2\x80\x93 a sort of \xe2\x80\x9cheads-I-win-tails-you-lose\xe2\x80\x9d\nmeasure for taxpayers who found themselves with (substantial amounts of)\nunplanned-for taxable income. Basically, net gains from such transactions would\nbe treated as capital gains; net losses from such transactions would be treated as\nordinary losses. Don\xe2\x80\x99t forget that corporations still enjoyed a capital gains rate\npreference. World War II ended a long time ago, but \xc2\xa7 1231 is still with us. It has\nbecome a very important provision in the sale of a business\xe2\x80\x99s productive assets.\nSection 1231 applies to \xe2\x80\x9cproperty used in the trade or business\xe2\x80\x9d and to any capital\nasset held for more than one year in connection with a trade or business.\n546\n\n\x0c\xc2\xa7 1231(a)(3). Section 1231(b) defines \xe2\x80\x9cproperty used in the trade or business\xe2\x80\x9d\nessentially as \xe2\x80\x9cproperty used in the trade or business, of a character which is subject\nto the allowance for depreciation provided in section 167, held for more than 1 year,\nand real property used in the trade or business, held for more than 1 year[.]\xe2\x80\x9d\n\xc2\xa7 1231(b)(1). Such property is the same as the property that \xc2\xa7 1221(a)(2) describes,\nbut which the taxpayer has held for more than one year. Such property does not\nencompass property that \xc2\xa7 1221(a)(1, 3, and 5) describes.\nSection 1231 requires two netting processes \xe2\x80\x93 both of which adopt the \xe2\x80\x9cheads-Iwin-tails-you lose\xe2\x80\x9d characterization of transactions. If the first netting process\nyields a gain, the net gain becomes a part of the second netting process. Those who\nwrite about \xc2\xa7 1231 often describe this in terms of mixing ingredients in two pots.\nIf the mixture in the first pot yields a net positive, it is added to the second pot;\notherwise, it is not added. We are talking about non-statutory terms so we can use\nany terminology we wish \xe2\x80\x93 but let\xe2\x80\x99s consider the first netting process to occur in a\n\xe2\x80\x9cfirepot.\xe2\x80\x9d The second netting process occurs in a \xe2\x80\x9chotchpot.\xe2\x80\x9d\nFirepot: Section 1231 initially adopts the \xe2\x80\x9cheads-I-win-tails-you-lose\xe2\x80\x9d principle for\n\xe2\x80\x9cinvoluntary conversions\xe2\x80\x9d resulting from casualty losses of \xe2\x80\x9cproperty used in the\ntrade or business\xe2\x80\x9d or of a capital asset held for more than one year in connection\nwith a trade or business or transaction entered into for profit. \xc2\xa7 1231(a)(4)(C). If a\ntaxpayer\xe2\x80\x99s gains and losses from such \xe2\x80\x9cinvoluntary conversions\xe2\x80\x9d resulting from\ncasualty losses net to a loss, then \xc2\xa7 1231 does not apply to any such gains and losses.\n\xc2\xa7 1231(a)(4) (carryout paragraph). Gains/losses from condemnation are not\nincluded in the firepot. The upshot of this \xe2\x80\x9cinapplicability\xe2\x80\x9d is that such gains and\nlosses are treated as realized on the disposition of non-capital assets, so the net loss\nwill be an ordinary loss. If the gains and losses from such transactions yield a net\ngain or if the net gain (or net loss) is $0, then \xc2\xa7 1231 is applicable to them. See Reg.\n\xc2\xa7 1.1231-1(e)(3). Such transactions are added to the \xc2\xa71231 hotchpot.\nSection 1231 Hotchpot: Section 1231 requires a netting of \xe2\x80\x9csection 1231 gains\xe2\x80\x9d and\n\xe2\x80\x9csection 1231 losses.\xe2\x80\x9d \xe2\x80\x9cSection 1231 gain\xe2\x80\x9d is\n\xe2\x80\xa2gain recognized on the sale or exchange of \xe2\x80\x9cproperty used in the trade or\nbusiness\xe2\x80\x9d plus\n\xe2\x80\xa2gain recognized on the compulsory or involuntary conversion into money\nor other property as a result of whole or partial destruction, theft or seizure,\nor requisition or condemnation of \xe2\x80\x9cproperty used in the trade or business\xe2\x80\x9d\nor a \xe2\x80\x9ccapital asset held for more than 1 year\xe2\x80\x9d that \xe2\x80\x9cis held in connection with\na trade or business or a transaction entered into for profit.