About the Author
Professor Geier is a summa cum laude graduate of Baldwin Wallace University and a magna
cum laude graduate of the Case Western Reserve University Law School, where she was Articles
Editor of the Law Review. Following her graduation, she clerked for the Honorable Monroe G.
McKay of the United States Court of Appeals for the Tenth Circuit before joining the tax group of
the Wall Street firm of Sullivan & Cromwell in New York City. She joined the Cleveland-Marshall
College of Law faculty in 1989. She was a co-author of the 1st, 2nd, and 3rd editions of FEDERAL
INCOME TAX: DOCTRINE, STRUCTURE, AND POLICY (LexisNexis, with Joseph M. Dodge and J.
Clifton Fleming), before writing this textbook in an effort to reduce student textbook costs. She
has been a Visiting Professor of Law at Washington University in St. Louis, the University of
Michigan in Ann Arbor, and the University of Florida in Gainesville; she was also the John J.
Sparkman Chairholder of Law (Visiting) at the University of Alabama and was the inaugural
holder of the Leon M. & Gloria Plevin Professor of Law at Cleveland-Marshall (a three-year,
rotating, endowed professorship).
Geier is a member of the American Law Institute and has served both as a member of the
Executive Committee and as Chair of the Tax Section of the Association of American Law
Schools. She has also served as an Academic Adviser to the staff of the Joint Committee on
Taxation (comprised of the members of the House Ways and Means Committee and Senate
Finance Committee) in connection with a tax simplification study and has testified before the
Senate Finance Committee in connection with the tax consequences of home mortgage
foreclosures.

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i

Notices
This is the eighth version of this annually updated textbook and is current through December
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Deborah A. Geier, U.S. Federal Income Tax of Individuals 2022, Published by CALI eLangdell
Press. Available under a Creative Commons BY-NC-SA 3.0 License.
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Should you create derivative works based on the text of this book or other Creative Commons
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This material does not contain nor is intended to be legal advice. Users seeking legal advice
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Permissions
CALI gratefully acknowledges permission from the following individuals and organizations
to reprint materials:
The Urban Institute – charts appearing in Chapter 3 and elsewhere.
Giving Institute and Giving USA Foundation – Giving USA 2014, Giving USA Foundation™.
Center on Budget and Policy Priorities, www.cbpp.org – charts in Chapter 3 and elsewhere.

ii

OECD Health Data 2011, http:://www.oecd.org/health/healthdata
Robert W. Wood – 83 Tax Notes 1941 (1999) and Forbes’ Oscar Goody Bag article.
Tax Notes – graphs, charts and excerpts from the following articles: Geier, 113 Tax Notes 576
(2006); Sullivan, 157 Tax Notes 30, 303 (2017).
Kimberly A. Clausing, charts from Testimony before the House Ways & Means Committee, May
23, 2017.
Erik M. Jensen, 58 Tax Notes 1257 (1993) and Praeger.
Alice G. Abreu & Richard Greenstein, 11 Fla. Tax Rev. 306 (2011).
University of Florida Frederic G. Levin College of Law, Florida Tax Review, 11 Fla. Tax Rev.
306 (2011).
Jotwell: The Journal of Things We Like (Lots) and Neil H. Buchanan, Professor Buchanan’s book
review excerpted in Chapter 3 and elsewhere.
Institute on Taxation and Economic Policy—chart appearing in Chapter 3.
Tax Policy Center—charts appearing in Chapter 3.

iii

Preface
As one, lone law professor, I have little direct ability to reduce tuition costs for my students.
When writing this textbook, however, I decided to decline expressions of interest from the legacy
legal publishers in favor of making this textbook available as a free download over the internet (in
pdf and Word formats, as well as ePub format for iPads and Mobi format for Kindles. Fortunately,
eLangdell (a division of CALI, the Center for Computer-Assisted Legal Instruction) has been an
ideal partner in this regard. At-cost print versions can also be ordered at the eLangdell website.
In addition to eliminating (or lowering) student cost, this mode of publication permits me to
quickly and fully update the book each December, incorporating expiring provisions, inflation
adjustments for the coming calendar year, new Treasury Regulations, etc., in time for use in the
spring semester, an approach that avoids cumbersome annual supplements. This publication
method also makes the textbook suitable for use as a free study aid for students whose professors
adopt another textbook, as this textbook walks the student through the law with many more fact
patterns and examples than do many other textbooks. While this practice adds length, I believe
that it also makes the book more helpful to students in confronting what can be daunting material.
Finally, having the textbook easily accessible to foreign students enrolled in a course examining
the U.S. Federal income taxation of individuals is important to me, and having the textbook
available as a free internet download succeeds well in that regard.
A Teacher’s Manual is available for professors who adopt the book (or parts of it) for use in
their course.
This textbook is not intended to be an exhaustive treatise; rather, it is intended to be far more
useful than that for beginning tax law students by equipping the novice not merely with unmoored
detail but rather with a rich blueprint that illuminates the deeper structural framework on which
that detail hangs (sometimes crookedly). Chapter 1 outlines the conceptual meaning of the term
“income” for uniquely tax purposes (as opposed to financial accounting or trust law purposes, for
example) and examines the Internal Revenue Code provisions that translate this larger conceptual
construct into positive law. Chapter 2 explores various forms of consumption taxation because the
modern Internal Revenue Code is best perceived as a hybrid income-consumption tax that also
contains many provisions—for wise or unwise nontax policy reasons—that are inconsistent with
both forms of taxation. Chapter 3 then provides students with the story of how we got to where we
are today, important context about the distribution of the tax burden, the budget, and economic
trends, as well as material on ethical debates, economic theories, and politics as they affect
taxation.
Armed with this larger blueprint, students are then in a much better position to see how the
myriad pieces that follow throughout the remaining 18 chapters fit into this bigger picture, whether
comfortably or uncomfortably. For example, they are in a better position to appreciate how
applying the income tax rules for debt to a debt-financed investment afforded more favorable
consumption tax treatment creates tax arbitrage problems. Congress and the courts then must
combat these tax shelter opportunities with both statutory and common law weapons. Stated
another way, students are in a better position to appreciate how the tax system can sometimes be
used to generate (or combat) unfair and economically inefficient rent-seeking behavior.
The term “economic rents” here has a special meaning to economists that has nothing to do
with the common meaning of that word to those who pay money to a landlord to live in a flat. One

iv

way to define “rents” in this sense is to say that they are wealth accessions enjoyed by a person
(the rentier) that would not have occurred in a perfectly competitive and transparent economy.
Rent, in this special sense, represents the mere shift of wealth from others to the rentier (rather
than the creation of new wealth) through a manipulation of the social or economic environment to
enrich oneself or, in the pithy words of the The Economist magazine, “[c]utting yourself a bigger
slice of the cake rather than making the cake bigger.” 1 Blackmail is a form of illegal rent-seeking
behavior, but much rent-seeking behavior is perfectly legal. In the tax environment, it can mean a
“profit” that is nothing more than a transfer, in effect, from the Treasury (other taxpayers) to the
rentier, a phenomenon that raises not only economic efficiency concerns but fairness concerns.
Rent-seeking behavior is a significant problem in today’s economy—both inside and outside the
tax system 2—but the tax system can also provide policy makers with a ready tool to combat such
behavior (if they wish to use it).
The underlying conceptual framework, context, and ethical and economic theories provided
early on are then referenced throughout the book, providing the common thread with respect to
every topic studied.
In addition to providing a solid grounding in the conceptual and policy underpinnings of the
income tax imposed on individuals, this textbook explores a sufficient amount of detail to teach
students how to continue learning on their own. Indeed, so much of law school is guiding students
in learning how to learn so that they can practice effectively over the course of their careers as the
law ever evolves. Such an approach should well equip the students who go on to take upper-level
tax classes (who will add even more detail to the structural framework learned here), as well as
those who wish merely to be aware of the fundamental tax issues that might arise in their nontax
practices (so that they know to do more research when the time comes or to seek help from a tax
specialist where necessary).
I also have a third audience in mind for this book, however: legislators, judges, policymakers,
and those who simply wish to be better equipped as citizens in evaluating what they read about in
the popular press about taxation in the U.S. Because this textbook does not merely recite and apply
rules but explores the deeper internal logic (and evolution and policy) underlying the entire
structure of the Federal income tax, readers should leave with a more sophisticated understanding
of the often unspoken context underlying popular debates. In particular, Chapters 1, 2, and 3 may
be good vehicles to use as an introductory unit in a Tax Policy Seminar course—especially because
the book can be downloaded for free.
Indeed, I think that one reason why taxation is such a fascinating subject (no sniggers, please)
is that it affects everyone in society, whether directly or indirectly—everyone from the single
mother trying to make ends meet, to the bright student putting herself through college and incurring
large debts to do so, to the entrepreneur with a good idea, to the Fortune 500 company
contemplating a merger. As Professor Michael Graetz (Columbia University) once observed, many
more people file tax returns than vote in Presidential elections. 3 How we choose to tax ourselves
says a lot about how we view ourselves as a country and as members of a community that are
1

www.economist.com/economics-a-to-z/r.
Cf. Adam Liptak, First Amendment, “Patron Saint“of Protester, Is Embraced by Corporations, at
http://www.nytimes.com/2015/03/24/us/first-amendment-patron-saint-of-protesters-is-embraced-bycorporations.html?_r=0 (quoting Professor John Coates of Harvard as writing, “Concentrated, moneyed interests …
are … increasing the share of the economy devoted to rent-seeking rather than productive activity”).
3
Jeffrey Y. Yablon, 100 Years of the Tax Code: 100 Tax Quotes, 140 TAX NOTES 1617 (2013).
2

v

inextricably interrelated, as tax dollars create the common physical and intangible infrastructure
that permits the flourishing of both human capital and the economy. Fascinating stuff!
In addition to text, cases, and other primary authority (and problems), this textbook is unusual
in including not only charts and graphs but also links to a few New York Times articles that help
to illuminate contrasting viewpoints, to provide relevant data or history in a very short space, or to
reveal useful context surrounding the issue under study. I publicly thank the New York Times
Company for permitting links to articles without charge. (I would have done the same with articles
from other sources if they had similarly permitted such use without charge.)
I have provided hyperlinks to certain Internal Revenue Code sections and Treasury
Regulations where I thought it would be helpful or appropriate (e.g., the first time a Code
section is cited on a page or when I specifically instruct the reader to consult the source).
Those with a hyperlink are underlined. Those without hyperlinks are not underlined. The
hyperlinks take you to the Legal Information Institute’s web page (Cornell University), which is
an open access site.
Case excerpts are often abbreviated to be more manageable as pedagogical tools (especially in
light of the many demands on student time). Case footnotes that are included use their original
numbering and are enclosed in brackets. My own original footnotes are not bracketed.
______________________________________
Senator Everett Dirksen is famously thought to have once said: “A billion here, a billion there,
and pretty soon you’re talking about real money.” 4 At different points in this book, some very
large numbers are inevitably used, including millions, billions, and trillions. As they all use the
same word ending, sometimes it is easy to lose sight of the magnitude of differences among them.
For example, studies show that many people unconsciously estimate 1 billion to be about a third
larger than 1 million because it contains three additional zeros when written in numerals
(1,000,000,000 versus 1,000,000), but one billion is in fact 1,000 millions. And one trillion is 1,000
billions.
Here is a helpful tool that aids in visualizing the vast differences among 1 million, 1 billion,
and 1 trillion. One million seconds is only about 11.5 days. One billion seconds is almost 32 years.
One trillion seconds is more than 31,688 years.
_____________________________________
Finally, you will learn in the Introduction that Congress enacts our tax laws, as signed by the
President. Here is one bit of context to keep in mind as you move through the course: the majority
of members of Congress are millionaires. 5 “If the idea of Congress was that you have the butcher,
baker, candlestick maker representing the people, we’ve come to a system where we certainly
don’t have that anymore.” 6
________________________________________

4

Although many claim to have heard Senator Dirksen speak this phrase, it has never been documented. See
www.dirksencenter.org/print_emd_billionhere.htm.
5
See Karl Evers-Hillstrom, Majority of Lawmakers in 116th Congress are Millionaires,
https://www.opensecrets.org/news/2020/04/majority-of-lawmakers-millionaires/.
6
Richard Rubin, Second-Home Deduction Future Depends on Congress Using It, at
www.bloomberg.com/news/2013-07-23/second-home-deduction-future-depends-on-congress-using-it.html..

vi

I would like to thank several tax law professors who served as peer reviewers for many of the
chapters in this book. Their comments were substantive and insightful, and they resulted in
material changes in the course of my final revisions that substantially improved the book. After
working on this textbook for nearly two and one-half years, I was so close to it that I could no
longer see some of the ways in which it could be improved, and I deeply appreciate the time and
effort that they took in their careful reviews. In alphabetical order, they are Ellen Aprill, Neil
Buchanan, Pat Cain, Adam Chodorow, Leandra Lederman, Roberta Mann, and Kerry Ryan. Many
thanks!
I would like to dedicate this textbook to the many, many Cleveland-Marshall College of Law
students that I have had the pleasure of having in my classroom since I began teaching law in 1989.
You rock!
The 1.0 version of this textbook was published in 2014, the 2.0 version in 2015, the 3.0 version
in 2016, the 4.0 version in 2017, the 5.0 version in 2018, the 6.0 version in 2019, the 7.0 version
in 2020, and the 8.0 version in 2021. This 9.0 version (for tax year 2022) is current through
December 15, 2021. Happy journey!
Deborah A. Geier
Professor of Law
Cleveland-Marshall College of Law
Cleveland State University
My bio can be found at: https://www.law.csuohio.edu/meetcmlaw/faculty/geier

vii

Table of Contents
About the Author ………………………………………….…………………………........ i
About CALI eLangdell Press ………………………………………………………........... i
Notices ……………………………………………………….…………………………… ii
Permissions ……………………………………………………………………………….. ii
Preface ……………………………………………………………………………………. iv

Introduction …………………………………………………………………................. xxii
The legislative branch ………………………………………………………………. xxiv
The executive branch ………………………………………………………………... xxiv
Tax procedure overview …………………………………………………………….. xxix
The judicial branch ………………………………………………………………….. xxx
Excerpt from Of Crud and Dogs: An Updated Collection of Quotations in Support of
the Proposition That the Supreme Court Does Not Devote the Greatest of Care and
Attention to Our Exciting Are of the Law by Erik M. Jensen ……………………... xxxii

Unit I: The Core Structures of Income
and Consumption Taxation and Tax Policy
Introduction to Chapters 1 through 4 ……………………….…………………….………….. 1

Chapter 1: The Essential Structure of the Income Tax ……............................... 3
A. The theoretical core structure of a tax on income and how it is implemented in
positive law ……………………………………………..……………………………. 3
Introduction to § 61 Gross Income ……………………………………………………. 5
Deductions (part 1): nondeductible capital expenditures vs. potentially
deductible expenses …………………………………………………………..…........... 7
§ 61(a)(3) gains derived from dealings in property and the critical role of basis ……...8
Deductions (part 2): which expenses are deductible and why? ………………………. 14
Deductions (part 3): § 1001 loss (and more on normative income tax theory) ………. 17
Deductions (part 4): depreciation …..……………………………………………….... 18
§ 1016 basis adjustments ……………………………………………………………… 19
A brief introduction to the concept of capital gains and losses ……………….………. 20
Problems ………………………………………………………………………………. 24
B. Subsistence consumption, tax rates, and more ……………...……………………….... 25
§ 62 Above-the-Line Deductions ……………………………………………………… 26

viii

The (suspended) Personal Exemption and Dependent Deduction and
(continuing) Standard Deduction ………………………………………………………27
§ 67: (suspended) Miscellaneous Itemized Deductions (MIDs)……………………….. 28
The Alternative Minimum Tax (AMT) ………………………………………………….30
Child Tax Credit and Earned Income Tax Credit …………………………..…….……32
Effective tax rate versus marginal tax rate ……………………………………………. 34
The new § 199A deduction for sole proprietors and owners of pass-through entities… 38
Problems ………………………………………………………………………………. 41

Chapter 2: Consumption Taxation and Our Hybrid Income/Consumption
Tax …………………………………………………………………………………… 43
A. Consumption taxation forms and comparison to income taxation ……………………. 43
A retail sales tax ………………………………………………………………………. 44
A value added tax ……………………………………………………………………... 44
A cash-flow consumption tax ………………………………………………………….. 46
Exempting capital returns from tax: the wage tax and the E. Cary Brown
yield-exemption phenomenon …………………………………………………………. 48
B. Consumption tax provisions in the Internal Revenue Code …………..………………. 52
C. The additional wrinkle of debt ………………………………….……………………... 53
D. Tax arbitrage: the income tax treatment of debt coupled with consumption tax
treatment of the debt-financed investment …………………………………….……… 55
Introduction to the concept of capture ……………………………………………....... 56

Chapter 3: Ethical Debates, Economic Theories, and Real-World
Impacts ……………………………………………………………………………………. 60
A. The development of the income tax and how taxes affect the Federal budget and
living standards ……………………………………………………………………….. 61
Excerpt from The Taxing Power: A Reference Guide to the United States
Constitution by Erik M. Jensen ……………………………………………………….. 64
B. Fairness norms, economic theories, and politics ………………………………………. 81
Fairness norms in general …………………………………………………………….. 82
Fairness and the wage tax …………………………………………………………….. 84
Fairness and other forms of consumption taxation …………………………………… 86
Welfare economics ……………………………………………………………………. 87
Chicago-school-style economics ……………………………………………………… 89
Negative and positive externalities and Pigovian taxes…..…………………………… 91
Rent-seeking behavior ………………………………………………………………… 92
ix

Supply-side economics ………………………………………………………………... 93
The limits of economic theory ………………………………………………………… 96
Tax expenditures………………………………………………………………………. 98
Final thoughts ………………………………………………………………………... 101

Chapter 4: The Contours of Capital Expenditure v. Expense
(or Current Depreciation) …………………………………………………………… 103
A. Outlays pertaining to intangibles …………………………………………………….. 106
INDOPCO, INC. v. COMMISSIONER ……………………………………………... 107
Post-INDOPCO developments ………………………………………………………. 109
Outline of the regulations pertaining to intangibles ………………………………… 110
Problems ………………………………………………………………………………112
B. Outlays pertaining to tangible assets ……………………………….………………... 112
Two mutually exclusive de minimis elections ………………………………………...113
The § 162 deduction for materials and supplies …………………………………….. 114
Problems …………………………………………………………………………….. 114
The difficult distinction between repair (expense) and improvement (capital
expenditure)………………………………………………………………………….. 115
Improvement: betterment, restoration, or adapting the property to a new use ……....116
Determining the unit of property ……………………………………………………. 117
Routine maintenance safe harbor …………………………………………………….117
Small business safe harbor election for building improvements ……………………. 118
Problems ………………………………………………………………………………118
C. Indirect costs of producing inventory (and other property)………………………….. 119
COMMISSIONER v. IDAHO POWER CO. ……………………………………….. 119
§ 263A codification ………………………………………………………………….. 120

Unit II: Two Types of Gross Income:
Compensation and Residual Gross Income
Introduction to Chapters 5 and 6 ……………………………………………………........... 122

Chapter 5: § 61(a)(1) Compensation ……………………………………………... 124
OLD COLONY TRUST CO. v. COMMISSIONER ……………………………….. 124
REVENUE RULING 79-24 ………………………………………………………… 127
A. Section 119 ………………………………………………………...…………………129
COMMISSIONER v. KOWALSKI ………………….………………………………130

x

LINDEMAN v. COMMISSIONER ….………………………………………………132
B. Section 132 ………………………………………….………………………………..137
Excerpt from General Explanation of the Revenue Provisions of the Deficit
Reduction Act of 1984 ……………………………………………………………….138
C. The Employer’s Business Expense Deduction for Compensation …………………...140
Problems ……………………………………………………………………………...141
D. Section 83 …………………………………………………………………………….143
Problems ……………………………………………………………………………...146

Chapter 6: § 61 Residual Gross Income ………………………………………….147
COMMISSIONER v. GLENSHAW GLASS ……..…………………………………148
A. What is an accession to wealth within the meaning of Glenshaw Glass? …………..152
Cash receipts that are not basis recovery (or loan principal or excluded by statute)..152
REVENUE RULING 76-131 ………………………………………………………...152
Consumption received in kind ………………………………………………………..155
Oscar Freebies Balloon to $80K (Don’t Tell IRS) by Robert W. Wood …………….157
UNITED STATES v. GOTCHER …………………………………………………...160
Problem ………………………………………………………………………………164
HAVERLY v. UNITED STATES …………………………………………………...164
Problem ………………………………………………………………………………166
B. When is a wealth accession clearly realized within the meaning of Glenshaw Glass? 167
The bargain purchase rule …………………………………………………………...167
Problem ………………………………………………………………………………167
Commercial rebates ………………………………………………………………….168
REVENUE RULING 76-96 ………………………………………………………….168
Problem ………………………………………………………………………………169
Lessee improvements that are not rent ……………………………………………….170
HELVERING v. BRUUN ……………………………………………………………170
Treasure trove ………………………………………………………………………..173
Excerpt from Defining Income by Alice G. Abreu & Richard K. Greenstein …….....174

Unit III: The Possibilities for Income Shifting
Introduction to Chapters 7 and 8 .….……………………………………………….............180

Chapter 7: Gifts and Bequests ……………………………………………………...181
Possible taxation approaches to the transfer and receipt of gifts and bequests ……..181
xi

A brief description of positive law ……………………………………………………183
A. The basis of property received in kind as a gift or bequest (and related rules) ……....187
Problems …………………………………………………………………………….. 187
Historical development of the basis rules….………………………………………….188
Is § 1014 justified? If not, which alternative would be better? ……………………....189
The effect of the Internal Revenue Code on Racial Wealth Inequities ……………… 191
B. What is a gift within the meaning of § 102(a)? ……………………………………….193
COMMISSIONER v. DURBERSTEIN …………………………………………….. 193
Consequences of the Duberstein approach to gift ……….………………………….. 201
Problem ……………………………………………………………………………… 202
A Duberstein example and introduction of small tax case jurisdiction
in the Tax Court ……………………………………………………………………... 202
JUE-YA YANG v. COMMISSIONER ……………………………………………... 202
The possible limits of the Duberstein intent approach ……………………………… 204
OLK v. UNITED STATES ………………………………………………………….. 204
The relationship between § 61 and exclusion provisions …………………………… 207
Final thoughts ………………………………………………………………………...208
C. Life insurance proceeds received on death of the insured ………………....................208
Is the § 101(a)(1) exclusion justified? ………………………………………………. 208
Sales of life insurance policies to investors …………………………………………. 209
Problems …………………………………………………………………………….. 209

Chapter 8: Income Shifting in the Happy and Fractured Family ……….....210
A. Income splitting via the joint return ………………………………………………… 210
LUCAS v. EARL ………………………………………………………………….… 210
POE v. SEABORN ………………………………………………………………….. 212
Registered domestic partnerships (RDPs) and civil unions ………………………….219
CHIEF COUNSEL ADVICE 201021050 …………………………………………... 220
B. Income-shifting possibilities outside the joint return ……………………...................221
Problems …………………………………………………………………………….. 221
BLAIR v. COMMISSIONER ………………………………………………………..223
HARRISON v. SCHAFFNER …….…………………………………………………226
The § 1(g) kiddie tax ….…………………………………………………………....... 229
The grantor trust rules …….…………………………………………………………230

xii

HELVERING v. CLIFFORD ……………………………………………………….. 231
Income splitting using a nongrantor trust ……………………………………………234
Final thoughts ……………………………………………………………………….. 235
C. Income Shifting in the fractured family ……………………………………………..235
Cash payments …..………………………………………………………………........236
GOULD v. GOULD ………………………………………………………………….236
Retirement savings in divorce…………………………………………………………240
Transfers of property in kind …..……………………………………………………..240
Problems …………………………………………………………………………….. 244
Unmarried cohabitants with no formal legal relationship ………………………….. 244
REYNOLDS v. COMMISSIONER ………………………………………………….244
Property Transfers in RDPs and civil unions……………………………………….. 248
Problem ………………………………………………………………………………249

Unit IV: Everything You Ever Wanted To
Know About Debt but Were Afraid To Ask
Introduction to Chapters 9 through 11 . …………………………………………………… 250

Chapter 9: Borrowing and Lending ...……………………………………………..252
A. The basic rules of the road ….………………………………………………………..252
B. Section 7872 ………………………………………………………………………….254
C. Identifying principal and interest (including original issue discount)
and the timing of interest inclusions and deductions ………………………………...257
Identifying principal and interest ……………………………………………………257
Segue to a brief discussion of methods of accounting ………………………………..260
Original issue discount ………………………………………………………………262
OID pertains to realization rather than accounting methods ….…………………… 264
D. Recovery of annuity basis under § 72 ………………………………………..............266
Problem ………………………………………………………………………………268
E. Which receipts fall within the borrowing exclusion? ………………………………...268
JAMES v. UNITED STATES ……..…………………………………………………268
NORTH AMERICAN OIL CONSOLIDATED v. BURNET ………………………..271
Lewis and the enactment of § 1341 …………………………………………………...273
A workable tax definition of loan: absolute versus contingent obligation to repay .... 274
COMMISSIONER v. INDIANAPOLIS POWER & LIGHT ………………………...275

xiii

Problem …………………………………………………………………………….....279

Chapter 10: The Bad-Debt Deduction (for Lenders) and Debt-Discharge
Income (for Borrowers) ……………………………………………………………….281
A. The lender’s deduction for a bad debt (or worthless security) ….……………………….281
§ 165(g) deduction for a worthless security ………………………………………… 281
§ 166 bad-debt deduction …………………………………………………………….282
Bona fide debt ……………………………………………………………………….. 284
Worthlessness ………………………………………………………………………...285
Deduction limited to basis ……………………………………………………………285
REVENUE RULING 93-27 ………………………………………………………… 286
Problems …………………………………………………………………………….. 288
B. § 61 income from the discharge of indebtedness …………………............................. 288
UNITED STATES v. KIRBY LUMBER ….………………………………………... 289
The modern rationale underlying § 61 debt-discharge income: the borrowing
exclusion itself ………………………………………………………………..…….... 291
Deferral of § 61 debt-discharge income under § 108 ………………………………… 292
Failure to grasp the modern rationale by some courts ………………………………. 295
PAYNE v. COMMISSIONER ………………………………………………………. 296
Problems …………………………………………………………………………….. 298
Measuring the economic value received in the borrowing year with
seller-financed purchases …………………………………………………………………... 299
ZARIN v. COMMISSIONER (Tax Court) …………………………………………. 300
ZARIN v. COMMISSIONER (Third Circuit) ……………………………………….308

Chapter 11: Debt and Property …………………………………………………….314
A. The purchase of property with borrowed money: the front-end rule in Crane…….... 315
B. The transfer of property subject to debt: the back-end rule in Crane, Tufts, and
Rev. Rul. 90-16 ……………………………………………………………………… 318
Relief from recourse debt not in excess of property FMV …………………………... 318
Relief from nonrecourse debt—whether or not in excess of property FMV ………… 320
COMMISSIONER v. TUFTS ………………………………………………………..321
Relief from recourse debt in excess of property FMV ……………………………......329
REVENUE RULING 90-16 ………………………………………………………….329
C. Reduction of property debt without a property transfer ………………………………333
REVENUE RULING 91-31 …………………………………………………………. 333

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§§ 108(a)(1)(D) and (e)(5) …………………………………………………………... 335
Final thoughts ………………………………………………………………………... 337
Problems ……………………………………………………………………………... 338

Unit V: The Ownership and Disposition of Property
Introduction to Chapters 12 through 15 …………………………………………….............339

Chapter 12: Properly Accounting for, and the Nonrecognition of,
§ 1001 Realized Gain or Loss ………………………………………………..............340
On the disposition of property ………………………………………………………. 340
A. Properly accounting for realized and recognized gain and loss ……………………...341
Inventory sales ……………………………………………………………………….342
Timing of § 1001 realized and recognized gain inclusion …………………………...344
Installment sale reporting …………………………………………………………....345
Open transaction reporting …………………………………………………………..346
B. The nonrecognition of § 1001 realized gain or loss ………………………………….346
§ 1033 involuntary conversions of built-in gain property …………………………...347
§ 1031 like kind exchanges …………………………………………………………..349
Three-corner exchanges ……………………………………………………………...356
CRANDALL v. COMMISSIONER ………………………………………………....356
Does § 1031 reflect sound policy? …………………………………………………...360
§§ 1400Z-1 and -2 Qualified Opportunity Zones and Funds ………………………...361
§ 267(a)(1) sales of loss property to a related party ………………………………...363
§ 1091 wash sales of loss securities ………………………………………………….363
Problems …………………………………………………………………………….. 363

Chapter 13: Depreciation in a Realization Income Tax and the
Business Interest Deduction…………………………………....................................365
A. Economic depreciation in a realization-based income tax …………..........................366
B. “Wear and tear” within the meaning of § 167(a) …………………….........................369
SIMON v. COMMISSIONER ….……………………………………………………370
C. Depreciation of tangible assets ……………………………………………………… 381
Non-real estate ……………………………………………………………………… 382
§ 179 expensing …………………………………………………………………....... 382
§ 168 depreciation …………………………………………………………………....383
Real estate ……………………………………………………………………………387

xv

§ 280F limitations ……………………………………………………………………388
D. Amortization of intangible assets …………………………………………….............390
E. Amortization of start-up costs ………………………………………………………..392
F. Tax arbitrage: the business interest deduction for debt-financed purchases of
expensed (or nearly expensed) assets………………………………………………...392
Problems …………………………………………………………………………......394

Chapter 14: Capital Gains and Losses …………………………………………... 396
A. Capital losses …………………………………………………………………….......396
Problem ………………………………………………………………………………399
B. Net capital gain ………………………………………………………………….........399
Why is net capital gain taxed at a preferential rate? ………………………………...400
The double tax argument regarding capital returns …………………………………403
Lock-in effect …………………………………………………………………………404
Inflation gain …………………………………………………………………………404
Encouraging risk-taking entrepreneurship to stimulate economic growth ………….408
Bunching effect from the realization requirement …………………………………...409
The definition of net capital gain …………………………………………………… 410
Planning possibilities regarding the timing of realized capital gains and losses …...411
C. The meaning of capital asset and sale or exchange …………………........................ 413
§ 1221(a)(1): the inventory or dealer exception ……………………………………. 413
BYRAM v. UNITED STATES ……………………………………………………... 414
§ 1221(a)(2): certain property used in the taxpayer’s trade or business …………… 418
§ 1221(a)(3): certain copyrights, works of art, musical compositions, and
similar property ………………………………………………………………………418
§ 1221(b)(3): the election for self-created musical works …………………………...421
§ 1221(a)(7): hedging transactions …………………………………………………. 421
The sale of a right to collect ordinary income in the future ………………………… 424
The sale or exchange requirement …………………………………………………...424
The Arrowsmith doctrine …………………………………………………………….425
D. Section 1231 gains and losses and depreciation recapture …………………………..426
§ 1231 gains and losses ……………………………………………………………....426
§§ 1245 and 1250 depreciation recapture ………………………………………...... 428
Problems ……………………………………………………………………………...430

xvi

E. The § 1(h) rates applicable to net capital gain ……………………………………...... 431

Chapter 15: Tax Shelters ……………………………………………………………..431
Policy concerns ………………………………………………………………………435
A. Common law doctrines used in tax shelter litigation ……………………...................436
Sham debt …………………………………………………………………………….436
KNETSCH v. UNITED STATES ……………………………………………………436
ESTATE OF FRANKLIN v. COMMISSIONER ……………………………………440
Tax ownership ………………………………………………………………………..446
The business purpose doctrine ……………………………………………………….447
The economic substance doctrine ……………………………………………………448
B. Statutory tools in combatting tax shelters ……………………………………………452
The § 163(d) investment interest deduction rules ……………………………………452
Problem ………………………………………………………………………………455
The § 465 at-risk rules and § 469 passive activity loss rules ………………………..455
Section 461(l)…………………………………………………………………………460
Problems ……………………………………………………………………………..461

Unit VI: Distinguishing Between IncomeProducing Activities and Personal Consumption
and the Personal Consumption Tax Expenditures
Introduction to Chapters 16 through 19 …………………………………………………….463

Chapter 16: On Human Capital ……………………………………………............464
A. Education costs ………………………………………………………………….........464
Problems ……………………………………………………………………………...467
Treas. Reg. § 1.162-5: education costs as § 162 business expenses …………………468
SHARON v. COMMISIONER ……………………………………………………....470
Problems ……………………………………………………………………………..477
B. Compensation received on account of the loss of human capital ……………………478
Excerpt from Murphy and the Evolution of “Basis” by Deborah A. Geier ………….478
§ 104(a)(2) as tax expenditure ……………………………………………………….483
Determining the excludable amount: deducted medical costs, structured
settlements, prejudgment interest, and punitive damages ……………………...........484
The treatment of attorney fees ……………………………………………………….486
AMOS v. COMMISSIONER ………………………………………………………..489

xvii

Problems ……………………………………………………………………………..495

Chapter 17: Homes, Health, Charity, and More ……………………................497
A. Owner-occupied housing …………………………………………………………….497
The exclusion of imputed income with respect to owner-occupied housing …………497
Tax policy critiques of the home ownership tax expenditures ..…………………….. 499
The § 163(h)(3) deduction for qualified residence interest …………………............ 501
Problems ……………………………………………………………………………..504
The § 121 exclusion of gain on the sale or exchange of a principal residence …….. 505
Problem ………………………………………………………………………………507
The §§ 108(a)(1)(E) and (h) exclusion of principal residence § 61 debt-discharge
income ………………………………………………………………………………. 508
Excerpt from Before the Senate Committee on Finance, at a Hearing on “The Housing
Decline: The Extent of the Problem and Potential Remedies by Deborah A. Geier … 509
Problem ………………………………………………………………………………. 511
B. Personal casualty and theft losses …………………………………………………… 511
Determining the amount and character of a personal casualty or theft loss
and whether it is an Itemized Deduction or Above-the-Line Deduction …………….. 512
Problem ………………………………………………………………………………514
C. Health care ……………………………………………………………………….......514
The § 213 deduction for certain medical costs ………………………………………515
The §§ 105(b) and 106 exclusions for employer-provided health care (and the
§ 162(l) deduction for the self-employed) ……………………………………………517
The consumer-driven health care movement: HSAs and high-deductible plans …… 520
The § 36B premium health care credit ………………………………………………521
Problems ……………………………………………………………………………..521
D. Charitable contributions …………...............................................................................522
Tax-exempt organizations ……………………………………………………………522
Who benefits from the § 170 deduction and where do our charitable dollars go? ….523
What is a contribution or gift within the meaning of § 170(c) ………………………526
HERNANDEZ v. COMMISSIONER ……………………………………………….528
SKLAR v. COMMISSIONER ……………………………………………………….539
Determining the deductible amount when property is contributed in kind ………….542
Contributions of services in kind ………………………………………………….....547
Substantiation requirements …………………………………………………………547

xviii

AGI percentage contribution limits ………………………………………………….547
Problems ……………………………………………………………………………..549
E. State and local taxes …………………………………………………………….........550
F. Expenses for the determination, collection, or refund of any tax ……….....................550

Chapter 18: Gambling and Hobby Losses………………………………………..552
A. Gambling losses: § 165(d) ……………………………………………………............552
GENERAL LEGAL ADVICE MEMORANDA 2008-011 ………………………….553
Problem ………………………………………………………………………………557
B. Hobby losses: § 183 …………………………………………………………….........557
Establishing a profit motive .........................................................................................559
ZARINS v. COMMISSIONER ……………………………………………………... 561
The § 183(d) presumption and § 183(e) election …………………………………….566
Defining the scope of the activity ………………………………………………........ 567
TOPPING v. COMMISSIONER …………………………………………………….567
Hobby or Business: Brothel-Hopping Scrutinized by the IRS by Robert W. Wood ...574
Problems ……………………………………………………………………………...576

Chapter 19: Allocating Costs Between Income Production and Personal
Consumption …………………………………………………………............................577
A. The meaning of ordinary and necessary ………………………………......................577
Lobbying costs as business expenses ………………………………………………...581
Bribes and kickbacks, fines and penalties, treble damages under the antitrust
laws, and the end of the common law public policy exception (or is it?) ……………581
Excessive compensation …………………………………………………………….. 584
B. The origin-of-the-claim test ………………………………………………….............586
UNITED STATES v. GILMORE ……………………………………………………586
Gilmore II …………………………………………………………………………….591
How far back do we go in looking for the origin of a cost? ………………………… 592
The origin of commuting, clothing, and meal costs unconnected to travel
or entertainment ……………………………………………………………………...593
PEVSNER v. COMMISSIONER ……………………………………………………593
MOSS v. COMMISSIONER ………………………………………………………...596
Problems ……………………………………………………………………………...602
C. Travel and entertainment costs ……..……………………………………...................602

xix

Away from home in pursuit of a trade or business ………………………………….. 603
COMMISSIONER v. FLOWERS …………………………………………………...604
REVENUE RULING 93-86 …………………………………………………………607
HENDERSON v. COMMISSIONER ………………………………………………..610
Mixed trips …………………………………………………………………………... 615
§ 274 entertainment …………………………………………………………………..616
Business meals ……………………………………………………………………… 617
Substantiation of costs ……………………………………………………………….618
Problems ……………………………………………………………………………..619
D. Use of a personal residence for income production ………………………………….620
Converting a former personal residence wholly to income production ……………..620
The so-called home office deduction ………………………………………………....621
RAYDEN v. COMMISSIONER …………………………………………………….623
Revenue Procedure 2013-13: the safe harbor method for home office deductions ….630
E. Distinguishing between business and investment …………………………………… 631
UNITED STATES v. GENERES …………………………………………………… 632

Unit VII: The Taxable Year and Methods of Accounting
Introduction to Chapters 20 and 21 ………………………………………………...............640

Chapter 20: The Taxable Year …………………………………………………......641
A. The annual accounting principle in general ………………………………………….641
The borrowing exclusion ……………………………………………………………..641
§ 61 debt-discharge income ………...……………………………………………..... 642
Receipts subject to a contingent obligation to repay ………………………………...642
Depreciation recapture and the Arrowsmith doctrine ……………………………….643
B. The tax benefit rule …………………………………………………………………...643
REVENUE RULING 2019-11 ……………………………………………………….646
Problem ……………………………………………………………………………… 648
C. Net operating losses ……………………………………………………………......... 649
BURNET v. SANFORD & BROOKS CO. …………………………………………. 649
Problem ……………………………………………………………………………… 653

Chapter 21: Methods of Accounting ……………………………………………… 654
A. The cash method of accounting ……………………………………………………… 655

xx

The constructive receipt doctrine …………………………………………………..... 656
Deferred compensation, the economic benefit doctrine, rabbi trusts, and § 409A ….. 656
SPROULL v. COMMISSIONER …………………………………………………… 658
PRIVATE LETTER RULING 88113107 …………………………………………… 661
Problem ……………………………………………………………………………… 663
B. The accrual method of accounting …………………………………………………… 664
Accrual accounting in financial reporting and the divergence of financial
accounting and income tax values……………………………………………………. 664
THOR POWER TOOL CO. v. COMMISSIONER …………………………………. 666
The all-events test and its use as a tool for diverging from GAAP ………………….. 676
The accrual (deduction) of expenses not yet paid …………………………………… 677
FORD MOTOR CO. v. COMMISSIONER ………………………………………… 679
The accrual (inclusion) of prepaid income (advance payments) ……………………. 688
Back to our roots and the elimination of accrual accounting for income tax
purposes? …………………………………………………………………………… 691
Problem ……………………………………………………………………………… 693

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Introduction
Congratulations, law student, on your smart decision to take the introductory course exploring
the U.S. Federal income taxation of individuals! Nervous? Don’t be. I want to take some time to
dispel several misapprehensions about the study and practice of tax law.
Some law students believe that tax lawyers spend their time filling out annual income tax
returns. Even John Grisham—a lawyer (though not a tax lawyer) before becoming a novelist—
wrote the following opening paragraph in Chapter 29 of his novel The Firm, the hero of which was
(wait for it) a tax lawyer.
A week before April 15, the workaholics at Bendini, Lambert & Locke [a boutique tax
firm] reached maximum stress and ran at full throttle on nothing but adrenaline. And
fear. Fear of missing a deduction or a write-off or some extra depreciation that would
cost a rich client an extra million or so. Fear of picking up the phone and calling the
client and informing him that the return was now finished and, sorry to say, an extra
eight hundred thousand was due. Fear of not finishing by the fifteenth and being forced
to file extensions and incurring penalties and interest. The parking lot was full by 6
a.m. The secretaries worked twelve hours a day. Tempers were short. Talk was scarce
and hurried. 1
A good read—but an absolutely ridiculous description of tax law practice! How boring that
would be. The only annual tax return I have ever completed is my own. While some tax lawyers
(particularly in smaller firms) may complete annual tax returns for their clients as an ancillary
service to them, most tax lawyers in law firms (and tax lawyers providing tax consulting services
in accounting firms, as opposed to compliance services) typically are transactional lawyers who
advise clients in structuring transactions in a tax-efficient manner—whether the “transaction” is a
personal one, such as a divorce, or a business one, such as a corporate merger. Tax practice is,
therefore, forward-looking and can be very creative. Other tax lawyers work in resolving tax
disputes between taxpayers and the Federal government, first through Internal Revenue Service
(IRS) internal appeals processes and second, if necessary, through litigation.
In addition, some students worry that they will be at a significant disadvantage in this course if
they believe themselves to be bad at math (or “maths,” as my British friends say) or if they never
took accounting or business classes as an undergraduate. Balderdash! My undergraduate major
was Psychology, and I was also a Registered Nurse in Maternity Surgery for seven years. Yet, I
practiced tax law with the Wall Street firm of Sullivan & Cromwell. (I would have laughed out
loud if anyone had told me on the first day of law school that I would become a tax lawyer, but I
took my first tax law class and was hooked.) Moreover, I am living proof that you need not be a
math whiz to be a tax lawyer. While simple math (such as addition, subtraction, multiplication,
and division) is often necessary to illustrate the underlying principle at stake, tax law is a deeply
conceptual body of law based on primary principles surrounding the meaning of the word
“income” for tax purposes. Tax law practice is not financial accounting and has little to do with
“generally accepted accounting principles.” Indeed, what makes perfect sense in creating an
income statement for financial accounting purposes can violate fundamental income tax principles
1

JOHN GRISHAM, THE FIRM 363 (Dell Publishing paperback ed. 1991).