\xe2\x80\x9d \xc2\xa7 1231(a)(3)(A).\n547\n\n\x0cBut \xe2\x80\x93\n\xe2\x80\xa2Such gain does not include depreciation recapture. \xc2\xa7 1245(d), \xc2\xa7 1250(h),\nReg. \xc2\xa7 1.1245-6(a), Reg. \xc2\xa7 1.1250-1(e)(1).\n\xe2\x80\x9cSection 1231 loss\xe2\x80\x9d is loss recognized on such sales, exchanges, or conversions \xe2\x80\x93\nbut not, of course, net losses resulting from involuntary conversions resulting from\ncasualties. Compare \xc2\xa7 1231((a)(3)(A)(ii) with \xc2\xa7 1231(a)(4)(C).\nSection 1231(a)(1 and 2) implements the \xe2\x80\x9cheads-I-win-tails-you-lose\xe2\x80\x9d principle.\n\xe2\x80\xa2If section 1231 gains for any taxable year exceed section 1231 losses, such\ngains and losses are treated as LTCG or LTCL as the case may be.\n\xc2\xa7 1231(a)(1).235\n\xe2\x80\xa2If section 1231 gains do not exceed236 section 1231 losses for the taxable\nyear, then such gains and losses are not treated as gains and losses derived\nfrom sales or exchanges of capital assets. \xc2\xa7 1231(a)(2).\nA provision so taxpayer-friendly would be subject to some abuse. With only a little\nplanning, a taxpayer may dispose of section 1231 \xe2\x80\x9cwinners\xe2\x80\x9d in one taxable year\nand section 1231 \xe2\x80\x9closers\xe2\x80\x9d in a different taxable year. Hence, \xc2\xa7 1231(c) creates a socalled \xe2\x80\x9c5-year lookback rule.\xe2\x80\x9d For any year in which taxpayer recognizes net\nsection 1231 gains, such gains are taxed as ordinary income to the extent taxpayer\nrecognized section 1231 losses during the five most recent preceding taxable years.\n\xc2\xa7 1231(c).\nDo the CALI Lesson, Basic Federal Income Taxation: Property Transactions:\nIdentification of Section 1231 Property.\nDo the CALI Lesson, Basic Federal Income Taxation: Property Transactions:\nSection 1231 Mechanics.\nThis rule does not change the character of assets. In a case involving a contract to sell depreciable\nproperty \xe2\x80\x93 which is not a capital asset, \xc2\xa7 1221(a)(2) \xe2\x80\x93 that fell through, taxpayer could neither rely on \xc2\xa7\n1231 because there was no sale, nor on \xc2\xa7 1234A (LTCG treatment for cancellation of obligation with\nrespect to property that is a capital asset) to get LTCG treatment. CRI-Leslie, LLC v. Commissioner, 882\nF.3d 1026,1029 (CA11 2018) (receipt of nonrefundable deposit from would-be buyer of taxpayer\xe2\x80\x99s hotel\nand restaurant property gave rise to ordinary income).\n235\n\n236\n\nThis would include cases where section 1231 gains equal section 1231 losses.\n\n548\n\n\x0cIV. More Matching\nThe following materials should make the point that matching income and expenses\nwith respect to character is more than simply the rule of some Code sections: it is a\nbedrock principle that pervades construction of the Code.\nArrowsmith v. Commissioner, 344 U.S. 6 (1952)\nMR. JUSTICE BLACK delivered the opinion of the Court.\nThis is an income tax controversy growing out of the following facts ... In 1937,\ntwo taxpayers, petitioners here, decided to liquidate and divide the proceeds of a\ncorporation in which they had equal stock ownership. Partial distributions made in\n1937, 1938, and 1939 were followed by a final one in 1940. Petitioners reported\nthe profits obtained from this transaction, classifying them as capital gains. They\nthereby paid less income tax than would have been required had the income been\nattributed to ordinary business transactions for profit. About the propriety of these\n1937-1940 returns there is no dispute. But, in 1944, a judgment was rendered\nagainst the old corporation and against Frederick R. Bauer, individually. The two\ntaxpayers were required to and did pay the judgment for the corporation, of whose\nassets they were transferees. [citations omitted]. Classifying the loss as an ordinary\nbusiness one, each took a tax deduction for 100% of the amount paid. ... The\nCommissioner viewed the 1944 payment as part of the original liquidation\ntransaction requiring classification as a capital loss, just as the taxpayers had treated\nthe original dividends as capital gains. Disagreeing with the Commissioner, the Tax\nCourt classified the 1944 payment as an ordinary business loss. Disagreeing with\nthe Tax Court, the Court of Appeals reversed, treating the loss as \xe2\x80\x9ccapital.