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Introduction
by inadvertently providing consumption tax treatment through the backdoor—an irrelevant
concern for financial accounting purposes—or even providing better-than-consumption-tax
treatment in the form of tax shelter “profits.” Where accounting majors might have a teensyweensy initial advantage is in familiarity with some of the nomenclature (if they have heard tax
terms of art before), but that is quickly overcome. Just as your first-year law professors assumed
that you had no prior knowledge of contracts, torts, or criminal law, this book assumes no prior
knowledge. Here is where you are expected to learn about the subject matter, not before arriving
here. Some of the best tax law students, in my opinion, are English majors because they have had
lengthy practice in reading language carefully, which brings me to my next point.
One of the best reasons to take tax (even if you have no intention of considering tax as a
specialty area of law practice) is because it is the best course, in my opinion, in which to practice
the skill of reading, pulling apart, and making sense of complex statutory language. While the U.S.
still considers itself a common law country, most of the law that you will practice today is
embedded in statutes and their related administrative materials. Even much of the formative
common law in such areas as contracts, property, and criminal law has now been codified. The
skill of pulling apart the clauses and subclauses of statutory language and understanding their
complex sentence structures is not intuitive. It takes practice. After having practiced this skill in
tax, you should be in a much better position to pull apart the language in statutes enacted in the
future (and in other areas of law) that are not even a glimmer in the eye of any legislator today.
Finally, tax law will affect your civil practice. Whether you are advising the divorcing couple
who will be dividing property and arranging cash payments from one to the other, drafting a
complaint for an injured person who is wondering whether damage awards are includable in Gross
Income, discussing with the entrepreneur the factors to consider in choosing the best entity form
through which to start her new business, and more, tax issues will arise in your practice. If only to
get a tax lawyer involved at the right time (ideally before the event), you need to be aware of
potential tax issues, and this is the course in which to begin forming that awareness.
This textbook focuses on the Federal income tax as it applies to the individual, whether that
individual is an employee, the sole proprietor of a business, or the sole owner of a limited liability
company (LLC), an entity created under state law through which the business is conducted. To
explore the latter two categories, think of a plumber who “works for himself,” as the saying goes.
The plumber may choose to operate his plumbing business directly, without creating any state law
entity (a sole proprietorship), or he may choose to house the business in an LLC that he creates
under state law. So long as our plumber owns 100% of the LLC ownership interests, the existence
of the LLC is usually ignored for Federal income tax purposes, as though the owner owns the
business directly as a sole proprietor. In tax jargon, single-owner LLCs are “disregarded entities.”
The LLC’s Gross Income and allowable deductions appear on the owner’s individual tax return.
Many of you may go on to other tax courses, such as the course examining the income tax
consequences of operating a business through a corporation, partnership, or multi-owner LLC.
Some will take the course exploring the Federal income tax consequences of international
transactions or the course examining the gift and estate tax consequences of wealth transfers from
one generation to the next. And more. This course provides the solid foundation for them all.
As a tax lawyer, I cannot resist dropping a quotation from the late Erwin N. Griswold, former
tax lawyer, former Solicitor General of the United States, and former Dean of the Harvard Law
School, who once wrote:
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Introduction
It is high time that tax lawyers rise up to defend themselves against the charge that tax
work is narrowing and stifling. On the contrary, it seems difficult to find a field which
leads practitioners more widely through the whole fabric of the law. A tort lawyer is a
tort lawyer, and a corporation lawyer is a corporation lawyer. But a tax lawyer must
deal constantly not only with statutes and committee reports and regulations, but also
with questions of property, contracts, agency, partnerships, corporations, equity,
trusts, insurance, procedure, accounting, economics, ethics, philosophy. [They] must
be broad in [their] background and in [their] outlook, if [they are] to deal with the
manifold problems which make up the modern field of tax law. 2
Although written in 1944, the sentiment is truer today than ever before in “the modern field of tax
law.”
______________________________________
Federal tax law involves all three branches of government, which means that the study of tax
law is a study in administrative law, as well.
The legislative branch
Congress enacts tax statutes, which are periodically re-codified in Title 26 of the U.S. Code,
commonly referred to as the Internal Revenue Code of 1986, as amended. 3 Under the origination
clause of the U.S. constitution, 4 tax bills must originate in the House of Representatives, though
the clause adds that “the Senate may propose or concur with Amendments as on other Bills.”
Because of the last-quoted phrase, “in practice the Senate’s power to amend is generally
understood to be so broad that the Senate can replace the entire text of a bill that technically
originates in the House.” 5 Today the origination clause may mean little more than that the bill must
have an H.R. number (for House of Representatives) rather than an S. number (for Senate).
The most important (and powerful) Congressional committees in tax matters are the Ways and
Means Committee in the House and the Finance Committee in the Senate. If the bills passed by
the House and Senate, respectively, differ (as they virtually always do), a Conference Committee
is appointed to hammer out the differences. Once the conference bill is passed by both houses and
signed by the President, it becomes law.
The executive branch
The law that Congress enacts is not self-executing but rather must be administered by the
executive branch, primarily through the Treasury Department and the Internal Revenue Service,
with the latter being a semi-autonomous institution within the former. The Treasury Department,
through its Assistant Secretary for Tax Policy, played a particularly important role in tax reform
efforts in the 1980s, though its role in tax reform appears to be less pronounced today.
Treasury Regulations. One of the most important functions of the Treasury is to draft and
issue Treasury Regulations. Most of these regulations are issued under the general authority found
2

Erwin N. Griswold, The Need for a Court of Tax Appeals, 57 HARV. L. REV. 1153, 1183-84 (1944).
Prior to the Tax Reform Act of 1986, the Code was referred to as the Internal Revenue Code of 1954, as amended.
The 1986 recodification accompanied fundamental reforms enacted in the Tax Reform Act of 1986, which you will
read about in Chapter 3. The Tax Cuts and Jobs Act enacted in late 2017 did not change the name of the Internal
Revenue Code, so it is still referred to as the Internal Revenue Code of 1986, as amended.
4
Article I, § 7, clause 1.
5
ERIK M. JENSEN, THE TAXING POWER: A REFERENCE GUIDE TO THE UNITED STATES CONSTITUTION 171 (2005).
3

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Introduction
in § 7805 of the Code, which empowers the Treasury to issue “all needful rules and regulations for
the enforcement of this title, including all rules and regulations as may be necessary by reason of
any alteration in law in relation to internal revenue.” Some commentators refer to § 7805
regulations as “interpretive” regulations because they further interpret the law enacted by Congress
by providing examples, resolving ambiguity, and filling in gaps. For example, you will learn in
Chapter 5 that § 119 allows employees to exclude from Gross Income the value of meals and
lodgings provided to them in kind by their employers only if they are furnished for the
“convenience of the employer,” but Congress does not define “convenience of the employer” in
the statute. Treasury defines those terms in Treas. Reg. § 1.119-1 and provides several examples.
In addition, Congress sometimes specifically directs the Treasury in a particular Code section
to issue regulations that, in effect, create the law where Congress has not, referred to by some
commentators as “substantive” or “legislative” regulations (as opposed to interpretive regulations
issued under § 7805). The best example of this is found in § 1502, which delegates authority to the
Treasury to create the rules under which a group of commonly owned corporations can file a single,
consolidated tax return instead of separate returns. These regulations, found in Treas. Reg. §
1.1502, are quite long, detailed, and comprehensive. Another good example is § 482, which
empowers the Treasury to issue regulations that allocate income, deductions, credits, etc., among
related entities in order to “clearly reflect the income” of each. Those of you who go on to the
course examining the Federal income tax consequences of international transactions will encounter
the complex “transfer pricing” regulations issued under this authority in Treas. Reg. § 1.482, which
seek to prevent cross-border income shifting between related entities through manipulated sales,
services, royalty, and interest rates and prices—particularly when it results in a shift to a tax haven
that does not have any real economic connection to the underlying business activities.
As these examples imply, the Treasury regulations pertaining to a particular Code section are
usually preceded by the number “1” and a period, though you will see a few preceded by a different
number (such as 301, 305, 31, 35, etc.) followed by a period (for procedural reasons).
Treasury regulations are issued in proposed form for public notice and comment in the Federal
Register before being made final. Tax lawyers are often very active in commenting on proposed
regulations, both as individuals and as members of professional organizations, such as the
American Bar Association Section of Taxation and the New York State Bar Association Section
of Taxation. The Treasury may (or may not) amend the proposed regulations before finalizing
them in reaction to suggestions from the practicing bar. Under § 7805(b), final regulations can be
made applicable retroactive to the date on which first proposed to the public, though the Treasury
may decide to make them prospective only if the final regulations make significant changes to the
proposed regulations.
Some proposed regulations are also issued simultaneously as Temporary regulations if
immediate guidance is needed. Unlike proposed regulations, Temporary regulations are effective
immediately, but they automatically sunset in three years under § 7805(e)(2) if not made final by
then. Temporary regulations are indicated with the letter T in its notation, such as § 1.263(a)-2T—
a regulation that lost its “T” in 2013 when it was made final.
While the statute enacted by Congress is the supreme source of legal authority (and so is your
best authority to cite in a legal memorandum or brief), Treasury regulations are not far behind.
Nevertheless, taxpayers sometimes argue in court that a particular Treasury regulation imposing
an unfavorable outcome is invalid as beyond Treasury’s interpretive authority or as inconsistent
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Introduction
with its related statutory language. Such cases are very difficult, though not impossible, to win,
but they raise a subsidiary question. What level of judicial deference is accorded to Treasury
regulations by courts? More specifically, does the administrative law analysis provided in Chevron
v. Natural Resources Defense Council 6 govern judicial review of Treasury regulations? Under
Chevron, the first question is whether Congress has “directly addressed the precise question at
issue,” and this inquiry is made using the “traditional tools of statutory construction.” If the
reviewing court believes that Congress has done so, the court must abide by the answer provided
by Congress, even if different from that provided in the regulation under review. If the court
determines that Congress has not directly answered the question, the second inquiry is “whether
the agency’s answer is based on a permissible construction of the statute.” Under this inquiry, the
court must defer to a “permissible” construction of the statute provided in the regulation, even if
the construction is not one that the court would adopt on its own in the absence of the regulation.
Prior to the Supreme Court’s 2011 ruling in Mayo Foundation v. United States, 7 some
commentators clung to a belief in tax exceptionalism, under which tax-specific, pre-Chevron cases
called for greater deference to legislative or substantive regulations than to interpretive regulations
and used different language to test the validity of each type. 8 Mayo put an end to such speculation,
stating that “we are not inclined to carve out an approach to administrative review good for tax
law only. To the contrary, we have expressly ‘[r]ecogniz[ed] the importance of maintaining a
uniform approach to judicial review of administrative action.’” 9 It is now fairly clear that
Chevron’s two-step analysis governs judicial review of the validity of a Treasury regulation.
The national office of the IRS Office of Chief Counsel (essentially, the IRS’s lawyer) also issues
various forms of guidance to the public, although this guidance—unlike most Treasury
regulations—is not published in the Federal Register for notice and comment. Today, the most
important of these are Revenue Rulings and Revenue Procedures, various forms of Chief Counsel
Advice (including email Chief Counsel Advice), Private Letter Rulings, and Technical Advice
Memorandums. Each of these is briefly described below.
Revenue Rulings and Revenue Procedures. Revenue Rulings and Revenue Procedures are
sometimes referred to as “public rulings” to differentiate them from private rulings issued to an
individual taxpayer. Revenue Rulings usually contain a short description of a fact situation,
relevant law, and the IRS’s conclusion regarding how the law applies to the facts. They are often
issued when a recurring fact pattern comes to its attention, and the IRS decides public guidance is
necessary. Revenue Procedures, among other roles, provide guidance regarding the representations
that taxpayers must make in requesting a Private Letter Ruling for a particular type of transaction.
The IRS states in the Internal Revenue Manual that it will abide by outstanding revenue rulings
with a taxpayer-favorable outcome, as the IRS always has the option of withdrawing the ruling if
it subsequently determines that its analysis is incorrect. 10 You can be confident in advising your
client of the favorable outcome reflected in a Revenue Ruling so long as the facts are identical (or
not meaningfully different) and the ruling has not been withdrawn or declared obsolete. If, in
6

467 U.S. 837 (1984).
562 U.S. 44 (2011).
8
These tax-specific cases included National Muffler Dealers v. U.S., 440 U.S. 472 (1979), Rowan Co. v. United
States, 452 U.S. 457 (1981), and United States v. Vogel Fertilizer Co., 455 U.S. 16 (1982).
9
Mayo, 562 U.S. at 55 (quoting Dickinson v. Zurko, 527 U.S. 150, 154 (1999)).
10
Chief Counsel Publications Handbook, INTERNAL REVENUE MANUAL § 32.2.2.10 at
http://www.irs.gov/irm/part32/irm_32-002-002.html#d0e850.
7

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Introduction
contrast, a Revenue Ruling arrives at a conclusion that is contrary to the taxpayer’s desired
outcome, and the taxpayer pursues litigation, what level of judicial deference will be accorded to
a Revenue Ruling or Revenue Procedure by a court?
No Supreme Court decision directly answers this question, but we can undertake an informed
analysis. The Court held in United States v. Mead Corporation 11 that an agency interpretation that
is not eligible for Chevron deference may nevertheless “claim respect according to its
persuasiveness” under Skidmore v. Swift & Co. 12 “given the ‘specialized experience and broader
investigations and information’ available to the agency … and given the value of uniformity in its
administrative and judicial understandings of what a national law requires.” 13 Whether the agency
guidance is due heightened Chevron deference or only Skidmore respect turns on whether
Congress has delegated authority to the agency to issue rules carrying “the force of law” and
whether the guidance in question has been issued under such authority. The Mead Court made
clear that using notice-and-comment procedures may not be necessary for guidance to be subject
to Chevron deference and provided a multi-factor analysis to consider in making this
determination. Nevertheless, while we have no definitive answer, many commentators believe that
Revenue Rulings and Revenue Procedures, which are not issued with notice and comment in the
Federal Register, do not carry the “force of law” and are entitled only to Skidmore deference, if
that. 14 That is to say, if a court remains unpersuaded that the analysis contained in a cited Revenue
Ruling is convincing on its own merits, it need not defer to the IRS guidance by mere fact of its
publication. Going further, the Tax Court (discussed below) has stated that “revenue rulings are
generally not afforded any more weight than that of a position advanced by the Commissioner on
brief,” 15 though these pronouncements preceded Mayo and Mead.
Revenue Rulings and Revenue Procedures appear in the Internal Revenue Bulletin, which is
issued weekly and which is semi-annually collected into the Cumulative Bulletin. For example, in
Chapter 6, you will read Revenue Ruling 76-96, 1976-1 C.B. 23. The title of the ruling means that
it was the 96th ruling issued in 1976, and the citation means that it can be found on page 23 of the
first of the two semi-annual issues of the Cumulative Bulletin published in 1976. Because the title
provides no indication of the ruling’s subject matter, the best way to research Revenue Rulings is
through an online database.
Private Letter Rulings (PLRs), Technical Advice Memoranda (TAMs), Notices, and other
forms of Chief Counsel Advice (CCA). A taxpayer contemplating a particular transaction may
want advance assurance from the IRS, before undertaking it, that the taxpayer’s analysis of the
proposed transaction’s tax consequences is correct. So long as the matter is not on the IRS’s
annually issued no-rulings list (such as matters requiring fact-finding), the taxpayer (invariably
through her tax lawyer) may draft and submit a Private Letter Ruling request, accompanied by a
fee that varies based on the nature and complexity of the ruling. If the IRS agrees that the taxpayer’s
proposed tax analysis is correct, it will issue a Private Letter Ruling to that effect, which the
taxpayer submits with her tax return in the year in which the transaction takes place. If preliminary
conversations with IRS personnel indicate that a ruling would not be favorable, the taxpayer can
withdraw the ruling request and weigh whether or not to proceed with the transaction.
11

533 U.S. 218 (2001).
323 U.S. 134 (1944).
13
Mead Corp, 533 U.S. at 234.
14
See, e.g., Marie Sapirie, DOJ Won’t Push Chevron Deference for Revenue Rulings, 131 TAX NOTES 674 (2011).
15
General Dynamics Corp. v. Comm’r, 108 T.C. 107 (1997) (citing Laglia v. Comm’r, 88 T.C. 894 (1987)).
12

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Introduction
Significant IRS budget cuts made by Congress has forced the IRS to reduce the issuance of
private letter rulings. Moreover, the cost and delay inherent in requesting a Private Letter Ruling
causes many taxpayers to decide instead to ask their tax advisor to issue an “opinion letter” to
them. As its name implies, an opinion letter describes the tax advisor’s informed opinion regarding
the likely tax analysis that will govern the proposed transaction based on the statute, Treasury
regulations, rulings, and case law. Opinion letters can be an important part of tax practice. Whether
reliance on the opinion letter of a reputable tax advisor can permit the taxpayer to avoid tax
penalties if the advice turns out to be wrong typically depends on whether the reliance was in
“good faith” and “reasonable” under the circumstances. 16
While taxpayers initiate PLRs in advance of a transaction, TAMs are typically initiated by IRS
field personnel when auditing a taxpayer’s return. If the field agent is unsure of the proper tax
analysis of a transaction uncovered on audit, she may request guidance from the national IRS
Office of Chief Counsel in Washington, D.C. The resulting answer is referred to as a TAM.
Both PLRs and TAMs are couched in the form of letters (to the taxpayer in the case of a PLR
and usually to the field agent in the case of a TAM). While the IRS has long published Revenue
Rulings and Revenue Procedures, it once did not publish PLRs and TAMs. Concerned that a vast
body of private guidance was effectively available only to large firms with a sophisticated tax
practice and routine contact with IRS personnel, the nonprofit tax publisher Tax Analysts sued the
IRS under the Freedom of Information Act, requesting that the IRS be forced to publish PLRs and
TAMs, and won. 17 Congress thereafter enacted § 6110, which since 1976 has required disclosure
of certain types of “written determinations,” including PLRs and TAMs, though identifying
taxpayer information is redacted. Section 6110(k)(3) provides, however, that these items cannot
be used or cited as precedent by other taxpayers. They are nevertheless quite helpful to the tax
advisor, as they provide insight into how the IRS analyzes a particular transaction. At the least,
they can help the advisor predict litigation risk.
Both PLRs and TAMS are titled by a series of numbers and a date. For example, Chapter 8 cites
PLR 201021048 (May 5, 2010), which is a Private Letter Ruling that was the 48th ruling (the last
three numbers) issued during the 21st week (the middle numbers) of 2010 (the first four numbers).
Because this numbering system provides no insight into the ruling’s subject matter, the best way
to research them is through an online database.
Notices are issued by the IRS when immediate guidance is needed.
In the early 1990s, the IRS significantly decreased the number of TAMs that it issued, replacing
them with a new type of document called Field Service Advice (FSA) and claiming that FSAs
were not required to be published. Once again, Tax Analysts sued and won. 18 Congress thereafter
added § 6110(i) to the Code, specifically requiring publication of “Chief Counsel Advice,” defined
in very broad terms. Nevertheless, the IRS then argued that Chief Counsel Advice created in less
than two hours and sent to field offices by email was not subject to disclosure (the two-hour rule).
Once again, Tax Analysts sued in 2005, the District Court granted summary judgment, the D.C.
16

See, e.g., U.S. v. Boyle, 469 U.S. 241 (1985). Tax advisors can also be subject to certain penalties for aiding and
abetting an understatement of tax liability or promoting an abusive tax shelter. See, e.g., §§ 6700, 6701. The standards
under which tax lawyers and others can practice before the IRS are found in Circular 230, at https://www.irs.gov/taxprofessionals/circular-230-tax-professionals.
17
See Tax Analysts v. IRS, 505 F.2d 350 (D.C. Cir. 1974).
18
See Tax Analysts v. IRS, 117 F.3d 607 (D.C. Cir. 1997).

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Introduction
Circuit affirmed, and the parties thereafter entered into a settlement in 2009 regarding the
procedures under which the IRS will disclose such general legal advice, including email advice. 19
Today, guidance from the Office of Chief Counsel can come in a number of forms, including
Chief Counsel Advice (CCA), Notices, General Legal Advice Memorandum (GLAMS), and email
advice. While some of these can often be researched through online databases and on the irs.gov
website, email advice is usually found most easily through weekly updates published by Tax
Analysts in Tax Notes and Tax Notes Today and similar tax news sites. 20
Finally, when a lower court issues a decision that is adverse to the government’s position in the
case, the Office of Chief Counsel will sometimes issue an “Action on Decision” (AOD) that
announces the future litigation position that the IRS will take with regard to the issue. The AOD
may announce, for example, that the IRS does not acquiesce in the outcome and will continue to
litigate the issue. Or it may announce that it will acquiesce in the outcome and not pursue litigation
in similar cases. If you find a judicial decision in favor of your client’s position, you will want to
research whether the Office of Chief Counsel has issued an AOD. 21
Tax procedure overview
A separate course can examine tax procedures and penalties, but I provide below a cursory
overview of the basic civil tax procedural mechanisms that arise from the filing of a tax return to
the initiation of litigation, if necessary.
For virtually all individual taxpayers, the taxable year (considered in Chapter 20) is the calendar
year, and individual taxpayers are generally required to file an income tax return reporting their
Taxable Incomes by April 15th of the year following the close of the calendar year and to pay any
tax owed by the same date. Section 6065 requires the return to be signed under penalties of perjury.
Most taxpayers may request an automatic six-month extension of time to file without having to
provide any justification for the delay by timely filing Form 4868, but they must nevertheless pay
the estimated tax due by the April 15th due date. If the later filed return shows that the tax due
exceeded the estimated amount paid by no more than 10%, Treas. Reg. § 301.6651-1(c)(3)(i)
provides that the IRS will not assert penalties, though the taxpayer will owe interest on the
underpayment between the April 15th due date and the date on which the underpayment is paid.
The IRS engages in several types of audit review of taxpayer returns, including computer
matching of amounts reported by payors and payees (of compensation, for example),
correspondence examinations (by letter), office audits (at an IRS office), and field examinations
(at a taxpayer’s business, for example). If the examining agent accepts the return as filed, he will
issue a “no change letter” to the taxpayer. In contrast, if the examining agent concludes that tax
has been underpaid, he will issue a “30-day letter” containing the proposed tax adjustment. The
30-day nomenclature arises from the fact that the taxpayer has 30 days from the date of issuance
to invoke the appeals process within the IRS, though the 30-day period is often extended. The
19

See 2009 TNT 58-1, Tax Analysts, Tax Notes Today.
Tax Notes is published in hard copy weekly and is likely available at your law library. It contains the weekly tax
news on many fronts, as well as descriptions of new cases and short law-review-type articles on hot tax topics. Tax
lawyers rely on it, and it is a great resource for students looking to learn more about tax practice and what is going
on in the tax world. Tax Notes Today (TNT) is an online daily dose of tax news, but it can be accessed online only
by Tax Notes subscribers. Those who subscribe to Bloomberg News can also access the “Daily Tax Report,” another
daily online news source for the latest tax news.
21
See http://apps.irs.gov/app/picklist/list/actionsOnDecisions.html.
20

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Introduction
taxpayer invokes the appeals process by filing a “protest” of the adjustment that describes her
analysis of the facts and law, often drafted by a tax lawyer or other representative under a power
of attorney executed on Form 2848. If the proposed adjustment is less than $25,000, however, the
protest can take the form of a simple letter requesting appeals consideration.
During the appeals process, the taxpayer’s representative will meet with the assigned appeals
officer for a conference, which the taxpayer may (or may not) attend, in an attempt to reach a
settlement of the outstanding issues. The conferences are informal, with no transcript or rules of
evidence. “Depending on the kind of case and the particular office, Appeals usually resolves 80%
to 90% of the cases it takes, whether by full concession by the IRS, full concession by the taxpayer,
or compromise.” 22 A “closing agreement” to memorialize the settlement, which is generally
binding on both parties, can be entered under § 7121. Arbitration or mediation is also a possibility.
If settlement talks fail, the IRS will issue a statutory notice of deficiency, often referred to as
the “90-day letter.” The 90-day nomenclature arises from the fact that the taxpayer has 90 days to
file a petition with the Tax Court under § 6213, which tolls the statute of limitations, to litigate the
proposed adjustment without first paying the asserted tax owed. If the taxpayer does not file a Tax
Court petition, the IRS can formally “assess” the tax at the expiration of the 90 days.
The IRS’s formal assessment of the tax owed under § 6203 (which is nothing more than a
recording of the tax debt in the IRS’s system and a mailing to the taxpayer’s last known address)
must occur within the applicable statute of limitations, which generally is three years from the
later of the date the return is filed or its due date (absent tolling). If a taxpayer fails to file a return,
therefore, the statute of limitations remains open indefinitely. There is no statute of limitations for
fraud, and certain items have special statutes of limitations that differ from the general three-year
rule. Formal assessment is required before collection can commence, including the possible use of
property liens. A few of the more important penalty provisions are discussed in Chapter 15.
The judicial branch
As noted above, the statutory rules governing Tax Court jurisdiction permit the taxpayer to
litigate a proposed deficiency without first paying the asserted tax owed. The Tax Court is an
Article I (rather than Article III) court located in Washington, D.C., consisting of 19 judges
appointed by the President and confirmed by the Senate for 15-year terms. Retired judges whose
terms have expired may serve as “senior judges” if recalled by the Chief Judge. In addition, the
Tax Court employs a number of “special trial judges,” which are the counterparts of magistrates
in other Federal courts. Tax Court cases are heard by a single Tax Court judge, although the other
judges have an opportunity to review a decision before it is published. In addition, if a case contains
a novel issue or is one in which the court may reverse its own prior precedent, the Chief Judge
may designate a case to be reviewed by the court conference, which consists of all 19 Tax Court
judges, with a senior judge participating if it is his or her case that is before the conference. Such
a decision is referred to as a “reviewed decision” and is similar to an en banc decision in other
forums. A reviewed decision may have majority, concurring, and dissenting opinions. Although
the court is based in Washington, D.C., the judges effectively “ride circuit” by hearing Tax Court
cases in cities around the country throughout the year, which permits individuals to avoid the cost
of traveling to Washington, D.C. IRS lawyers from the nearest Office of Chief Counsel represent
the government before the Tax Court.
22

DAVID RICHARDSON, JEROME BORISON & STEVE JOHNSON, CIVIL TAX PROCEDURE 126 (2nd ed. 2008).

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Introduction
Reviewed and “regular” opinions (as distinguished from memorandum and small-case
decisions, described below) are formally reported in the United States Tax Court Reports. Long
ago, the last name of the IRS Commissioner at the time appeared as the government party in Tax
Court case names. For example, you will see many case names with “Helvering” as the government
party, after Guy T. Helvering, who served as the Commissioner of Internal Revenue from 1933 to
1943 (and as a Congressman before and a Federal District Court judge after his service as
Commissioner). Today, the government is represented simply by “Commissioner” in Tax Court
decisions (e.g., O’Donnahbain v. Commissioner, 134 T.C. 34 (2010), cited in Chapter 17).
Tax Court decisions involving the routine application of law to fact are published in
“memorandum decisions,” which are not formally reported in the United States Tax Court Reports.
Nevertheless, some private publishers have long published memorandum decisions, and you can
find them easily online. Similarly, “small case” decisions under § 7463, involving deficiencies of
$50,000 or less that the taxpayer elects to litigate under simplified procedures at the cost of waiving
appeal rights, are not formally published. The Tax Court’s website, however, now posts all
decisions (whether reviewed, regular, memorandum, or small case decisions). 23
Two other trial forums are available in addition to the Tax Court, which creates the ability to
engage in some forum shopping: (1) the Federal District Court in which the taxpayer resides 24 and
(2) the Court of Federal Claims, which is located in Washington, D.C. To gain access to either of
these courts, the taxpayer permits the IRS to assess the deficiency by allowing 90 days to pass
without filing a Tax Court petition, pays the asserted tax owed, and sues the Federal government
for a refund of the claimed overpayment within the time frame required under the relevant statute
of limitations. The taxpayer must pay the asserted tax owed because the subject matter jurisdiction
of these courts is predicated on the claim that the government owes the taxpayer money.
These two refund forums are also available in the case of overpayments outside of an audit, as
well, such as when an employer or other taxpayer withholds (and sends to the IRS) too much
estimated tax from a payment owed to the taxpayer. In that case, the taxpayer must first timely file
a refund claim with the IRS. If the IRS fails to pay the requested refund, the taxpayer can file a
refund claim in either of these two forums. The government is usually represented by lawyers from
the Department of Justice, Tax Division, in these two forums, and the government is usually
indicated by “United States” in the case name (e.g., United States v. Gotcher, 401 F.2d 118 (5th
Circ. 1968), cited in Chapter 6).
Choosing the forum. Because Tax Court jurisdiction can be obtained without first paying the
asserted tax deficiency, between 85% and 90% of tax litigation occurs there. A taxpayer litigating
in either of the refund forums avoids interest accruals on any tax underpayment because the tax at
issue has already been paid. Although interest continues to mount on the tax deficiency during the
pendency of Tax Court litigation (should the taxpayer lose on the merits), the taxpayer can both
prevent interest from accruing and maintain Tax Court jurisdiction if he pays the asserted
deficiency after issuance of the 90-day letter.
Depending on the nature of the dispute, a taxpayer may wish to have issues of fact determined
by a jury, available only in Federal district court, though jury trials are rare in civil tax cases.
Taxpayer cost can also factor into forum choice. A taxpayer living outside the Washington, D.C.,
area may be able to avoid travel costs by litigating in either the Tax Court (as it rides circuit) or
23
24

See www.ustaxcourt.gov.
Bankruptcy courts can also hear tax disputes that arise in the course of bankruptcy adjudication.

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Introduction
his local Federal District Court. Unlike the Tax Court, the Court of Federal Claims usually hears
cases only in Washington, D.C. In addition, the Tax Court requires informal discovery before
formal discovery proceeds, which can reduce costs. The two refund forums do not have similar
informal discovery proceedings. Finally, taxpayers can represent themselves pro se relatively
easily in Tax Court, although this choice can often be an unwise one under the old adage that “he
who represents himself has a fool for a client.” Leandra Lederman and Warren B. Hrung conducted
an empirical study and found that pro se representation was detrimental in tried cases, though it
did not affect the outcome in settled cases. 25
Finally, each court’s prior precedent—as well as the precedent of the court that would hear any
appeal—should be an important factor in deciding where to litigate. The Tax Court’s prior
precedents include decisions of the Board of Tax Appeals (cited as B.T.A.), the predecessor to the
Tax Court. Similarly, precedents for the Court of Federal Claims include decisions of its two
predecessors: the Court of Claims and the Claims Court. Decisions of both the Tax Court and
Federal District Court are appealed to the Circuit Court of Appeals in which the taxpayer resides.
Decisions of the Court of Federal Claims are appealed to the Federal Circuit Court of Appeals.
Prior to 1970, the Tax Court believed that its role as a national court required it to be free to
ignore Circuit Court of Appeals precedent with which it disagreed—even if that meant that a
taxpayer appeal from an unfavorable Tax Court decision would likely result in an automatic
reversal because the taxpayer lived in a circuit containing clear precedent in favor of the taxpayer.
Because this stance imposed unnecessary costs on such taxpayers, the Tax Court announced a
change of heart in Golsen v. Commissioner. 26 Today, the Tax Court will abide by precedent of the
Circuit Court of Appeals in which the taxpayer resides under the so-called Golsen rule if the
precedent is directly on point, even if the Tax Court disagrees with it. Whether a particular
precedent is directly on point or is distinguishable in a relevant respect remains an issue, however.
Cases can be heard by the Supreme Court if it grants a writ of certiorari from the losing party
at the Circuit Court of Appeals level. The Court is most likely to grant cert. in the case of a
significant split among the various Circuit Courts of Appeals regarding the matter at issue—
although the Court is generally known to dislike tax cases.
Excerpt from Of Crud and Dogs: An Updated Collection of Quotations in Support of the
Proposition That the Supreme Court Does Not Devote the Greatest Care and Attention to
Our Exciting Area of the Law 27
Erik M. Jensen
‘‘This is a tax case. Deny.’ That was [Justice William] Brennan’s normal reaction to a
[certiorari] request in a tax case.’ [1]
‘If one’s in the doghouse with the Chief [Justice Burger], he gets the crud. He gets the tax cases.
. . .’ — Justice Harry Blackmun. [2]
25
Leandra Lederman & Warren B. Hrung, Do Attorneys Do Their Clients Justice? An Empirical Study of Lawyers’
Effects on Tax Court Litigation Outcomes, 41 WAKE FOREST L. REV. 1235 (2006), at
http://papers.ssrn.com/sol3/papers.cfm?abstract_id=899461.
26
54 T.C. 742 (1970).
27
58 TAX NOTES 1257 (1993). Reprinted with permission of the author.
[1]
Bob Woodward & Scott Armstrong, THE BRETHREN 362 (1980).
[2]
Quoted in Stuart Taylor, Jr., Reading the Tea Leaves of a New Term, N.Y. TIMES, Dec. 22, 1986, at B14.

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Introduction
A dog is ‘‘a case that you wish the Chief Justice had assigned to some other Justice.’ A deadly
dull case, ‘a tax case, for example.’’ — Recently retired Justice Lewis F. Powell Jr. [3]
‘Asked why he sings along with the chief justice at Mr. Rehnquist’s annual Christmas carol
party, [Justice David Souter] replies: ‘I have to. Otherwise I get all the tax cases.’’ [4]
_______________________________________
Add to the list above the late Justice Ruth Bader Ginsburg’s initial reply (in her law professor
days before she joined the D.C. Court of Appeals and then the Supreme Court) to her husband, the
late, great tax lawyer and tax law professor Marty Ginsburg, when he brought a Tax Court opinion
for her to read one evening as they were working in their separate studies:
I went next door, handed the advance sheets to my wife, and said, “Read this.” Ruth
replied with a warm and friendly snarl, “I don’t read tax cases.” I said, “Read this
one,” and returned to my room. No more than 5 minutes later—it was a short
opinion—Ruth stepped into my room and, with the broadest smile you can imagine,
said, “Let’s take it.” And we did. 28
The 1970 case was Moritz v. Commissioner, 29 in which the Tax Court denied Mr. Moritz a
deduction under (now repealed) § 214(a) of the Internal Revenue Code for expenses incurred in
caring for his dependent invalid mother. The statute permitted the deduction to be taken only by a
woman, a widower or divorced man, or a man whose wife was incapacitated or institutionalized.
Mr. Mortiz was denied the deduction solely because he was a never-married man. The Ginsburgs
agreed to represent Mr. Moritz pro bono in his appeal, and the Tenth Circuit Court of Appeals
reversed on equal protection grounds. And there is more to the story!
The government, amazingly, petitioned for certiorari on the asserted ground that the
10th Circuit’s decision cast a cloud of unconstitutionality over literally hundreds of
federal statutes that, like … § 214, contemplated differential treatment on the basis of
sex. In those pre-personal computer days, there was no easy way for us to test the
Government’s assertion but the Solicitor General (Erwin Griswold, whom many of
you will recall) took care of that by attaching to his petition a list—generated by the
Department of Defense’s mainframe computer—of those hundreds of suspect statutes.
Cert. was denied in Moritz, and the computer list proved a gift beyond price. Over the
balance of the decade, in Congress, [before] the Supreme Court, and many lower
courts, Ruth successfully urged the unconstitutionality of those statutes.
So Mr. Moritz’s case mattered a lot. First, it fueled Ruth’s early 1970s career shift
from diligent academic to enormously skilled and successful appellate advocate—
which in turn led to her next career on the higher side of the bench. Second, with Dean
Griswold’s help, Moritz furnished the litigation agenda Ruth actively pursued until she
joined the D.C. Circuit in 1980.
All in all, great achievements from a tax case with an amount in controversy that
totaled exactly $296.70.
[3]

Quoted in Stuart Taylor, Jr., Powell on His Approach: Doing Justice Case by Case, N.Y. TIMES, July 12, 1987, at

1.
[4]

Paul M. Barrett, David Souter Emerges as Reflective Moderate on the Supreme Court, WALL ST. J., Feb. 2, 1993,
at 1.
28
Martin D. Ginsburg, A Uniquely Distinguished Service, 10 GREEN BAG 2D 173, 174-75 (2007).
29
469 F.2d 466 (10th Cir. 1972), reversing 55 T.C. 113 (1970).

xxxiii

Unit I:
The Core Structures of Income
and Consumption Taxation and Tax Policy
Introduction to Chapters 1 through 4
Taxation is the means by which all governments, including our Federal government, raise
revenue to pay for the costs of government, including the military, infrastructure, court system,
Federal agencies, Medicare, Social Security, basic research that the private sector cannot
accommodate, interest on loans used to smooth the peaks and valleys of the tax revenue stream
when economic activity decelerates with recessions, etc. We can call the aggregate tax collected
in any particular year $X. Regardless of whether you think $X is too high or too low, we must
decide how the economic burden of $X—whatever the amount—should be allocated across the
members of the population. Two attributes of a tax system that will affect the allocation of $X are
(1) the tax base, i.e., what is taxed and (2) the tax rate structure.
For example, suppose that Mary earns $75,000 in wages and no investment income. John earns
$50,000 in wages but also receives $30,000 in interest paid on his substantial investment in
corporate bonds. The burden of $X will be allocated very differently between Mary and John if we
choose to tax, say, only investment income (such as John’s interest), only wages, or both.
Similarly, suppose that Mary spends only $60,000 of her $75,000 in wages on personal
consumption purchases for the year (such as food, clothing, rent, entertainment, etc.) and saves the
remaining amount (after paying any tax that she owes) by depositing it in a bank savings account.
Of the aggregate $80,000 that John earns in wages plus interest, he spends $40,000 on consumption
purchases, depositing the remaining amount (after paying any tax that he owes) in a savings
account. The burden of $X will be allocated very differently between Mary and John if we choose
a tax base comprised only of amounts spent on personal consumption, excluding amounts saved.
The tax rate structure also has an effect on how the burden of $X is apportioned across the
members of the population. If our tax base comprises only wages, for example, notice how the
allocation of the tax burden differs depending on whether we decide that a single tax rate should
apply to each and every dollar earned (including the first dollar earned), a single tax rate should
apply to wages exceeding a floor of tax-free wages, or progressively higher rates should apply to
each chunk of wages earned (such as, say, 0% of the first $20,000 of wages, 10% of the next
$30,000, 20% of wages between $40,000 and $100,000, 30% of wages between $100,000 and
$500,00, and 40% of wages above $500,000).
Finally, the tax rate structure is necessarily affected by our prior choice of tax base. Generally
speaking, the narrower the tax base, the higher rates must be to raise $X. The broader the tax base
(the more items that are taxed), the lower rates can be to raise that same $X. For that reason,
decisions to accord preferential tax treatment to certain classes of activities or income affect not
only those who benefit from these decisions but every remaining taxpayer who does not so benefit
because their tax rates are higher than they would otherwise need to be to raise $X. In this way,
decisions regarding how to tax, say, multinational corporations affect not only the shareholders of
-1-

multinational corporations (and their workers) but also the barista at the local coffee shop.
Our choice of tax base and tax rate structure will be affected by our shared (or contested) notions
of (1) fairness in allocating $X, (2) the evidence (or beliefs, even in the absence of empirical data)
of how different tax bases and rate structures affect economic activity (affecting aggregate societal
wealth), and (3) administrative concerns. Our stated goal always is to raise $X in a way that is fair,
administrable, and least damaging to economic growth. Or, as once stated more colorfully by Jean
Baptiste Colbert, minister of finance to King Louis XIV of France, taxation is the art of “plucking
the goose as to obtain the largest possible amount of feathers with the smallest possible amount of
hissing.”
Chapters 1 and 2 consider the two most viable possibilities under our current Constitution for a
tax base broad enough to raise sufficient revenue for a modern industrialized state: income and
consumption. Chapter 1 also introduces you to the essential structure of our Federal income tax,
which often departs from a theoretically pure income tax, including mechanisms to prevent a
certain amount of subsistence consumption from taxation. It also explores the difference between
marginal and effective tax rates. With this information in hand, you will be in a better position to
consider the history of how we got to where we are today, data regarding economic trends, as well
as the ethical and economic theories affecting tax policy debates, all discussed in Chapter 3.
Because the capitalization principle is the mechanism that primarily distinguishes an income tax
from a consumption tax, Chapter 4 rounds out Unit 1 with a deeper look at current law regarding
which outlays constitute a capital expenditure.

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Chapter 1: The Essential Structure of the Income Tax
Part A. of this chapter introduces the core structure of an income tax under tax theory and how
that theory is translated into positive law (or, in some cases, how positive law departs from theory).
The idea is to demystify the Code, as many of the provisions that make up the backbone of the
current Federal income tax is what you would expect to find there once you grasp the contours of
that underlying normative theory.
Part B., in contrast, departs from core theory to explore three topics: (1) the mechanisms used
in current law that permit a certain amount of subsistence consumption to escape taxation, (2) how
several provisions categorize groups of deductions in a manner that devalues some of them (or,
stated differently, how certain deductions are favored over others), and (3) the difference between
marginal tax rates and effective tax rates.