\xe2\x80\x9d This\nlatter holding conflicts with the Third Circuit\xe2\x80\x99s holding in Commissioner v. Switlik,\n184 F.2d 299. Because of this conflict, we granted certiorari.\nI.R.C. \xc2\xa7 23(g) [(1222)] treats losses from sales or exchanges of capital assets as\n\xe2\x80\x9ccapital losses,\xe2\x80\x9d and I.R.C. \xc2\xa7 115(c) [(331)] requires that liquidation distributions\nbe treated as exchanges. The losses here fall squarely within the definition of\n\xe2\x80\x9ccapital losses\xe2\x80\x9d contained in these sections. Taxpayers were required to pay the\njudgment because of liability imposed on them as transferees of liquidation\ndistribution assets. And it is plain that their liability as transferees was not based on\nany ordinary business transaction of theirs apart from the liquidation proceedings.\nIt is not even denied that, had this judgment been paid after liquidation, but during\n549\n\n\x0cthe year 1940, the losses would have been properly treated as capital ones. For\npayment during 1940 would simply have reduced the amount of capital gains\ntaxpayers received during that year.\nIt is contended, however, that this payment, which would have been a capital\ntransaction in 1940, was transformed into an ordinary business transaction in 1944\nbecause of the well established principle that each taxable year is a separate unit for\ntax accounting purposes. United States v. Lewis, 340 U.S. 590; North American Oil\nConsolidated v. Burnet, 286 U.S. 417. But this principle is not breached by\nconsidering all the 1937-1944 liquidation transaction events in order properly to\nclassify the nature of the 1944 loss for tax purposes. Such an examination is not an\nattempt to reopen and readjust the 1937 to 1940 tax returns, an action that would\nbe inconsistent with the annual tax accounting principle.\n....\nAffirmed.\nMR. JUSTICE DOUGLAS, dissenting. \xe2\x80\xa6 There were no capital transactions in\nthe year in which the losses were suffered. Those transactions occurred and were\naccounted for in earlier years in accord with the established principle that each year\nis a separate unit for tax accounting purposes. See United States v. Lewis, 340 U.S.\n590 (1951). I have not felt \xe2\x80\xa6 that the law made that an inexorable principle. But\nif it is the law, we should require observance of it\xe2\x80\x94not merely by taxpayers but by\nthe government as well. We should force each year to stand on its own footing,\nwhoever may gain or lose from it in a particular case. We impeach that principle\nwhen we treat this year\'s losses as if they diminished last year\'s gains.\nMR. JUSTICE JACKSON, whom MR. JUSTICE FRANKFURTER joins,\ndissenting. [omitted].\nNotes and Questions:\n1. Upon liquidation of a corporation, the corporation distributes its assets to its\nshareholders in exchange for their stock. Shareholders treat this as a sale or\nexchange of a capital asset. \xc2\xa7 331(a). Recall from our discussion of Gilliam that\npayment of a tort judgment would have been an ordinary and necessary business\nexpense, deductible under \xc2\xa7 162(a).\n550\n\n\x0c2. The opinion of Justice Jackson spells out just what is at stake. First, recognition\nof capital losses would save taxpayers less than recognition of the same losses as\nordinary. Second, capital losses are \xe2\x80\x93 except to the narrow extent permitted by\n\xc2\xa7 1211 \xe2\x80\x93 only offset by capital gains. If a taxpayer does not or cannot recognize\ncapital gains, the long-term capital losses simply become a useless asset to the\ntaxpayer. Also, the tax liability of the liquidated corporation should have been less\nunder the majority\xe2\x80\x99s view because of the deductions, but the statute of limitations\nhad no doubt run.\n3. Two policies came into conflict in Arrowsmith. The Tax Court and Justice\nJackson bought into the annual accounting principle. The other principle that\npermeates the Code is that a taxpayer may not change the character of income or\nloss \xe2\x80\x93 whether capital or ordinary. This is a very strong policy that only rarely yields\nto another policy. Often, taxpayers\xe2\x80\x99 machinations are much more deliberate than\nthey were in this case.\nA. Matching Tax-Exempt Income and Its Costs\nOurs is an income tax system that taxes net income. But what if certain income is\nnot subject to tax because it falls within an exception to the first of our three guiding\nprinciples? Should the expense of producing such income be deductible? Logically,\nsuch expenses should not be deductible \xe2\x80\x93 and this is indeed a rule that the Code\nimplements in at least two places.\nSection 265 denies deductions for the costs of realizing tax exempt income. Section\n264(a)(1) provides that a life insurance contract beneficiary\xe2\x80\x99s premium payment is\nnot deductible. Of course, the life insurance payments made by reason of death are\nexcluded from the beneficiary\xe2\x80\x99s gross income. \xc2\xa7 101(a)(1). This same principle\ngenerally applies to interest incurred to pay life insurance contract premiums.\n\xc2\xa7 264(a)(4).\nB. More Matching: Investment Interest\nSection 163(d)(1) limits the interest deduction to interest on indebtedness properly\nallocable to property held for investment to the extent of taxpayer\xe2\x80\x99s \xe2\x80\x9cnet investment\nincome ... for the taxable year.\xe2\x80\x9d Taxpayer may elect to treat his \xe2\x80\x9cqualified dividend\nincome,\xe2\x80\x9d see \xc2\xa7 1(h)(11)(B), as \xe2\x80\x9cinvestment income,\xe2\x80\x9d thereby increasing the amount\n551\n\n\x0cof investment interest he may deduct. \xc2\xa7 163(d)(4). Taxpayer may carry forward any\ninvestment interest disallowed to the succeeding taxable year. \xc2\xa7 163(d)(2). Until\n2026, \xc2\xa7 67(g) suspends even this deduction.\nC. Passive Activities Income and Losses\nA passive activity is a trade or business in which the taxpayer does not \xe2\x80\x9cmaterially\nparticipate.\xe2\x80\x9d \xc2\xa7 469(c)(1). An individual taxpayer may not deduct aggregate passive\nactivity losses in excess of his passive activity income, nor claim credits in excess\nof the tax attributable to the aggregate of his net income from passive activities.\n\xc2\xa7\xc2\xa7 469(a)(1), 469(d). We defer discussion of the details of \xc2\xa7 469 to a course in\npartnership tax. The important point here is that there is absolutely no mismatching\nof losses derived from passive activities with any other type of income \xe2\x80\x93 whether\nordinary income or portfolio (investment) income \xe2\x80\x93 until taxpayer has sold all his\ninterests in passive activities.\nD. Excess Business Losses of Noncorporate Taxpayers: \xc2\xa7 461(l)\nFor tax years 2018 through 2025, net business loss is limited to $250,000 per year,\nindexed for inflation. The limit for a joint return is\nThe CARES Act \xc2\xa7 2304\ntwice that. Specifically, non-corporate taxpayers\nmodified \xc2\xa7 461(l) to provide\nmay not deduct \xe2\x80\x9cexcess business loss.\xe2\x80\x9d \xc2\xa7\nthat its effective date is 2021\n461(l)(1)(B). An \xe2\x80\x9cexcess business loss\xe2\x80\x9d is the\nrather than 2018.\naggregate of a taxpayer\xe2\x80\x99s trade or business losses\nminus (the taxpayer\xe2\x80\x99s aggregate gross income attributable to such trades or\nbusiness plus $250,000). \xc2\xa7 461(l)(3)(A). The $250,000 amount is twice that amount\nin the case of a joint return, \xc2\xa7 461(l)((3)(A)(ii). These figures are adjusted for\ninflation. \xc2\xa7 461(l)(3)(B). A disallowed \xe2\x80\x9cexcess business loss\xe2\x80\x9d is treated as a \xe2\x80\x9cnet\noperating loss.