A. The theoretical core structure of a tax on
income and how it is implemented in positive law
As you will read about more fully in Chapter 3, the modern Federal income tax was enacted in
1913 after ratification of the 16th amendment to the Constitution. What does that term “income”
mean for tax purposes? In the early days of the income tax, before a tax-specific meaning of the
term was explored and developed, the temptation was great to borrow meanings from other
disciplines where the term “income” had been used for some time.
For example, suppose that Father died 200 years ago. In his will he directed that all of his land,
which is rented to tenant farmers, be contributed to a trust. The trust document instructed the trustee
(who managed the trust property) to distribute the income from the trust annually to his surviving
wife for the rest of her life (a life estate to you property law buffs) with the remainder distributed
to his son on his wife’s death. Upon his wife’s demise, the trust would distribute the land to the
son, and the trust would be dissolved.
Under trust law at the time, the rent collected from the tenant farmers would be classified as
income that would be distributed to the wife annually. If, however, the trustee decided to sell a
plot of land for $100 that had been purchased by Father before his death for, say, $75, the $25
profit from that sale would not be considered income that would be distributed to the wife. Rather,
the cash (even if not reinvested in a different plot of land) would be considered to be part of the
trust corpus that would eventually be distributed to the son under his remainder interest. Does that
mean that the $25 profit should not constitute income for tax purposes, as well? Early on, some
argued that it did. (And some continue to argue that such profit should not be taxed. Stay tuned.)
Similarly, financial accountants had long been used to constructing income statements for
businesses so that those interested in the economic health of the business (such as potential
investors and lenders) could have relevant information upon which to make informed financial
decisions. Here, the $25 profit earned on the sale of land for $100 that had been purchased for $75
would show up on the income statement. But should financial accounting be determinative? Or
might the rules of financial accounting deviate from the underlying values that inform how the
aggregate tax burden $X ought to be apportioned among the members of the population?
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Chapter 1

Over time, theorists such as Henry Simons and Robert Haig (in the U.S.), George Schanz (in
Germany), and others began to develop a tax-specific meaning for income that sometimes
coincided with the meaning of the term in other disciplines and sometimes did not. They
recognized that different disciplines may have different underlying purposes and values that
inform the contours of the term income in a way that is uniquely suited to its particular purposes.
By 1938, for example, Henry Simons, a public finance economist at the University of Chicago,
described income for uniquely tax purposes in the following way.
Personal income may be defined as the algebraic sum of (1) the market value of rights
exercised in consumption and (2) the change in the value of the store of property rights
between the beginning and end of the period in question. 1
While “the period in question” could theoretically be one’s entire life, with no tax due until death,
for administrative ease (and regular tax collection) the “period in question” is usually one year.
What does this language mean? Generally, the language after (2), above, implies that we should
tax the net increases in the taxpayer’s wealth between the beginning and end of the year. That is
to say, the taxpayer’s increases in wealth and reductions in wealth should be netted together, and
the net increase (if any) should be taxed. Suppose, however, that the taxpayer’s reduction in wealth
arises from, say, spending $5,000 on a vacation trip. The taxpayer is certainly less wealthy after
the trip than before because of the outlay, but should that wealth reduction be factored into his net
wealth increase for the year? The language after (1) implies that a reduction in wealth should not
reduce the tax base if that wealth reduction reflects personal consumption spending because
consumption spending is intended to remain within the tax base. We can tax consumption spending
(the vacation trip) only if we forbid that wealth decrease from entering into our determination
under (2) regarding whether the taxpayer has enjoyed a net wealth increase or suffered a net wealth
decrease for the year. Thus, more simply, the formula above could be restated essentially as:
Annual income equals wealth increases less wealth reductions but only if the
wealth reduction does not represent personal consumption.
In this way, wealth reductions spent on personal consumption (such as the vacation trip mentioned
above) do not reduce the tax base (what is taxed). Because they do not reduce the tax base, they
are taxed—albeit indirectly—by remaining within the tax base.
Because Schanz and Haig came to essentially the same conclusion, you will often hear this
construction called the “Haig-Simons” or “Schanz-Haig-Simons” definition of income for
purposes of income taxation. For shorthand, we can refer to it as SHS income.
Let’s use a simple fact pattern to explore how a given item would be treated under the SHS
economic conception of income and then proceed to the outcome under positive law found in the
Internal Revenue Code. This exercise not only helps to rationalize the core structure of an income
tax for you; the best tax lawyers are those whose knowledge of the underlying core concepts helps
them to advise a client on the likely outcome when positive law is ambiguous.
John and Mary are married and have two minor children, Oliver (age 10) and
Sophie (age 7). Mary is an employee—the CEO of a mid-size corporation—and
receives an annual salary of $1 million. John is a dentist and the sole owner of an
LLC that houses his dental practice. As described in the Introduction, a singleowner LLC is a disregarded entity for Federal income tax purposes, which means
1

HENRY SIMONS, PERSONAL INCOME TAXATION 50 (1938).

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Chapter 1

that its Gross Income and any allowable deductions will appear on John’s and
Mary’s joint income tax return. 2
John’s gross revenue collected from billing patients is $500,000 each year. This
amount, however, is only his gross revenue. Unlike Mary, who is an employee,
John incurs many costs in running his business. For example, he pays his
receptionist and dental assistants a salary, he pays rent and utilities for his office
space, and he purchases a new dental chair and X-ray machine this year.
John and Mary owned investment land that they rented to tenant farmers, which
they purchased more than two years ago in May for $12,000 (Year 1). By
December 31 of Year 1, the land had increased in value by $1,000 and was worth
$13,000. By the end of Year 2, it had decreased in value to $10,000. In August of
this year (Year 3), they sell it for $14,000 in cash. Before the sale of the land, they
receive $1,000 in monthly rent from their tenant farmers. They also have a bank
savings account, which generates $200 of interest this year.
John’s mother makes a substantial gift of $10,000 in cash to her son this year
toward a down payment on the purchase of a new home for $1.5 million.
John and Mary buy food and clothing, pay rent for a flat (before they buy their
new house), pay utility costs with respect to both their rented flat and new home
(after moving in), and take the kids to Disney World this year.
Turning for a moment to positive law, look at § 1 of the Internal Revenue Code, which reveals
that the tax base—what is ultimately taxed—is called “Taxable Income.” Taxable Income is
multiplied by the tax rates in § 1 to reach the tax due. (The tax rates you see in § 1, as well as the
floors and ceilings for each bracket, do not reflect the changes in law since 1986 or the inflation
adjustments mandated by § 1(f). We shall examine the current rate structure in Part B.) If Taxable
Income incorporates perfectly the SHS concept of income, it should result in a tax base that
consists of wealth increases less wealth reductions but only if the wealth reduction is not spent
on personal consumption. What is Taxable Income under the Code?
For now, Taxable Income is “Gross Income” less allowable deductions. Gross Income pertains
to wealth increases. In contrast, deductions pertain to certain wealth reductions.
Gross Income (wealth increases)
Less Deductions (certain wealth reductions)
Taxable Income (the tax base—what is ultimately taxed)
Introduction to § 61 Gross Income
Gross Income under the Code is defined in § 61: “Gross Income means all income from
whatever source derived, including (but not limited to)” the listed items. Notice how open-ended
it is (even circular, by referencing “income” in defining “Gross Income”). Notice also that the
specifically listed items do not exhaust the outer reaches of Gross Income because Congress
included that crucial parenthetical: “(but not limited to).” In other words, Congress clearly
contemplated that items of Gross Income exist in the world that are not found in that list. In Chapter
2

If John had created a corporation instead of an LLC, the entity would not be ignored for Federal income tax purposes.
The Federal income taxation of corporations, partnerships, and multi-owner LLCs and their owners are beyond the
scope of this introductory textbook, which focuses on the income taxation of individuals.

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Essential Structure of the Income Tax

Chapter 1

6, we shall consider what items that are not listed in § 61 nevertheless constitute Gross Income
under that vague residual clause at the beginning: Gross Income means income from whatever
source derived.
Some of the listed items are obvious SHS wealth increases, such as § 61(a)(1) “compensation
for services, including fees, commissions, fringe benefits, and similar items,” § 61(a)(4) interest,
and § 61(a)(5) rents. In each case, the recipient is wealthier after the receipt than before.
So let’s return to Mary and John. Mary’s $1 million in wages is listed in § 61(a)(1) and so is
clearly includable in Gross Income, as is true for the interest generated by their savings account (§
61(a)(4)) and the rent received from their tenant farmers (§ 61(a)(5)). The $500,000 that John
receives from his patients for performing dental services is also described in § 61(a)(1) or §
61(a)(2) (“Gross Income derived from business”), as this amount constitutes fees for services that
he performs for his patients in his sole proprietor business.
You might at first object that we should not tax John on the entire $500,000 under SHS
principles because even a cursory consideration of the facts indicates that John incurs substantial
costs in earning that Gross Income (unlike Mary, an employee). That is to say, it is obvious that
he does not enjoy a wealth increase from his dental practice by the entire $500,000. While you
would be correct, remember from our computation above that Gross Income under the Code is not
the tax base (what will end up being taxed) but only the first step in reaching the tax base of
“Taxable Income.” John will be able to reduce his Gross Income by any allowable deductions
(considered below) in reaching Taxable Income. John cannot take shortcuts, however, and reduce
the $500,000 gross payments received from his patients to some lesser amount and include only
the net profit in determining § 61 Gross Income in the first place. He must include every dollar of
that $500,000 in his § 61 Gross Income. Only then can he consider allowable deductions in
reaching Taxable Income.
What about the $10,000 that John’s mother gives to him in order to help John and Mary
purchase a home? Under SHS principles, John clearly enjoys a wealth increase on receipt of the
$10,000 in cash. Notice, however, the introductory language to § 61(a): “[u]nless as otherwise
provided in this subtitle.” This language puts you on notice that what may otherwise constitute
includable Gross Income (a wealth accession) might be rendered “excludable” under a specific
statutory provision found elsewhere in the Code. One such provision is § 102(a), which provides
John with statutory authority to exclude from Gross Income “gifts, bequests, devises, and
inheritances.” Why does positive law deviate from the core SHS concept of income here?
Deviations from SHS income are not necessarily illegitimate, but they do make us pause and ask
“why”? Stay tuned. We shall consider many such exclusions before the course is over, including
an entire chapter devoted to the gift exclusion (Chapter 7). For now, I introduce you to § 102(a)
chiefly to familiarize you with the concept of an exclusion. An “exclusion” pertains to a receipt
or other wealth accession that nevertheless is not included in § 61 Gross Income. The whys
and wherefores will have to wait.
So we can amend our little formula from above.
Gross Income (wealth increases: exclusion available?)
Less Deductions (certain wealth reductions)
Taxable Income (the tax base—what is ultimately taxed)
Notice that “exclusion” is not the same thing as “deduction.” Although both have the same
economic effect of reducing the tax base (what is ultimately taxed), one (exclusions) pertain to
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Chapter 1

Essential Structure of the Income Tax

Chapter 1

wealth increases—an inflow idea—that never enter into Gross Income in the first place. The other
(deductions) pertain to wealth reductions—an outflow idea—that reduce Gross Income in reaching
Taxable Income (what is ultimately taxed). So let’s turn to a few of John’s and Mary’s potential
wealth reductions and consider whether they should be deductible.
Deductions (part 1): nondeductible capital expenditures vs. potentially deductible expenses
Which outflows or wealth reductions of John and Mary might be deductible in reducing § 61
Gross Income to reach Taxable Income? Our facts state that John and Mary pay salaries to his
receptionist and dental assistant, pay rent and utilities for his office space, pay rent (before their
home purchase) and utility costs for their personal residence, buy food and clothing, and take the
kids to Disney World on vacation.
Recall our restatement of SHS income for tax purposes: annual income equals wealth increases
less wealth reductions but only if the wealth reduction does not represent personal consumption.
The language after “less” in the formulation above implies that an outlay must satisfy two,
independent conditions before it should reduce the tax base via a deduction (if we are to honor
SHS principles):
To be deductible under SHS principles,
(1) the outlay or event must decrease wealth; AND
(2) the wealth reduction must not represent personal consumption.
Let’s first consider John’s and Mary’s purchase of the investment land (which they rented to
tenant farmers) for $12,000 in Year 1. Should that $12,000 cash outlay be deductible under SHS
principles? To be deductible, the first requirement is that the outlay must decrease their wealth.
Are John and Mary any less wealthy after taking $12,000 in cash (from, say, Mary’s salary) and
using it to purchase land worth $12,000? No, they are not any less wealthy. Rather, they have
merely changed the form in which they are holding their wealth from dollar bills to land. This cash
outlay to purchase the land should not generate a deduction.
In general, the nomenclature for an outlay that does not reduce wealth but rather merely
changes the form in which wealth is held is called a “capital expenditure.” In contrast, an
“expense,” in general, is an outlay that immediately reduces wealth. In other words, a capital
expenditure is the opposite of an expense (and vice versa). Notice, by the way, that “expense” is a
defined word of tax art. You must not make the mistake of using the word casually to mean any
old outlay, even though the word “expense” is common and used outside of tax every day (whereas
“capital expenditure” rarely comes up in casual conversation).
In order to deduct a wealth reduction under the Internal Revenue Code, you must find a
Code section containing the magic words “there shall be allowed a deduction” and satisfy each
and every requirement contained in that Code section. Even if you satisfy this Code section, you
must then consider whether another, different Code section steps in to take away an otherwise
allowable deduction.
Is there a Code section that says “there shall be allowed a deduction for capital expenditures”?
No, there is not. Indeed, § 263 expressly disallows deduction of capital expenditures. Why did
Congress go to the bother of enacting a Code section expressly forbidding the deduction of capital
expenditures if they would not be deductible in any event with silence? Before 1954, no Code
section expressly forbade the deduction of capital expenditures, but that does not mean that capital
expenditures were deductible; they were not deductible even before 1954 because no Code section
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Essential Structure of the Income Tax

Chapter 1

authorized the deduction. But how do we know which outlays constitute capital expenditures
(nondeductible) and which constitute expenses (potentially deductible)? The enactment of an
express prohibition on deducting capital expenditure in § 263 provided a place for the Treasury
Department to issue Treasury Regulations that help us to determine whether an outlay is—or is
not—a capital expenditure (the topic of Chapter 4).
For example, take a sneak peek at Treas. Reg. § 1.263(a)-2(d)(1) and (2), Ex. (1). It states that
“a taxpayer must capitalize amounts paid to acquire or produce a unit of real or personal property
… including … land and land improvements, buildings, machinery and equipment, and furniture
and fixtures,” and the example provides that the cost of purchasing new cash registers for use in a
retail store is a nondeductible capital expenditure. The purchase of a new cash register merely
changes the form in which the taxpayer is holding wealth rather than decreases his wealth.
Mary and John are not permitted to deduct the $12,000 outlay in purchasing the land in Year 1
because the outlay is categorized as a capital expenditure. Similarly, John cannot deduct the cost
of the new dental chair and X-ray machine that he purchases this year in connection with his dental
practice (absent any special rule that deviates from core SHS principles) and they cannot deduct
the purchase price of their new personal residence. None of these outlays reduce John’s and Mary’s
wealth immediately but rather merely change the form in which they hold their wealth.
The same would have been true if they had decided to purchase shares of corporate stock
(intangible property) instead of land, equipment, or a personal residence (tangible property). Look
at Treas. Reg. § 1.263(a)-4(b)(1) and (c)(1)(i). Together, they provide that “a taxpayer must
capitalize an amount paid to acquire an intangible,” such as an ownership interest in a corporation,
partnership, or limited liability company, among other items.
By being denied deductions for the land, dental equipment, and personal residence purchased
in Year 1, John and Mary are indirectly taxed on these business, investment, and personal
purchases of long-lived property in the year of purchase. While they do not include anything in
Gross Income on making these outlays, deduction denial ensures that the outlay stays within their
tax base for the year of purchase. A SHS income tax effectively taxes additions to savings (such
as stock purchases, land purchases, purchases of business equipment, additions to a savings
account, etc.) by denying deductions for these capital expenditures.
§ 61(a)(3) gains derived from dealings in property and the critical role of basis
We have seen that John and Mary were not permitted to deduct the cost of their $12,000 outlay
when they purchased the land in May of Year 1 because the outlay did not reduce their wealth.
The facts also tell us that the land increased in value to $13,000 by December 31 of Year 1. Does
this $1,000 wealth increase result in a § 61 Gross Income inclusion for them at the end of Year 1?
If the Internal Revenue Code perfectly incorporated the SHS concept of income, the answer
would be “yes.” Mary and John are wealthier on December 31 of Year 1 than they were on January
1 by $1,000 because the value of the land that they purchased in May increased by that amount.
Yet, the current Internal Revenue Code does not reach this wealth increase for tax purposes until
a realization event occurs—most commonly a sale for cash, an exchange of the property for
other property, the destruction or theft of the property, or a similar event, i.e., an identifiable
marketplace event of some sort. Similarly, potentially deductible decreases in property value are
also not taken into account (such as the decrease in the value of the investment land in Year 2)
until “realized.” Why? As I mentioned above in connection with the gift exclusion, deviations from
SHS principles are not necessarily illegitimate, but they do give us pause to ask “why”?
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Chapter 1

Essential Structure of the Income Tax

Chapter 1

The answer cannot be mere lack of liquidity (cash) to pay tax. The cash to pay the tax could
come from their savings or Mary’s current salary. A taxpayer could perhaps even mortgage the
land itself to obtain the cash with which to pay the tax on this increase in wealth. Do not make the
mistake of thinking that income means cash. (Notice that the SHS formulation does not mention
cash but, rather, asks only whether the taxpayer’s wealth has increased.) Indeed, if Mary is paid
her $1 million salary one-half in cash and one-half in shares of corporate stock, the shares of stock
generally must be valued and included in her Gross Income on receipt under § 61(a)(1), as the
receipt constitutes compensation for services rendered. If wealth increases were rendered
nontaxable by the mere expedient of not using cash, we would simply become a barter society,
which would be very inefficient economically (reducing aggregate wealth). It would also be unfair
in that only those with greater bargaining power, such as CEOs, would be in the position to demand
nontaxable property in kind rather than cash, as it is far easier for most employers to simply pay
cash compensation
The answer also cannot be that the wealth increase or decrease may be temporary in nature. A
business may be profitable in Year 1 and operate at a loss in Year 2, but we do not delay taxation
of the profit in Year 1 to see what will happen in Year 2. A loss in Year 2 may perhaps generate a
refund of tax paid on Year 1’s profit, but it does not allow Year 1’s profit to go untaxed in the first
place until the end of the taxpayer’s life (to see if the taxpayer had an overall profit or loss for his
lifetime). Rather, the general rule under the annual accounting principle is that we take each year
as it comes. To be administrable, the tax system must artificially compartmentalize our lives into
annual units. The realization principle, however, is a major and important deviation from the
annual accounting principle. Indeed, compensation, interest, rents, etc., are all taxed on an annual
basis, whether paid in cash or in kind. Why should increases in property value be different?
One answer is administrative concerns, as it would be an administrative nightmare for every
taxpayer to value each and every piece of property at the beginning and end of each year in order
to pay tax on the net increase in wealth (or perhaps to deduct the net reduction in wealth). This
administrative concern is minimized, however, with respect to some kinds of property, such as
publicly traded corporate stock, where all you would have to do is look up the trading price on
December 31. For this reason, certain dealers in securities and investors in regulated futures
contracts must “mark to market” their securities inventories or futures contracts each year,
including the increase in value in Gross Income and deducting the loss in value (because these
would be business or investment losses under § 165(c), more below) under §§ 475 or 1256. The
ordinary investor in corporate shares is free from § 475, however, and can ignore the changes in
value of her securities until a realization event, such as a sale or exchange, just as Mary and John
can ignore the changes in value of their land in Years 1, 2, and 3 before its sale.
The ability to defer the taxation of unrealized gain in property until a realization event provides
a critically important financial benefit to those whose income is in the form of such gain. Even if
no special, reduced tax rate applies to such gain when the property is eventually sold, the aggregate
tax paid by the owner is less in real economic terms than it would be if the taxpayer’s wealth
increases were taxed each year as they accrued because of the time value of money.
Suppose, for example, that John’s and Mary’s $1,000 wealth increase in the value of the land
by the end of Year 1 would have generated a 10% tax of $100 if the realization requirement were
repealed (i.e., if the land were taxed under a “mark to market” system each year). If they were
required to pay the $100 tax at the end of Year 1, the current cost (as of Year 1) would have been
the full $100. Now suppose, however, that they can defer paying that $100 tax (without paying
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Chapter 1

Essential Structure of the Income Tax

Chapter 1

interest to the government for the privilege of deferring the payment) until the end of Year 10
simply by delaying the sale until then. How much would the current cost be for John and Mary—
measured at the end of Year 1—if they could earn, say, 3% (after-tax) interest on their wealth
increase in the meantime? The present value” (or current cost) of that future $100 obligation would
be only $74.40, as this is the amount that they would have to set aside today for it to grow (after
taxes) to $100 by the end of Year 10. We know this by looking at Table B, below, where the
number at the intersection of Year 10 and 3% is .744.
Table A: Compound Interest
Amount to Which $1 Now Will Grow by
End of Specified Year at Compounded Interest
Year

3%

4%

5%

6%

7%

8%

10%

12%

15%

1
2
3
4
5
6
7
8
9
10
11
12
13
14
15
16
17
18
19
20
25
30
40
50

1.03
1.06
1.09
1.13
1.16
1.19
1.23
1.27
1.30
1.34
1.38
1.43
1.47
1.51
1.56
1.60
1.65
1.70
1.75
1.81
2.09
2.43
3.26
4.38

1.04
1.08
1.12
1.17
1.22
1.27
1.32
1.37
1.42
1.48
1.54
1.60
1.67
1.73
1.80
1.87
1.95
2.03
2.11
2.19
2.67
3.24
4.80
7.11

1.05
1.10
1.26
1.22
1.28
1.34
1.41
1.48
1.55
1.63
1.71
1.80
1.89
1.98
2.08
2.18
2.29
2.41
2.53
2.65
3.39
4.32
7.04
11.50

1.06
1.12
1.19
1.26
1.34
1.41
1.50
1.59
1.68
1.79
1.89
2.01
2.13
2.26
2.39
2.54
2.69
2.85
3.02
3.20
4.29
5.74
10.30
18.40

1.07
1.14
1.23
1.31
1.40
1.50
1.61
1.72
1.84
1.97
2.10
2.25
2.41
2.58
2.76
2.95
3.16
3.38
3.62
3.87
5.43
7.61
15.00
29.50

1.08
1.10 1.12
1.15
1.17
1.21 1.25
1.32
1.26
1.33 1.40
1.52
1.36
1.46 1.57
1.74
1.47
1.61 1.76
2.01
1.59
1.77 1.97
2.31
1.71
1.94 2.21
2.66
1.85
2.14 2.48
3.05
2.00
2.35 2.77
3.52
2.16
2.59 3.11
4.05
2.33
2.85 3.48
4.66
2.52
3.13 3.90
5.30
2.72
3.45 4.36
6.10
2.94
3.79 4.89
7.00
3.17
4.17 5.47
8.13
3.43
4.59 6.13
9.40
3.70
5.05 6.87
10.60
4.00
5.55 7.70
12.50
4.32
6.11 8.61
14.00
4.66
6.72 9.65
16.10
6.85 10.80 17.00
32.90
10.00 17.40 30.00
66.20
21.70 45.30 93.10 267.00
46.90 117.00 289.00 1080.00

Table B: Present Value
What $1 at End of Specified Future Year Is Worth Today
Year

3%

4%

5%

6%

7%

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8%

10%

12%

15%

Chapter 1
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Essential Structure of the Income Tax
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Chapter 1

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Similarly, John and Mary would have liked to deduct the loss in value of their land in Year 2 when
it occurred because of the time value of money, as deducting $1 today is worth more than deducting
$1 in a future year. They are prohibited from doing so, however, under the realization requirement.
While you may never be asked to calculate the precise time-value-of-money benefit of being
able to defer inclusion of a wealth increase (or being able to accelerate a deduction to an earlier
year), it is quite important for you to appreciate the time value of money as a general principle
because it often is the silent, underlying stake at issue in tax planning. As you move through this
course, you will begin to appreciate better that the real tax issue, while often phrased as “is this
item includable” or “is this item deductible,” is more often than not (when you peel back the layers
of the onion) actually “when is this item includable” or “when is this item deductible”? All things
being equal (and they are sometimes not, for reasons that we shall also examine in due course),
taxpayers are often willing to go to quite a bit of tax planning to defer Gross Income or accelerate
deductions—all because of the time value of money.
While John and Mary were able to ignore the changes in land value during their ownership
period under the realization requirement, the sale in Year 3 is a realization event. Section 61(a)(3)
requires that they include “gains derived from dealings in property” in Gross Income.
What does the word “gains” mean in § 61(a)(3)? The facts state that Mary and John sell the
land for $14,000. Is $14,000 thus their gain that must be included in their Gross Income? After all,
they now have $14,000 in cold, hard cash in hand after the sale. But you have already learned that
income is not the same as cash. Indeed, John and Mary should not include the entire $14,000 in
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cash received if we want to conform to normative income tax principles because $12,000 of that
cash was made part of the tax base in Year 1 (the purchase year) through deduction denial. Only
$2,000 is new wealth that has never been taxed to them before.
Two fundamental precepts underlying a tax on “income” are:
(1) the same dollars should not be taxed to the same taxpayer more than once,
and
(2) the same dollars should not provide a double tax benefit to the same
taxpayer.
Recall that John and Mary were prohibited from deducting the $12,000 outlay when they
purchased the land because it was a nondeductible capital expenditure. The deduction denial in
the year of purchase meant that the $12,000 was indirectly taxed to them in that year by remaining
within their tax base. If we had allowed them to deduct the $12,000 cost of the land in Year 1—
contrary to current law—that $12,000 would have been removed from their tax base in Year 1,
and the entire $14,000 received in Year 3 would then properly constitute amounts that have never
been taxed to them before. Because Mary and John were already effectively taxed on that $12,000
in Year 1 through deduction denial, however, they cannot now be taxed on that same $12,000 a
second time without violating fundamental precept (1), above.
The two fundamental precepts above differentiate an income tax from a wealth tax. For
example, homeowners subject to state property taxes (a wealth tax) know that the “same dollars”
are taxed to them again and again each year because a property tax is typically calculated by
multiplying the property’s aggregate fair market value each year by the tax rate. An income tax is
more favorable to wealth creation than a wealth tax in that a $1 increase in wealth is taxed only
once to the same taxpayer (in the year in which that $1 wealth increase is realized) rather than
again and again, year after year.
How does the Internal Revenue Code implement these precepts to ensure that only $2,000 of
the $14,000 received on the sale is included in their Gross Income under § 61(a)(3)? While “gain”
is another term (like “expense”) that you might use casually in nontax contexts, the Internal
Revenue Code defines it precisely as a tax term of art in § 1001(a), which also defines “loss”
(another common word used in everyday life). Read § 1001(a) and (b) now. It defines realized
gain as the excess of “amount realized” over “adjusted basis” and loss as the excess of adjusted
basis over amount realized. More terms of art! “Amount realized” (A/R for short) is defined
precisely in § 1001(b) as “the sum of any money received plus the fair market value of the
property (other than money) received” on the property disposition. Because John and Mary sell
their land for $14,000 in cash, the amount realized is $14,000. If John and Mary had instead
received $9,000 in cash plus shares of corporate stock with a fair market value (FMV) of $5,000,
their amount realized would again have been $14,000 (the sum of the $9,000 cash and the $5,000
FMV of the stock received in exchange for the land). If they had exchanged their land entirely for
stock worth $14,000 (and no cash), their amount realized would, once again, have been $14,000
(the sum of $0 cash and the $14,000 FMV of the stock received in exchange for the land).
What is John’s and Mary’s “adjusted basis” (A/B for short) in the land that they sold for
$14,000? Section 1001(a) refers to § 1011, which provides that basis is determined under § 1012
or any other relevant basis section in the Internal Revenue Code, “adjusted as provided in § 1016.”
Section 1012, in turn, provides that the basis of property shall be “the cost of such property,” unless
another Code section governs the basis of the particular property at issue. Because John and Mary
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purchased the land, § 1012 does provide them with a $12,000 cost basis in the land.
What if the land had not been purchased but rather, say, inherited or obtained in a property
settlement in a divorce action? These situations (and others) are where the cross-references in §§
1011(a) and 1012(a) to (essentially) any other relevant basis rule found in the Internal Revenue
Code come into play. We shall examine some of these other basis rules in due course. John’s and
Mary’s basis is easy to determine because they did, in fact, purchase the land.
You will have to take my word for it for now that none of the adjustments listed in § 1016
(which we shall examine shortly) would have affected their initial $12,000 cost basis, which means
that their “adjusted basis” at the time of the sale in Year 3 remains $12,000. John and Mary’s
realized gain is $2,000 ($14,000 A/R less $12,000 A/B). (Notice, by the way, that “amount
realized” is not the same as “gain realized” or “realized gain.” “Amount realized” is the precisely
defined term found in § 1001(b) and is $14,000 on our facts. These terms of art are very confusing
at first, but you must get comfortable in using them or communication chaos results.)
Notice that basis is the mechanism that allowed us to ensure that the same dollars were
not taxed to the same taxpayer more than once. Basis generally represents previously taxed
dollars (or concurrently taxed dollars in the same year) that should not be taxed a second time
to the same taxpayer. Basis can always be recovered tax free, in the sense that John and Mary’s
$12,000 basis in the land is recovered tax free from the $14,000 obtained on the sale. Only $2,000
of that $14,000 (the amount realized in excess of basis) could not be protected from taxation as
basis recovery. You will often hear of this rule as “tax-free return of basis” or “tax-free recovery
of capital.” While “tax free” implies special dispensation from taxation, in reality it refers to the
fact that these dollars were already once taxed to John and Mary (when they purchased the land
and were denied a deduction for the outlay) and thus should not be taxed to them a second time.
What do I mean by the parenthetical above: “or concurrently taxed dollars in the same year”?
The dollars may not literally have been previously taxed in the sense that the purchase
(nondeductible capital expenditure) occurred in a prior year. The same result would occur if Mary
and John had bought the land for $12,000 in January of Year 1 and sold it in December of Year 1
for $14,000. The purchase price in January would be a nondeductible capital expenditure (creating
basis), which would be recovered tax-free on the December sale under § 1001. Their realized
(includable) gain would again equal $2,000.
Let’s return to Mary and consider again the variant in which she receives her $1 million salary
one-half in $500,000 cash and one-half in shares of corporate stock worth $500,000. We have
already determined that Mary must include the entire $1 million in Gross Income under § 61(a)(1),
i.e., not only the $500,000 in cash but also the FMV of the shares received as compensation in
kind. What is her § 1001 realized gain if she later sells the shares for, say, $700,000? Under §
1001(b), her amount realized (A/R) is the $700,000. What is her adjusted basis (A/B) in the shares?
Now that you appreciate the critical role of basis as the means by which we can keep track of
previously (or concurrently) taxed dollars, you know—even before looking at any authority—that
Mary must have a basis in the shares equal to the $500,000 that she included in Gross Income on
their receipt under § 61(a)(1), even though she did not purchase that stock herself for $500,000. If
we were to conclude, instead, that she takes a $0 basis in the shares, her sale for $700,000 would
produce a § 1001 realized gain of the entire $700,000 ($700,000 A/R less $0 A/B). Such a result
would violate precept (1), above, by taxing the same dollars ($500,000) to the same taxpayer
(Mary) more than once. Because Mary must include the $500,000 FMV of the shares in her Gross
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Income on their receipt as compensation under § 61(a)(1), she should be able to recover $500,000
of the $700,000 on sale without tax.
As expected, Treas. Reg. § 1.61-(2)(d)(2) provides that Mary’s cost basis in the property
received as compensation for services rendered equals any amount that she paid for the shares ($0
on our facts) plus the amount that she included in Gross Income as compensation for services
rendered under § 61(a)(1) ($500,000). Her initial basis in the shares is $500,000, and her § 1001
realized gain on the later sale for $700,000 is $200,000 ($700,000 A/R less $500,000 A/B).
Basis can generally be created in one of two ways: (1) the making of a nondeductible
capital expenditure or (2) a Gross Income inclusion.
An example of (1) is the purchase by John and Mary of their land for $12,000. Because the land
purchase is a nondeductible capital expenditure, they take an immediate basis of $12,000 in that
land to reflect the nondeduction of the $12,000, which means that the $12,000 remains in their tax
base for the purchase year and is thus indirectly taxed to them in that year. John and Mary should
not be taxed a second time on that same $12,000. When they sell the land for $14,000, they can
recover their $12,000 basis tax-free under § 1001(a). Only the excess of the $14,000 A/R over
their $12,000 A/B is § 1001 gain, includable in Gross Income under § 61(a)(3).
An example of (2) is the receipt by Mary of corporate shares worth $500,000 as compensation
for services rendered. Because Mary must include the $500,000 FMV of the shares in her Gross
Income under § 61(a)(1) upon receipt, she takes an immediate cost basis of $500,000 in those
shares to reflect the fact that she includes that $500,000 in Gross Income. She should not be taxed
a second time on that same $500,000. If she sells the shares for $700,000, she can recover her
$500,000 basis tax-free under § 1001(a). Only the excess of the $700,000 A/R over her $500,000
A/B would be § 1001 gain, includable in Gross Income under § 61(a)(3).
Deductions (part 2): which expenses are deductible and why?
You have learned a lot already! You have learned, for example, that capital expenditures, as
mere changes in the form in which wealth is held (rather than immediate wealth reductions), are
not deductible under SHS income principles because they fail to satisfy the first requirement
reviewed below (with a new, clarifying parenthesis).
To be deductible under SHS principles,
(1) the outlay or event must decrease wealth (e.g., the capitalization inquiry);
AND
(2) the wealth reduction must not represent personal consumption.
In sum, you now know that Mary and John cannot deduct the cost of the investment land, the
personal residence that they purchased, or (absent any special rule that deviates from SHS
principles) the cost of the new dental chair and X-Ray machine because each of these purchases
constitutes nondeductible capital expenditures.
Let’s move on to consider outlays that do survive the step-1 capitalization inquiry, i.e., to
outlays that do represent a current wealth decrease and thus are properly categorized as expenses
instead of capital expenditures. In John’s and Mary’s fact pattern, these include the salaries that he
pays to his receptionist and dental assistant, the rent and utility costs for his dental office space,
the rent that John and Mary pay with respect to their apartment (before they moved into their new
home), the utility costs for both the apartment and their new home, and the costs of the vacation
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trip to Disney World (among other everyday living costs). Because each of these outlays represent
an immediate wealth decrease rather than a mere change in form in which wealth is held, they are
properly categorized as expenses instead of capital expenditures, thus surviving the step-1 inquiry.
On to step 2! Recall our earlier point that even a current wealth decrease should not reduce the
tax base under SHS normative principles if the wealth decrease represents the purchase of personal
consumption because personal consumption costs should remain in the tax base. When we turn to
positive law, we find that § 262 confirms that “no deduction shall be allowed for personal,
living, or family expenses” (using that tax term of art). As with § 263 with respect to capital
expenditures, § 262 is not necessary to deny deduction for personal expenses. Remember that, in
order to take any deduction, you must always find a Code section expressly authorizing it with the
magic words “there shall be allowed a deduction.” Nevertheless, by enacting § 262, Congress
provided a handy place for the Treasury Department to issue regulations that help us to determine
whether a particular expense is, in fact, a personal one.
As with the introductory language to § 61, which reminds us that other Code sections might
expressly authorize an exclusion of a Gross Income item that would otherwise be includable under
§ 61, the introductory language in § 262 reminds us that other Code sections might expressly
provide authority to deduct certain personal expenses that would otherwise be nondeductible under
a normative SHS income tax. Examples include the deduction for charitable contributions made
to certain tax-exempt entities (§ 170) and the deduction for interest paid on a loan incurred to
purchase a personal residence (§ 163(h)(3)), each of which (and more) we shall examine in future
chapters. The term used to describe a provision that deviates from a pure, normative SHS
income tax is “tax expenditure,” and we shall examine the concept of tax expenditures more
closely in Chapter 3. Because none of John’s and Mary’s personal expenses are of this type, they
cannot deduct any of their personal expenses.
The amounts that John pays as salaries to his receptionist and dental assistant, as well as the
rent and utility costs for his office space are, however, current expenses that do not purchase
personal consumption but rather help to generate business Gross Income. In other words, these
costs satisfy both conditions for deduction under a normative SHS income tax.
Turning to positive law, we need to find a Code section containing the magic words “there shall
be allowed a deduction” for these outlays, and we find it in § 162, which provides that “[t]here
shall be allowed as a deduction all the ordinary and necessary expenses [as opposed to capital
expenditures] paid or incurred during the taxable year in carrying on any trade or
business….” Unless some other Code section steps in to take away these otherwise allowable
deductions (and there would be none in John’s case), John can deduct the business expenses
incurred in his dental practice from his $500,000 of Gross Income under § 61(a)(1) or (2) in
arriving at § 1 Taxable Income (the tax base).
The deduction for business expenses does not reflect some sort of special solicitude or
preference for business activity (as opposed to personal consumption). Rather, business expenses
are normatively required to be deducted if we wish to ensure taxation of SHS income. Recall
fundamental precept (1) of an income tax: the same dollars should not be taxed to the same
taxpayer more than once. If we require John to include every dollar of his $500,000 gross
revenue from his patients’ payments in § 61 Gross Income and did not then allow him to deduct
from this gross revenue the costs incurred to produce it, we would be doubly taxing John on the
same dollars (equal to the undeducted costs), violating fundamental precept (1).
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To see why this is true, return for a moment to John’s and Mary’s purchase and sale of their
land. There, we denied John and Mary a deduction on their $12,000 outlay in purchasing the land,
which meant that they were indirectly taxed on that $12,000 in the purchase year. This
nondeduction created a $12,000 basis in the land to represent the previously taxed dollars reflected
in the land. When they sold the land for $14,000, we did not require them to include the entire
$14,000 gross sales proceeds in § 61 Gross Income. Rather, they were permitted to recover their
$12,000 basis tax-free under § 1001 first so that only $2,000 was Gross Income within the meaning
of § 61(a)(3). In this way, Congress ensured that fundamental precept (1) was honored by not
taxing that $12,000 twice to John and Mary, which would have occurred if we both denied them a
deduction of the $12,000 purchase price and required that they include the entire $14,000 gross
sales proceeds in § 61 Gross Income.
Section 61(a)(3) is unusual in the sense that the Gross Income from the sale is already a net
figure because of the simultaneous basis offset under § 1001. The basis is, in a sense, deducted
before even arriving at § 61 Gross Income in the first place regarding the land sale. Congress could
have reached the same end result by requiring John and Mary to include the entire $14,000 amount
realized (the entire sales proceeds) in § 61 Gross Income and then creating a new deduction (not
in fact found in the Code) of $12,000 equal to their basis in the land in arriving at $2,000 of Taxable
Income (the tax base). But because the undeducted purchase price of the land is so obviously
connected to the later sales proceeds of that very land, basis is created in the land directly and
offset against the amount realized directly under § 1001 in arriving at § 61 Gross Income in the
first place.
The salary that John pays to his employees, the rent that he pays for his office space, and the
utility costs incurred for that space are clearly connected to creating the $500,000 of gross revenue,
just as the $12,000 purchase price of the land was clearly connected to the $14,000 sale price of
the land. Unlike with the land costs and sales revenue, however, we cannot say with any precision
whether the receptionist’s salary this week (or this month’s rent or utility expense) should be tied
to any particular patient’s payment. We cannot, in other words, easily create “basis” in any
particular business cost that could be used to offset (in § 1001 fashion) a portion of John’s $500,000
in revenues in order to arrive at a § 61 Gross Income figure that is (like the land profit) already
reduced to a net profit figure. In short, while the expenses are clearly income-producing costs of
his business, the connection between any particular expense and any particular revenue receipt is
not easy to determine, unlike the land purchase and later sale.
For this reason, Congress requires John to include every dollar of his $500,000 gross revenue
in § 61 Gross Income (unreduced by any of the costs that he incurred to produce this revenue) but
then also explicitly provides him with a current deduction from Gross Income under § 162 (in
reaching Taxable Income) equal to all of the business expenses incurred in producing that gross
revenue stream. When the smoke clears, he will be taxed only on his net profit, in order to ensure
that we are not doubly taxing John on the same dollars.
What about expenses (current wealth decreases) incurred not in pursuit of business profit
(generally, selling goods or services to others) or in pursuit of personal consumption (the trip to
Disney World) but rather in pursuit of investment profit (managing your own savings)? For
example, suppose that you rent a safety deposit box at a cost of $20 per month to safeguard a
winning lottery ticket until you have the opportunity to claim your prize. There has always been a

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version of § 162 in the Code. In an early case construing it, Higgins v. Commissioner, 3 the Supreme
Court concluded that managing one’s own investments does not rise to the level of a “trade or
business” within the meaning of the predecessor to § 162, no matter how large the investment
portfolio. (Mr. Higgins was a very wealthy man who hired employees to manage his large holdings
of U.S. investment properties for him while he lived abroad.) Under Higgins, the $20 safety deposit
box fee could not be deducted under § 162—even though the lottery proceeds are clearly wealth
accessions that are includable in Gross Income—because collecting lottery winnings does not
comprise operating a “trade or business.”
Requiring inclusion of the full gross proceeds of an investment while, at the same time,
disallowing deduction of the expenses incurred to produce that investment Gross Income would
twice tax the same dollars to the same taxpayer for the same reason that we would be doubly taxing
John on the same dollars if we required John to include every dollar of the $500,000 received from
his patients in Gross Income and, at the same time, denied him deduction of the expenses incurred
to produce those receipts. Under SHS normative principles, the only salient inquiry is whether the
outlays contribute toward producing includable Gross Income of some sort (as opposed to
purchasing personal consumption).
Congress responded to Higgins not by statutorily expanding § 162 to reach investment activity
in addition to business activity but by enacting an entirely new Code section pertaining, essentially,
to investment expenses. Section 212(1) and (2) allow the deduction of expenses incurred in an
income-producing activity not rising to the level of a trade or business.
Deductions (part 3): § 1001 loss (and more on normative income tax theory)
Suppose that John and Mary had sold the land (purchased in Year 1 for $12,000) when it was
worth only $10,000 in Year 2. You know now that John and Mary should always be permitted to
recover their $12,000 basis tax-free (in order to honor fundamental precept (1)), so you know that
the entire $10,000 received on the sale would constitute tax-free basis recovery. But what about
the $2,000 of unrecovered basis? They would have obtained a tax benefit from that basis if they
had been able to sell the land for more (additional tax-free recovery of basis), but the land is now
sold. Can they obtain any tax benefit for their unrecovered basis?
Notice that the amount of unrecovered basis on a property disposition satisfies the statutory
definition of loss found in § 1001(a): “loss shall be the excess of the adjusted basis … over the
amount realized.” John and Mary would have realized a $2,000 loss rather than a gain (both
defined terms of tax art in § 1001(a)) if they had sold their property with a basis of $12,000 for an
amount realized of only $10,000. In other words, by definition a loss is unrecovered basis.
We now have a realized wealth decrease (basis that we know will never be recovered),
satisfying the first requirement in our SHS deduction inquiry. This property is not personal
consumption property, such as a personal residence or an automobile used for personal purposes,
so the second requirement is satisfied as well. This loss should be deductible under SHS principles.
Under positive law, we need to find a Code section that contains the magic words “there shall
be allowed a deduction” for a “loss.” See § 165(a) and (c). Consistent with SHS principles, we see
authorization to deduct business and investment losses in §§ 165(a) and (c)(1) and (2), but losses
realized with respect to personal consumption property are generally disallowed under § 165(c)(3)
(with minor exceptions in §§ 165(c)(3) and (h), which we shall peruse in Chapter 17).
3

312 U.S. 212 (1941).

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We can now go a step further in defining what we really mean by a wealth reduction in the
normative SHS income tax sense. Suppose that Becky owns an art gallery and that she purchases
a painting for $10,000 that increases in value several years later when the artist becomes popular.
At this time, the painting is formally appraised at $50,000. Two of her regular customers consider
purchasing it for its $50,000 appraised value. Before the sale, however, a thief burgles the store
and, alas, makes off with the painting. While Becky thought that her store inventory insurance was
up to date, it has in fact lapsed, and she is unable to obtain any insurance recovery for the loss.
If you ask the hypothetical “man on the street” the amount of Becky’s “loss” on these facts, the
likely response would be $50,000 because Becky clearly lost $50,000 of economic value. Before
the theft, she owned a painting that was worth $50,000, but after the theft she owned nothing. For
income tax purposes, however, what is the amount of Becky’s loss deduction under § 165? See §
165(b). Becky is limited to deducting her $10,000 basis in the painting rather than its $50,000
economic value. Why? What would be wrong (as a matter of income tax theory) with allowing
Becky to deduct her $50,000 economic loss (rather than a deduction limited to her $10,000 basis)?
Recall fundamental precept (2): the same dollars should not provide a double tax benefit
to the same taxpayer. Because of the realization requirement, Becky did not include in her Gross
Income the unrealized $40,000 appreciation in value of the painting. If Becky were both entitled
to exclude this $40,000 (under the realization requirement) and deduct this same $40,000 (if §§
1001 and 165(b) permitted her to deduct the full $50,000 FMV of the painting), Becky would
enjoy a double tax benefit for the same dollars, violating fundamental precept (2). This outcome
is also another reminder that the word “loss,” while used in everyday parlance, is a tax term of art
under the Internal Revenue Code. A “loss” for Federal income tax purposes is unrecovered basis,
which generally represents previously taxed dollars, not lost value.
Indeed, if we are to honor SHS principles, all deductions under the Internal Revenue Code
(not just loss deductions) must be supported by previously or concurrently taxed dollars (i.e.,
after-tax dollars) in order to ensure that we are not providing a double tax benefit to the
same taxpayer for the same dollars (both exclusion and deduction). Basis is the clearest
example of previously or concurrently taxed dollars, but business and investment expenses,
as well as depreciation (below), also should represent previously or concurrently taxed
dollars because they pertain to producing what was (or will be) includable Gross Income.
This outcome is explicit under §§ 1001 and 165(b) with respect to loss deductions, but it is
equally true with respect to any other deduction that is premised on normative income tax
principles, i.e., those deductions that are necessary to properly measure SHS income. Expense
deductions under §§ 162 and 212 are allowed only because they represent outlays stemming from
includable Gross Income, usually in the same year.
Recall, for example, John’s $500,000 of includable Gross Income from his dental practice and
the § 162 business expense deductions that he was allowed for his employees’ salaries, office rent,
office utility costs, etc. Those deductions are justified only because of the Gross Income inclusion
of the entire $500,000, from which he was able to pay these business expenses. In other words,
they are “same dollars” (previously or concurrently taxed), justifying the § 162 deductions.
Deductions (part 4): depreciation
We have seen that John and Mary are not permitted to deduct the acquisition costs of their land
or personal residence and that John is not permitted to deduct, absent any special rule deviating
from SHS principles, the acquisition cost of the new business equipment that he purchased this
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year (the dental chair and X-ray machine) because each of these outlays are properly categorized
as capital expenditures, creating basis, rather than current expenses. We have also seen that basis
can be recovered tax-free on later sale of the property under § 1001. But can this basis be recovered
earlier—before sale or other disposition?
Read § 167(a). It allows a taxpayer to take a series of basis deductions, called depreciation
deductions, during the life of the property, so long as the property is (1) of a type subject to “wear
and tear” and (2) used in business or held for the production of income (i.e., business or
investment property). Notice that no depreciation deductions are allowed with respect to
personal-use property, consistent with the SHS principle that property used to provide personal
consumption (as opposed to producing Gross Income) should not reduce the tax base. The “wear
and tear” requirement—explored in Chapter 13 in more detail—essentially means that the property
at issue must waste away as a result of the business or investment activity in some predictable
manner. In other words, the property must have an ascertainable useful life up front, when placed
in service in the business or investment activity. Property with a potentially infinite life, such as
land, collectibles, or corporate stock, is never depreciable because it does not predictably waste
away from use. Buildings, no matter how solidly built, can be depreciable assets because they do
eventually collapse, even with good care.
John and Mary cannot depreciate their investment land (because it fails to satisfy the “wear and
tear” requirement) or their personal residence (because it is personal consumption property). John
can, however, depreciate the business equipment (dental chair and X-ray machine) that he
purchases this year for use in his business. The actual mechanics of how to schedule these basis
deductions over time under §§ 167, 168, 197 and related provisions are addressed in Chapter 13.
For now, it is enough to know that John will be able to accelerate the tax benefits of his basis in
the business equipment. Why does John like this result? All together now: because of the time
value of money. Deducting his basis beginning in the year of acquisition (instead of waiting until
a realization event and recovering his basis tax-free then) has real economic value to John!
Some may think that allowing deduction of property basis prior to a realization event is
inconsistent with the realization principle. A fuller discussion of this issue must await Chapter 13,
but the short version is that losses can legitimately be considered final and irretrievable (and thus
realized in a nontrivial sense) even before disposition—so long as the property wastes away over
time in some predictable fashion and gets ever closer to the end of its useful life in producing
Gross Income solely with the passage of time. Thus, the “wear and tear” requirement is critical in
determining which properties should properly be depreciable in the first place. Stay tuned!
§ 1016 basis adjustments
Suppose that John’s new dental chair cost $10,000 (creating an initial § 1012 cost basis of
$10,000) and that he is permitted to depreciate this basis in a series of $1,000 deductions over the
first 10 years of his ownership under the depreciation provisions. At the end of each of Years 1
and 2, John properly deducts $1,000 (for a total of $2,000) before selling the chair for $8,500 on
January 1 of Year 3 because he wants to buy the new edition. The sale triggers § 1001, of course.
Because he sold the chair for $8,500, the amount realized within the meaning of § 1001(b) is
$8,500. What is John’s adjusted basis in the chair at the time of sale, which will be used as an
offset against the amount realized in determining his § 1001 gain or loss?
What would be wrong with using his original $10,000 basis in calculating his § 1001 gain or
loss? Recall fundamental precept (2): the same dollars should not provide a double tax
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benefit to the same taxpayer. If John is permitted to deduct $2,000 of his $10,000 basis in Years
1 and 2 under the depreciation provisions, he should not be permitted to use that same basis a
second time to reduce his § 1001 gain (or create or increase a § 1001 loss) in the year of sale. For
this reason, § 1016(a)(2) requires John to reduce his original $10,000 basis by the $2,000 deducted
under the depreciation provisions, resulting in an adjusted basis of $8,000 at the time of sale. When
he sells for $8,500, John realizes a $500 § 1001 gain ($8,500 A/R less $8,000 A/B). As an aside,
note that the depreciation deductions allowed during Years 1 and 2 exceeded the real loss in FMV
during his ownership period, a common occurrence (as we shall see).
Just as basis is the tool used to ensure that the same dollars are not taxed more than once
to the same taxpayer, basis is the tool used to ensure that the same dollars do not provide a
double tax benefit to the same taxpayer.
Let’s consider another § 1016 basis adjustment. Ann has long owned a hotel, and its current
A/B is $400,000 (after reduction for depreciation deductions under § 1016(a)(2)). She decides to
construct a major addition to the hotel, doubling its square footage, at a cost of $500,000. Can Ann
immediately deduct this cost under § 162? While incurred in business (rather than for personal
consumption), is the $500,000 outlay an expense (as required for immediate deduction under §
162) or a capital expenditure (nondeductible under § 263)? Compare Treas. Reg. § 1.162-4(a) with
Treas. Reg. § 1.263(a)-1(a) and (d)(2). We shall spend all of Chapter 4 examining the capitalization
rules in more detail, including the ever-difficult line between a “repair” (a current expense) and an
“improvement” (a nondeductible capital expenditure), but this is an easy case. The $500,000
expansion is an improvement rather than a mere repair and must be capitalized. How do we do that
with respect to property that is already owned by the taxpayer?
Read § 1016(a)(1). The language “properly chargeable to capital account” means capital
expenditure. This $500,000 capital expenditure incurred with respect to property already owned
increases its basis from $400,000 to $900,000. Because this building is used in business and is
subject to “wear and tear,” this new basis will also be permitted to be depreciated going forward,
as was her original basis. Again, stay tuned.
A brief introduction to the concept of capital gains and losses
If the § 1001 gain or loss on a sale, exchange, destruction, or other realization event with respect
to property is includable in Gross Income (if a gain) or deductible under § 165 (if a loss), you must
then consider whether the gain or loss is characterized as “ordinary” or “capital” in nature and why
that characterization matters. We shall devote an entire chapter (Chapter 14) to examining the
special rules that apply to capital gains and capital losses, but it is important for you to acquire an
initial grasp of the two most fundamental consequences of these characterizations now because
they will affect the discussion of topics throughout this course. The concept of capital gain and
loss does not arise from the SHS conception of income. They are sui generis to the income tax, for
assorted rationales that we shall explore in Chapter 14.
The first thing to note is that whether a § 1001 realized gain or loss is capital has nothing to do
with whether the original purchase of the property qualified as a capital expenditure, even though
both (unfortunately for beginning tax students trying to keep all of this straight) use the term
“capital.” Virtually all purchases of long-lived property are capital expenditures, but that fact does
not mean that the § 1001 gain or loss realized on a later sale or exchange of that property is capital
gain or loss. You simply have to learn about these concepts in their own right. A capital
expenditure, you have learned, is simply an outlay that does not reduce wealth but rather merely
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changes the form in which wealth is held and is the opposite of an expense. In contrast, § 1001
gain or loss is capital (rather than ordinary) if the requirements found in § 1222 are satisfied.
Let’s use a series of examples to illustrate the requirements in § 1222.
Suppose that Steve owns a retail shop that purchases jewelry on the wholesale market and then
resells it to customers. Steve purchases a gold necklace at wholesale for $7,000 in Year 1 and sells
it for $12,000 to a customer, Ellen, in Year 3, who wears it for personal adornment. After wearing
the gold necklace for a few years, Ellen tires of it and sells it to Marty for $15,000 in Year 6
(because the price of gold has increased in the interim).
Steve cannot deduct the $7,000 cost of the necklace as a business expense under § 162 when he
purchases it from the wholesaler because the $7,000 outlay fails to qualify as an expense. Rather,
the purchase is a § 263 nondeductible capital expenditure, and he takes a $7,000 § 1012 cost basis
in the necklace. When he sells the necklace for $12,000 to Ellen, Steve realizes a $5,000 § 1001
gain ($12,000 A/R less $7,000 A/B). Similarly, when Ellen purchases the necklace for $12,000,
she cannot deduct the $12,000 cost of the necklace because it is a nondeductible capital
expenditure, creating a $12,000 basis. When she sells it for $15,000 to Marty, Ellen realizes a
$3,000 § 1001 gain ($15,000 A/R less $12,000 A/B). Even though both Steve’s and Ellen’s
purchases of the necklace are categorized as capital expenditures, Steve’s $5,000 § 1001 gain is
not characterized as capital gain, while Ellen’s $3,000 § 1001 gain is characterized as capital gain.
Why? And what difference does it make?
A § 1001 gain or loss that is realized with respect to property is characterized as capital (instead
of ordinary) if the three requirements repeated in §§ 1222(1) through (4) are satisfied. If you peruse
those subsections of § 1222, you will note three common features. To be capital:
(1) the § 1001 realized gain or loss must be includable (if a gain) or deductible (if a loss);
(2) the asset disposed of must satisfy the definition of “capital asset” found in § 1221; and
(3) the realized gain or loss must have arisen from a “sale or exchange” (as opposed to,
for example, a theft or destruction).
The first requirement alerts us to the possibility that some realized gains that would otherwise
be immediately includable in Gross Income under § 61(a)(3) or realized losses that would
otherwise be deductible under §§ 165(a) and (c) may, under some specific Code section, be
excluded (if a gain) or disallowed as a deduction (if a loss). The tax term of art for such realized
gains and losses that are not taken into account is that they are “unrecognized.” (A realized gain
or loss that is recognized is one that is taken into account now.) We shall examine some
nonrecognition provisions in later chapters. For current purposes, it makes sense to stop the
analysis regarding whether a realized gain or loss is capital or ordinary if the gain or loss is not
going to show up on the tax return in any event. You will have to take my word for it (for now)
that no nonrecognition provision would permit Steve’s or Ellen’s realized gains on their sales for
cash to go unrecognized, which means that the first requirement for both Steve’s and Ellen’s §
1001 gain to be characterized as capital gain is satisfied.
Similarly, the third requirement—that the gain be realized by way of “sale or exchange”—is
also obviously satisfied for both Steve and Ellen on these facts because both sold the necklace for
cash. If Steve had exchanged the necklace for, say, a new cash register for use in his business, the
“sale or exchange” requirement would likewise have been satisfied.
The necklace is not, however, a “capital asset” as defined in § 1221 in Steve’s hands, though it
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is a “capital asset” in the hands of Ellen, which means that the second requirement, above, is failed
(and the gain is characterized as ordinary instead of capital) with respect to Steve’s sale only. We
shall examine § 1221 in greater detail in Chapter 14, but do read § 1221(a)(1) for now. Notice that
the introductory phrase (before arriving at (1)) refers to all property in all the world—regardless
of whether that property is held for business, investment, or personal purposes—unless the
property is listed in one of the subsections of § 1221(a). In other words, if the necklace is described
in one of the paragraphs in § 1221(a), it is not a capital asset. For Steve, the necklace is, in fact,
described in the § 1221(a)(1) inventory or dealer exception. Because Ellen, unlike Steve, does not
hold the necklace as inventory, it is a capital asset in her hands. In short, you cannot simply
conclude that gold necklaces are—or are not—capital assets. They are capital assets in the hands
of some taxpayers (if they are not held as inventory for sale to customers, for example) and not
capital assets in the hands of others. Jewelry held for personal purposes (as opposed to inventory)
is just one example of a capital asset. Another is shares of corporate stock held as an investment
(as opposed to be being held as inventory by a stock dealer).
When the smoke clears, Steve’s § 1001 gain is ordinary, but Ellen’s § 1001 gain is capital. Why
does that matter? Certain kinds of capital gain, called “net capital gain” (defined in § 1222(11)),
is subject to a reduced tax rate under § 1(h), whereas ordinary gain is not. We shall tease apart the
definition of “net capital gain” in Chapter 14, but it requires (as a first ingredient) that the capital
asset have been held for more than one year before the sale or exchange, creating “long-term
capital gain.” So “net capital gain” (which requires at least some long-term capital gain) is
preferably taxed compared not only to ordinary gain or short-term capital gain but all other kinds
of ordinary income, including compensation, rent, interest, royalties, etc. 4 Net capital gain falling
within Taxable Income of $400,000 ($450,000 for married couples filing jointly) or less is
generally taxed at 15% (0% for taxpayers whose ordinary income is otherwise taxed at 15% or
less). Net capital gain falling within Taxable Income exceeding the $400,000 (or $450,000)
threshold is generally taxed at 20%. In contrast, the top tax rate on ordinary gain and ordinary
income is 37%, reduced from 39.6% in the legislation enacted in the waning days of 2017
informally called the Tax Cuts and Jobs Act [hereinafter referred to in this textbook as the TCJA].5
In short, certain capital gains are preferably taxed at a lower rate than ordinary gain (and
ordinary income other than gain). This rate differential is at the root of a good deal of tax
planning, as we shall see.
What if Ellen had sold the jewelry, which she had purchased for $12,000, for only $5,000
(instead of $15,000) because the price of gold had fallen during her ownership period? Instead of
realizing a § 1001 gain, she would have realized a § 1001 loss of $7,000 ($5,000 A/R less $12,000
A/B). Could Ellen deduct this loss under §§ 165(a) and (c)(3)? No. In Ellen’s hands, the jewelry
is personal consumption property, and personal consumption wealth reductions are intended to
stay within the tax base under SHS principles. Because the loss will not appear on Ellen’s tax
return, the loss is not capital under the first requirement listed above (that the loss be deductible).
Indeed, because the loss is not deductible, its character is irrelevant.
What if the property that Ellen purchased for $12,000 and then sells for $5,000 are shares of
corporate stock in Gaggle, Inc., instead of jewelry worn for personal adornment? In that case,
4

Certain dividends received on corporate stock are also subject to the special reduced tax rate under § 1(h)(11).
While the bills had been called the Tax Cuts and Jobs Act throughout the legislative process, the parliamentarian
ruled that title to be out of order for legislation enacted under budget reconciliation authority. Thus, the official title
of the act is, “H.R. 1—An Act to provide for reconciliation pursuant to titles II and V of the concurrent resolution on
the budget for fiscal year 2018.” Nevertheless, everyone calls it the Tax Cut and Jobs Act, and I shall as well.
5

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Ellen’s loss is deductible under § 165(c)(2), and all three requirements found in § 1222 are
satisfied. Her deductible loss is a capital loss. Why does that matter?
Even though Ellen has authority to deduct the loss under § 165(c)(2)—the first step in the
analysis—she must also take note of § 165(f), which refers her to § 1211 because her deductible
loss is capital. Read § 1211(b) now. Notice that § 1211 does not contain the magic words “there
shall be allowed a deduction.” Section 165 is the Code section that authorizes Ellen’s loss
deduction. But even if you find a Code section that contains the magic words “there shall be
allowed a deduction” and satisfy its terms, you must always then consider whether another,
separate Code section steps in to take away the otherwise allowable deduction. Section 1211 is the
first Code section among others that we shall examine that can step in to take away (or defer) an
otherwise allowable deduction.
Capital losses that are deductible under the authority of § 165 are then subject to §
1211(b), which limits deduction of capital losses (whether short-term or long-term) in any
year to an amount equal to included capital gains (whether short-term or long-term) for that
year plus up to $3,000 in additional capital loss. Under § 1212(b), any capital loss that is
disallowed under § 1211(b) can be carried forward indefinitely to future years until it is
either deducted under §§ 165 and 1211(b) or the taxpayer dies.
For example, assume that Ellen also owns shares of stock in Realty, Inc., with an unrealized
capital gain (which we can refer to as built-in gain) of $9,000. If she sells the Realty stock this
year, realizing and including that $9,000 capital gain, she could then deduct her entire $7,000
realized and deductible capital loss on the sale of the Gaggle stock under §§ 165 and 1211(b). If
she chooses not to sell the Realty stock with the $9,000 built-in gain, she can deduct only $3,000
of her otherwise deductible capital loss on the Gaggle stock sale this year. The remaining $4,000
would be carried forward. If, in the next year, Ellen realizes no capital gain, she could deduct
another $3,000, carrying forward the last $1,000 to the next year, when it could finally be deducted.
The § 1211 capital loss limitation rule stems chiefly from the realization requirement (coupled
with the special, reduced tax rate under § 1(h) for net capital gain) and the cherry picking that
could result without § 1211(b). Absent § 1211(b), the taxpayer could choose to sell only properties
with deductible, unrealized loss (built-in loss) and choose not to sell properties with built-in gain,
making it appear as though the taxpayer lost wealth for the year under SHS notions of income
when she may be, on net, wealthier (though the wealth increase is unrealized). Section 1211(b)
essentially requires the taxpayer that wishes to deduct otherwise deductible (under § 165) capital
losses to realize at least that much in capital gains in order to avoid deliberate mismeasurement of
net wealth increases or decreases for the year. The ability to deduct an additional $3,000 in capital
losses (in excess of realized capital gains) should be thought of as nothing more than a de minimis
rule for small investors.
Note that only capital losses are subject to the § 1211(b) limitation, while ordinary losses that
are deductible under § 165 are not so limited. For example, if Steve, our jewelry shop owner, sells
the gold necklace to Ellen for less than he purchased it, his § 1001 loss is both deductible under §
165(c)(1) and ordinary (not capital) because the necklace is not a capital asset in his hands under
the § 1221(a)(1) inventory exception. His loss deduction is allowable without limit, unconstrained
by § 1211(b).
In short, capital gains are treated favorably when compared to ordinary gains and
ordinary income because certain capital gains may be taxed at a special, reduced tax rate.
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Capital losses are treated unfavorably when compared to ordinary losses because otherwise
deductible capital losses are subject to deduction restrictions in § 1211(b) that do not apply
to ordinary losses.
Problems
1. Rachel, a medical doctor, purchases a painting to hang on the wall of her living room (i.e.,
for personal enjoyment) for $15,000 in February of Year 1 from an up-and-coming artist, Randy
Borehall. At the end of Year 1, the painting is appraised at $17,000. At the end of Year 2, after a
particularly nasty piece of publicity regarding Borehall’s antics, the painting is appraised at
$10,000. When Borehall dies in Year 3, Rachel is able to sell the painting in November for $20,000
in cash (you know what death can do to the value of an artist’s work) to Jacob.
a. What does Rachel include in Gross Income (or deduct in reaching Taxable Income) in each
of Years 1, 2, and 3 under current law?
b. What would Rachel include or deduct in each of Years 1, 2, and 3 under a pure SHS income
tax, under which changes in wealth are taken into account annually, regardless of whether or
not there has been a realization event (i.e., under a mark-to-market system)? Recall the crucial
role of “basis”—generally, a running record of previously or concurrently taxed dollars or,
stated differently, dollars that have not yet been deducted. What would Rachel’s basis in the
painting be at the end Year 1, at the end of Year 2, and at the time of sale in Year 3? Remember
also that she is using this painting for personal purposes, which will affect, in particular, your
analysis of the loss in value in Year 2.
c. Is the result in a. or b. more favorable to Rachel and why?
d. In a., what is the character of Rachel’s § 1001 realized gain: capital or ordinary? Why does
Rachel care?
e. Do your answers to a. and d. change if Rachel exchanges the painting for a boat owned by
Jacob that is worth $20,000 (rather than selling the painting for $20,000 in cash)?
2. Rachel’s mother gives her $5,000 in cash for her birthday in February of Year 1. What tax
consequences to Rachel under SHS notions of income and under current law if she uses the cash
to:
a. take a trip to Paris?
b. purchase shares of corporate stock worth $5,000, which she then sells for $7,000 in August
of Year 2? Is this result consistent with the role that basis usually plays? Why or why not?
3. Tired of all of the clutter in her home, Rachel holds a garage sale where she sells a bunch of
old furniture, clothes, dishes, toys, small appliances, etc. As in typical garage sales, she sold each
item for less than she originally paid for it. When she counted the money in her till at the end of
the day, she had $300 in cash. Does Rachel include this $300 in her Gross Income under current
law? Why or why not?
4. Rachel pays her office nurse a salary of $50,000, pays rent for her medical office premises
of $20,000, pays rent for her personal apartment of $15,000, pays $10,000 for food, and purchases
a new patient examining table for $10,000. Describe Rachel’s tax consequences under both SHS
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notions of income and current law for each of these outlays. (Do not worry about figuring out
actual depreciation deductions, if any, to which she is entitled. Just note whether or not she would
be entitled to take any.)
5. What is Rachel’s § 1001 gain or loss if, after several years of use in her business, Rachel
decides to sell for $6,000 the examining table purchased in 4., above, after properly deducting
$5,000 in depreciation deductions under §§ 167 and 168? (Skip, for now, the characterization of
her § 1001 gain or loss as “ordinary” or “capital,” as there are special characterization rules that
govern the sale of property that has been the subject of depreciation deductions. As usual, stay
tuned.)
6. Ryan, a lawyer, purchases shares of corporate stock for $20,000 in December of Year 1. At
the end of Year 2, they are worth $17,000. He sells the shares in October of Year 3 for $13,000.
Describe Ryan’s tax consequences with respect to the purchase and ownership of the shares under
both SHS notions of income and under current law.
7. Lindsey buys an office building for $100,000. After properly deducting $20,000 in
depreciation, she has the building appraised, and it is demonstrably worth $110,000 because the
surrounding neighborhood is quickly gentrifying. That is to say, Lindsey’s office building has
appreciated to a value above her original purchase price so that she now owns economic wealth of
$110,000 with respect to the building. (As an aside, you will learn that the fact that Lindsey’s
property has increased in value does not mean her depreciation deductions were improper. Stay
tuned.) Unfortunately, shortly after the appraisal, the building burns to the ground, and she learns
that (because she failed to make payments) her insurance coverage has lapsed. What is the amount
of Lindsey’s § 165 “loss” deduction? She clearly lost $110,000 of real economic value, but can
she deduct that amount? Why or why not? See § 165(b).
8. Luke purchases a boat in Year 1 for $200,000 for use in his business as a fisherman. In Year
2, Luke spends $30,000 to fix the boat up. Explain why Luke would like to categorize the $30,000
outlay as a mere “repair” (an “expense” under Treas. Reg. § 1.162-4) rather than an “improvement”
(a ”capital expenditure” under Treas. Reg. § 1.263(a)-1(a)(1) and (d)(2) and -3).
_______________________________________
Whew! There was a lot of information packed into Part A., which serves as the anchor for the
rest of the course. In a sense, the rest of the book merely fills in additional detail to the big picture
sketched here. For that reason, I recommend that you periodically reread this Part A. throughout
the course when you feel yourself getting lost in the forest for the trees. Going back to first
principles can provide that compass to get you back on track. Metaphor overload!!

B. Subsistence consumption, tax rates, and more
You learned in Part A. that the tax base of Taxable Income is, generally speaking, § 61 Gross
Income less any allowable deductions. This Part B. dives deeper, distinguishing between so-called
Above-the-Line Deductions and Itemized Deductions, as well as exploring mechanisms to protect
a basic amount of subsistence consumption from tax. It also considers the difference between a
taxpayer’s marginal tax rate and effective (or average) tax rate. Let’s start with a roadmap from
Gross Income to tax due.
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Computation of Tax
Gross Income ……………...... [§ 61, case law; statutory exclusion available?]
Minus Deductions from
Gross Income ……………….. [deductions listed in § 62 but allowed by a
Code section that says “there shall be allowed
a deduction ….”]
Equals Adjusted Gross
Income (Individuals) ………... [defined in § 62]
Minus Personal Exemptions ……….. [§§ 151 and 152, suspended through 2025]
Minus either Standard Deduction …. [§ 63]
or Itemized Deductions … [deductions other than those listed in § 62, the Standard
Deduction, the Personal Exemption Deduction, § 199A
Deduction, as limited by § 67, where applicable]
Minus § 199A Qualified Business ….. [for eligible sole proprietors and owners of
Income Deduction
pass-through entities]
Equals Taxable Income …………….. [defined in§ 63]
Apply Tax Rates or Tax Tables …… [§§ 1 and 3]
Yields Tax Before Credits
Minus Tax Credits …………………. [§§ 21-42, 53, and 6315]
Equals Tax Due
(Alternative Minimum Tax?) ……….. [§§ 55-59]
Let’s consider Joan and Jim, a married couple with two minor children, Larry
(age 10) and Laura (age 7). Joan is a teacher who earns $70,000 in 2022, and
Jim is a construction worker who earns $60,000. In addition, they receive a
$10,000 gift from Jim’s wealthy grandmother. They do not yet own a home but
rather rent an apartment. They contribute $2,000 to their church, a recognized
charity, and they pay $3,000 in state and local income taxes.
The first step in the chart listed above is to determine the § 61 Gross Income that Joan and Jim
must include on their joint tax return. 6 They must include their $130,000 in aggregate salary under
§ 61(a)(1), but the $10,000 that they receive as a gift is excludable from their Gross Income under
the authority of § 102, even though it represents economic income to them.
§ 62 Above-the-Line Deductions
After determining their § 61 Gross Income, they are next permitted to take any deductions
listed in § 62, typically referred to as Above-the-Line Deductions, but allowed by some other
Code section in reaching Adjusted Gross Income (AGI). In other words, AGI is Gross Income
less the Above-the-Line Deductions.
6

We shall discuss the joint tax return as an income-splitting mechanism in Chapter 8.

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Note that § 62 does not provide the authority to take any deduction. You must find the authority
to take the deduction in a Code section that contains the words “there shall be allowed a deduction”
and satisfy its terms. Once satisfied that you have initial authority to take the deduction, you must
then consider whether another Code section steps in to deny or reduce this otherwise allowable
deduction. For example, you learned in Part A. that a loss on the sale of investment property
(deductible under the authority of § 165(c)(2)) may nevertheless be limited by § 1211(b) if the
deductible loss is a capital loss. Once you have survived this obstacle course and are convinced
that you are, indeed, entitled to take the deduction, you must (as the last step in the analysis)
determine where on the roadmap from Gross Income to Taxable Income the deduction is taken.
The Above-the-Line Deductions are the most preferred deductions because, unlike Itemized
Deductions (considered below), they are not limited in any way. The first item on this preferred
list is business deductions (such as § 162 ordinary and necessary business expenses and
depreciation deductions under §§ 167 and 168 of assets used in the business) so long as these
business deductions are incurred by the self-employed rather than in one’s capacity as an employee
of another. See § 62(a)(1). A good example of these deductions would be the ones incurred by our
dentist John in Part A. He paid his dental assistant and receptionist a salary, paid rent and utility
costs for his office, and incurred depreciation deductions for his new dental chair and X-ray
machine, all of which would be taken above the line, directly from Gross Income in reaching AGI.
Losses incurred on the sale of property, such as capital losses, are listed in § 62(a)(3), and all
deductions attributable to property that produces rents or royalties are listed in § 62(a)(4).
Notice that employee business deductions are taken above the line only in certain limited
circumstances. The most important of these is the first: employee business deductions that are
reimbursed by their employers under “accountable plans,” as defined in § 62(c). See §§ 62(a)(2)(A)
and (c). If the reimbursement arrangement requires the employee both to substantiate the business
expense and to return any excess reimbursement to the employer, the employee is permitted to
deduct the business expense directly from Gross Income in arriving at AGI. But the reimbursement
itself, because coming from an employer, would be includable in the employee’s Gross Income
under § 61(a)(1) as compensation. Because the inclusion under § 61(a)(1) would exactly offset
the Above-the-Line business expense deduction under §§ 162 and 62(a)(1), Treas. Reg. § 1.622(c)(4) permits the employee to ignore both the inclusion and the offsetting deduction. This
simplification measure has real economic benefits, as the reimbursement is also excludable for
purposes of the payroll taxes mentioned in Chapter 3 (under which no deductions are allowed).
Because Joan and Jim have no Above-the-Line deductions listed in § 62, their AGI is also
$110,000, not uncommon in the case of employees.
The (suspended) Personal and Dependent Exemption Deduction and (continuing) Standard
Deduction
Every taxpayer effectively has a zero bracket amount on the first dollars earned on the rationale
that subsistence income should not be taxed on “ability to pay” grounds. (The ability to pay fairness
norm is discussed in Chapter 3.) Prior to the enactment of the TCJA in late 2017, Congress
effectuated this zero bracket amount through (1) the Personal and Dependent Exemption
Deduction, (2) the Standard Deduction, (3) the Child Tax Credit, and (4) the Earned Income Tax
Credit, but in the TCJA Congress suspended the first (the Personal Exemption and Dependent
Deduction) but nearly doubled the second through the end of 2025. Before suspension, the
Personal Exemption and Dependent Deduction for each taxpayer and their dependent would have
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been $4,150 in 2018.
The Standard Deduction is a flat amount that is available to all taxpayers merely for existing.
Prior to the TCJA, the 2018 Standard Deduction for a married couple filing jointly would have
been $13,000. The TCJA increased it to $24,000 for a married couple filing jointly (to $12,000
from 6,500 for single individuals), indexed for inflation. 7 For 2022, the Standard Deduction is
$25,900 for a married couple filing jointly and $12,950 for unmarried individuals.
Itemized Deductions, which taxpayers can elect to take in lieu of the Standard Deduction,
consist of the universe of all deductions except (1) Above-the-Line Deductions, (2) the
suspended Personal Exemption and Dependent Deductions, (3) the Standard Deduction, and
(4) for eligible sole proprietors and owners of pass-through entities, the § 199A deduction
(discussed shortly). Before 2018, about 70% of taxpayers took the Standard Deduction and 30%
itemized. Because the TCJA not only increased the Standard Deduction but also eliminated some
itemized deductions entirely and reduced others, discussed below, the number of itemizers has
been reduced to about 12% or 13%.
The original impetus behind the 1944 enactment of the Standard Deduction was the desire for
simplification during the period when the class tax was becoming a mass tax during WWII, as
described in Chapter 3. 8 The Standard Deduction allowed taxpayers who did not wish to keep track
of the individual Itemized Deductions to which they would otherwise be entitled to simply take
the Standard Deduction, instead. Of course, most taxpayers will keep track of their Itemized
Deductions and take whichever amount is larger. Therefore, in a nontrivial way, the Standard
Deduction represents an amount of tax-free subsistence spending available to all taxpayers because
every taxpayer is entitled to it simply for existing.
Particularly after enactment of the TCJA, Itemized Deductions consist chiefly of the personal
deductions that would not be allowed under a pure SHS income tax (i.e., they are “tax
expenditures”): charitable contributions under § 170, qualified residence interest on a personal
residence under § 163(h)(3), state and local income and property taxes under § 164(a) (newly
capped under the TCJA to no more than $10,000 in total), and certain casualty losses arising in
Presidentially declared disaster areas under § 165(c)(3). Certain other Itemized Deductions, called
“Miscellaneous Itemized Deductions,” are no longer deductible after the TCJA, discussed next.
§ 67: suspended Miscellaneous Itemized Deductions (MIDs)
Under § 67, all Itemized Deductions except those that are listed in § 67(b) are
“Miscellaneous Itemized Deductions,” or MIDs, a subset of all Itemized Deductions. Prior to
the enactment of the TCJA, MIDs were deductible for purposes of the regular tax only to the extent
that their aggregate exceeded 2% of AGI. If, for example, aggregate MIDs were $2,500 and the
taxpayer’s AGI was $100,000, the taxpayer could deduct only $500 of the total MIDs—not the
entire $2,500. If the taxpayer’s MIDs totaled only $1,500, none of the $1,500 was deductible. You
often heard this rule referred to as the 2% floor under MIDs or the § 67 haircut. Even before the
TCJA, however, MIDs were entirely nondeductible for purposes of the AMT, described below.
7

Most of the individual tax changes (except the use of the slower inflation adjustment measure described after the tax
tables and the changes to the tax treatment of alimony) sunset at the end of 2025, which means that the Personal
Exemption and Dependent Deduction will be revived and the Standard Deduction will be reduced absent
Congressional action. Changes made to the corporate tax under Subchapter C of the Code, in contrast, do not sunset.
8
See Joseph J. Thorndike, The Love-Hate Relationship With the Standard Deduction, 142 TAX NOTES 1394 (2014)
(describing how charities lobbied against the enactment out of fear that the new Standard Deduction would reduce
charitable giving, though a look back from 1960 showed that it did not).

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The TCJA extended that deductibility ban to the regular tax, as well, through 2025. See § 67(g).
Notice that the four Itemized Deductions listed above (§ 170 charitable contributions, § 164
state and local income and property taxes up to $10,000, § 163(h)(3) qualified residence interest,
and § 165(c)(3) personal casualty losses in a disaster zone) are found in the § 67(b) list and so
continued to be deductible by itemizers. Obviously missing from that list are §§ 162 (pertaining to
business expenses) and 212 (pertaining to investment expenses). As you learned earlier, the § 162
business expenses of the self-employed are not Itemized Deductions in the first place but rather are
Above-the-Line Deductions. See § 62(a)(1). Similarly, § 212 deductions are also taken above the
line if they pertain to property that produces rents or royalties. See § 62(a)(4). But consider the §
162 unreimbursed employee business expenses. Because they are not reimbursed, they are not
Above-the-Line Deductions listed in § 62(a)(2)(A) but rather are Itemized Deductions. Moreover,
because § 162 is not listed in § 67(b), unreimbursed employee business expenses are also MIDs,
currently nondeductible under § 67(g). In addition, any § 212 deduction that does not pertain to
the production of rents or royalties—and so are not Above-the-Line Deductions under § 62(a)(4)—
are Itemized Deductions and, because not listed in § 67(b), nondeductible MIDs.
Most employees (unlike sole proprietors) will not incur significant deductible business
expenses, but a few will. For example, suppose that Ellen’s AGI is $70,000 as a lawyer working
as in-house corporate tax counsel for Expo, Inc., and that she travels twice to ABA Tax Section
meetings, where she earns CLE credit to renew her law license. Further assume that $2,000 of the
total costs would be deductible as business expenses under Treasury Regulations that you will
study in Chapter 16 but that Expo, Inc., refuses to reimburse Ellen’s business expenses. When
Ellen attempts to deduct this $2,000 on her own tax return, she will be hampered first by her ability
to itemize (will she have enough Itemized Deductions to allow her to itemize, or will she take the
Standard Deduction, instead?) and second by § 67. Prior to the TCJA, she would have been able
to deduct $600 of the amount that she pays (the excess of $2,000 over 2% of her AGI) if she
itemized, but after 2017 she can deduct nothing, even if she itemizes. In other words, though
technically deductible under § 162, her business expense would be nondeductible in fact under §
67(g). In this manner, MIDs are the least favored deductions. (The most favored are the Abovethe-Line Deductions, and the second most favored are Itemized Deductions that are not MIDs.)
Indeed, § 162 unreimbursed employee business expenses and § 212 deductions (other than those
deductible above the line under § 62(a)(4)) were the prime targets in the crosshairs of Congress
when it first enacted § 67 in 1986 as a base-broadening measure to help pay for the dramatic
reduction in the top marginal rate from 50% to 28% (described in Chapter 3). 9
9

Here is a bit of legislative history:
The Congress concluded that the prior-law treatment of employee business expenses, investment
expenses, and other miscellaneous itemized deductions fostered significant complexity, and that some
of these expenses have characteristics of voluntary personal expenditures…. The use of the deduction
floor also takes into account that some miscellaneous expenses are sufficiently personal in nature that
they would be incurred apart from any business or investment activities of the taxpayer. For example,
membership dues paid to professional associations may serve both business purposes and also have
voluntary and personal aspects; similarly, subscriptions to publications may help taxpayers in
conducting a profession and also may convey personal and recreational benefits. Taxpayers presumably
would rent safe deposit boxes to hold personal belongings such as jewelry even if the cost, to the extent
related to investment assets such as stock certificates, were not deductible.

STAFF OF THE JOINT COMM. ON TAX’N, GENERAL EXPLANATION OF THE TAX REFORM ACT OF 1986, JCS-10-87, May
4, 1987, at 78-79, at www.jct.gov/jcs-10-87.pdf.