\xe2\x80\x9d \xc2\xa7 461(l)(2).237 Thus, \xe2\x80\x9cexcess business losses\xe2\x80\x9d are disallowed only\nfor the tax year in which they were incurred. Section 461(l) is taken into account\nafter application of \xc2\xa7 469. \xc2\xa7 461(l)(6). Section 461(l) will have the effect of limiting\ntrade or business losses that offset non-trade-or-business income until they can be\ntreated as an NOL to $250K (to be indexed for inflation). The provision is subject\nto criticism. See Steven Z. Hodaszy, The Curious Case of Section 461(l): Why\nThe rule of \xc2\xa7 461(l) is to be applied at the partner or subchapter S shareholder level. \xc2\xa7 461(l)(4)\nAlso, \xc2\xa7 461(l) is to be applied after \xc2\xa7 469 (disallowance of passive activity losses and credits).\n237\n\n552\n\n\x0cThis Unclear and Unwise New Rule Should Be Construed as Narrowly as Possible,\n73 TAX LAW. 61 (2019).\nE. General Comment about Matching Principles\nPerhaps it does not seem very significant that implementation of matching\nprinciples results in disallowance of a deduction, loss, or credit because usually\nthere is a carryover. Your attitude may be \xe2\x80\x9cpick it up next year.\xe2\x80\x9d Reality may be\nquite different. When losses are \xe2\x80\x9clocked inside\xe2\x80\x9d an activity or type of income, it\nprobably is the case that circumstances are not going to change radically for a\ntaxpayer from one year to the next. The investor who loses a deduction because of\ninsufficient income of a particular type is not likely suddenly to receive a lot of that\ntype of income during the next year. The effect of implementing matching\nprinciples may be that the excess expense or loss is simply disallowed \xe2\x80\x93 forever.\nHowever, forewarned is forearmed. Taxpayers may choose their activities or\ntransactions so that they will have gains against which losses can be matched. The\neffect of \xc2\xa7 67(g), which denies taxpayers \xe2\x80\x9cmiscellaneous deductions\xe2\x80\x9d until 2026,\nwill be to alter taxpayers\xe2\x80\x99 calculus of risk and reward further.\n\nWrap-Up Questions for Chapter 10\n1. What policy (policies) is served by the exceptions to the definition of \xe2\x80\x9ccapital\nasset\xe2\x80\x9d in \xc2\xa7\xc2\xa7 1221(a)(1, 2, 3, 4, 6, 7, 8)?\n2. In Fribourg Navigation Co. v. Commissioner, 383 U.S. 272 (1966), the Supreme\nCourt held that a taxpayer was entitled to depreciation deductions up to the date it\nsold an asset. In the days before \xc2\xa7 1245 (but after \xc2\xa7 1231), why would this have\nbeen important?\n3. Why should capital loss carryovers expire \xe2\x80\x93 and simply disappear \xe2\x80\x93 on the death\nof the taxpayer?\n4. In what ways does \xc2\xa7 1031 help facilitate growth within our economy?\n5. Why should a taxpayer not be permitted to deduct the cost of obtaining taxexempt income?\n\nWhat have you learned?\nCan you explain or define \xe2\x80\x93\n553\n\n\x0c\xe2\x80\xa2What is a capital asset? What types of assets are not capital assets?\n\xe2\x80\xa2Describe how \xc2\xa7 1(h) works?\n\xe2\x80\xa2Describe the netting of LT/ST capital gains/losses that \xc2\xa7 1221 prescribes?\n\xe2\x80\xa2To what extent does \xc2\xa7 1211(b) allow an individual taxpayer to offset capital gains\n(LT or ST) with capital losses (LT or ST)?\n\xe2\x80\xa2What is depreciation recapture? Why is it needed? What is its effect?\n\xe2\x80\xa2What is \xc2\xa7 1231 property? What tax treatment does the Code provide for the sale\nor exchange of \xc2\xa7 1231 property? In what way(s) does \xc2\xa7 1231 implement a \xe2\x80\x9cheadsI-win-tails-you-lose\xe2\x80\x9d scheme with the taxpayer?\n\xe2\x80\xa2What is a like-kind exchange? What is the tax treatment of a like-kind exchange?\n\n554\n\n\x0c'