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The Alternative Minimum Tax (AMT)
MIDs provide a handy segue to a short discussion of the Alternative Minimum Tax (AMT),
which you see mentioned at the bottom of the earlier flow chart. The AMT is a parallel tax system
alongside what is referred to as the regular tax (to distinguish it from the AMT). The AMT was
originally enacted in 1969 when the national press reported that 155 wealthy taxpayers paid no
income tax, even though they realized large amounts of economic income, because deductions,
exclusions, timing rules, credits, etc., combined to result in zero tax. Every taxpayer must calculate
the tax due under both the regular tax and the AMT and pay whichever is larger. The maximum
AMT tax rate is currently 28% for individuals, which is lower than the 37% maximum tax rate
under the regular tax, but the AMT tax base is broader than the regular tax by denying some
deductions, exclusions, etc., that are permitted under the regular tax. For this reason, the AMT
tax may be larger, even though the top AMT marginal tax rate is lower.
Among the most important deductions that are (or were, prior to 2018) allowed for regular tax
purposes but denied for AMT purposes under § 56(b)(1) are the Personal Exemption and
Dependent Deductions (currently suspended through 2025 under the regular tax), the § 164
deduction for certain state and local income and property taxes, and all MIDs (instead of only
MIDs below the 2% floor under the regular tax prior to 2018). The preferential tax rate applicable
to capital gains and dividends is maintained under the AMT, so realizing a lot of low-tax capital
gains and dividends (which are heavily concentrated in high-income households) will not trigger
the AMT. The TCJA substantially increased the AMT exemption amount (the equivalent of the
Standard Deduction under the regular tax) so that it will affect far fewer taxpayers than in the past.
Whew!
We finally can summarize the status of business deductions, in particular, considering both
Above-the-Line Deductions and Itemized Deductions (except for new § 199A, discussed shortly):
BUSINESS DEDUCTIONS:
↙
↘
Nonemployee:
↘
↘
Above the Line.
↘
See § 62(a)(1).
Employee
↙
↘
and reimbursed under an “accountable
and not reimbursed (and not
plan” or unreimbursed and performing
performing artist, state government
artist, state government official,
official, or primary/secondary teacher
or primary/secondary teacher
Itemized Deduction (itemizing?)
Above the line. See § 62(a)(2).
Also MID, currently nondeductible to any extent
See also Treas. Reg. § 1.62-2(c)(4):
under either regular tax or AMT.
ignore both inclusion and deduction
See §§ 67(g), 56(b)
Joan’s and Jim’s only Itemized Deductions would be the $2,000 in charitable contributions and
the $3,000 in state and local income taxes. They are Itemized Deductions because §§ 170 and 164
are not listed in § 62. Because this total ($5,000) is less than Joan and Jim’s $25,900 Standard

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Deduction, they will take the Standard Deduction instead of itemizing. Notice, therefore, that
Itemized Deductions are entirely worthless to the extent that their aggregate does not exceed
the Standard Deduction. Stated another way, Itemized Deductions have value only to the
extent that their aggregate exceeds the Standard Deduction. For that reason, Itemized
Deductions are less valuable than Above-the-Line Deductions—the preferred deductions—
where each dollar offsets Gross Income in reaching Taxable Income.
Joan and Jim’s Taxable Income within the meaning of § 63 is:
$130,000 Gross Income (also their AGI)
Less 25,900 Standard Deduction
$104,100 Taxable Income
The two most common tax rate schedules are reproduced below for 2022. 10
2022 Tax Table for Married Couples Filing a Joint Return
If Taxable Income is:

The tax is:

Not over $20,550 …………………………10% of Taxable Income
Over $20,550 but not over $83,550 ………$2,055 plus 12% of excess over $20,550
Over $83,550 but not over $178,150 ……..$9,615 plus 22% of excess over $83,550
Over $178,150 but not over $340,100 ……$30,427 plus 24% of excess over $178,150
Over $340,000 but not over $431,900 …... $69,295 plus 32% of excess over $340,100
Over $431,900 but not over $647,850 …... $98,671 plus 35% of excess over $431,900
Over $647,850 …………………………... $168,993.50 plus 37% of excess over $628,300
2022 Tax Table for Unmarried Individuals
If Taxable Income is:

The tax is:

Not over $14,650 ………………………….10% of Taxable Income
Over $14,650 but not over $55,900 ……… $1,465 plus 12% of excess over $14,650
Over $55,900 but not over $89,050 ……… $6,415 plus 22% of excess over $55,900
Over $89,050 but not over $170,050 …….. $13,708 plus 24% of excess over $89,050
Over $170,050 but not over $215,950 …... $33,148 plus 32% of excess over $170,050
Over $215,950 but not over $539,900 …… $47,836 plus 35% of excess over $215,950
Over $539,900 ………………………….... $161,218.50 plus 37% of excess over $539,900
The tables show that the highest marginal tax rate on ordinary income is currently 37% (39.6%
before the TCJA), but a graduated rate structure begins at 10% and rises to 37% on each chunk of
Taxable Income. The first chunk is taxed at 10%, the next chunk at 12%, and so on at rates of 22%,
24%, 32%, 35%, and 37%.
The beginning and end of each tax bracket are indexed for inflation to prevent the effects of
inflation (rather than a real gain in purchasing power) to cause income to creep into the next higher
tax bracket (formerly known as bracket creep before the inflation adjustments were adopted in
1986). The TCJA changed the inflation measure from the Consumer Price Index (CPI) to “chained
CPI,” which rises more slowly. For this reason, the bracket floors and ceilings (as well as the
10

Three additional rate schedules in § 1 that are not reproduced here apply to Heads of Household, Married Couples
Filing Separate Returns, and Estates & Trusts. The last one is reproduced in Chapter 8.

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Standard Deduction and other inflation-adjusted items) will rise more slowly than in the past, a
subtle way to increase taxes over time (compared to pre-2017 law) without having to enact a
statutory rate increase. While most of the TCJA individual tax changes sunset at the end of 2025,
the substitution of chained CPI as the new inflation measure is permanent.
Notice that Joan’s and Jim’s $104,100 Taxable Income falls within the bracket described in line
3 of the Table for Married Couples Filing a Joint Return. That line provides that their tax due is
$9,615 plus $4,521, which is 22% of the excess of their $104,100 Taxable Income over $83,550
(or 22% of $20,550). Their tax due (before considering any offsetting tax credits) is $14,136.
Child Tax Credit and Earned Income Tax Credit
Joan and Jim would next consider whether they are entitled to any tax credits. While a
deduction reduces Gross Income in reaching Taxable Income (the tax base—what is taxed), a tax
credit offsets the tax due. While a $1 tax credit saves $1 in tax for taxpayers in every tax
bracket, a $1 deduction saves an amount of tax that varies by the taxpayer’s marginal tax
rate that would have otherwise applied to the income absent the deduction. A $1 deduction
saves a taxpayer whose marginal dollars fall within the 37% bracket 37 cents (because, absent the
deduction, the extra $1 of Taxable Income would generate an additional 37 cents in tax), while the
same $1 deduction saves a taxpayer in the 22% bracket only 22 cents (because, absent the
deduction, the extra $1 of Taxable Income would generate an additional 22 cents in tax). In
contrast, a $1 tax credit saves the taxpayer exactly $1 in tax, regardless of tax bracket.
In other words, a tax credit has the same value to high and low bracket taxpayers alike, while a
deduction is worth more to high-bracket taxpayers than to low-bracket taxpayers. For this reason,
Congress will usually choose the tax credit mechanism when it intends particularly to target lowincome taxpayers with a special tax benefit and a deduction when it intends particularly to target
high-income taxpayers.
Taxpayers with minor children (or dependent adults) have a second mechanism (in addition to
the Standard Deduction) to augment the amount of subsistence income that will be free from
income tax. The TCJA increased the § 24 Child Tax Credit from $1,000 to $2,000 for every child
under age 17 (through 2025), an amount that is not indexed for inflation. Prior to the TCJA, the
Child Tax Credit was phased out by $50 for every $1,000 (or fraction thereof) of modified AGI
exceeding $110,000 for a married couple filing jointly ($75,000 for singles), but the TCJA
increased those phase-out thresholds quite substantially—to $400,000 for married couples filing
jointly ($200,000 for singles). In addition, the TCJA created a new $500 tax credit for non-child
dependents, such as elderly parents living with their children, or child dependents who phased out
of the Child Tax Credit. If a taxpayer owes less in tax than their Child Tax Credit, up to $1,500 of
the $2,000 credit is refundable for 2022, though refundability is dependent on having at least
$2,500 of earned income. For low-income families, the doubling of the credit had little effect, and
yet they lost their Personal Exemption and Dependent Deductions. In contrast, “income-rich
households received an increase in their [Child Tax Credit to] $2,000 per qualifying child with no
cap.” 11
The American Rescue Plan, enacted in March 2021, made several significant changes to the
Child Tax Credit but for one year only (2021). It (1) raised the eligibility limit to include 17-yearold children, (2) increased the credit to $3,000 ($3,600 for children under 6 years), (3) altered the
phase-out thresholds for the additional credit (only), made the credit entirely refundable ( and with
11

See Francine J. Lipman & James E Williamson, Child Tax Credit Redux, 165 TAX NOTES 1303 (2019).

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no earnings minimum), and (4) permitted 50% of the credit to be paid to parents in the form of
direct deposits during the last 6 months of 2021. These amendments were estimated to reduce child
poverty by 45% for 2021. 12 The Build Back Better Act, passed by the House of Representatives
in November 2021, would extend this provision for one year (2022) but as of this writing had not
passed the Senate.
Because Joan and Jim’s AGI does not exceed $400,000, their $4,000 Child Tax Credit ($2,000
for each of their two children) is not reduced, and their $14,136 tax due (before credits) is reduced
to $10,136. They are thankful that their AMT liability is less (take my word for it), so $10,136 is
their final Federal income tax.
Because Joan and Jim are employees, estimated Federal income taxes should have been
withheld from their paychecks during the year by their employers, who must send the withheld
amounts to the Treasury or suffer severe penalties. (Self-employed individuals must submit
estimated tax payments quarterly.) Under § 31, Joan and Jim will take a tax credit against their
$10,136 tax owed for the amounts withheld by their employers. If, for example, their employers
withheld a total of $10,000 in Federal income tax in 2022, they would credit $10,000 against their
income tax liability and remit the remaining $136 owed. If, in contrast, their employers withheld
a total of, say, $12,000 from their paychecks in estimated Federal income taxes, their $12,000 tax
credit would offset their entire tax liability, and they would receive a refund of $1,864 from the
Treasury. In other words, the § 31 credit is a so-called refundable credit, which entitles the
taxpayer to a payment from the Treasury to the extent that the tax credit exceeds the tax owed.
As an aside, many taxpayers love getting a tax refund from the Treasury and sometimes
intentionally have their employer withhold from their paychecks more than their anticipated tax in
order to ensure a large refund. In the 2017 tax season, for example, about 75% of individual tax
returns resulted in refunds totaling $285 billion, averaging $2,800 apiece. 13 Because the Federal
government does not pay interest on what is essentially a loan from the taxpayer to the government
(equal to the amount of tax overpayment), this behavior is not entirely rational, but cognitive
psychologists are not surprised. The refund “feels” like free money, even though it simply
represents the return of an interest-free loan. Chapter 3 will introduce you to several cognitive
biases that affect tax policy analysis, but we can introduce the first here: loss aversion, under
which people strongly prefer avoiding losses to acquiring gains. The pain of having to make up a
shortfall (if withholding falls short) hurts more than the pleasure enjoyed on receiving what feels
like a windfall (upon receiving a refund of overpaid tax). In short, many taxpayers are willing to
make an interest-free loan to the government in order to avoid having to pay what feels like “extra”
tax owed at the time the return is filed—even though the amount of tax owed, of course, does not
depend on the amount withheld. In Joan and Jim’s case, they owe $10,136 Federal income tax,
regardless of whether they had $10,000 or $12,000 withheld from their paychecks. (If far too little
tax is withheld, however, Joan and Jim can owe additional penalties.)
Another very important tax credit for the working poor that effectively augments the amount of
subsistence living expenses protected from the income tax is the Earned Income Tax Credit (EITC)
under § 32, which is a refundable tax credit (i.e., if the EITC exceeds the Federal income tax owed,
the excess is paid to the taxpayer). The EITC originated in 1975 as a means to effectively rebate
the payroll taxes (Social Security Tax and Medicare Tax) on subsistence wages of low-income
12

Jason DeParle, Monthly Payments to Families With Children to Begin,
https://www.nytimes.com/2021/07/12/us/politics/child-tax-credit-payments.html.
13
See www.nytimes.com/2019/01/27/us/politics/tax-refund-code-shutdown.html.

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taxpayers—particularly those with children—because the payroll taxes have no zero bracket
amount; the first dollar earned is taxed. Over time the amount of the credit increased so that it can
exceed the amount of payroll taxes paid on subsistence wages as a work incentive. In other words
the EITC is an anti-poverty tax expenditure aimed at the working poor. 14 A cursory glance at § 32,
however, reveals its complexity. It phases in, plateaus, and then phases out, depending on the
number of children, income levels, and marital status. Joan and Jim would not be eligible for any
EITC in light of their income level.
Effective tax rate versus marginal tax rate
We must distinguish between the marginal rate and the effective (or average) rate. First, let’s
consider the marginal rate, which is the rate at which the taxpayer’s last (or marginal) dollar
of Taxable Income is taxed. Joan’s and Jim’s marginal tax rate was 22% because, under the third
line in the tax table, their last or marginal dollars were taxed at 22%.
The marginal rate is important for at least two reasons. As described more fully in Chapter 3,
economists care about marginal rates because it is at the margins where behavior might change in
response to this rate, which can affect economic efficiency and thus economic growth (if behavior
really does change significantly in response to the tax—a contested notion). The marginal rate is
also important in connection with effective tax planning, as illustrated in Chapters 7 and 8
(examining income-shifting possibilities among family members).
In measuring the fairness of the distribution of the tax burden over the members of the
population, the important parameter is the effective (or average) tax rate, which broadly speaking
should reflect the percentage of economic income paid in tax. While Joan’s and Jim’s marginal
rate is 22%, what is their effective rate? We know that we should put $10,136 in the numerator,
but what should we put in the denominator? If we put Taxable Income in the denominator, their
effective tax rate would be about 9.7% ($10,136/$104,100), but Taxable Income is never used
because of the significant base-narrowing measures (such as the Standard Deduction, gift
exclusion, personal deductions, etc.) that severely skew the measurement of wealth accessions for
the year. Adjusted Gross Income (or AGI), while still leaving out considerable economic income,
is often used for rough comparisons of effective tax rates. If we use AGI, their effective tax rate
is 7.8% ($10,136/$130,000).
The most accurate measure would be true economic income, which would at the least also throw
into the denominator the $10,000 gift that can be spent on personal consumption or saved (and so
would constitute SHS income), producing an effective tax rate of 7.2% ($10,136/$140,000). Each
(7.8% or 7.2%) is far less than their 22% marginal rate. Another item that we might want to add
to the denominator to better approximate Joan and Jim’s economic income is the value of
employer-provided healthcare, which is excludable from their Gross Income (thanks to §§ 105 and
106, considered in Chapter 17) but which is the equivalent of additional cash wages paid to them
(otherwise includable), which they spend on nondeductible personal consumption.
Congressional Budget Office (CBO) data show that, as a result of the TCJA, effective tax rates
on income before taxes and transfers have been significantly reduced for upper-income taxpayers
between 2016 and 2021 but only modestly reduced for lower income taxpayers, as shown in the

14

See, e.g., Kerry A. Ryan, EITC as Income (In)stability, 15 FLA. TAX REV. 583 (2014).

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chart below. 15

Effective tax rates are used in tax policy analysis regarding the fairness of the distribution of
the tax burden. For example, some readers may have read in the popular press during the 2012
Presidential election season that President Obama’s effective Federal income tax rate in 2010
(using AGI for the denominator) was 26.3% while Governor Mitt Romney’s effective Federal
income tax rate was nearly half that at 13.9%, even though the Romneys’s income was much
higher. The Obama AGI was $1,728,096, consisting mostly of his salary as President and
substantial book royalties, both of which are taxed at ordinary income tax rates, and their tax
payment was $453,770 ($453,770/$1,728,096 is 26.3%). 16 The Romney AGI was $21,646,507,
consisting mostly of capital gains and dividends taxed at 15% (which would have been 20% if
current law had applied), with some ordinary income each year from speaking fees and other forms
of investment income. The Romneys paid $3,009,766 in tax ($3,009,766/$21,646,507 is 13.9%).17
While the Romney tax payment was roughly four times larger than the Obama tax payment, the
Romney AGI was roughly ten times higher than the Obama AGI. A tax with an effective tax rate
that decreases as income rises is “regressive relative to income.” Governor Romney’s effective
tax rate would have been even lower (very significantly lower) if unrealized gain had been included
in his denominator, as explored below. In contrast, a tax with an effective tax rate that increases
as income rises is “progressive relative to income.”
While the CBO chart above shows the income tax to be progressive, it does not break down the
results within the top 1% itself, where we have seen (in connection with the 2010 effective Federal
income tax rates for President Obama and Governor Romney) that effective rates can be lower for
the very wealthy than for the merely wealthy. The graph below 18 shows the effective Federal
income tax rate across the entire income spectrum for 2015 using AGI, and it confirms that the
15

CBO, PROJECTED CHANGES IN THE DISTRIBUTION OF HOUSEHOLD INCOME, 2016 TO 2021 (Dec. 19, 2019) at 21,
https://www.cbo.gov/system/files/2019-12/55941-CBO-Household-Income.pdf or
https://www.cbo.gov/publication/55941.
16
www.scribd.com/doc/53364352/President-Mrs-Obama-s-2010-tax-returns.
17
http://thorndike.com/wp-content/uploads/2012/01/Romney1040-2010.pdf.
18
Martin A. Sullivan, Will Reform Undo Income Tax Regressivity at the Top End?, 157 TAX NOTES 301, 302 (2017).
Reprinted with permission of Tax Analysts.

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effective tax rate for the very wealthy continues to remain more than three percentage points lower
than for the merely wealthy (using AGI).

The reason for this remains that net capital gain and qualified dividends (low-tax income)
remains heavily concentrated at the upper end of the income spectrum, 19 with fully 82% of the
capital gains and dividends preference enjoyed by taxpayers with the highest 5 percent of
income. 20

19
20

Id. at 303.
Martin A. Sullivan, Repeal of SALT Deduction More About Politics Than Policy, 156 TAX NOTES 137 (2017).

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Using AGI in the denominator to measure effective tax rates, however, fails to include
unrealized gain, which seriously overstates effective tax rates at the top end of the income scale.
As one of my favorite public finance economists has written:
We all know … even adjusted gross income can be far less than true economic
income. Although it gives economists no pleasure to discomfit lawyers, we must
insist that true economic income includes unrealized capital gains. [Sources
omitted.] To best portray any taxpayer’s income tax burden, the denominator of an
effective tax rate should as much as possible approximate economic income.
Without adjusting … income upward to included unrealized capital gains, the
denominator of an effective tax rate would be too small, and so the estimated
effective tax rates would be biased upward. Because the vast bulk of Americans
own small amounts of stock, this bias is trivial for most. But for the wealthy, it
could be large. 21
Indeed, a good deal of economic income is never taxed at the top end of the income scale
because of the combination of the realization requirement, nonrecognition provisions (which allow
certain realized gain, particularly with respect to financial assets and real estate, to go unrecognized
under various Code provisions explored in Chapter 12 and upper-level tax courses), and the taxfree step up in basis at death under § 1014 (explored in Chapter 7).
CBO uses a broader concept of income for the denominator than AGI, but it still fails to
include the built-in gain in property (or undistributed corporate income in excess of corporate tax
paid on that income), which are wealth accessions, even though not yet realized. The reduced
denominator overstates their effective tax rate if these items meaningfully reflect ability to pay
tax. At the same time, CBO includes in the denominator of low- and middle-income taxpayers
not only their cash compensation (including compensation contributed to tax-preferred
retirement accounts) but also employer-paid health insurance premiums, the employer’s share of
Social Security, Medicare, and federal unemployment insurance payroll taxes, the 25% share of
corporate income taxes that CBO allocates to workers (including that figure in both the
numerator and denominator), Social Security benefits, Medicare benefits (measured by the
average cost to the government to provide those benefits), unemployment benefits, and workers
compensation. Including these amounts in the denominator can understate their effective tax rate
to the extent that any of these items do not meaningfully reflect ability to pay tax, such as health
care received in kind under Medicare or the employer portion of the payroll taxes. 22
In an effort to rectify the first bias noted above, two economists (one from the President’s
Council of Economic Advisors and one from the Office of Management and Budget) recently
modeled the effective tax rate for the 400 wealthiest households by including in the denominator
the built-in gain of property owned by this cohort. 23 They estimate an average tax rate of 8.2%
on $1.8 trillion of income for the period 2010 to 2018. Using other start years (going back to
1992) and 2014 as an end year (instead of 2018) records average tax rates between a low of 5.3%
21

Martin A. Sullivan, Risking the Wrath of 900 Billionaires, 165 TAX NOTES 398, 401 (2019).
CONGRESSIONAL BUDGET OFFICE, The Distribution of Household Income, 2018, Aug. 2021, Appendix C, p. 51,
https://www.cbo.gov/publication/57061.
23
See Greg Leiserson & Danny Yagan, What is the Average Federal Income Tax Rate on the Wealthiest
Americans?, Sept. 23, 2021, https://www.whitehouse.gov/cea/blog/2021/09/23/what-is-the-average-federalindividual-income-tax-rate-on-the-wealthiest-americans/.
22

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(with a 2013 start year and 2014 end year) and a high of 12.1% (with a 2001 start year and 2014
end year). 24
Including unrealized property gain in the denominator of lower- and middle-income
households would not alter their effective tax rates significantly because most families do not
have significant investment assets with unrealized gain.
The new § 199A deduction for sole proprietors and owners of pass-through entities
So-called C corporations (named for Subchapter C of the Internal Revenue Code) are taxed
under § 11 at the entity level on their Taxable Income at a marginal rate of 21% (reduced from
35% under the TCJA). About 70% of corporate stock is held today by tax-exempt shareholders
(up from less than 20% in 1965), primarily pension plans (and other retirement accounts) and
foreign shareholders, which means that the § 11 corporate tax is the only tax paid on a large portion
of income earned by C corps. 25 When C corps distribute dividends from their after-tax income to
the 30% of shareholders that are not tax-exempt, however, a second tax is imposed because
dividends are included in Gross Income under § 61(a)(7) (and not deducted by the distributing
corporation), but most dividends are taxed at the same reduced rate applying to the taxpayer’s net
capital gain (15% or 20%, depending on the taxpayer’s income). If corporations don’t distribute
their after-tax earnings but rather retain them, increasing the value of their stock, the second tax is
imposed when the shareholder sells the stock at a gain, though this second tax enjoys the time
value of deferral until sale and is typically taxed at the preferential capital gains rate. Ignoring the
time value of deferral, corporate income distributed to the 30% of non-tax-exempt shareholders is
taxed at a combined rate of 36.8% between both the § 11 corporate tax and the 20% dividend or
capital gains tax at the shareholder level (using the higher 20% dividend rate for purposes of
illustration), which approximates the same top 37% rate applicable to individuals. 26
Sole proprietors and independent contractors include their business’s Gross Income on their
individual tax return and deduct the business’s expenses, interest, loss, and depreciation above the
line under § 62(a)(1) in reaching AGI. Similarly, LLCs, partnerships, and so-called S corporations
(named for Subchapter S of the Code) are not taxed at the entity level, unlike C corporations.
Rather, the entity nets together the business’s Gross Income and deductions and allocates the
resulting Taxable Income to the owners for inclusion on their individual tax returns, similar to a
sole proprietor. In other words, the business’s Taxable Income is “passed through” to the business
owners (in tax jargon) for inclusion on the individual owners’ tax returns, and distributions from
the LLC, partnership, or S corp to the owners are then generally excluded from Gross Income.
(They are not taxed a second time on distribution.)
If no other change had been made in the TCJA, the reduction in the corporate tax rate to 21%
would mean that business income earned by corporations, on the one hand, and individuals outside
of corporations, on the other, would be subject to essentially the same top tax rate. You will learn
in Chapter 3 about the neutrality economic norm, under which the tax Code should change
behavior as little as possible from what would occur in a no-tax world, as those behavior changes
can result in a misallocation of human and investment capital across the economy, resulting in less
24

Id. at
See Leonard E. Burman, Kimberley A. Clausing, and Lydia Austin, Is U.S. Corporate Income Double-Taxed?, at
www.taxpolicycenter.org/publications/us-corporate-income-double-taxed.
26
To illustrate, a C corporation earning $100,000 of Taxable Income pays $21,000 in tax, distributing the remaining
$79,000 as a dividend to its sole non-tax-exempt owner. The shareholder pays tax of 20% ($15,800). Between both
the corporation and its shareholder, $36,800 of the $100,000 of Taxable Income is paid in tax, or 36.8%.
25

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aggregate income for the economy as a whole. Economists could, therefore, support this move
because there would be no incentive (or disincentive) to operate a business through a corporation
or directly (as a sole proprietor) or through a pass-through entity that is not taxed at the entity level.
Yet, that’s not what happened. One of its most significant changes made by the TCJA is the
new 20% deduction for “qualified business income” taken by owners of certain sole
proprietorships and pass-through entities through 2025. This deduction does not reflect a reduction
in the taxpayer’s wealth (the first requirement for a deduction under SHS principles, as you learned
in Part A). Rather, the intention and effect of this new deduction is simply to lower the marginal
rates on each line of the tax tables below that which would apply to an equivalent amount of wage
income earned by an employee. The top tax rate is effectively reduced from 37% to 29.6% (.20 of
.37 is .074, and .37 less .074 is .296). The 35% rate is effectively reduced to 28% (.20 of .35 is .07,
and .35 less .07 is .28). And so on.
For example, compare married couple 1 (MC1) with married couple 2 (MC2). Both spouses in
MC1 are employees (like Joan and Jim in our last example), and they earn $200,000 of aggregate
wages. One spouse in MC2 earns $30,000 of wages at a retail shop while the other spouse owns a
sole proprietorship earning $270,000 of Gross income and deducting (above the line) $100,000 in
business expenses and depreciation, resulting in $170,000 of “qualified business income” within
the meaning of § 199A. Both couples have $200,000 of Adjusted Gross Income, both couples take
the $25,900 Standard Deduction, and both couples have $174,100 of Taxable Income—before
considering the new § 199A deduction. Prior to enactment of the TCJA, they would have owed the
same tax. Not so now.
MC1 gets no § 199A deduction because they are employees. See § 199A(d)(1)(B). Using the
tax tables above, they owe $29,536 of tax, and their effective tax rate using AGI is 14.8%
($29,536/$200,000).
MC2 can deduct 20% of their $170,000 of “qualified business income” under § 199A, reducing
their Taxable Income by $34,000 from $174,100 to $140,100. This deduction is neither an Abovethe-Line Deduction nor an Itemized Deduction but is an extra deduction taken below the line.
Therefore, the deduction can be taken even by those who do not itemize. Using the tax tables
above, they owe $22,056 of tax, which is $7,480 less than MC1, and their effective tax rate using
AGI is 11% ($22,056/$200,000), nearly four percentage points less than MC1 on the same amount
of economic income.
The § 199A deduction cannot generally offset more than 20% of Taxable Income (reduced by
net capital gain) before considering the § 199A deduction. See § 199A(a). Assume, for example,
that both spouses in MC2 work in the family business (i.e., one spouse does not, as before, earn
$30,000 of outside wages), that the business earns $200,000 of “qualified business income”
(instead of $170,000), and that, as before, they take the $25,900 Standard Deduction. As before,
their AGI is $200,000, and their Taxable Income is $174,100 before the § 199A deduction.
Although 20% of $200,000 is $40,000, MC2 can deduct no more than $34,820 (20% of $174,100).
Although MC1 was denied any § 199A deduction because all of their income was wages, a
portion of the $30,000 of outside wages earned by one spouse in the first version of MC2 was
effectively offset by the § 199A deduction when you consider the outcome in the second iteration
of MC2, which had the same AGI and Taxable Income but where 100% of the income was passthrough income and where the 20% deduction was reduced. In the first iteration, the § 199A
deduction offsets a portion of the second spouse’s wages, in effect, which is inconsistent with the
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notion that wages should not be offset by the § 199A deduction.
In addition to the 20%-of-Taxable-Income cap, § 199A contains other complex limitations, a
few of which are listed below.
• First, taxpayers with aggregate Taxable Income exceeding inflation-indexed thresholds of
$440,100 (married) or $220,050 (singles) in 2022 are not eligible for any deduction if their
business provides“specified services,” which include services in the fields of health, law,
accounting, actuarial science, performing arts (though not those who manage or promote
them), consulting, athletics, financial services and the like, as well as any business where the
principal asset is the reputation or skill of one or more of its owners or employees. 27
• Second, the 20% deduction cannot apply to W-2 wages paid by an S corp to its owners or §
707(c) guaranteed payments made by a multi-owner LLC or partnership to its owners for
services. In effect, only the owners’ share of the S corp, LLC, or partnership “bottom-line
income” (which does not count wages or § 707(c) payments for services) is eligible for the
20% deduction. This limitation applies regardless of the owner’s Taxable Income.
• Third, for business owners with Taxable Income exceeding $440,100 (married) or $220,050
(single), the § 199A deduction against any eligible income is the lesser of
(1) 20% or
(2) the greater of
(a) 50% of W-2 wages paid by the business to employees or
(b) 25% of W-2 wages paid plus 2.5% of the unadjusted basis of all depreciable
property used in the business immediately after acquisition.
• Fourth, for taxpayers with Taxable Income between $340,100 and $440,100 (married) or
between $170,050 and $220,050 (single), the specified services limit (first bullet) and the
W-2 wage limits (third bullet) are phased in.
These threshold and phase-out limits are applied individually to each owner, not to the passthrough business as a whole. For example, a law firm with $10 million in bottom-line income
allocates that income among its partners for inclusion on their individual tax returns. Those
partners with Taxable Income below the $340,100 (married) or $170,050 (single) thresholds can
potentially deduct 20% of their bottom-line law income, even though law is a specified service.
In Chapter 3, you will learn about a fairness norm called horizontal equity, under which
taxpayers with similar economic income (and family size) should be taxed similarly. New § 199A
violates this fundamental fairness norm in a huge way. If you are interested in reading more, you
can read the following article:
www.nytimes.com/interactive/2017/12/20/us/politics/small-business-tax-cut-passthroughs.html?_r=0
As the article above illustrates, one feature that you will see in this chapter (as well as in future
27

Under proposed regulations, a business is considered a “specified service” business under the “reputation or skill”
provision only if it generates income from: (1) endorsements of products or services, (2) use of an individual’s
image, likeness, name, signature, voice, trademark, or any other symbols associated with the individual’s identity, or
(3) appearances on radio, television, or other media. Only a small number of businesses built around a celebrity or
famous person will be affected by this limitation.

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chapters) is an optional link to short articles that succinctly illustrate or summarize (in an
interesting way, I hope) a policy issue that I discuss or empirical data that are important in
considering the policy issue. 28 These inclusions are unusual in that they are not traditional,
academic articles. I hope that these materials provide compelling context that adds richness to your
understanding of how we got to where we are today, where the tension points are situated that may
lead to change, and how one might think about these issues in an ordered way. Some of these short
pieces will have a definite viewpoint, but none will (I hope) be perceived as ones that seek only to
conform to my own confirmation bias (discussed in Chapter 3).
For the first time in our tax history, the Code effectively imposes different marginal Federal
income tax rates on business income earned by individuals, depending solely on whether that
income is earned as wages by an employee or whether it is earned as a business owner. No other
country in the world provides similar differential treatment.
You have now learned of two TCJA changes that reflect an animus toward those who earn their
income as employees: unreimbursed employee business expenses are no longer deductible to any
extent (under § 67(g)), and the new § 199A 20% deduction for business income earned by
individuals is denied to employees. In Chapter 15, you will learn of another change enacted in the
CARES Act (the 2020 pandemic legislation) that carries forward this theme of the 116th Congress.
No hearings were held on this new Code section (or any other provision in the TCJA). While
the TCJA drafters said that hearings were unnecessary because many of the items in the bills were
the subject of previous tax reforms efforts that weren’t enacted, no prior Federal tax reform effort
had a similar provision for pass-through entities. At the state level, Kansas adopted a provision
that imposed a 0% tax rate on pass-through income in 2012, with promises of turbo-charged
economic growth. When the state’s economy continued to grow more slowly than both
surrounding states and the national average and deficits became unmanageable, requiring massive
reductions in school funding, the Republican state legislature repealed the provision over Governor
Sam Brownback’s veto in 2017.
Additional data and context is provided in Chapter 3, where we shall delve into tax policy
questions more deeply, but we are getting ahead of ourselves. The main reason for the discussion
here was to explore the difference between marginal and effective tax rates. Try your hand at
applying the material that you learned in this section to the following problems.
Problems
1. David and Daphne are married and have no children. David is a police sergeant who earns
$70,000 this year, and Daphne is a registered nurse who earns $80,000. They earn no investment
income this year, but they did receive a $20,000 gift from Daphne’s parents. See § 102(a). David
and Daphne file a joint return and take the Standard Deduction.
a. What is Daphne’s and David’s Adjusted Gross Income (AGI) for this year? Taxable Income?
28
These links are to articles from the New York Times (only) because the New York Times Company graciously
allows such links without payment of copyright reprint permission. See
www.nytimes.com/content/help/rights/linking/linking.html. As I did in the Preface, I want again to publicly thank the
New York Times Company for this policy. I wanted to include links to articles from other publications but could not
do so without paying reprint permission fees, which were (unfortunately) cost prohibitive. I also want to publicly
thank those authors and sources who provided reprint permission without charge with respect to excerpts and charts
that you will read from time to time in the body of the textbook.

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b. What is Daphne’s and David’s marginal tax rate? Their effective tax rate (using AGI)?
c. How would your answers change, if at all, if David were not a police sergeant but rather
owned his own lawn-care business, earning $70,000 of “qualified business income” within the
meaning of § 199A as a sole proprietor? As before, Daphne earns $80,000 as a registered nurse.
2. Sheila and Shane are married, file a joint tax return, and have two children: Erik, age 17, who
is a junior in high school, and Becky, age 10. Sheila does not work outside the home, and Shane
is an executive earning $400,000 as an employee of Tectronics, Inc., this year. Together, they also
receive $10,000 in interest on corporate bonds and $5,000 in interest on Ohio state bonds. In
Chapter 2, you will learn that the interest on the Ohio state bonds is excludable from Gross Income
under the authority of § 103, notwithstanding § 61(a)(4). They contribute $5,000 to the Cleveland
Orchestra, $4,000 to the United Way, and $3,000 to their local Food Bank, all of which are
deductible charitable contributions under § 170. They pay $7,000 in real property taxes on their
personal residence to their local Ohio county and pay $8,000 in Ohio state income taxes, both
payments of which are deductible under § 164(a), though the TCJA now caps the state and local
income and property tax deduction to $10,000 (in the aggregate). They pay $6,000 of interest on
their home mortgage, which is deductible “qualified residence interest” under § 163(h)(3) (as
explored more fully in Chapter 17). Finally, Shane travels to (and pays for) several professional
association meetings in order to keep up to date on the latest information in his field, even though
Tectronics does not reimburse these costs. The total amount that is potentially deductible by Shane
under § 162 is $3,000.
a. What is Sheila and Shane’s AGI for this year? Taxable Income?
b. Tectronics has announced that there will be no employee raises for next year because of
sluggish growth. Nevertheless, do you have any advice to Shane in negotiating next year’s
salary arrangement with Tectronics?
c. Now for your first attempt at meaty statutory reading. Read §§ 24(a), (b)(1), (2), (c)(1), and
(h) very carefully. If the 2021 expansion to the Child Tax Credit has been extended to 2022
by the time you encounter this problem, you will also need to examine § 24(i). How much is
Sheila’s and Shane’s Child Tax Credit under § 24 for this year?

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Chapter 2: Consumption Taxation
and Our Hybrid Income/Consumption Tax
In Chapter 1, you explored the core concepts informing the SHS concept of income, under
which an individual’s annual income generally equals her wealth increases less her wealth
decreases but only if the wealth decreases do not represent personal consumption. Stated another
way, an income tax base reaches both personal consumption spending and amounts added to
savings (capital expenditures) by preventing both from being deducted—though you also learned
that Congress frees subsistence consumption from taxation through various mechanisms. What if
Congress decided to tax only the first part of the SHS equation, i.e., only personal consumption
spending (in excess of subsistence consumption), protecting additions to savings from taxation?
This chapter describes several methods that would accomplish such a goal.
We shall investigate consumption taxes for three reasons.
First, as you will read in more detail in the next chapter, the Federal government collected most
of its revenue in the form of consumption taxes for more than 100 years before the 16th amendment
was ratified and the modern income tax was enacted in 1913. Recent years have seen calls by some
to return to our roots by repealing the income tax (and sometimes the payroll and other taxes, as
well, which you will also read about in the next chapter) and replacing it with some form of pure
consumption tax or adding a Federal consumption tax. 1 One goal of this chapter is to equip you
with a basic understanding of how consumption taxes differ from income taxes and how the
various forms of consumption taxation differ among themselves so that you can better digest these
modern-day debates.
A second—and far more important—reason to study the various forms of consumption taxation,
however, is that the current Internal Revenue Code is best understood as a hybrid
income/consumption tax. Some Code provisions that are inconsistent with an SHS income tax are
perfectly consistent with a consumption tax of one sort or another. A few of these provisions will
be introduced in this chapter, and we shall identify additional examples as we progress.
Finally, a third reason to study this material is so that you can begin to appreciate the serious
problem of tax arbitrage opportunities that arise when the income tax rules pertaining to
borrowed money (briefly described in this chapter and explored in more detail in Unit IV) are
applied to a debt-financed investment otherwise accorded more favorable consumption tax
treatment. If this attempt is successful, the investor can achieve a tax result that is better than
would occur under either a pure income or a pure consumption tax, which raises both fairness and
economic efficiency concerns (both of which are explored in the next chapter, as well).

A. Consumption taxation forms and comparison to income taxation
How could a tax be structured to reach only consumption spending and not additions to savings?
1

For example, several of the Republican candidates for President in 2016 advocated adopting a VAT and reducing
the tax collected under the income tax. See John Harwood, Momentum Builds to Tax Consumption More, Income Less,
at www.nytimes.com/2015/11/24/upshot/momentum-builds-to-tax-consumption-more-income-less.html?_r=0.

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There are several approaches. At first, we shall ignore debt by assuming that the taxpayer uses no
borrowed money. Then we shall add the additional wrinkle of debt in Part C.
A retail sales tax
The easiest consumption tax to understand is a retail sales tax (RST), which is commonly
imposed by state and local governments. Under this method of taxation, amounts spent to purchase
consumer goods (and sometimes consumer services) are typically subject to a flat-rate tax with no
exemption amount on the first dollars spent. For example, suppose that Mary goes to Specialty
Toy Store and sees a child’s carved wooden toy on the shelf priced at $100. Mary takes that toy to
the store counter and purchases it to give to her child for his birthday. The state in which Mary
resides imposes a 5% RST on retail sales of consumer goods. The clerk informs Mary that she
must pay a total of $105. The receipt that she obtains shows that she paid $100 for the toy and $5
in tax. The store transfers $5 of Mary’s total $105 payment to the state as RST.
A value added tax
A variation of an RST used by many other countries (in addition to their annual income taxes)
is a value added tax (VAT). You can think of it, essentially, as an RST collected on the “value
added” in each stage throughout the manufacturing and selling process, rather than all at once at
the point of the final retail sale to the customer. One of the weaknesses of an RST is that the tax is
collected only on the final retail sale to the consumer, so a seller must determine whether the buyer
is a consumer that is going to use the item for personal consumption (taxable) or another business
that is going to use the item in the course of its own business (not taxable). Businesses can typically
obtain a tax-exemption certificate or number to present at a retail establishment to show to the
clerk to establish that a particular purchase is not to be taxed because it is not going to be used for
personal consumption but, rather, is going to be used in business. States with high RSTs often have
to deal with fraud in the form of phony tax-exemption certificates and numbers. A VAT avoids
the necessity of making this determination and so tends to be less prone to fraud. Moreover, in
order for a business to get a benefit from any VAT paid by it to another, it must collect and remit
the VAT on its own sales. In this way, it tends to be self-reinforcing in a way that RSTs are not.
Because of enforcement difficulties with RSTs, public finance economists Joel Slemrod and Jon
Bakija once noted that “only six countries have operated retail sales taxes at rates over 10 percent.
Four of them, Iceland, Norway, South Africa, and Sweden, have since switched to a VAT, and a
fifth, Slovenia, is about to.” 2 The total collected in tax under a VAT should nevertheless be the
same as under an RST. Here is an example.
Example: Assume that the VAT rate is 5%. Toymaker purchases wood for $10 from
Lumberman, who cut the wood from his own land. Lumberman must charge a $.50
VAT ($10 x .05) on the sale of wood to Toymaker, collecting $10.50 and remitting
$.50 to the state. Toymaker carves a wooden toy from that wood, which he sells to
Specialty Toy Shop for $50. Toymaker must charge a $2.50 VAT ($50 x .05) on the
sale of the toy to Specialty Toy Shop, collecting $52.50. Before Toymaker remits the
VAT that he collected from Specialty Toy Shop to the state, however, Toymaker
properly deducts the $.50 VAT that he, in turn, had paid to Lumberman. Toymaker
remits only $2.00 to the state. Specialty Toy Shop sells the toy to Mary for $100 and
must charge a $5.00 VAT ($100 x .05) on the sale to Mary, collecting $105. Before
2

JOEL SLEMROD & JON BAKIJA, TAXING OURSELVES: A CITIZEN’S GUIDE TO THE GREAT DEBATE OVER TAX REFORM
214 (2nd ed. 2003).

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Specialty Toy Shop remits the VAT that it collected from Mary to the state, Specialty
Toy Shop properly deducts the $2.50 VAT that it, in turn, had paid to Toymaker.
Specialty Toy Shop remits only $2.50 to the state. In total, the state collects $5.00
($.50 from Lumberman, $2.00 from Toymaker, and $2.50 from Specialty Toy Shop).
As with RSTs, economists conclude that the “economic incidence” (described in
Chapter 3) of VATS falls entirely on the end consumer, Mary.
One of the disadvantages of an RST or VAT is that they are transactional taxes (taxes imposed
on a transaction-by-transaction basis) rather than annual personal taxes (annual taxes calculated
by reference to some personal characteristic, such as income, wealth, or consumption).
Transactional taxes necessarily must use a single tax rate, which makes it difficult to build into the
system any sort of 0% tax bracket on subsistence consumption. Indeed, the first dollar of
consumption purchased by Poor is taxed at the same rate as the last dollar of luxury consumption
purchased by Rich. Some states attempt to ameliorate this effect by exempting certain goods from
taxation, such as food, but the effect is imperfect. Moreover, consumer services (as opposed to
consumer goods) are often not taxed by many states, and consumer services are more often
purchased by wealthier households than low-income households.
Some have proposed an RST on all consumer goods and services with an annual rebate (or
“prebate” if it is sent monthly) to everyone in an amount equal to the RST that would be owed on
poverty-level expenditures to ameliorate this effect. For example, some of you might have heard
about the FairTax (one word), first championed by former Representative John Linder from
Georgia (and others). 3 As introduced in Congress in 1999 and every congressional session since
then, it would repeal the income tax, the payroll taxes (which fund Social Security and Medicare),
and the estate and gift taxes and replace them with an RST on every consumer purchase of goods
and services, with no exemptions.4 All U.S. residents would receive monthly checks (the
“prebate”) equal to the FairTax that would be owed on poverty-level expenditures. All consumer
purchases of new goods (used goods would be exempted), including the purchase of a newly
constructed home, would be subject to the FairTax, as would all personal services, including the
payment of tuition, the purchase of healthcare, legal, and financial services (such as interest on
credit cards, home mortgages, and car loans), utilities, gasoline, auto repair services, the renting of
an apartment and other real property, etc. Whether the payment of state income and property taxes
would be subject to the FairTax (as representing the purchase of police and fire protection, public
school education, and the like) is unclear.
The tax rate used in the FairTax bill is described as 23%, but that 23% rate is the “tax-inclusive
rate,” not the “tax-exclusive rate” that U.S. residents are most familiar with from their experience
with state-level RSTs. The tax-exclusive rate is 30%. The difference between a tax-inclusive rate
and tax-exclusive rate is easiest to illustrate with our earlier example. Recall Mary’s purchase of
the $100 toy, above. We stipulated that the RST was 5% and that the she paid a total of $105 to
the store clerk, who remitted $5 of that $105 to the state. That 5% rate is the tax-exclusive rate.
The tax-inclusive rate is 4.8%, equal to the $5 that she owed in tax divided by the total $105 that
she paid to the clerk, including the tax itself (hence, the “tax inclusive” terminology). I described
the $5 RST that Mary paid in our example above at the 5% tax-exclusive rate rather than the 4.8%
tax-inclusive rate because that is the way that most U.S. residents experience RSTs at the state and
3

See NEAL BOORTZ & JOHN LINDER, THE FAIRTAX BOOK: SAYING GOODBYE TO THE INCOME TAX AND THE IRS
(2005). See also www.FairTax.org.
4
As with most RSTs, purchases of business and investment property and services would generally be exempt.

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local levels. 5 In short, Mary would pay a $30 FairTax on the $100 toy that she purchased,
notwithstanding the advertised 23% FairTax rate.
The FairTax drafters assert that they describe the tax rate by using the tax-inclusive approach
because the U.S. income tax is, itself, described in tax-inclusive terms. Under § 275(a)(1), the
Federal income tax paid is not deductible from the tax base for practical reasons, as Senator Henry
Hollis noted when a deduction for Federal taxes was repealed in 1917. “It is a pure matter of
expediency. If you so arrange the income tax this year that you allow those who pay it to take back
a third of it next year [through a deduction next year], you have simply got to put on a bigger tax.”
Because Federal income tax is not deductible from the Federal income tax base, one’s aggregate
income for a year is spent in three ways: personal consumption, additions to savings, and tax.
Most economists believe that the 23% (tax-inclusive) or 30% (tax-exclusive) rate would not be
sufficient to be revenue neutral for several reasons, including that it assumes perfect compliance
and the enactment of no exemptions. In addition, the revenue calculations assume that the Federal
government would pay FairTax to itself on its own purchases, such as defense purchases, but did
not increase Federal outlays by the equivalent amount in determining revenue neutrality. The
consensus view is that those who earn $200,000 or more would pay a lower percentage of
aggregate Federal tax revenue under the FairTax than they do now, while those earning between
$15,000 or $24,000 per year (depending on the source) and $200,000 would see their aggregate
share of the Federal tax burden increase. 6
For these and other reasons, some have devised annual personal consumption taxes that, like
annual income taxes, could incorporate a basic tax-free amount and graduated tax rates.
A cash-flow consumption tax
The purchase of investment property (such as shares of corporate stock) by an investor or the
purchase of business assets (such as a dental chair purchased by a dentist for use in his business)
would not trigger an RST because those purchases do not represent personal consumption
spending. How can we create the same end result as an RST using an annual tax return instead of
imposing tax at the time of each consumer purchase?
We have seen that an SHS income tax reaches not only consumption spending (as do an RST
or VAT) but also the amounts that are saved. The mechanism by which we ensure that amounts
saved are effectively taxed under an SHS income tax is through the denial of a deduction for
capital expenditures. If Hallie purchases XYZ stock for $5,000, she is denied a deduction for this
addition to her savings under an income tax because the outlay is a nondeductible capital
expenditure. She has merely changed the way in which she is holding her wealth, which is an act
of savings. Similarly, John’s purchase of a dental chair for $10,000 to use in his dental practice is
a nondeductible capital expenditure under an SHS income tax. Like Hallie, John has merely
changed the way in which he is holding his wealth. How can we avoid taxing these additions to
savings on an annual tax form so that only personal consumption spending is taxed? By allowing
deductions for these outlays—even though they would be nondeductible under an income tax!
The annual tax base under a cash-flow consumption tax, which will reach the same end result
as would an RST or VAT, starts with all cash receipts for the year, even receipts that would not
5

Those of you who visit Europe, in contrast, know that most VATs are not added at the counter as an extra amount
owed at the time of purchase. Rather, the VAT is already included in the posted shelf price, which makes the tax less
transparent.
6
See www.factcheck.org/taxes/unspinning_the_fairtax.html.

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constitute “income” under an income tax, such as basis recovery. If Paul sells stock for $10,000,
the entire $10,000 initially enters his cash-flow consumption tax base, regardless of whether he
originally purchased that stock for $5,000 or $12,000. The reason why that $10,000 initially enters
his tax base is that he could potentially spend that $10,000 on personal consumption, and a cashflow consumption tax seeks to reach consumption spending.
Next, all outlays not in pursuit of personal consumption would be deducted. Hallie’s purchase
of stock for $5,000 and John’s purchase of his dental chair for $10,000 both would be immediately
deducted in the purchase year under a cash-flow consumption tax because those outlays do not
purchase personal consumption but rather represent an addition to savings. There is no concept of
“basis” (generally representing undeducted, previously taxed dollars) in a cash-flow consumption
tax on the purchase of business or investment assets because those outlays would be immediately
deducted in the purchase year. We would generally need no mechanism to keep track of previously
taxed dollars, as we do under an SHS income tax, for business and investment assets. 7
Even the aggregate net deposits made to your checking account for the year (balance at the end
of the year less balance at the beginning of the year) would create a deduction under a cash-flow
consumption tax because the increased balance represents an addition to savings. Remember, we
are replicating the end result of an RST, and depositing savings in a bank account would not
generate an RST. The net increase in your bank accounts would presumably be reported at the end
of each year to the government to ensure that your deduction of these amounts was proper.
When the smoke clears, all that should be left in the tax base is the amount that is spent on
personal consumption for the year, which is what would be taxed under an RST. Here is an
example.
Example: This year, John, a dentist, collects $500,000 from his patients, pays his
dental assistant $30,000, pays his receptionist $20,000, purchases a new X-ray
machine for $10,000, purchases a new dental chair for $5,000, purchases stock in XYZ
Corp for $10,000, and sells stock in ABC Corp for $15,000, which John had purchased
five years ago for $7,000.
John must include on his cash-flow consumption tax return the $500,000 received
from patients, as well as the entire $15,000 received on the sale of his ABC stock (not
merely what would be the $8,000 gain that he would include under an income tax).
John would deduct the following non-consumption outlays: $50,000 paid to his dental
assistant and receptionist (which would also be deductible in an income tax world as
business expenses), the $15,000 that he spent in purchasing the new X-ray machine
and dental chair (even though these would be nondeductible capital expenditures in an
income tax world, subject only to depreciation deductions over time), and the $10,000
used to purchase the XYZ stock (even though this would be a nondeductible capital
expenditure in an income tax world and would not generate depreciation deductions).
In sum, a cash-flow consumption tax is not concerned with keeping savings—capital
expenditures—within the tax base. Rather, like an RST or VAT, it reaches only personal
7

Some complications and gray areas would arise, particularly with respect to personal-use assets that have the
potential to appreciate in value, unlike most personal-use assets. For example, the cost of a diamond engagement ring
should not be deductible, as that outlay represents personal consumption. If it is sold for more than its original cost,
however, only the amount exceeding the undeducted original purchase price should be included in the cash-flow
consumption tax base because the purchase price was already taxed in the purchase year (via deduction denial).

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consumption spending. I hope that you can now better appreciate why the capitalization principle
is the defining difference between an income tax and this form of consumption taxation.
Exempting capital returns from tax: the wage tax and the E. Cary Brown yield-exemption
phenomenon
In Chapter 1, you learned that, under an SHS income tax, investment deductions are necessary
only because capital returns are included in the tax base. If we were to require inclusion of capital
returns but—at the same time—deny deduction of the costs incurred to produce that includable
capital return, we would violate fundamental precept (1) that the same dollars should not be taxed
to the same taxpayer more than once. On the flip side of the coin, if capital returns are exempt
from tax, no deductions should be allowed in order to honor fundamental precept (2) that a
taxpayer not enjoy a double tax benefit for the same dollars. No deductions are necessary to
reduce the gross return to a net profit if the gross return is not included in the first place.
With respect to employees, who have few (if any) business deductions, what if Congress taxed
only wages, exempting all capital returns from their investments from tax, such as capital gains,
interest, dividends, rents, and royalties? No deductions would be allowed except for a Standard
Deduction that would vary by family size because no deductions would be needed if investment
income is tax-free. All wages exceeding the threshold would be taxed at a single rate. Business
entities (and sole proprietors) could be subject to a cash-flow tax, similar to a cash-flow
consumption tax, by requiring them to include all cash receipts but allowing immediate deduction
of all business and investment outlays, including what would otherwise be nondeductible capital
expenditures under an income tax.
With some variation, this is essentially the tax base under the so-called flat tax advocated
initially by Robert E. Hall and Alvin Rabushka and by others since then. 8 It was also part of
Congressman Paul Ryan’s tax-reform plan that he introduced as part of the 2012 Budget, which
was approved by the House of Representatives but not by the Senate. 9 Such a wage tax can be
viewed as one form of consumption taxation because, as shown by E. Cary Brown, 10 an influential
economist in the 1950s, the end result of taxing only labor income and exempting the yield or
investment return on capital (e.g., capital gains, interest, rent, and royalties) from tax can
produce the same end result as under a cash-flow consumption tax, i.e., the same end result
as deducting the original investment but including 100% of the returns, both the original
investment and the capital return. This equivalence will hold, however, only if (1) tax rates do
not change over time and (2) the investments that are taxed under a cash-flow consumption tax,
on the one hand, or a wage tax, on the other, produce only the expected market return (the normal
8

See ROBERT E. HALL & ALVIN RABUSHKA, THE FLAT TAX (2d ed. 1995). Steve Forbes, a 1996 candidate for
President, championed the flat tax as the centerpiece of his campaign, which first brought the tax to popular attention.
Hall and Rabushka actually recommended a VAT at the business level, rather than a business cash-flow tax. Under a
traditional VAT, wages paid by businesses are not deducted from the tax base. Hall and Rabushka argued that some
progressivity could be introduced into a VAT by nevertheless allowing businesses to deduct wages paid from their
VAT base and requiring individuals to include such wages on an individual return, normally not required in a VAT
system. The wages would then be taxed at the same single VAT rate to the extent that they exceeded a Standard
Deduction that would vary by family size. In this way, some progressivity could be introduced into the VAT (to the
extent of the wages not taxed because of the Standard Deduction). The “flat” in “flat tax” comes from the single tax
rate that would apply to labor income (only) in excess of the Standard Deduction, but by far the more extraordinary
feature of the so-called flat tax is not the single tax rate but the radical change in tax base, exempting capital returns.
9
THE ROADMAP PLAN, http://roadmap.republicans.budget.house.gov/plan/#Federaltaxreform.
10
See E. Cary Brown, Business Income Taxation and Investment Incentives, in INCOME EMPLOYMENT & PUBLIC
POLICY: ESSAYS IN HONOR OF ALVIN H. HANSEN 300 (1948).

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return) and not an extraordinary (or supranormal) return, unforeseen by the market (and thus not
affecting the original purchase price of the investment).
Not only can the result be identical under a cash-flow consumption tax and a wage tax; the tax
owed under an income tax on the same facts will be higher, and the additional amount of tax owed
will precisely equal the tax expressly not owed on the capital return under the wage tax and
implicitly not owed on the same return under the cash-flow consumption tax. Let’s compare the
results of all three kinds of taxes under a common fact pattern to see why these statements are true.
Assume that the tax rate under the cash-flow consumption tax, the wage tax, or
the income tax is a flat 20%. George earns $100,000 in wages. He invests in shares
of corporate stock using whatever is left after paying any tax on his wages that he
cannot avoid under the tax system, but notice that whether the wages will be
taxed will depend (under the cash-flow consumption tax) on what George does
with the $100,000, and our facts state that George will invest whatever he can in
the shares. After one year, the stock has appreciated by 5%, and George sells the
shares and spends the entire amount (both the original purchase price of the stock
and the gain on sale) on personal consumption.
Income Tax
Here is a nice review of the rules that you learned in Chapter 1, Part A. The $100,000 in wages
is includable in Gross Income under § 61(a)(1), and George has no deductions, so his Taxable
Income is also $100,000, generating a $20,000 tax. The remaining $80,000 used to purchase the
stock is a nondeductible capital expenditure, creating a basis of $80,000. The sale of the stock after
it appreciates by 5% results in a sale price of $84,000 ($80,000 x .05= $4,000), and George has,
for the moment, $84,000 of cash in hand. However, George’s § 1001 gain is $4,000 ($84,000 A/R
less $80,000 A/B), which is also subject to the 20% tax, generating an additional $800 tax ($4,000
x .20). After paying this additional tax, George has $83,200 after-tax cash left ($84,000 sales
proceeds less $800 tax owed on the gain), which he spends on personal consumption.
For an investment to be taxed under income tax principles, both (1) the investment must be
made with undeducted (after-tax) dollars (George was prohibited from deducting the $80,000
capital expenditure in purchasing the stock) and (2) the capital return (whether gain, interest,
rents, royalties, etc.) must be included in the tax base (the $4,000 investment return in the form
of § 1001 gain was included).
Cash-Flow Consumption Tax
The $100,000 in wages is initially included in his cash-flow consumption tax base as potential
consumption. Because George wishes to invest as much as he can in the stock, he can ensure that
his wages effectively will not be taxed at this time by investing the entire $100,000 and thereby
generating a $100,000 offsetting deduction against his wages equal to the $100,000 nonconsumption outlay. George owes no tax yet ($100,000 wages less $100,000 stock purchase = zero
cash-flow consumption tax base). After the stock has appreciated by 5%, George sells it for
$105,000 ($100,000 x .05 = $5,000), and George has, for the moment, $105,000 of cash in hand.
George must include the entire $105,000 in his cash-flow consumption tax base as potential
consumption. Because he purchases no other investments (but rather will spend whatever is left
on personal consumption), George has no offsetting deductions, generating a $21,000 tax
($105,000 x .20). George has $84,000 after-tax cash left ($800 more than he had under an income
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tax), which he spends on personal consumption
George’s investment return was nominally included in the tax base under a cash-flow
consumption tax (i.e., George had to include the entire $105,000, including the 5% return of
$5,000, in his tax base). Note, however, that this return was earned on deducted (pre-tax) dollars
(George was permitted to deduct his $100,000 stock purchase when he made the initial
investment), and the outcome was more favorable than under an income tax.
Wage Tax
The $100,000 in wages is taxed, generating a $20,000 tax. The remaining $80,000 is invested
in the stock, and George cannot take any deductions. After the stock appreciates in value by 5%,
George sells it for $84,000 and owes no tax on the $4,000 profit, as it is a capital return, not wages.
George has $84,000 after-tax cash left (the same amount as under the cash-flow consumption
tax), which he spends on personal consumption.
Although George’s investment return is earned on after-tax dollars (as under an income tax),
the investment return is expressly excludable from the tax base, and the outcome is more favorable
than under an income tax.
When the smoke clears, George has $84,000 in after-tax cash left to spend on personal
consumption under either a cash-flow consumption tax or a wage tax, whereas he had only
$83,200 of after-tax cash under an income tax. Notice also that the $800 difference is precisely
equal to the tax owed under the income tax on the capital return that was expressly exempted under
the wage tax and implicitly free of tax under the cash-flow consumption tax. “Wait,” you say. “The
5% capital return was not exempt from tax under the cash-flow consumption tax because George
had to include the entire $105,000 sales proceeds of the stock sale on his cash-flow consumption
tax return and pay a 20% tax on it, and that $105,000 includes the 5% appreciation in value of the
stock.” Ahhhhhh, I reply, although that capital return was nominally included on George’s cashflow consumption tax return, was it effectively taxed when you look more deeply? Although you
are correct that George had to include that capital return, that return was earned on untaxed (or
pre-tax) dollars. He enjoys the same end result as under a wage tax that denies deduction of the
initial investment (as under an income tax) but explicitly excludes the capital return from tax.
Under the E. Cary Brown yield-exemption phenomenon, deducting the cost of an investment
and including 100% of the sale proceed or other return in the tax base (as under a cash-flow
consumption tax) results in the same outcome as not deducting the cost of the investment but
expressly exempting the capital return from the tax base (as under a wage tax) under certain
conditions. Both results are better than under an income tax. To be taxed under income tax
principles (1) the investment must be made with undeducted (after-tax) dollars and (2) the
capital return must be included in the tax base. If either (1) or (2) is lacking, the investment is
being treated to more favorable consumption tax treatment—not income tax treatment.
The equivalence between a cash-flow consumption tax and a wage tax does not hold if the
investment unexpectedly produces an outsize return that was unanticipated by the market. The
reason for this is that the tax comes at the back end under a cash-flow consumption tax (when
the investment is sold and spent on consumption) but at the front end under a wage tax (when
the investment is made with undeducted, after-tax dollars). If an investment earns
unanticipated market returns (which were not reflected in a higher purchase price when the
investment was acquired because they were not anticipated), the unanticipated return (often called

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supranormal returns) would effectively be captured and taxed when spent on consumption under
a cash-flow consumption tax but would escape taxation entirely under a wage tax.
To understand this point, we need to take a detour and discuss one way in which the market
comes up with the fair market value (FMV) of an asset. One common way to describe how the
market arrives at the FMV is to say that it is the market’s best guess at the present, discounted
value of the future stream of payments expected to be generated by that asset. For example, the
FMV of a plot of land that is rented to tenant farmers may be calculated by discounting to present
value the future stream of rental payments expected to be paid by the tenant farmers to the land’s
owner, added to the present value of the sale price eventually expected to be obtained on the land’s
sale. Let’s say that this discounted present value is $10,000, so Brenda is able to purchase the land
for $10,000 from its current owner. What happens if oil is discovered and the land suddenly (and
unexpectedly) is worth $100,000—much more than the market originally anticipated that it would
be worth when Brenda purchased it? If the market had known about that oil when Brenda
purchased it, she would have had to pay much more than $10,000 for the land, but that was not the
case. When Brenda sells it for $100,000 and spends the entire amount on personal consumption,
the increased consumption that she can purchase with her unanticipated return would effectively
be taxed under a cash-flow consumption tax but would escape taxation under a wage tax.
Example: Assume that George is subject to a cash-flow consumption tax but that
Brenda is subject to a wage tax, both using a 20% flat tax rate. They each earn
$100,000 in wages and invest whatever is left after paying any tax on the wages
that cannot be avoided under the tax system. Both George and Brenda expect to
earn a 5% return on their investments, as that rate reflects the average market
return. George does, in fact, earn a 5% return, but Brenda’s investment
unexpectedly hits it big and her return is 20%. George and Brenda sell their
investments and spend the entire amount (both the original purchase price of the
investment and the gain on sale) on personal consumption.
George’s outcome is precisely the same as described above under the cash-flow consumption
tax, as the facts are the same. George pays $21,000 in tax and enjoys $84,000 of personal
consumption from his original $100,000 in wages. Because Brenda is taxed under a wage tax
instead of a tax-flow consumption tax, the $100,000 in wages is taxed at the front end, generating
a $20,000 tax, and the remaining $80,000 of after-tax dollars are invested. She anticipates only a
5% return (for an anticipated sale price of $84,000), but the she enjoys an unexpectedly large 20%
return, and she is able to sell it for $96,000, instead ($80,000 x .20 = $16,000). If that 20% return
had been anticipated by the market, she would undoubtedly have had to pay much more than
$80,000 to purchase the investment, but the market failed to anticipate such a large return. When
Brenda sells the investment for $96,000, she owes no tax on the unexpectedly large $16,000 profit,
as the profit is a capital return, not wages. Brenda pays $20,000 in tax (less than George) and
enjoys $96,000 of personal consumption (more than George) from her original $100,000 in
wages. In short, she owes no additional tax on her extra consumption.
For this reason (and as more fully explored in the next chapter), between the two, a cash-flow
consumption tax is considered to allocate the tax burden (on consumption) more fairly than does
a wage tax that exempts capital returns because only the former ensures that two taxpayers
enjoying the same amount of consumption will pay the same tax.

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B. Consumption tax provisions in the Internal Revenue Code
We generally refer to the Internal Revenue Code as imposing an “income tax,” but numerous
consumption tax provisions are embedded within it. Any Code section that allows the exclusion
of a capital return from the tax base is a consumption tax provision consistent with the wage
tax model, and any Code section that allows the premature deduction of a capital expenditure
(or otherwise allows an investment to be made with pre-tax dollars) is a consumption tax
provision consistent with the cash-flow consumption tax model. In either case, the returns from
capital are either explicitly (wage tax model) or implicitly (cash-flow consumption tax model to
the extent of the normal return) free from tax. Here are just a few examples.
Certain retirement savings. Traditional Individual Retirement Accounts (IRAs) under § 219
of the Code, qualified pension plans (under §§ 401-417), and § 401(k) plans (named after § 401(k)
of the Code) provide cash-flow consumption tax treatment for retirement savings. Contrary to an
SHS income tax but consistent with a cash-flow consumption tax, contributions to these accounts
are immediately deductible (even though they are capital expenditures) if made directly by a
taxpayer. If a portion of compensation earned is contributed to these accounts by an employer, the
contributed compensation is not included in the employee’s Gross Income under § 61(a)(1) but
rather is excluded. In short, these IRA, qualified pension plan, and § 401(k) accounts are funded
with pre-tax dollars (instead of after-tax dollars). Moreover, the investment return earned in these
accounts is not currently taxed as it accrues, so the taxpayer has no basis in the account because
no dollars in the account have yet been taxed. Withdrawals from these accounts are therefore fully
includable at the back end, as under a cash-flow consumption tax.
Instead of cash-flow consumption tax treatment, so-called Roth IRAs under § 408A provide
wage tax treatment. Contributions to the account are not deductible (or excludable, if paid by an
employer on an employee’s behalf), unlike with the retirement plans described above, so these
investments are made with after-tax dollars, as under an SHS income tax. The investment return,
however, is excludable from Gross Income when withdrawn, as under the wage tax variety of
consumption taxation (and unlike under an SHS income tax).
Accelerated depreciation. Depreciation deductions under §§ 167 and 168 are allowed at a rate
that is faster than would occur under so-called economic depreciation. The early deduction of basis
provides subtle but important cash-flow consumption tax treatment. Even though the profit earned
by the business is nominally includable in the tax base, it is effectively free from tax between the
time that the investment is prematurely deducted and the time that it would have been deducted
under economic depreciation principles because the profit is earned on pre-tax dollars to the extent
of the premature deductions. We shall study §§ 167 and 168 in Chapter 13.
Section 179 expensing. Certain purchases of business equipment are immediately deductible
by small businesses under § 179, also explored in Chapter 13, as though they were expenses rather
than capital expenditures. The early deduction of basis provides subtle but important cash-flow
consumption tax treatment. Even though the profit earned by the business is nominally includable
in the tax base, it is effectively free from tax between the time that the investment is deducted and
the time that it would have been deducted under economic depreciation principles because the
profit is earned on pre-tax dollars.
Exclusion of personal residence gain. Section 121 of the Code is a consumption tax provision
of the wage tax variety. Taxpayers can generally exclude up to $250,000 of realized § 1001 gain

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($500,000 in the case of a married couple filing jointly) on the sale of a principal residence. We
shall study § 121 in Chapter 17.
Exclusion of state and local government bond interest. Section 103 is a consumption tax
provision of the wage tax variety, as it expressly authorizes exclusion of one kind of capital return:
the interest received on bonds issued by state and local governments. More on § 103 in Part D.
The realization requirement. The realization requirement, permitting deferral of tax on
economic wealth increases until the property is disposed of, is a subtle cash-flow consumption tax
feature, as it allows further investment gains (and dividends in the case of stock, rent in the case
of tangible property, royalties in the case of intellectual property) to be earned on pre-tax dollars
instead of after-tax dollars, as would occur under a mark-to-market system (explored in Chapter
1). Only a market-to-market system avoids this consumption tax component of current law.
Deferred gain under nonrecognition rules. Several provisions allow § 1001 realized gain on
the sale or exchange of property to be deferred to the future (to go “unrecognized” in tax jargon)
so long as the proceeds are reinvested in certain kinds of replacement property. These provisions
are consistent with a cash-flow consumption tax, which effectively defers taxation even when
investments are sold or exchanged so long as the proceeds are reinvested (rather than consumed).
Two such provisions that we shall study in Chapter 12 are §§ 1033 and 1031. Those who go on to
study corporate and partnership taxation will study many more.
Forgiveness of unrealized gain at death. The complete forgiveness of built-in gain at the time
of the taxpayer’s death under § 1014, considered in Chapter 7, is a consumption tax provision of
the wage tax variety, excluding what would otherwise be an includable capital return.
Reduced tax rate on net capital gain. The reduced tax rate applied to § 1222(11) “net capital
gain” is a subtle wage-tax-like feature of current law. Though the rate is usually not 0%, as it would
be under a pure wage tax, the § 1(h) rate (usually 15% or 20%) is lower on this particular form of
capital return than it is on an equivalent amount of wages (or other forms of capital return, such as
interest or royalties). Coupled with the cash-flow consumption tax advantage of the realization
requirement itself, net capital gain is really super special under current law!

C. The additional wrinkle of debt
The income tax treatment of the borrowing and lending of money is very different from the
treatment of debt under the various forms of consumption taxation. While Chapters 10 through 12
are devoted to examining the income tax treatment of debt more closely, we need to take a sneak
preview of the broad outline of how borrowed money is treated under an income tax here. For this
purpose, we need focus only on the borrower’s tax consequences.
Suppose that Lori borrows $10,000 from National Bank in Year 1 for use in her business at 5%
annual interest, with the principal to be repaid in Year 10. National Bank transfers $10,000 to Lori
in Year 1. Each year of the 10-year loan period, Lori pays $500 to National Bank as interest, which
you can think of as rent paid to use the money owned by National Bank (just as tenants pay rent
to use an apartment owned by a landlord). In Year 10, Lori transfers $10,000 to National Bank.
What are Lori’s tax consequences (the borrower) under an SHS income tax?
Lori’s $10,000 cash receipt in Year 1 raises a Gross Income issue. Must she include the $10,000
in cash as a wealth accession? Under current law, her future obligation to repay the $10,000 results
in the conclusion that Lori has not, in fact, enjoyed a current wealth accession in Year 1, which
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means that she does not include the $10,000 in Gross Income under § 61. One way to think about
this issue (though not the only way) is to construct a balance sheet for Lori and list her assets on
the left side and her liabilities on the right. When she receives the $10,000 loan, she would increase
her assets by the $10,000 in cash that she receives (which superficially looks like a wealth
accession), but she would simultaneously increase her liability side by that same $10,000. Her “net
worth” or “wealth” (the value of her assets less her outstanding indebtedness) does not increase by
reason of the cash receipt.
When she repays the $10,000 of borrowed principal in Year 10, can she deduct that cash
payment? While Lori transfers cash (which can superficially look like a wealth reduction), she also
eliminates this same $10,000 liability from her balance sheet. Her net worth or wealth (assets less
liabilities) again remains unchanged. In this sense, Lori is not less wealthy for having repaid this
$10,000 obligation, so she is entitled to no deduction.
Lori’s interest payments, however, stand on an entirely different footing. The $500 interest that
she pays each year is properly categorized as an “expense,” as the payment represents an
immediate wealth decrease (the opposite of a capital expenditure). Moreover, because we have
stipulated that she uses this borrowed principal in her business, it is a business expense. While §
162 generally authorizes the deduction of business expenses, this particular expense (interest) has
its own special Code section—§ 163—but § 163(a) would generally authorize Lori’s business
interest deduction. Similarly, § 163(d) (studied in Chapter 15) can permit deduction of interest
paid in connection with investment assets.
The receipt and repayment of borrowed principal has no tax consequences under an SHS
income tax for the borrower, but the borrower’s payment of interest is generally deductible if
incurred in business or investment activities but nondeductible (with exceptions) if incurred in
personal consumption activities.
How is borrowed money treated under an RST? Assume that you reside in a state that imposes
a 5% RST on consumer purchases, that you go to a car dealer and purchase an automobile for
$10,000 (which you will use for personal purposes), and that you finance this $10,000 purchase
entirely with borrowed money (whether from the dealer or a bank). Whether you purchase the car
entirely from past savings or borrowed money makes no difference to your RST liability; you will
owe $500 in RST upon the purchase of the personal-use car. In short, borrowed money that is used
to purchase personal consumption is implicitly taxed under an RST.
Let’s next consider the tax treatment of borrowing under a wage tax. Recall that a wage tax
base consists only of wages (capital returns are expressly excluded) and that no deductions are
permitted. Borrowed principal is not included in the wage tax base (because not wages), but
interest is not deductible—even if the borrowed money is used in an investment activity. In
short, we need to allow investment deductions (such as interest on a loan used to purchase
investment property) only if investment returns are includable in the tax base, and investment
returns are not included in the tax base under a wage tax.
Finally, what about borrowed money under a cash-flow consumption tax? Recall that all cash
receipts are includable in the tax base of a cash-flow consumption tax because those cash receipts
represent potential consumption, and this rule applies to the borrowed principal of a loan, as well.
Also recall that all non-consumption outlays can be deducted under a cash-flow consumption tax.
Principal and interest repayments do not purchase personal consumption and so are deductible
under a cash-flow consumption tax, regardless of how the borrowed money is used. On your

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$10,000 car purchase using borrowed money, you would have to include the $10,000 of borrowed
money in your cash-flow consumption tax base in the purchase year. Moreover, because you use
the car for personal purposes (rather than business or investment purposes), you do not obtain an
offsetting deduction for the car purchase. In addition, however, you would be able to deduct the
principal and interest payments as you made them under a cash-flow consumption tax, as those
outlays do not purchase additional personal consumption.
Recall that, under certain circumstances, the tax outcomes (unrelated to debt) under a cash-flow
consumption tax and wage tax are equivalent. The same is true with respect to the treatment of
debt: including borrowed principal and deducting both principal repayments and interest (under a
cash-flow consumption tax) will reach the same end result as not including the borrowed principal
and not deducting either the principal repayments or interest (as under a wage tax). Because the
inclusion of all borrowed principal in the cash-flow consumption tax base and the subsequent
deduction of both principal and interest from that tax base is cumbersome, the wage tax approach
to debt could be used, instead: no inclusion of borrowed principal and no deduction of either
principal repayments (as under an income tax) and no interest deduction—even if the interest is
incurred in investment activity (unlike under an income tax).
Adopting that last simplification, we can summarize these rules in the following way:
• Borrowed principal is excluded by the borrower, whether under an SHS income tax, a wage
tax, or a cash-flow consumption tax;
• Principal repayments are nondeductible by the borrower, whether under an income tax, a
wage tax, or a cash-flow consumption tax; and
• Interest is never deductible under a wage tax or cash-flow consumption tax but is deductible
under an income tax if incurred in income-producing activities (business or investment).

D. Tax arbitrage: the income tax treatment of debt coupled
with consumption tax treatment of the debt-financed investment
With respect to George’s investment described in Part A., above, we saw that his tax outcome
was more favorable under either a cash-flow consumption tax or wage tax than under an SHS
income tax. In other words, consumption tax treatment of an investment is more lucrative for
George than the income tax treatment of that same investment. George can obtain even better
than consumption tax treatment, however, if he can succeed in applying the income tax rules
pertaining to debt (deductible interest) to an investment otherwise accorded more favorable
consumption tax treatment (either the investment is made with pre-tax dollars or the
investment return is excludable). The common jargon used to describe this phenomenon is “tax
arbitrage” because he is arbitraging the rules of one tax system (the income tax rules for debt)
against the rules of another tax system (the consumption tax treatment of the investment, itself).
The bottom-line consequence is that George, if successful, can achieve tax nirvana: a double tax
benefit for the same dollars to the same taxpayer. Such a result is inconsistent with both an SHS
income tax and a consumption tax and thus raises both fairness and economic efficiency concerns.
To consider an example of the cash-flow consumption tax variety, suppose, that George
borrows $10,000 to purchase a widget-making machine in his small business. Under income tax
principles, this purchase is a nondeductible capital expenditure. As mentioned in Part B. (and as
you will explore more fully in Chapter 12), however, small businesses are permitted to treat this
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machine purchase as an immediately deductible business “expense,” as under a cash-flow
consumption tax. Take a sneak preview of § 179(a). George gets to (1) exclude the $10,000
borrowed cash, (2) deduct that $10,000 capital expenditure immediately (cash-flow consumption
tax treatment), and (3) deduct the interest on the debt as business interest under § 163(a) (which
would not be permitted under a cash-flow consumption tax)!
The TCJA increased the ability of both big and small businesses to currently deduct as expenses
the cost of long-lived assets under both §§ 179 and 168(k), which you will study in Chapter 13.
The TCJA also, for the first time, disallows deduction of some business interest (broadly speaking,
about 30% of business interest) by some taxpayers, which we’ll also explore in Chapter 13. The
reason for this new limitation on business interest is tax arbitrage.
To consider an example of tax arbitrage with a consumption tax provision of the wage tax
variety, consider § 103, which permits an exclusion from Gross Income of one kind of capital
return: the interest received on bonds issued by state and local governments. What if a § 103 bond
is purchased with borrowed cash? Suppose, for example, that Profiteer is in the 37% tax bracket
and borrows from National Bank at 5% interest to purchase $100,000 of tax-exempt § 103 bonds
yielding 4% interest. At first, it does not seem to make economic sense for Profiteer to borrow at
5% interest to purchase an investment yielding only a 4% return. Who in their right mind would
do this? Well, what if the interest expense is deductible (under the income tax rule that business
and investment interest expense is generally deductible) but the capital return is excludable?
Tax-exempt interest received
Less after-tax interest cost: $5,000 paid reduced
by tax saved via the interest deduction ($1,850)
“Profit”

$4,000
- 3,150
$850

Notice that this “profit” does not come from some daring act of entrepreneurship that adds
wealth to the economy (increases GDP). Rather, it is a “profit” merely in the form of a payment
from the U.S. Treasury funded by other taxpayers (i.e., you and me), which raises both fairness
and economic efficiency concerns. That is to say, this $850 “profit” represents a mere shift in
wealth rather than the creation of new wealth. The fancy word for this activity is “rent-seeking,” a
term that you will read in the next chapter. Keep this example in mind when you come to it.
But even if the arbitrage is not so substantial as to create an actual “profit,” this better-thanconsumption-tax treatment reduces positive tax owed in a way that is inconsistent with either a
pure income tax or pure consumption tax (and which represents rent-seeking). Congress has
attempted to disallow this tax arbitrage. Read § 265(a)(2). But § 265(a)(2) is notoriously difficult
to enforce. Moreover, debt-financed investments that otherwise are provided more favorable wage
tax treatment other than excludable § 103 interest can provide similar tax arbitrage opportunities,
and § 265(a)(2) would not step in to deny them. For example, many investments that produce lowtaxed capital gain (which have a wage-tax flavor because of the reduced tax rate, even though it’s
not a 0% tax rate) are purchased with debt producing fully deductible interest. 11 So stay tuned, as
we shall be conscious of these tax arbitrage problems that arise as we move through the course.
Introduction to the concept of capture
Introducing you to §103 here has an additional purpose unrelated to exploring the tax arbitrage
11

Similar to § 265(a)(2), Congress has attempted to prevent this type of arbitrage under § 163(d), which you will study
in Chapter 15 (Tax Shelters), but as with § 265(a)(2), enforcement has proven difficult.

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possibilities posed by it. Section 103 is an ideal provision to introduce you to the concept of
“capture,” which will affect the tax policy analysis of many provisions that we shall study. When
Congress enacts a special deduction or exclusion aimed at Taxpayer A on the face of the
statute, Person B might be able to step in and effectively “capture” that tax benefit through
the price mechanism, sometimes unbeknownst to A. In future chapters, we shall consider the
capture phenomenon in connection with the exclusions and deductions pertaining to home
ownership, the exclusion for employer-provided health care, and other provisions. In these
scenarios, the average taxpayer may not appreciate that the economic benefit of the exclusion or
deduction that appears to be aimed at him on the face of the statute may, in fact, be captured by
other actors in the marketplace.
The language in § 103 appears to provide the tax benefit (exclusion of the interest) to the
bondholder. But who may effectively captures that tax benefit? The answer is (or at least should
be—more below) the bond issuer, which is the state or local government, through being able to
borrow at lower interest rates than would otherwise be the case if the interest payments were
included in Gross Income by the bondholders under § 61(a)(4). The § 103 exclusion (unlike the
provisions mentioned above) is one in which the capture phenomenon is above board; everybody
knows about it and expects it, which is why it makes an ideal provision to illustrate the capture
phenomenon. Indeed, the idea is that the market should react to this preference in order to allow
state and local governments to borrow at a lower interest cost
For example, assume that market conditions require corporations to offer 5% annual interest on
a $100,000 corporate bond. Because the $5,000 annual interest is includable in Gross Income under
§ 61(a)(4), a bondholder in the 37% tax bracket pays $1,850 in tax ($5,000 x .37) and has $3,150
in after-tax cash left each year. A state or local government could offer an interest rate of only
3.15% of excludable interest on a $100,000 § 103 bond to attract a bond buyer in the 37% bracket
because the bond buyer would be in the same after-tax position with either the corporate bond or
the § 103 bond ($3,150 in annual after-tax cash in either case). In short, a 37% bracket taxpayer
would be tax-indifferent between buying a corporate bond paying 5% includable interest or a §
103 bond paying 3.15% excludable interest.
As it turns out, however, §103 is an inefficient, wasteful way to deliver this subsidy to state and
local governments because tax-exempt bonds must offer a rate higher than implied by the highest
tax bracket in order to attract enough buyers from lower brackets to buy all of the bonds that state
and local governments want to sell. The reason for this is not only that state and local governments
want to sell a lot of bonds but also that the market for them is significantly narrowed by the high
number of tax-exempt purchasers who do not benefit from the exclusion and so have no desire to
buy the lower-interest-paying bond. For example, among the biggest investors in stocks and bonds
in the U.S. are tax-exempt qualified pension plans, § 401(k) plans, etc., as well as foreign
individuals and corporations, who generally do not pay tax on any interest or capital gain earned
in the U.S., even on corporate stocks and bonds that produce includable gain and interest for you
and me. For that reason, such buyers are more interested in purchasing the higher return investment
(the corporate bond paying 5% interest rather than the tax-exempt bond paying 3.15% interest)
because they will not owe U.S. income tax on the higher return in any event.
If corporate bonds are paying 5% (includable) interest, and there are an insufficient number of
bonder buyers in the highest 37% bracket to offer only 3.15% interest on the tax-exempt bond, our
tax-exempt bond issuer must offer 3.25% interest to attract buyers in the 35% bracket, or 3.4% to
attract 32% bracket taxpayers, or 3.8% to attract buyers 24% bracket taxpayers, and so on. When

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the smoke clears, the Federal government loses more revenue from the § 103 exclusion than
ends up in the hands of state and local governments. Moreover, this revenue shortfall inures
entirely to taxpayers in the higher brackets, who obtain interest at a rate that is higher than
necessary for them to be tax-indifferent between the taxable corporate bond and the taxexempt § 103 bond. Here is an example.
Example: Assume a simplified tax world in which there are only two tax brackets:
40% and 20%. The prevailing market interest rate paid on taxable corporate bonds is
10%. The Grovers Corners Public School District wishes to issue $10 million of school
construction bonds. Without § 103, the School District would have to offer 10%
interest to compete with corporate bonds (an interest cost of $1 million each year), but
with § 103 in place, the School District can offer only 6% interest (entailing an interest
cost of $600,000 each year) to attract buyers in the 40% tax bracket. Unfortunately,
there are an insufficient number of U.S. non-tax-exempt buyers in the 40% tax bracket
willing to purchase the Grovers Corners bonds, so the School District must offer an
interest rate of 8% on all of the bonds to attract buyers in the 20% tax bracket, as well,
because there is no feasible way to segment the bond offering between 40% bracket
purchasers and 20% bracket purchasers.
The subsidy indirectly received by the School District under § 103 is $200,000 each
year ($1 million interest that the School District would have had to pay on bonds
paying 10% includable interest less $800,000 interest paid on the tax-exempt bonds
paying 8% interest). Assume that half of the bonds ($5 million) are purchased by 40%
bracket taxpayers and half ($5 million) are purchased by 20% bracket taxpayers. The
tax revenue lost by the Federal Treasury under § 103 with respect to the 20% bracket
taxpayers equals $100,000 ($500,000 of interest that would have been paid on bonds
paying includable 10% interest multiplied by the buyers’ 20% tax bracket) and with
respect to the 40% bracket taxpayers equals $200,000 ($500,000 multiplied by 40%).
The Federal government loses a total of $300,000 in tax revenue under § 103 in order
to provide a subsidy to the state or local government of only $200,000—and that
$100,000 ends up entirely in the hands of the 40% bracket buyers (through receiving
8% tax-free interest instead of the tax-indifferent rate of 6%). The 40% bracket buyers
end up with $100,000 more cash in hand after taxes are taken into account than they
would have had in hand with corporate bonds paying 10% includable interest.
A more efficient and less wasteful system would be to repeal § 103, effectively
requiring the state or local government to issue bonds paying 10% includable interest
on our facts, and then to have the Federal Treasury send a check for $200,000 to the
state or local bond issuer. Such a system would avoid the $100,000 waste and would
also avoid the windfall to high-bracket taxpayers. 12
The American Reinvestment and Recovery Act of 2009 allowed, for the first time, just such an
arrangement, albeit on a temporary basis. Under temporary § 54AA, state and local governments
were provided, in effect, the option to issue bonds for certain specified purposes (called “Build
America Bonds”) before the end of 2010 paying includable interest (rather than tax-exempt
interest), coupled with a subsidy check from the Federal Treasury to the state or local issuer keyed
to the top 35% tax rate then in effect. They were a hit. Through early spring of 2010, $90 billion
12

The § 103 exclusion for interest on state and local bonds used to be thought of as constitutionally mandated, but the
1988 decision in South Carolina v. Baker, 486 U.S. 1062 (1988), rejected that notion.

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of Build America Bonds were sold in 1,066 bond issues in 48 states. 13
Finally, while the cash borrowed with § 103 bonds can be used by state and local governments
for such classic public goods as roads, bridges, universities, firehouses, and police stations, a
sizable amount (with caps keyed to the population in each state) can effectively be borrowed by
private businesses with the assistance of state and local governments—called “private activity
bonds”—raising serious questions regarding the justification for the tax subsidy. 14

13

See Build America Bonds Will Save $12.3 Billion, Analysis Say, N.Y. TIMES, Apr. 2, 2010, at B9.
See, e.g., Mary Williams Walsh & Louise Story, A Stealth Tax Subsidy for Business Faces New Scrutiny, at
www.nytimes.com/2013/03/05/business/qualified-private-activity-bonds-come-under-new-scrutiny.html?_r=0.

14

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Chapter 3: Ethical Debates,
Economic Theories, and Real-World Impacts
Chapters 1 and 2 explored the contours of two common types of “tax base” (what is taxed):
income and consumption. Part A. of this chapter will relate information regarding the adoption
and development of the income tax over time and its impact on the Federal budget and living
standards. Part B. will explore the norms, theories, and politics of taxation, which will draw on
some of the information conveyed in Part A. regarding economic trends over time. While the
material in Chapters 1 and 2 was chiefly descriptive, some of the material in this chapter comes
with a lot of baggage in the political arena. Thus, I want to say a word first about how we
sometimes approach material of this type.
We all have unique ways of looking at the world and making sense of it. We all begin our
decision-making processes and evaluations with certain models in our minds of how the world
works and should work, which have been ingrained by culture, education, family, religion, events,
and perhaps even our genes. These models shape how we perceive the world. Two different people
looking at precisely the same situation can have very different perceptions about what the most
consequential facts are. Indeed, cognitive psychologists have identified the so-called confirmation
bias as one of the most potent cognitive biases that we all share.
Although he is a cognitive psychologist and not an economist, Daniel Kahnman won the 2002
Sveriges Riksbank Prize in Economic Sciences in Memory of Alfred Nobel (commonly referred
to as the Nobel Prize in Economics) in recognition of the contributions that he and the late Amos
Tversky made in helping us to better understand how thought patterns and behavior differ in
predictable ways from the “rational man” assumptions that economists often typically build into
their economic models. Their work (and the work of others) led to the burgeoning field of
behavioral economics, which seeks to study these behaviors in a systematic way.
Behavioral economists and cognitive psychologists have identified numerous cognitive biases.
The confirmation bias is the tendency to search for or interpret information in a way that
confirms one’s preconceptions. Disconfirmation bias, as one would expect, is the opposite: the
tendency for people to dismiss or avoid information which contradicts their prior beliefs.
The technology revolution, with the introduction first of cable television and then the internet,
has created niches that make it ever easier to indulge in (or exploit) the confirmation bias. In the
dark ages of my childhood, with only three nationally broadcast news stations with a high number
of homes watching each evening, the three national news programs had to steer a path that appealed
broadly and thus could not cater in an obvious way to the extreme left or right of the political
spectrum. In addition, prior to 1987 the Federal Communications Commission (FCC) required,
under the so-called fairness doctrine, that radio and television broadcasters using the public air
waves must present multiple viewpoints on contentious public debates. The FCC members
appointed by President Ronald Reagan abolished the fairness doctrine in 1987. These events have
combined to allow us to subdivide ourselves into information niches in which we hear only echoes
of our prior beliefs, reinforcing them even further, turbo-charging the confirmation bias.
Another cognitive bias is the bias blind spot, or the tendency to see oneself as less biased
than other people, or to be able to identify more cognitive biases in others than in oneself.
Particularly in my role as a teacher, I always try to remain sensitive to this bias in myself.

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Other cognitive biases that can have an impact on taxation include the endowment effect (or
divestiture aversion), which is the tendency to ascribe more value to items or a position merely
because we own them. Studies show that people who are given, say, a coffee mug demand more
in cash to give up the mug than they would be willing to pay to purchase the item. This effect
contributes to the cognitive bias known as loss aversion, under which people strongly prefer
avoiding losses to acquiring gains. These biases can result in behavior that is inconsistent with
the rational man assumptions made by some economists in modeling predictions of anticipated
behavior changes in connection with a proposed change in law, including tax law.
Several other cognitive biases combine to make us sometimes make judgments based on a
personally known anecdote or widely reported example in the press of one case or incident, while
downplaying larger pools of evidence or data that contradict the individual anecdote. These include
the base rate neglect or base rate fallacy, or the tendency to base judgments on specifics,
ignoring general statistical information; the availability heuristic, or estimating what is more
likely by what is more available in memory, which is biased toward vivid, unusual, or
emotionally charged examples; and the anchoring effect, or the tendency to rely too heavily,
or anchor, on a past reference or on one trait or piece of information when making decisions
(also called insufficient adjustment). As an example of this cognitive bias in the tax policy
setting, the popular press widely reported that the French actor Gerard Depardieu obtained a
Russian passport after the former French President recommended temporarily raising (for two
years) the top marginal income tax rate from 41% to 75% on income exceeding €1 million. This
vivid example of fleeing a country (or a state in the U.S.) in response to an increase in the top tax
rate can cause a reader to believe that this response is a common one, a belief that can affect the
analysis of the policy issue, but broader empirical data is not consistent with this assumption. 1
As an aside, those looking for good empirical data can often find it by looking at material
published by the Congressional Budget Office, the Tax Policy Center (a joint undertaking between
the Urban Institute and the Brookings Institution), the Census Bureau, the IRS Statistics of Income
Division, and the Joint Committee on Taxation, a committee nominally made up of the members
of the House Ways & Means Committee and the Senate Finance Committee, but whose work is
done by its professional staff consisting of economists and lawyers charged with, among other
duties, doing studies mandated by Congress. Information pertaining to the experience of other
nations can often be found in data compiled by the Organization for Economic Cooperation and
Development (OECD).

A. The development of the income tax and
how taxes affect the Federal budget and living standards
Under the Articles of Confederation that preceded the Constitution, the Federal government
had no power to tax individuals, states, or business entities directly. Rather, the Federal
government could only send a requisition to each state to collect a stated amount to turn over to
the Federal government, and the states were left to decide for themselves how to fulfill the
requisition. As you might expect, states often failed to comply, and the very survival of the new
country was threatened, as the Federal government needed revenue to retire the Revolutionary War
debt, maintain the military and courts, etc. A primary reason for calling a Constitutional
1

See, e.g., James B. Stewart, The Myth of the Rich Who Flee from Taxes, at
www.nytimes.com/2013/02/16/business/high-taxes-are-not-a-prime-reason-for-relocation-studies-say.html.

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Convention to replace the Articles of Confederation was the need to provide the Federal
government with the power to tax citizens and residents directly, without going through the states.
“For a generation that had fought a war with England about taxation, however, it was equally
important that any taxing power be constrained.” 2 Thus, both a uniformity and apportionment
requirement were included with respect to the Federal taxing power.
Under Article 1, § 8, clause 1, of the Constitution, Congress is granted power to “lay and
collect Taxes, Duties, Imposts, and Excises” on individuals, entities, transactions, etc., without
going through the states, but these levies and taxes must “be uniform throughout the United
States.” This uniformity requirement prevents express discrimination among the states. If, for
example, Congress enacted an excise tax on the extraction of each barrel of oil from the ground, it
could not impose that tax at a rate of, say, 10% for oil found in Texas but 20% for oil found in
Alaska without violating the uniformity clause. The fact that oil is distributed unevenly among the
states, however, which means that entities and individuals in Texas and Alaska would pay much
more of this hypothetical oil excise tax than would residents in Tennessee or Vermont, would not
violate the uniformity clause.
Under Article 1, § 9, clause 4, “direct” taxes, including any “capitation” tax (or per-person
head tax), must be apportioned among the states according to population. Taxes that are not
direct taxes are not subject to the apportionment requirement. Though the Constitution does not
use the term, taxes that do not qualify as direct have come to be known as “indirect” taxes. The
distinction between a direct and indirect tax is somewhat cloudy (more below), but taxes imposed
on individuals for merely existing (a capitation tax) or merely owning property (such as real estate)
have been held to be direct taxes, while taxes imposed only on a transaction, such as the
hypothetical oil excise tax described above or a retail sales tax imposed on the purchase of
consumer items, have been held to be indirect.
Direct taxes were thought to have greater potential for abuse because they were imposed merely
for existing or owning real estate and thus could not easily be escaped by taxpayers. Excise and
sales taxes, in contrast, were relatively noncontroversial forms of taxation because they could be
avoided simply by choosing not to extract the oil (in the hypothetical example provided above) or
choosing not to purchase the consumer item. As Alexander Hamilton wrote in Federalist 21:
It is a signal advantage of taxes on articles of consumption that they contain in their
own nature a security against excess. They prescribe their own limit; which cannot be
exceeded without defeating the end proposed, that is, an extension of the revenue.
When applied to this object, the saying is as just as it is witty, that, “in political
arithmetic, two and two do not always make four.” If duties are too high, they lessen
the consumption; the collection is eluded; and the product to the treasury is not so great
as when they are confined within proper and moderate bounds. This forms a complete
barrier against any material oppression of the citizens by taxes of this class, and is
itself a natural limitation of the power of imposing them.
To illustrate how the apportionment requirement imposed on direct taxes might work, assume
that Congress decided that it would levy an annual tax on the value of real property that would, in
the aggregate, collect $X each year, just as many states and local governments impose real estate
property taxes. Under the apportionment clause, the portion of $X that would be collected from
2

ERIK M. JENSEN, THE TAXING POWER: A REFERENCE GUIDE TO THE UNITED STATES CONSTITUTION 17 (2005).
Reprinted with permission.

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individuals in each state must mirror the state’s percentage of the total U.S. population. Because
12.15% of the U.S. population lives in California, 12.15% of $X must be collected from California
residents. Similarly, because .19% of the U.S. population lives in Vermont, .19% of $X must be
collected from residents of Vermont. In order to ensure that the proper amount of $X was collected
from each state, the apportionment rule would require that different tax rates would necessarily
have to be imposed in each state (which would then be multiplied by the value of the real estate in
that state. As this simple example illustrates, the apportionment requirement “makes direct taxes
more difficult to implement than they otherwise would be.” 3
As is obvious with some thought, no tax other than a capitation or head tax (e.g., each resident
must pay a $10 tax to the Federal government) could simultaneously satisfy both the uniformity
and apportionment requirements. Therefore, these clauses have been interpreted together to mean
that indirect taxes must satisfy the uniformity requirement, and direct taxes must satisfy the more
onerous apportionment requirement.
The ugly issue of slavery also had an impact on the shape of the taxing power. The number of
Representatives awarded to each state in the House of Representatives is based on population, as
determined by the census required to be taken every ten years under Article 1, § 2. The slaveholding states wanted slaves to count in full for purposes of representation in the House, which
would give the southern states more congressional power. But counting them in full would harm
the southern states when it came to apportioning direct taxes because the higher the population,
the higher the aggregate Federal direct tax that could be apportioned to southern states. The
infamous three-fifths compromise counted slaves as three-fifths of a person for purposes of both
representation in the House and direct taxation (overturned by the 14th amendment).
In 1794, at the urging of Alexander Hamilton, Congress enacted a tax on carriages “kept by or
for any person, for his or her own use, or to be let out to hire, or for the conveying of passengers.”
The tax was geographically uniform but was not apportioned among the states according to
population. If the carriage tax was an indirect tax, it was constitutional, but if it was a direct tax it
was unconstitutional because unapportioned. In Hylton v. United States, 4 the Supreme Court held
that the carriage tax was not a direct tax and suggested that only capitation and real estate taxes
were direct taxes.
Until the Civil War, Congress raised nearly all revenue through various forms of consumption
tax, such as excise taxes and tariffs on the use or purchase of goods. With the significantly
increased revenue needed to fund the Civil War effort, Congress (controlled by Republicans) first
considered raising revenue primarily through an apportioned land tax. Instead, Congress enacted
a combination of several new taxes in 1861, including both the first income and inheritance taxes,
controversial though they were. 5 The Supreme Court upheld the constitutionality of the income
tax against a charge that it was an unapportioned direct tax in Springer v. United States, 6 stating
that “direct taxes, within the meaning of the Constitution, are only capitation taxes, as expressed
in that instrument, and taxes on real estate….” 7 Congress allowed the tax to expire in 1872.
The period between the 1872 expiration of the Civil War tax and the enactment of the
3

JENSEN, supra note 2, at 24.
3 U.S. (3 Dall.) 171 (1796). For more on the Hylton saga, see JENSEN, supra note 2, at 38-44.
5
For an interesting description of the debates surrounding the Civil War enactment of the first income and inheritance
taxes, see Sheldon D. Pollack, The First National Income Tax 1861-1872, 67 TAX LAW. 331 (2014).
6
102 U.S. 586 (1881).
7
Id. at 602.
4

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1894 income tax saw several panics and depressions, including one in 1893 (which
gave a sense of immediacy to the 1894 debates). That period nevertheless also saw an
astonishing accumulation of wealth by some very visible Americans. The contrast
between wealth and suffering was one of the reasons several radical political parties,
including the People’s (Populist) party, were created in the late nineteenth century. 8
The income tax enacted in 1894 was held to be unconstitutional as an unapportioned direct tax
in Pollack v. Farmers’ Loan & Trust Co. 9 Thereafter, Democrats and Republicans adopted a Joint
Resolution containing the 16th amendment to the Constitution in 1909, and the amendment was
ratified by the necessary three-fourths of the states (under Article V) in 1913. The 16th amendment
provides: “The Congress shall have power to lay and collect taxes on incomes, from whatever
source derived, without apportionment among the several States, and without regard to any census
or enumeration.” This amendment did not repeal the direct tax clause but merely excuses the
income tax from the apportionment requirement that otherwise applies to direct taxes. For
example, Congress could not enact an annual real estate property tax (or likely any other form of
annual wealth tax) without satisfying the apportionment requirement, as it is a direct tax that is not
protected from the apportionment requirement under the 16th amendment. The modern income tax
was enacted the same year, in 1913.
The debates that occurred both before the enactment of the 1894 income tax and the introduction
of the 16th amendment in 1909 were very similar in flavor. Both focused on shifting more the of
the tax burden from the lower classes to the wealthy. Both also showed a surprisingly sophisticated
understanding of the difference between an income tax and a consumption tax.
Excerpt from The Taxing Power: A Reference
Guide to the United States Constitution 10
Erik M. Jensen
Commentators generally see the late nineteenth-, early twentieth-century proponents of an
income tax as trying to reorient the tax system. As historian Gerald Eggert put it in describing the
background of the 1894 income tax:
Congressional debates made it clear … that the tax was, in part, a response to the
widespread demand to equalize the tax burdens borne by the various classes. The tariff,
which was the Federal government’s chief source of revenue, lay most heavily on the
poorer classes—ran the argument—while the proposed income tax would be paid by
the wealthier classes.
Edward Whitney (Assistant Attorney General at the time of Pollack) explained the 1894 tax the
same way: “The [Democratic] party controlling the House of Representatives, accepting the theory
that the prevailing taxes on consumption bore especially hard on the smaller incomes, undertook
to make up the deficit with a compensatory duty upon the larger ones.”

8

JENSEN, supra note 2, at 38.
157 U.S. 429 (1895). An income tax imposed on corporations was upheld, however, as an excise tax (an indirect tax)
on the privilege of doing business in the corporate form. Flint v. Stone Tracy Co., 220 U.S. 107 (1911).
10
JENSEN, supra note 2, at 52-55 and 62-64 (footnotes omitted). See also Sheldon D. Pollack, Origins of the Modern
Income Tax, 1894-1913, 66 TAX LAW. 295 (2013) (recounting the political battles and strategies surrounding the
adoption of an income tax in the late 19th and early 20th centuries).
9

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… Consumption taxes like tariffs were thought to be shifted to purchasers, and, if that was right,
a poor man bore the same tax burden in buying a bag of sugar as did a rich man. The tax burden,
that is, had nothing to do with respective abilities to pay the taxes, and that was not fair.
The difference between an income tax and a consumption tax—one is consistent with ability to
pay, one is not—was stressed throughout the congressional debates. The bill began in the House
of Representatives, where Democratic Representatives Benton McMillan of Tennessee, chairman
of the Ways and Means Subcommittee on Internal Revenue and a longtime proponent of income
taxation, and the already legendary William Jennings Bryan of Nebraska recommended a twopercent tax on incomes of $4,000 or more…. McMillan explained the income tax legislation this
way:
I ask of any reasonable person whether it is unjust to expect that a small per cent of
this enormous revenue shall be placed upon the accumulated wealth of the country
instead of placing all upon the consumption of the people…. And yet when it is
proposed to shift this burden from those who cannot bear it to those who can; to divide
it between consumption and wealth; to shift it from the laborer who has nothing but
his power to toil and sweat, to the man who has a fortune made or inherited, we hear
a hue and cry raised by some individuals that it is unjust and inquisitorial in nature.
… High and low income people who, McMillan posited, spend about the same on necessities “pay
the same taxes to the Government, because taxes are to be paid upon what they consume!”
… And, said McMillan, the relative burdens on the poor had been growing: “The taxes having
continually increased upon consumption, and no corresponding increase having been placed upon
accumulation, we see such colossal fortunes amassed as were never concentrated in any other age
or in any other country in the world.”
… [T]here were other reasons why tax obligations should be connected with ability to pay. For
one thing, income tax supporters believed the rich had disproportionately benefited from national
policies. The rich were rich because of what government had done. Moreover, the wealthy received
more from government—the value of protecting property, for example, goes up with the value of
property protected, or so it was argued—and income tax proponents argued that the wealthy should
have to pay for the extra services.
… To conform to ability-to-pay standards, tax law had to relieve burdens on consumption. That
was the constant theme advanced by income tax supporters. The House Ways and Means
Committee report on the 1894 legislation made the point like this: “The wealth of this country
amounts to more than $65,000,000,000, and the question arises whether it is not just and fair that
a portion of this money should be raised by a tax on the earnings of wealth instead of imposing it
all, or nearly all, on consumption.”
Because of the push for fairness, the disputes inevitably had a class-versus-class flavor. With a
proposed rate of only two percent, the charges of socialism seem a bit much today: “vicious,
socialistic and un-American” and “the most socialistic measure which was ever enacted in this
country,” noted a couple of typical authors. But there was a class aspect to the legislation. The tax
affected only about one percent of the population, the legislative attack on the wealthiest of the
wealthy was no accident, and once the principle of an income tax had been accepted, there was no
guarantee that rates would stay low. Lawyer James C. Carter, representing a bank nominally
defending the tax before the Supreme Court, conceded it was “class legislation in th[e] sense [of
distinguishing between rich and poor]. That was its very object and purpose.”

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… Income tax opponents did not limit themselves to questioning the populist origins of the tax;
they also marshaled an arsenal of substantive arguments against the tax, and in favor of a
consumption tax system. The income tax historically belonged to the states, they argued, and it
ought to be used by the national government only in emergencies, if at all. It was socialistic,
nothing but class legislation, and it was sectional in purpose—aimed at the East, where the wealthy
were concentrated. Moreover, it was a pernicious tax that would encourage Americans to lie about
their economic situations and, if the tax was going to be enforced, require that government agents
pry into the private affairs of citizens. “Inquisitorial” was an often used adjective.
President Cleveland stayed on the sidelines during the debates…. He … allowed the 1894
income tax legislation to become law without his signature….
[After the Pollack decision invalidating the 1894 income tax, a renewed movement for an
income tax] began to hit its stride near the end of the first decade of the twentieth century.
Democratic Representative Cordell Hull of Tennessee introduced income tax legislation in 1907,
and the Democratic Party called for an income tax amendment in its 1908 platform:
[W]e favor an income tax as part of our revenue stream, and we urge the submission
of a constitutional amendment specifically authorizing congress to levy and collect a
tax upon individual and corporate incomes, to the end that wealth may bear its
proportionate share of the burdens of the Federal government.
Support for an income tax had been building among Republicans as well. In 1906 President
Theodore Roosevelt stated that a “graduated income tax of the proper type would be a desirable
feature of Federal taxation ….” Roosevelt’s successor, William Howard Taft, also appeared to
accept … the desirability, at least in emergencies, of an income tax. In accepting the Republican
nomination in 1908, Taft stated: “I believe that an income tax, when the protective system of
customs and the internal revenue tax shall not furnish enough for governmental needs, can and
should be devised ….” Furthermore, “insurgent Republicans” had come to Congress willing to
join with Democrats and any remaining Populists to push for an income tax….
In short, by taxing more than what was spent on consumption and, as a result, reaching the
wealthy in a way that tariffs did not, the income tax was considered fundamentally different from
taxes on consumption. In Professor Michael Graetz’s words, “When this nation adopted the
Sixteenth Amendment, achieving fairness in the distribution of the tax burden was the essential
reason for taxing income and for taxing it at progressive rates.”
On the merits …, income tax debates in 1909 mirrored those of 1894…. As was true in 1894,
much of the discussion in 1909 was about how an income tax would further the ability-to-pay
principle in a way that consumption taxes did not. Senator Bailey explained his amendment to the
tariff bill: “I believe [the income tax] is the only tax ever yet devised by the statesmen of the world
that rises and falls with a man’s ability to pay it.”
When Cummins introduced his bill, Senator Augustus Octavius Bacon of Georgia pressed him
to justify it. Would Cummins favor the income tax if enough revenue could be raised by tariffs?
Bacon wanted to know “whether it was rested upon the importance of shifting the burdens of
taxation from the great masses of consumers, so far as we may be able to do it, to rest it in part, at
least, upon the shoulders of those who have the wealth of the country.” Cummins finally answered:
“[I]f I could change the situation I would so rearrange and readjust these schedules as to decrease
the revenue derived from the custom-houses and place it where it should belong—upon those
fortunate people who enjoy large incomes.” Said Bacon: “Now the Senator has stated exactly the

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thing I wanted him to state.”
Ability to pay dominated discussions of income tax proponents in 1909: Income taxes are
consistent with that principle, consumption taxes are not. What follows is a representative sample
of statements made on the floors of Congress; there are many more examples.
Senator Bailey (Texas): “Under any circumstances an income tax is more equitable than a tax
on consumption. It is more just as between the different classes, and it better conforms to that
sound canon of taxation which enjoins upon us to lay all taxes on those who can bear them….”
Senator William Borah (Idaho): An income tax was needed to supplement the tariffs “in order
that we may arrive as nearly as we can, as human ingenuity can make it, at a tax which is levied
upon a man’s ability to pay and in accordance with what he derives as a measure of benefit from
his Government.” He added, “We believe that every tax system based upon consumption should
be supplemented by a system which taxes property and the wealth of the country ….”
Senator Cummins (Iowa): “[A]n income tax, levied upon those who ought to bear the burdens
of government, … will meet even that principle more perfectly than to levy duties upon things that
the people must use, and impose the weight of government only by the rule of consumption.”
Representative Ollie M. James (Kentucky): “[N]o tax was ever more unjust … than a tax upon
consumption …. A tax upon what some people eat and what they wear would deny them the
necessities of life, while others, rolling in opulence …, would not feel such a tax.”
Representative Robert Lee Henry (Texas): “Equality in taxation should be the north star to light
our pathway and direct our feet in the enactment of such statutes. No tax more equitably distributes
the burdens of government than an income tax.”
Representative Adam M. Byrd (Mississippi): A tariff falls “upon consumption and not upon
wealth, upon what one eats and wears and not upon his property; it means that the citizen who can
scarcely provide food and raiment for his wife and children contributes as much or more to the
support of Government as does the multimillionaire.”
Representative William Sulzer (New York): “At the present time nearly all taxes … are levied
on consumption—on what the people need to eat and to wear and to live; on the necessities of life;
and the consequence is that the poor man … pays practically as much to support the Government
as the rich man ….”
Representative David A. DeArmond (Mississippi), a veteran of the 1894 battles: “There is no
good reason why taxation should not be according to ability to pay—according to wealth,
according to income. Your tariff tax is a tax upon necessity, a tax in proportion to the amount you
buy, a tax in proportion to what you must have, not a tax in proportion to what you possess.”
Representative Courtney W. Hamlin (Missouri): “The tariff tax is levied entirely upon
consumption. The laboring man must expend his income for food, fuel, clothing, and tools of
industry, and these taxes are heavier upon the necessities.” He added that Democrats had always
argued for shifting the burden of government “at least partially … from the backs of the poor to
those who can bear it; to divide these burdens between wealth and consumption; to divide them
between the man who has nothing but his labor and the man who has incomes many times greater.”
Representative William R. Smith (Texas): “No one can contend that our system of indirect
taxation [has no] objectionable features, because … its burdens are measured by what the citizen’s
needs require him to purchase for consumption and not by the amount of his wealth, nor by his

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ability to pay.”
Overall the tone of the debates was more civil than in 1894. There were fewer Populists around,
and, given the reduced opposition to an income tax, less reason to debate with “agrarian ferocity.”
But except for differences in tone, passages could be moved from 1894 to 1909 and back again
without changing the nature of the debate in either year.
Opponents also made the same points that had been made in 1894. An income tax, it was said,
was socialistic and inquisitorial. It ought to be available, if at all, only in emergencies….
But the opposition went nowhere. [In July of 1909, a] joint resolution containing the
Amendment passed unanimously in the Senate (77-0) and in the House a week later, after about
four hours’ debate, by a vote of 318 to 14. The level of opposition was greater than the vote suggest,
because of absences and abstentions, but the votes were nevertheless overwhelmingly favorable.
_______________________________________
The 16th amendment became part of the Constitution when the final state (Delaware) ratified it
on February 3, 1913. The first income tax enacted under the new amendment was passed by the
House (281 to 139) in May and by the Senate (44 to 37) in September and was signed by President
Wilson on October 3, 1913.
Consistent with the goals indicated in the debates, the new income tax was expressly aimed at
reaching chiefly the capital income of the wealthy, as opposed to the labor income of the working
man. Only between 1 and 2% of households containing married couples, divorced and widowed
men and women, and single men and women aged 20 or older owed income tax. 11 The act achieved
this by taxing “Taxable Income” (Gross Income less deductions) only above $3,000 for individuals
and $4,000 for married couples—a very high threshold in 1913 when the average annual income
was $800 12—at rates that graduated from 1% to 7%. Taxable Income from $0 to $20,000
($565,000 in current dollars) was taxed at 1%; between $20,000 and $50,000 at 2%; $50,000 to
$75,000 at 3%; $75,000 to $100,000 at 4%; $100,000 to $250,000 at 5%; $250,000 to $500,000 at
6%; and over $500,000 ($14 million in current dollars) at 7%.
With the increased revenue needs of WWI, the top marginal rate increased by 1918 to 77% on
Taxable Income exceeding $1,000,000 ($19.7 million in current dollars). After the war, rates
dropped in 1921, 1924, 1926, and 1928, with a top rate of 24% in 1928 on Taxable Income
exceeding $200,000 ($3.2 million in current dollars).
This pattern shows the clear intent of the enactors of the income tax to reach mainly the wealthy,
which made it a “class tax” for the first several decades of its life. The transition of the income tax
from a “class tax” to a “mass tax” occurred with the extraordinary revenue needs of WWII. Only
5% of households paid income tax in 1939; by 1945, 74.2% of households did.13 In addition,
Congress enacted the provisions requiring tax withholding at source for wage income in 1943. The
highpoint in marginal rates was 1944 and 1945, with the top rate at 94% for Taxable Income
exceeding $200,000 ($3.1 million in current dollars).
With the post-WWII cold war, the highest marginal rate stayed high—at 91% on Taxable
11

Thomas Piketty & Emmanuel Saez, Income Inequality in the United States 1913-2000, Table A0 at 65,
http://elsa.berkeley.edu/~saez/piketty-saezOUP04US.pdf.
12
www.irs.gov/app/understandingTaxes/student/whys_thm06_les01.jsp#taxTrivia.
13
Joseph J. Thorndike, Withholding Failed Before it Succeeded, 161 TAX NOTES 21, 24 (2018) (citing LAWRENCE A.
ZELENAK, FIGURING OUT THE TAX (2018)).

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Income exceeding $200,000—until the Kennedy administration, when the top rate was reduced to
70%. A special rule, however, provided that “earned income” would be taxed at no more than
50%—an explicit tax preference for labor income, as opposed to capital income.
During the Reagan administration, the top marginal rate was first reduced to 50% for all income
(not merely labor income) in 1981. The large deficits that ensued resulted in major tax increases
in 1982 and 1984 through base broadening; the top marginal rate did not increase. By 1986, the
top net capital gain rate was 20%, and the top marginal tax rate on ordinary income remained at
50%. The Tax Reform Act of 1986 reduced the top marginal tax rate on ordinary income to 28%,
but it increased the maximum net capital gain rate to 28% (from 20%) so that all income—whether
ordinary income or capital gain—was taxed at the same rate. It also lengthened depreciation
schedules, enacted limitations on real estate tax shelters, repealed the investment tax credit, all of
which increased the effective tax rate on capital income. Because capital income (including capital
gains) are so heavily concentrated in the highest income households (as illustrated in Part B. of
Chapter 1), the distribution of the overall tax burden among the members of the population was
not radically changed under the ’86 Act, even with the top rate on ordinary income being nearly
cut in half, though it did shift the tax burden down the income scale a bit.
With increased deficits, however, the top marginal tax rate on ordinary income increased from
28% to 31% in the George H.W. Bush administration, but the top 28% net capital gain rate was
not changed, thus reintroducing a small tax differential between the top tax rate applying to
ordinary income and gains and capital gains. Two additional rates were introduced in the Clinton
administration of 36% and 39.6%, with the latter applying to Taxable Income exceeding $250,000,
but the capital gains rate was reduced from 28% to 20%, resulting once again in a significant
differential between the top tax rate applying to ordinary income and capital gains.
During the George W. Bush administration, the top tax rate on ordinary income was reduced
from 39.6% to 35% in 2001, and the top tax rate imposed on net capital gain was reduced from
20% to 15% and extended to most dividends (which had previously been taxed at the ordinary
income tax rate) in 2003. The 2001 and 2003 rate reductions were expressly made temporary and
were scheduled to expire at the end of 2010. The rate reductions were extended temporarily in the
Obama administration through the end of 2012. On January 2, 2013, Congress passed the
American Taxpayer Relief Act of 2012, which generally extended the rates in effect under the
2001 and 2003 acts for most taxpayers permanently, except that the act restored the highest
marginal rate on ordinary income and gain to 39.6% and restored the 20% rate for net capital gain
for high-income taxpayers, with the 15% rate for middle-income taxpayers and a 0% rate for lowincome taxpayers, though most net capital gain is realized by high-income households.
The Tax Cuts and Jobs Act of 2017 reduced the tax on capital income substantially by reducing
the corporate tax rate from 35% to 21% and creating the new 20% deduction for certain “qualified
business income” of pass-through entities. It reduced the top tax rate from 39.6% to 37% and
doubled the exemption amount under the wealth transfer taxes, described in Chapter 7.
While only about 60% of households typically pay Federal income tax, nearly all pay so-called
payroll taxes on their labor income, and more than 60% of households pay more in payroll taxes
than income taxes. 14 The Social Security Tax was enacted in 1935, and the Medicare Tax was
enacted in 1966. Under the Social Security Tax, the employee must pay a 6.2% tax on wages up
14

See David Leonhardt, A Tax Plan to Turbocharge Inequality, in 3 Charts, at
www.nytimes.com/2017/12/17/opinion/taxes-inequality-charts.html.

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to $147,000 in 2022, and the employer must pay a 6.2% tax on the same base (summing to 12.4%).
The tax funds payments to current retirees under our pay-as-you-go Social Security system, as well
as certain other payments to non-retirees. The Social Security Tax wage base increases each year
by an amount equal to the increase in average wages (not median wages). Because average wages
have increased faster than the median wages (because of disproportionate wage gains at the top—
described below), the payroll tax burden on workers earning just above the Social Security wage
base (e.g., $150,000) has increased faster than have their wages. 15 Under the Medicare Tax, the
employee pays 1.45% on all wages, without limit, and the employer pays the same 1.45%
(summing to 2.9%), with the funds used for the Medicare program.
Taken together, the aggregate payroll tax is 15.3% on wages up to $147,000 in 2022, with onehalf of the tax paid by the employer and one-half by the employee. Wages above that amount are
generally subject (with an exception noted below) to a tax of 2.9% (the Medicare Tax portion),
again with one-half paid by the employer and one-half paid by the employee.
We need to take a detour for a moment here to discuss the “economic incidence” of a tax. The
person nominally charged with handing over a tax may not be the person who bears the burden of
the tax economically because the nominal payor may be able to effectively shift the economic
burden of the tax to others in the marketplace through the price mechanism. For example, a widget
seller who must pay a newly imposed 10% tax on each widget sale may be able to shift the
economic pain of that tax entirely to the widget buyer through increasing the price by 10%. Or
perhaps the widget seller keeps widget prices the same but shifts the burden of the tax to her
employees by lowering their salaries (over time, through smaller raises) by the equivalent amount.
Or perhaps the widget seller passes on the incidence of the tax to her suppliers by bargaining for a
reduced price for widget input components.
Economists generally agree that the economic burden of the individual income tax falls on the
actual payor but that the incidence of the employer portion of the payroll taxes falls entirely on the
employee (though nominally paid by the employer) through wages that are depressed by an
equivalent amount, i.e., that the entire tax is economically borne by the employee. The selfemployed pay the 15.3% aggregate payroll tax (and 2.9% tax on self-employment income above
the social security tax wage base) directly.
In short, someone earning $1 million (including the employer-paid payroll taxes) effectively
pays the same amount of Social Security tax as one who earns, say, $150,000 (12.4% of the first
$147,000 earned by each) in 2022. The $1 million earner, however, will pay more in Medicare
Tax than the $150,000 earner.
Someone earning $1 million in dividends, interest, rents, and capital gains (and no wage
income) paid neither Social Security Tax nor Medicare Tax in 2012. Beginning in 2013 under the
Patient Protection and Affordable Care Act (often referred to as Obamacare), an additional 0.9%
Medicare Tax is owed on wages exceeding $200,000 for individuals and $250,000 for married
couples so that their Medicare tax totals 3.8% instead of 2.9% on labor income exceeding those
thresholds. More significant was the extension of the 3.8% Medicare Tax to investment income
for the first time (instead of being levied only on labor income) for those with Taxable Income
exceeding those same thresholds.
The Social Security Tax base has always been limited to labor income on the theory that most
15

See, e.g., Deborah A. Geier, The Payroll Tax Liabilities of Low- and Middle-Income Taxpayers, 106 TAX NOTES
711 (2005).

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(though not all) Social Security payments constitute wage replacements so wages should fund
them. Medicare, on the other hand, has never had any formal relationship to past income (whether
labor or investment income), but the payroll tax system was easy to piggyback on in 1966 when
the Medicare Tax was first enacted.
The above analysis shows that labor income is often taxed twice to the same person at the
Federal level—once under the Federal income tax and once under the payroll taxes. Capital income
(interest, dividends, royalties, rents, and capital gains) are generally taxed only once (under the
income tax), though some investment income in households with Taxable Income exceeding
$200,000 is now taxed under both the Federal income tax and the Medicare Tax.
As you can see from the two charts below, 16 the aggregate amount collected under the
individual Federal income tax since the income tax was transformed from a class tax to a mass tax
with WWII has remained virtually constant, both as a percentage of gross domestic product
(GDP—roughly “national income”) and as a proportion of total Federal revenue, but the amount
collected in the payroll taxes (on labor income only) has substantially increased over that time
period.

The bottom tranche in the chart immediately below is the amount collected in individual Federal
income tax. Two tranches above that is the amount collected in payroll taxes. While it started out
as a relatively small portion of Federal revenue, it has notably increased over time so that today it
collects nearly as much as the individual income tax.

16

https://www.taxpolicycenter.org/briefing-book/what-are-sources-revenue-federal-government. Reprinted with
permission.

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The second tranche from the bottom shows corporate tax collections. Though corporations
nominally pay the income taxes owed on their income, corporations are artificial entities, not real
people, and only real people can bear the economic incidence of a tax. Precisely who bears the
economic incidence of the corporate tax has, unlike the payroll taxes, been subject to some debate.
It could be shareholders, whose dividends are smaller than they otherwise would be absent the
corporate tax. It could be all owners of capital (even those who do not own corporate stock) as
economy-wide capital returns reach equilibrium regardless of whether the return is earned inside
or outside a corporation. Or it could be the corporation’s employees, whose salaries are smaller
than they otherwise would be. While there are some dissents, the broad consensus of economic
opinion is that the corporate tax is borne mostly by all owners of capital, whether corporate stock,
partnership interests, real estate, etc., with some borne by labor. The Congressional Budget Office
(CBO) assumes that the incidence of the corporate tax falls 75% on capital and 25% on labor.
Notice how the portion of GDP collected in corporate tax has steadily decreased since WWII, a
trend that will accelerate after the TCJA, which decreased the corporate tax rate from 35% to 21%.
Indeed, the combined payroll and corporate tax tranches—viewed together—has increased only
slightly, but there has been a dramatic shift of the tax burden from capital (the corporate tax) to
labor (the payroll taxes). And recall that the amount of labor income that is reached under the
payroll taxes is capped (for 2022) at $147,000 per wage earner, so no taxes represented in this
tranche comes from wages above the relevant cap for the years at issue.
Of course, focusing only aggregate tax collections and who funds them provides an incomplete
fiscal picture. If tax collections are less than spending, the government must borrow (by selling
Treasury securities) to make up the shortfall. While such borrowing is expected (and even
beneficial) during times of recession—as during the pandemic—significant deficit spending
during the pre-pandemic period of economic expansion suggests that tax collections relative to
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spending were out of equilibrium when the TCJA was enacted, which reduced revenue further.
CBO data on spending, deficits, and surpluses (ancient history now) add additional context. The
first figure below shows annual deficits (or surpluses) for every year since 1967, with projections
through 2030. 17

The chart below shows the relationship of revenues to outlays since 1967. 18 The projections
assume, however, that the individual tax cuts under the TCJA expire at the end of 2025, as
scheduled. If they are extended, the revenues projected below will be lower.

The chart below shows the Federal debt, and it assumes that the individual tax cuts under the
TCJA expire at the end of 2025, as scheduled. If they are extended (and spending does not reduce),
the amount of projected debt will be higher. 19

17

CONGRESSIONAL BUDGET OFFICE, An Update to the Budget Outlook: 2020 to 2030,
https://www.cbo.gov/publication/56517/, p. 4.
18
Id. at 18.
19
CONGRESSIONAL BUDGET OFFICE, The 2020 Long-Term Budget Outlook (Sept. 2020),
https://www.cbo.gov/publication/56598, p. 6 [hereinafter 2020 Outlook].

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The chart below surprises some tax students, who may come into the course thinking that we
are a high-tax country.

Americans are among the most lightly taxed people among the members of the Organization
for Economic Cooperation and Development (OECD), which essentially consists of all of the
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major countries of the industrialized world. The U.S. collects—in Federal, state, and local taxes
combined—a smaller percentage in GDP than every other OECD country except Turkey, Iceland,
Chile, and Mexico. The chart is for 2016, 20 but the Tax Policy Center reports the figures (based on
OECD data) for 2019 (before the pandemic hit), which shows that the U.S. rate decreased to
24.5%, with Turkey, Ireland, Chile, and Mexico once again the only countries with a lower rate.
The 2019 OECD average was 33.8%. 21
Tax policy discussions often raise the relationship between taxes and economic growth. Even
though this relationship is contested, data on historical, present, and projected future GDP growth
and its constituent components can provide context.
Economic growth—i.e., increases in national income in the aggregate—comes chiefly from
increases in both population and what economists call “productivity”—the measure of goods and
services produced for each hour of work. The post WWII period until about 1980 was the golden
age of economic growth rates. Some years saw growth rates as high as 5%. 22 But the period since
1980 has shown lower average growth rates, with most years below 3%, with expectations of
slower growth in future years due to stagnant population growth, as shown in the charts below. 23

In short, immigration policy and the birth rate are relevant to GDP growth.

20

INSTITUTE ON TAXATION AND ECONOMIC POLICY, The U.S. is One of the Least Taxed Developed Countries, at
https://itep.org/the-u-s-is-one-of-the-least-taxed-developed-countries. Reprinted with permission.
21
TAX POLICY CENTER, OECD Taxes as Share of GDP, https://www.taxpolicycenter.org/statistics/oecd-taxes-sharegdp.
22
www.tradingeconomics.com/united-states/gdp-growth.
23
2020 Outlook, supra n. 19, at 21 & 46.

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An equally relevant discussion is how the gains from growth have been shared among the
members of the population over time. A 2017 chart created by Professor Kimberley Clausing for
testimony before the House Ways and Means Committee as it contemplated enactment of the 2017
TCJA is particularly pungent. Compare the left side with the right side in the chart below. 24

These bar graphs show the periods between 1946 and 1980 (left) and between 1980 and 2014
(right), illustrating how the gains from growth were shared by the members of the population
during these two periods. Notice how the sharing of the gains from growth has become
increasingly lopsided. Before 1980, the gains from growth were shared by both labor and capital;
24

Kimberly A. Clausing, Testimony before the House Ways & Means Committee, May 23, 2017 [hereinafter
Clausing]. Reprinted with permission.

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some went to workers in the form of higher wages, and some went to the owners of capital. Indeed,
notice that the top 10%, 1% and 1/10th of 1% on the left chart took a smaller share of the gains
from growth then did those in lower quintiles.
The reason for the trend over the last several decades is that the increased national income
from economic growth has gone substantially to the owners of capital, which is heavily
concentrated at the top—particularly the top 1% and even the top 1/10th of 1%—with
diminishing percentages of the gains from growth going to workers (wage income). In the
mammoth data-driven study described in Thomas Piketty’s 2014 book Capital in the TwentyFirst Century, Piketty had access to large data sets and computer software that were previously
unavailable. He concluded that the pre-tax return on capital has exceeded the rate of economic
growth for decades, which means that the pre-tax return on labor has been less than economic
growth, creating growing income inequality between those who earn their income from property
and those who earn their income from labor. Add to this data point the earlier charts showing
how taxation of labor income has provided a growing share of Federal revenue (between both the
individual income tax and payroll taxes) compared to the taxation of capital income—even as
capital income has claimed a larger share of the gains from economic growth compared to labor
income. The chart below, also from Professor Clausing, illustrates the result of these trends on
income shares. 25

Two of the most remarkable CBO charts, in my opinion, were issued in December 2019, i.e.,
just before the pandemic hit. It showed that the effects of the TCJA and reductions in transfer
payments supporting low-income taxpayers meant that income inequality between 2016 and

25

Id.

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2021 was projected to be worse after taxes and transfers were taken into account than before
taxes and transfers, as shown in the charts below. 26

Income inequality leads to wealth inequality. Wealth (assets less debts) is even more
concentrated than income, and wealth inequality has been growing faster than income
inequality. 27
26

CONGRESSIONAL BUDGET OFFICE, PROJECTED CHANGES IN THE DISTRIBUTION OF HOUSEHOLD INCOME, 2016 TO
2021 (Dec. 19, 2019), at https://www.cbo.gov/publication/55941, p. 1, 14.
27
CONGRESSIONAL BUDGET OFFICE, Trends in Family Wealth 1989-2013 (Jan. 18, 2017), at
www.cbo.gov/publication/51846.

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Economist Edward N. Wolff, who has long studied and documented wealth trends in the U.S.,
published date in 2016 showing that the wealthiest 1% of households now owns more than 40%
of the country’s wealth, a higher percentage than at any time since 1962. The top 1% now owns
more wealth than the bottom 90% combined, which owns about 21%. 28
In a report issued in May 2021, the JCT showed both net financial wealth levels (in dollars) 29
and net financial wealth shares (by percentages) 30 between 1990 and 2020 by wealth group: the
top 1%, the 90th to 99th percentile, the 50th to 90th percentile, and the bottom 50%. While all
groups saw a wealth decline during the 2008 financial crisis, the top 50% recovered their precrisis wealth level (in dollars) quickly, while the bottom 50% achieved their pre-2008 wealth
level (in dollars) only recently. Moreover, the second chart shows that the bottom 50%’s 2020
share of overall wealth remains well below its 1990 share. The wealth share of those in the 50th
to 90th percentile has also reduced substantially, with only those in the top 10%—and particularly
the top 1%—increasing their share of the nation’s wealth.

28

See Christopher Ingraham, The Riches 1 Percent Now Owns More of the Country’s Wealth Than at Any Time in the
Past 50 Years at www.washingtonpost.com/news/wonk/wp/2017/12/06/the-richest-1-percent-now-owns-more-ofthe-countrys-wealth-than-at-any-time-in-the-past-50-years/?utm_term=.b924e31aaa72 (describing Wolff’s study).
29
JOINT COMMITTEE ON TAXATION, Present Law and Background on the Taxation of High Income and High Wealth
Taxpayers, May 10, 2021, at 27, https://www.jct.gov/publications/2021/jcx-24-21/.
30
Id. at 28.

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Research in 2016 confirmed that the “main driver of wealth in recent years has been investment
income at the top. That is a switch from the 1980s and 1990s, when gains in income were primarily
generated by working.” 31
That divergence can slow innovation and further entrench inequities, said Heather
Boushey, an economist at the Washington Center for Equitable Growth. When labor
income provides the primary route to riches, it creates incentives for people to improve
their education and work harder…. But if getting ahead requires already having a
stockpile of cash or inheriting a windfall from your parents, then it is much harder to
work your way up.
“If you’re closing off entryways, then you are basically shutting off avenues to
competitiveness, innovation, and growth,” Ms. Boushey said, “even if you don’t care
about fairness.” 32
When these trends first began in the late 1970s, many middle-class families were able
nevertheless to maintain living standards by having spouses (usually the wife) enter the workforce
for the first time. The significant increase in dual-earner households in this era, in other words,
masked these trends at first. For example, only about 45% of women aged 25 to 54 were in the
workforce in 1964, whereas that figure rose to about 77% by 1998. 33 When second-earner spouses
31

Patricia Cohen, A Bigger Economic Pie, But a Smaller Slice for Half of the U.S., at
http://www.nytimes.com/2016/12/06/business/economy/a-bigger-economic-pie-but-a-smaller-slice-for-half-of-theus.html.
32
Id.
33
Len Burman, Rising Economic Inequality and Tax Policy, slide 5,

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saturated the workforce as the 20th century came to a close, many middle-class families then turned
to debt to maintain living standards. In particular, the deductibility of interest on second mortgages
or home equity lines of credit (studied in Chapter 17) turned many homes into ATMs, the proceeds
of which supported consumption spending. Perhaps most significantly, student loans increased
substantially. The amount of outstanding student loan debt exceeded the amount of outstanding
credit card debt for the first time in 2010, passed the $1 trillion benchmark in 2012, and now stands
at about $1.5 trillion. This debt load on the younger generation, coupled with stagnant middleclass incomes, can dampen demand for goods and services and thus dampen economic growth for
years to come. (More on “supply” and “demand” in Part B., below.)
Should these long-term trends in increasing income and wealth inequality inform the structure
of the Federal tax system?
As noted earlier, an annual wealth tax is likely unconstitutional under the apportionment clause.
But could the income tax rate structure be fashioned so that effective Federal income tax rates were
progressive relative to wealth (instead of income)? Such a rate structure would return the income
tax to a “class tax,” as it was in the first several decades of its life, with only the wealthy paying
it. Would that be consistent with notions of fairness? How might it affect economic growth?
Indeed, should we instead return to the pre-income tax days and tax only consumption, such as
with a national retail sales tax? Whether we stick with income or move to a consumption tax base,
what about the rate structure? Should it be progressive or flat? Should subsistence consumption be
freed from tax, whether under an income tax or consumption tax? These questions lead us to a
consideration of ethical norms and economic theories in more detail.

B. Fairness norms, economic theories, and politics
One chief takeaway from this part is that no single tax base and tax rate structure can be seen
as indisputably the “best” in raising $X (whatever that amount). In the end, which is the one that
you might consider the best will inevitably be a function of your values and worldview. Moreover,
after reading this material, you might well each come to different conclusions based on which bit
of evidence or argument below speaks most loudly to you. (Remember the confirmation bias?)
Nevertheless, I hope that this material can, at the least, help you to think about these issues (and
arguments that you will hear by one side or another in the popular press) in a more refined, formal
way. While the material is necessarily cursory in its depth, there is nevertheless a lot here. I hope
that you agree that this material adds richness to your study. We shall bring these norms to bear as
we progress through the course, particularly as we examine various provisions that depart from
SHS income tax principles.
The three major ingredients of tax policy discussions are fairness norms, economic norms, and
administrability. These can be brought to bear regarding both the tax base—what is taxed—and
the tax rate structure, though they are interdependent to a degree in the sense that the narrower the
tax base, the higher rates must be to raise $X (the aggregate revenue sought to be raised under the
tax). Thus, decisions to accord preferential tax treatment to certain classes of activities or income
affect not only those who benefit from these decisions but every remaining taxpayer who does not
so benefit because their tax rates are higher than they would otherwise need to be to raise $X.
Let’s first think about the issue of tax base—what should be taxed. As you read in Part A., the
at www.taxpolicycenter.org/press/upload/inequality%20and%20taxes.Burman.5-07.swf.

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Federal government raised nearly all of its revenue through various forms of consumption taxation
for more than a century before the 16th amendment was adopted and the modern Federal income
tax was enacted in 1913 in an attempt to shift more of the tax burden to the wealthy. Over the last
several decades, there has been vociferous calls by some to move back to our roots by repealing
the income tax in favor of some sort of pure consumption tax again, whether a retail sales tax, a
VAT, a cash-flow consumption tax, or the so-called flat tax that would tax only wage income (not
capital income) at the individual level, as described in Chapter 2.
Alternatively, some commentators have argued that we should add a broad-based consumption
tax to the income tax at the Federal level (common in most other countries) in order to raise
additional revenue that can then be used to reduce projected future deficits arising from current
spending commitments or to increase direct spending programs aimed particularly at the lower and
middle classes and at public goods that benefit even those not the direct recipient of the spending
(such as education and basic research). The goal would be to view the tax and spending systems
together to achieve fiscal progressivity as an integrated whole (even though the new consumption
tax would be regressive relative to income if viewed alone) by expanding the social safety net and
opportunity programs. 34 Of course, whether the new revenue obtained under any add-on Federal
consumption tax would be spent on such programs cannot be guaranteed. The current Congress
cannot bind future Congresses from changing how Federal revenue is spent.
Which fairness norms and economic norms may be relevant in thinking about these proposals?
Fairness norms in general
One of the most commonly discussed fairness norms in beginning tax textbooks is horizontal
equity. Horizontal equity is easy to state: like-situated taxpayers should be taxed alike. Who
could argue with that? Ah, but how do we measure “likeness”?
Jane has $10 million in wealth (the fair market value of her assets less outstanding
indebtedness). This year, she realizes $1 million in income (both labor and capital
income), and the FMV of her assets increases by $3 million. She spends only
$50,000 on personal consumption, adding $950,000 to her savings.
Patti has a negative net worth (more outstanding indebtedness than assets). This
year, she wins a $1 million prize. She spends $200,000 on personal consumption,
using the remainder to reduce debt and add to savings.
George has no savings but also no debt. This year, he realizes $50,000 in income
and spends all $50,000 on personal consumption, saving nothing.
Are Jane and George alike (and thus should be taxed alike) because each spends $50,000 on
personal consumption? If we impose a 20% retail sales tax on consumption and repeal the income
tax, both Jane and George will pay $10,000 in tax (.20 x $50,000 consumption expenditures), but
Jane’s effective tax rate relative to realized income would be .01% ($10,000/$1,000,000), while
George’s would be 20% ($10,000/$50,000). Flat-rate consumption taxes, such as retail sales
taxes, are regressive relative to income. But should that matter? If they are considered the “same”
because they spend the same amount on consumption, perhaps consumption (not income) should
be put in the denominator, with the result that they both have an effective tax rate—relative to
34

See,
e.g.,
Edward
Kleinbard, Progressive
Tax
or
Progressive
Fiscal
System?,
at
http://taxprof.typepad.com/taxprof_blog/2014/04/kleinbard-delivers-.html (lecture based on WE ARE BETTER THAN
THIS: HOW GOVERNMENT SHOULD SPEND OUR MONEY (Oxford University Press 2014)).

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consumption—of 20%.
Or are Jane and Patti alike because each has realized $1 million in income? Are they not alike
because Jane’s assets have also increased in FMV by $3 million in unrealized gain, which means
that Jane’s increase in wealth is higher than Patti’s? Are none of them alike because Jane has
wealth while Patti is underwater and George is in equipoise? Horizontal equity, while it sure
sounds nice, does not help very much in determining which kind of tax base is most “fair,” so we
must turn to other notions of tax fairness.
The ultimate question can be phrased as follows: what is the fairest way to allocate the costs of
maintaining a regulated capitalist economy, where the market’s laws of supply and demand create
wealth, among the members of the population?
Possibility 1: Allocate the costs equally among all members of the population.
Possibility 2: Allocate the costs according to wealth.
Possibility 3: Allocate the costs according to “ability to pay.”
Possibility 4: Allocate the costs according to “utility” or “standard of living.”
Possibility 5: Allocate the costs according to the benefits received from government.
Possibility 1 postulates an equal-amount head tax imposed on each member of the population.
In Fiscal Year 2020, the Federal government spent $6.6 trillion, or $19,962 per person. Because
an equal, per person head tax would have to be very low (much lower than $19,962) to be able to
be paid by children and the poor, such a distribution is not realistic to support a modern
industrialized state with a large military. We need to move on.
Possibility 2 postulates an annual tax on wealth (the fair market value of assets less outstanding
indebtedness). You learned in Part A. that wealth inequality has grown substantially over the last
50 years—and is even more pronounced than income inequality. Unlike an income tax, a wealth
tax taxes the same dollars to the same taxpayer more than once. Many European countries impose
annual wealth taxes, but in the U.S. an annual wealth tax would likely constitute a direct tax and
thus would need to be apportioned among the states according to population under Article 1, § 9,
clause 4, of the Constitution, described in Part A. Because apportionment would be
administratively infeasible, a wealth tax is not likely to be adopted in the U.S.—absent a
constitutional amendment removing the direct tax clause or removing the apportionment
requirement from a wealth tax (similar to the approach taken in the 16th amendment). 35
Possibility 3—that the costs of government should be allocated according to ability to pay—is
traditionally thought to be the primary fairness norm underlying the income tax. Recall the debates
that preceded the 1894 income tax and the congressional adoption of the 16th amendment in 1909
described in Part A. The most common argument in favor of income taxation is that it better
measures one’s ability to contribute to the national fisc than consumption taxation because both
amounts spent on consumption and amounts saved (an income tax base) represent ability to pay.
Possibility 4—that the costs of government should be allocated according to “utility”—requires
that we explore this term a bit. “Utility” is a fancy term introduced by the economist Daniel
Bernoulli and can be thought of, in this context, roughly as well-being or enjoyment in life. The
utility norm is generally thought to support consumption taxation over income taxation because
35

But see John T. Plecnik, The New Flat Tax: A Modest Proposal for a Constitutionally Apportioned Wealth Tax, 41
HASTINGS CONST. L.Q. 483 (2014).

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one’s utility or well-being can be measured by how much one consumes—i.e., by one’s standard
of living—not by how much one both consumes and saves. Of course, not everyone agrees that
having savings (wealth) provides no utility, but for purposes of discussion, we can assume that the
utility or standard-of-living norm would support consumption taxation over income taxation.
Possibility 5 postulates allocating the costs of government by reference to the benefits received
from government. The most easily understood benefit taxes are highway tolls, driver license fees,
gasoline taxes (the proceeds of which support highway maintenance), the entrance fee to enter
national parks, and the like. The Social Security Tax and Medicare Tax might be thought of as
benefit taxes, as their payment allows one to enjoy Social Security payments and medical care
later in life. On the other hand, perhaps that is not the only way to think about the benefit norm.
Although the ability-to-pay norm is thought to be the primary fairness norm underlying an
income tax, perhaps there is room for the benefit norm to be thought of as extra support for income
taxation over consumption taxation. Recall that some proponents of income taxation in the early
20th century cited not only the ability-to-pay norm but also the benefit norm in the sense that those
with more private property (more wealth) benefited proportionately more from government
protection of that property ownership (through law and through regulation) than did those without
much property. Anarchy is inimical to private property, while rule-of-law values and regulation of
such matters as contract, copyright, banking, etc.—government actions all—protect private
wealth. As Bill Gates’s dad once said in support of the estate tax: “It is a very legitimate claim of
society on an accumulation of wealth which would not have occurred without an orderly market,
free education and incredible dollars spent on research.” 36
Fairness and the wage tax
Is a tax only on labor income fair? One fairness argument sometimes heard in support of taxing
labor income only and excluding capital returns from tax (capital gains, dividends, interest, rents,
and royalties) is that taxing capital returns under an income tax taxes the same dollars to the same
taxpayer more than once, which is unfair. “Wait,” you say. “We learned in Chapter 1 that a
fundamental precept of an income tax is that the same dollars should not be taxed to the same
taxpayer more than once. That value is why basis keeps track of those dollars, to ensure that they
are not taxed again to the same party. Only the returns in excess of basis are taxed to ensure
compliance with that fundamental precept.”
But the wage tax proponents who make this argument look at the issue of “same dollars”
differently than the way in which we have viewed “same dollars” (as basis). Recall our discussion
in Chapter 2 (in connection with the wage tax) regarding a common way to describe how the
market arrives at the fair market value of any asset; it’s the market’s best guess at the present,
discounted value of the future stream of payments expected to be generated by that asset. The fair
market value of a share of stock may be calculated by discounting to present value (1) the future
stream of dividend payments expected to be paid by the corporation and (2) the future sales
proceeds expected to be received on later sale (including the appreciation in the share’s FMV).
Let’s say that this discounted present value is $10,000. When Ryan purchases that stock for
$10,000 and is denied a deduction for the $10,000 purchase price (as he would under both an
income tax and a wage tax), neither the dividends received nor the eventual sale gain realized
should be taxed to Ryan—or so the argument goes—because he was already implicitly taxed on
36

See Deborah A. Geier, Incremental Versus Fundamental Tax Reform and the Top One Percent, 56 SMU LAW
REV. 99, 119.

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those dollars when he was denied a deduction on the initial $10,000 purchase price.
This argument is reflected in Congressman Paul Ryan’s 2013 Budget, which was passed by the
House of Representatives in 2012 but not by the Senate. In the description of this provision in his
tax-reform plan, Congressman Ryan wrote:
Elimination of Double Taxation of Savings. The current system essentially taxes
savings twice: individuals pay tax on their earnings and, if they choose to invest those
after-tax funds, they pay another tax on the return from their savings (i.e., interest,
capital gains, or dividends). This proposal eliminates the second layer of taxation. Not
only is this fair to individual taxpayers, it also is good for the economy. Greater savings
leads to more investment and higher rates of productivity. Higher productivity
ultimately drives increased living standards. The plan also eliminates the estate tax,
another form of double taxation that is particularly harmful to small businesses. 37
Those who disagree with this argument note that this pricing mechanism merely describes a
way of arriving at market value and that the present value of those future payments is not the same
thing as the future payments themselves. Rather, taxpaying capacity over time is the relevant
inquiry. For example, Nicholas Kaldor, a mid-20th century British economist, rejected the “double
tax” argument when he wrote: 38
Some people would take strong objection to this statement on the ground that the
market value of property is merely the discounted value of its expected future yield;
wealth viewed as a stock and as a flow are merely two different aspects of the same
thing, and not two different things; to regard the discounted value of the flow of wealth
as something additional to the flow of wealth itself is counting the same thing twice
over. All this may well be true from some points of view, but from the point of view of
the measurement of taxable capacity—which is the only purpose in question here—it
is not correct to say that the one is just a reflection of the other.
Indeed, many who argue for a pure consumption tax base think that a tax on labor income only
is the least fair form of consumption taxation because it fails to reach the extraordinary (or
supranormal) return that exceeds the discounted present value of what the market expected when
the investment was purchased, as was also described in Chapter 2. To review, under the E. Cary
Brown yield-exemption phenomenon, denying deduction of the investment outlay but excluding
returns (under a wage tax) provides the same outcome as a cash-flow consumption tax (deducting
the investment in the year of purchase but including 100% of the return, including basis recovery)
only if the investment assets produce precisely the normal market return originally expected when
the market set the asset price. If the investment produces a higher return than originally expected,
that excess return is effectively taxed under a retail sales tax, VAT, or cash-flow consumption tax
(when the extra, unforeseen return is spent on consumption) but is free from tax forever—even
when spent on consumption—under a wage tax that reaches only labor income at the front end.
For this reason, the Roth IRA (listed as an example of the wage tax version of consumption
taxation in Chapter 2) can be criticized as being less fair than the traditional IRA, traditional §
401(k) plan, or qualified pension plan. When unexpected, outsized returns are obtained, more
37

THE ROADMAP PLAN, http://roadmap.republicans.budget.house.gov/plan/#Federaltaxreform. In his 2014 proposed
budget (announced in 2013), Congressman Ryan mentioned “the prevalence of double taxation of capital and
investment” but otherwise did not elaborate. See http://budget.house.gov/uploadedfiles/fy14budget.pdf, at 23.
38
NICHOLAS KALDOR, AN EXPENDITURE TAX 31-32 (3d ed. 1955) (emphasis added).

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revenue is lost to the Treasury with the Roth IRA than with the traditional IRA and its equivalents
(which means that tax rates on taxable wages must be higher than they otherwise would have to
be to raise $X). Moreover, the more favored treatment of the taxpayer whose Roth IRA obtains
that unexpected return is arbitrary when compared to those whose identical investment is taxed
under the rules of the traditional IRA and its equivalents, thus violating horizontal equity. To
appreciate this, review Brenda’s and George’s investments in Chapter 2. Both earned $100,000 in
wages, both purchased investments expected to earn 5%, but George was taxed under a cash-flow
consumption tax while Brenda was taxed under a wage tax. If their investments had both earned
the expected 5% return, they both would have enjoyed the same $84,000 of after-tax consumption.
Brenda’s investment, however, unexpectedly earned a 20% return, so she was able to enjoy
$96,000 of after-tax consumption without paying any additional tax on that extra consumption. If
George’s investment had also unexpectedly earned a 20% return, the extra return would have been
taxed under his cash-flow consumption tax when spent on consumption.
Fairness and other forms of consumption taxation
Because consumption taxes are regressive relative to income, fairness arguments in support of
them are difficult to mount. Nevertheless, some supporters of consumption taxation argue in moral
terms that consumption taxes are fair because they punish spenders, who take from society through
their spending (a notion attributed to the philosopher Thomas Hobbes), and reward savers, who
are virtuous. Hobbes wrote: “For what reason is there, that he which laboureth much, and sparing
the fruits of his labour, consumeth little, should be more charged, than he that living idlely getteth
little, and spendeth all he gets: seeing the one hath no more protection from the Commonwealth
than the other?” 39
Using such thinking, Professor Edward McCaffery, for example, argues that we should replace
the individual and corporate income, as well as the wealth transfer taxes (described in Chapter 7),
with a progressive-rate, cash-flow consumption tax.40 Consistent with Hobbes, he argues that it is
not unfair to impose the same tax burden on Jane, who earns $1 million and spends $50,000 on
consumption (saving $950,000), and George, who earns $50,000 and spends $50,000 on
consumption (saving nothing), because Jane is noble and George is selfish. Jane “isn’t getting
away with something [if we tax only her consumption spending]. She is simply living a noble,
prudent lifestyle and helping everyone else out in the process …” 41 while non-savers “are only
about themselves, who look to spend every last penny on their narrowly selfish desires.” 42 While
Jane would benefit from the failure to tax her savings and from the repeal of the estate tax, her
“good fortune will inure to the benefit of all. When the wealthy save, they help society.” 43
Exempting income from tax unless and until spent is inconsistent with the expanded version of
the benefit norm described above because it allows the taxpayer taking advantage of our regulated
capital system in amassing great wealth to avoid contributing meaningfully to the costs of
maintaining that system to the extent they avoid consumption spending. More important, the
argument that consumption spending takes from society and thus is to be discouraged is odd in the
sense that the voluntary market purchase of consumption (representing about 70% of economy
39

Gilbert E. Metcalf, Consumption Taxation, at www.taxpolicycenter.org/taxtopics/encyclopedia/ConsumptionTaxation.cfm.
40
EDWARD J. MCCAFFERY, FAIR NOT FLAT 75 (2002).
41
Id. at 105.
42
Id. at 75.
43
Id. at 110.

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activity) makes both the seller and the buyer better off under traditional economic thought.
Buyers and sellers engage in market exchanges because they benefit from the trade.
As a general rule both sides are better off after the exchange than they were before the
exchange. Buyers are better off because they have a net gain in consumer surplus [the
difference between the price actually paid by the consumer and the higher price that
the consumer was willing to pay]. Sellers are better off because they have a net gain
in producer surplus [the difference between the price actually received by the seller
and the lower price that the seller was willing to accept]. Voluntary market exchanges
are undertaken because they are beneficial to both sides of the transaction. If buyers
and sellers did not gain from the trade, then they would not voluntarily undertake the
trade. 44
When I buy apples from the orchard owner, both of us are thought to benefit. When I decline to
buy the apples, both of us are thought to suffer. The gains from trade are what make an economy
grow. Overconsumption of nonrenewable resources (think fossil fuels) can do damage (as
discussed below), but consumption tax advocates who decry consumption as “taking” from society
are not focused on the consumption of limited resources but rather all consumption.
While consumption tax advocates sometimes attempt to frame their support in terms of fairness,
the argument that saved wealth benefits society at large (mentioned in the quotation by Professor
McCaffery) is really, at bottom, an economic argument. Here is the argument: the economy would
benefit if all savings were freed from tax under a consumption tax because (1) there is an
insufficient supply of affordable capital for businesses to start and grow, (2) people would
substitute savings behavior for spending behavior if we taxed only consumption, (3) this increase
in savings would increase the pool of capital available to businesses, thus lowering the cost of
capital for businesses (by lowering interest rates), (4) businesses would deploy the newly
affordable capital supply to start and expand businesses that they could not before because of the
lack of affordable capital, (5) the increased supply of goods and services made possible by these
events would increase economic growth, (6) the gains from growth would be shared by both labor
and owners of capital, and thus (7) everyone in society would be made better off. This is what
Congressman Ryan meant when he said (in the quotation a few pages earlier): “Not only is this
[taxing only wages and not capital returns] fair to individual taxpayers, it also is good for the
economy. Greater savings leads to more investment and higher rates of productivity. Higher
productivity ultimately drives increased living standards.”
Each of these assumptions, of course, raises empirical questions and addressing them requires
that we move on to consider the economic theories and debates that influence tax policy choices.
Welfare economics
Economists care about economic efficiency, but different groups of economists can stress
different aspects of efficiency. The traditional adherents of welfare economics define economic
efficiency by reference to “utility” or well-being (with roots in utilitarianism), under which
government interference in the marketplace is considered efficient if it would make at least
one person better off and no one worse off (called “Pareto” efficiency). Measuring whether
people are better or worse off, however, is done by reference to their utility rather than to nominal
dollars taken or received. Moreover, even if Pareto efficiency is not present (because the move
will make at least some people worse off, measured by utility), welfare economists may still
44

www.amosweb.com/cgi-bin/awb_nav.pl?s=wpd&c=dsp&k=gains+from+trade.

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support the move if the utility gains of the winners outweigh the utility losses of the losers under
a cost-benefit analysis—referred to as Kaldor-Hicks efficiency, after the economists who
described it. Notice, therefore, that traditional welfare economics implicitly incorporates a concern
for both economic efficiency (a well-functioning economy) and equity.
Because utility theory has had the greatest impact in the tax realm on views regarding whether
the tax rate structure should be proportionate, regressive, or progressive relative to income, let’s
revisit that issue more deeply here. In each example below, assume that Poor earns $15,000 of
income each year and that Rich earns $500,000.
A tax rate structure that is proportional relative to income is one in which everyone’s
effective tax rate (tax paid/aggregate income) is the same. For example, assume that all income
is taxed at 15%. In other words, the first dollar earned is taxed at the same rate as the last dollar
earned. While Poor would pay $2,250 in tax and Rich would pay $75,000, each would have an
effective rate of 15% ($2,250/$15,000 for Poor and $75,000/$500,000 for Rich).
A tax rate structure that is regressive relative to income is one in which the effective tax
rate declines as income rises. For example, assume that the first $100,000 of income is taxed at
15% but that all income in excess of $100,000 is free from tax. Poor would again owe $2,250 and
again have an effective tax rate of 15% ($2,250/$15,000), while Rich would owe $15,000 and have
an effective tax rate of 3% ($15,000/$500,000). Rich paid more in tax ($15,000) than did Poor
($2,250), but his effective tax rate (the percentage of his income paid in tax) was less. (This roughly
describes the payroll taxes. As described earlier, in 2022, the first $147,000 of labor income is
taxed at a combined employer/employee Social Security and Medicare Tax rate of 15.3%, while
labor income in excess of that figure is taxed at 2.9.
A tax rate structure that is progressive relative to income is one in which the effective tax
rate rises as income rises. A progressive rate structure is argued by some to be more fair under
vertical equity (a companion to the notion of horizontal equity described earlier), under which
differently situated taxpayers should be taxed differently. For example, assume that the first
$10,000 if income is free from tax but that all income in excess of $10,000 is taxed at 15%. Poor
would owe $750 in tax and would have an effective tax rate of 5% ($750/$15,000), while Rich
would owe $73,500 and would have an effective tax rate of 14.7%. Notice that a rate structure
consisting of only two rates ($0 on a threshold amount of income and 15% on all income exceeding
that threshold) is progressive, though it is much less progressive than under a graduated rate
structure, in which marginal rates increase as income increases, as under current law. Recall,
however, the material in Chapter 1, Part B., where we saw that effective tax rates for the superrich
are lower than for the merely rich because of the preferential rate applied to net capital gain and
dividends (as well as the failure to tax some capital income effectively), when capital income is
heavily concentrated at the top of the income and wealth spectrum.
If one concludes that the tax burden should be progressive relative to income, another issue that
affects the debate is how progressivity should be framed. Is the right inquiry one that asks how
much of the aggregate tax burden is paid by each income group, e.g., how much of the aggregate
tax collected is paid by, say, the top one-tenth of 1% of income earners (or perhaps wealth
holders)? Or is the right inquiry how much of pre-tax income is paid in tax by each income group,
which takes into account trends in pre-tax income and changes in tax rates at the top?
You can see how framing issues affect the debate in the following excerpt from a Congressional
Research Service report: “[T]he top 0.1% of taxpayers paid 9.4% of all income taxes in 1996 and

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11.8% in 2006 but their share of income paid in taxes decreased from 33% in 1996 to 25% in
2006.” 45 An observer focusing on the first half of that sentence might say that the progressivity of
the income tax increased for the top one-tenth of 1% of taxpayers between 1996 and 2004 because
that portion of the population paid a larger portion of aggregate tax in 2004 than in 1996. Another
observer focusing on the second half of that sentence might say that the progressivity of the tax
burden decreased during that same period because the effective tax rate for the very wealthy
decreased between 1996 and 2004. (The second half of the statement also explains in part why
wealth inequality is growing even faster than income inequality.)
A graduated, progressive rate structure, under which both marginal and effective rates rise as
income rises, is sometimes defended by welfare economists by reference to the declining
marginal utility of money. The idea is that the last dollar earned by Warren Buffett, who is very
wealthy, is worth less to him than the last dollar earned by the Little Match Girl, who may die
without it because it represents subsistence income. That is to say, the “utility” or satisfaction that
each additional dollar brings decreases as you obtain more and more dollars, which justifies
allocating the tax burden so as to take progressively more of them as their utility decreases. In this
way the utility gains of the winners (the value that the $1 represents to the Little Match Girl)
outweigh the utility costs of the losers (the value of Warren Buffett’s last dollars earned).
Chicago-school-style economics
A group of economists at the University of Chicago in the 1970s and 1980s focused more
single-mindedly on economic efficiency and its impact on aggregate economic growth, with little
or no concern for utility or equity (i.e., the distribution of the fruits of that economic growth). The
work of this group is sometimes referred to as “the Chicago school” of economics 46 or sometimes
“neoclassical economics” and is most closely associated with a vigorous form of free market
economics, under which economic efficiency is defined as the unrestricted flow of dollars and
talent to their highest and best uses, maximizing aggregate societal wealth, through vigorous
bargaining among the buyers and sellers of goods and services, each with full information,
on price—without constraint or government interference. Unlike more traditional welfare
economics analysis, under which government action in the marketplace may not only be defensible
but desirable, Chicago school economists argue that government interference in the price
mechanism is (in the absence of a market failure) anathema. In short, to the neoclassical economist,
free and unfettered market behavior is the guiding star, without regard to its effects on the
distribution of wealth and income.
Except for one form noted below, taxation obviously interferes in the marketplace by affecting
the cost of a good or service, so the name of the game with respect to taxes for the Chicago school
is usually that taxes should be structured so as to distort marketplace behavior as little as
possible, commonly referred to as the neutrality norm. Market participants should not be
artificially encouraged (through the tax structure) to, say, engage in behavior A over behavior B or
to purchase good C over service D. Notice, therefore, that special tax preferences encouraging one
marketplace behavior over another is discouraged under this school of thought.
The only perfectly efficient tax for such economists is an equal-amount head tax, such as one
45

Thomas L. Hungerford, CONGRESSIONAL RESEARCH SERVICE, TAXES AND THE ECONOMY: AN ECONOMIC ANALYSIS
OF THE TOP TAX RATES SINCE 1945 (UPDATED) (2012), at www.fas.org/sgp/crs/misc/R42729.pdf.

46

See, e.g., Paul Krugman, The M.I.T. Gang, at www.nytimes.com/2015/07/24/opinion/paul-krugman-the-mitgang.html (comparing the work of “the Chicago school” of economists with those from M.I.T.).

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that requires each and every man, woman, and child to pay $19,962 (as described in Part A.). Such
a tax is perfectly efficient because it is imposed merely for existing. Except for the possibility of
suicide, no change in behavior can result in avoidance of the tax, which means that the market (the
price mechanism for goods and services) will not be distorted by the tax.
Because an equal-amount head tax is not realistic, what is the next best alternative? The
neutrality norm suggests a very broad tax base with few special exclusions or non-normative
deductions (deductions having nothing to do with properly measuring SHS income) because the
broader the tax base, the lower marginal rates can be and still raise $X. The lower the rates, the
less likely the tax will be to interfere with economic decision-making and distort market prices
because it is at the margins that behavior can (at least theoretically) be influenced. Here is an
example using work effort.
For example, if that last (marginal) dollar of labor income will be taxed at a high rate,
perhaps the worker will choose not to earn it and substitute untaxed leisure for work—the
substitution effect—decreasing economic efficiency (and aggregate wealth). Of course,
increasing tax rates can cause people to work harder (not less) in order to meet a fixed target
of after-tax income to save or spend. This offsetting effect is called the income effect.
Moreover, work effort may not be very responsive at all—one way or the other—to marginal
rates in the real world. The question is an empirical one. How sensitive is work effort to the
marginal rate at which that labor income would be taxed? In economics jargon, what is the
elasticity of work effort? Chicago school economists generally prefer that we tax “inelastic”
goods or services (rather than “elastic” goods or services) because taxing inelastic goods is less
likely to result in behavior change. An inelastic good or service is one for which supply or
demand is unaffected by a price change, including a price change due to taxation. If work
effort is not very sensitive to marginal tax rates, i.e., is relatively inelastic, then an increase in the
marginal rate will not change behavior much and thus will not reduce aggregate societal wealth.
Most of us are employees. Very few employees are in a position to decide whether or not to
work an extra hour for extra pay—to trade an hour of (untaxed) leisure for an additional hour of
(taxed) labor. The post-WWII era of very high marginal rates at the top saw robust economic
growth rates. Economic growth rates have been much lower in the modern era of relatively low
tax rates, though (as any good empiricist will tell you) correlation is not causation. At the least,
empirical evidence is weak regarding a strong disincentive effect of taxes on work effort. 47
A related issue to elasticity is tax salience. Tax salience refers to the visibility of the tax (or
a tax preference). The more invisible the tax (or a tax preference), the less likely it may affect
behavior and distort the allocation of resources across the economy. While low-salience taxes may
be more efficient, they may also present transparency and distributional concerns. If the salience
of a tax is low, the tax’s burden can be more easily imposed in a regressive manner on the
unsuspecting. For example, most employees probably do not appreciate that the incidence of the
employer-paid portion of Social Security and Medicare Taxes likely falls on them through wages
that are depressed by an equivalent amount, as discussed earlier.
By the way, beware the politician arguing that a tax preference benefiting business activity
needs to be enacted or maintained in order to help the economy grow. The partisan is misusing

47

See, e.g., Christina D. Romer, That Wishful Thinking About Tax Rates, at
www.nytimes.com/2012/03/18/business/marginal-tax-rates-and-wishful-thinking-economic-view.html?_r=0.

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economic theory to sound neutral while in fact advocating market distortion.
Even Chicago school economists do not object to interfering in market price, however, to
ameliorate market failures because market failures are presumptively inefficient, including the
distortions imposed by monopoly power, negative externalities, and rent-seeking behavior. In
addition, economists may not object to a special tax incentive to encourage behavior resulting in
positive externalities, if structured well.
Negative and positive externalities and Pigovian taxes
Negative externalities are harms imposed on others that are not captured in market price.
The most common current example is environmental damage, including exacerbating climate
change. For example, mining companies or oil companies can damage the environment but impose
the costs of that damage on others. A carbon tax imposed on oil and mining companies, effectively
increasing the price of their product to consumers, can decrease demand for the item (by
encouraging, under the substitution effect, the purchase of alternative fuels by consumers) or can
create revenue used to ameliorate the damage. The higher price effectively forces the companies
to “internalize” the environmental damage costs. Sometimes these penalty taxes imposed to
combat negative externalities are called Pigovian taxes (or sometimes Pigouvian taxes) after the
British economist Arthur Pigou, who showed how imposing a tax on pollution could in fact
increase economy efficiency.
Swapping a portion of our income tax or payroll taxes with some form of carbon tax (whether
imposed on carbon emitters or carbon consumers) in a revenue-neutral manner is a hotly debated
Pigovian tax topic. If you would like to explore further, you can read the following article:
www.nytimes.com/2012/07/05/opinion/a-carbon-tax-sensible-for-all.html.
Of course, a flat-rate carbon tax imposed on the first dollar of carbon consumption (like other
flat-rate consumption taxes) is regressive relative to income, which is why some consider them to
be less fair than income taxes. How regressive a carbon tax would be depends on which taxes
would be reduced in a revenue-neutral adoption of the tax. If the revenue raised through the new
carbon tax were used to reduce payroll taxes (or to augment the revenue pool used to pay Social
Security and Medicare benefits), for example, the distributional impact would be quite different
than if the revenue raised were used to reduce, say, corporate taxes or the estate tax. 48 (Other
common Pigovian taxes are those imposed on cigarettes and alcohol.)
Regulation is a common alternative to Pigovian taxes in combatting negative externalities, but
regulation tends to be less efficient than Pigovian taxes in reducing some types of negative
externalities. Returning to the carbon tax example, for instance, reducing gasoline consumption
through regulating mileage standards in new cars is not nearly as effective in reducing gasoline
consumption as a carbon tax would be.
The weakness with the fuel economy rules is that they don’t affect people’s behavior
the way higher gas prices do. They apply only to new vehicles—not the ones on the
road now—so it takes quite a long time to alter our overall gas use. And they carry
perverse incentives: because new vehicles go farther on a gallon of gas, they give us a
48

See, e.g., Donald Marron & Eric Toder, THE TAX POLICY CENTER, Carbon Taxes and Corporate Tax Reform, at
www.taxpolicycenter.org/UploadedPDF/412744-Carbon-Taxes-and-Corporate-Tax-Reform.pdf; Donald Marron,
Eric Toder & Lydia Austin, Taxing Carbon and Recyling the Revenue: Who Wins and Loses?, 149 TAX NOTES 1085
(2015).

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reason to drive more, leading to more congestion, pollution, and gas consumption….
According to economists crunching the numbers, this makes mileage standards
somewhere between 2.4 and 13 times more expensive than a gasoline tax as a tool to
reduce our use of fuel….
In Britain, where gas and diesel are taxed at $3.95 a gallon, the American automaker
Ford sells a compact Fiesta model that will go nearly 86 miles on a gallon. In the
United States, where gas taxes average 49 cents, Ford’s Fiestas will carry you only 33
miles on a gallon of gas. 49
While economists almost universally prefer a carbon tax over fuel economy regulation, surveys
show that the public is largely unimpressed by what most economics think, as illustrated in polling
described by THE ECONOMIST magazine. “Whereas 93% of economists reckoned a carbon tax is a
less costly way to cut emissions than car fuel-mileage standards, only 23% of the public agreed.
Such divergence may help to explain the lack of traction for the policy in Washington, D.C.” 50
Positive externalities are benefits enjoyed by others that are not captured in market price.
If a business cannot capture the full benefit (in market price) from certain activities that create
positive spillover effects for society at large, the business may underinvest in that activity, to the
detriment of society. A classic example is research and development.
An exception to the level-playing-field rule arises when industries generate positive
externalities. Businesses that conduct significant amounts of research and
development generate positive spillover benefits for the economy for which they are
not fully compensated. Therefore, there is an economic justification for a tax subsidy
directed to research-intensive industries. 51
But the incentive must be well targeted to activities that produce significant positive externalities
for society at large and structured to avoid “windfall benefits” (more below) to be efficient. 52
Rent-seeking behavior
Another important market failure relevant to tax policy, in addition to the problem of negative
externalities, is “rent-seeking” behavior—a phenomenon that we shall revisit from time to time
(particularly in connection with tax shelters). The term “economic rents” here has a special
meaning to economists that has nothing to do with the common meaning of that word to those
students who pay money to a landlord to live in an apartment. You can think of rent-seeking
behavior as manipulation of the social or economic environment to enrich oneself without
creating new wealth or, in the pithy words of the The Economist magazine, “[c]utting yourself a
bigger slice of the cake rather than making the cake bigger.” 53 The “profit” enjoyed by the
rentier is not real profit; rather, it represents mere wealth-shifting from one to another without
49

Eduardo Porter, Taxes Show One Way To Save Fuel, at www.nytimes.com/2012/09/12/business/fuel-efficiencystandards-have-costs-of-their-own.html.
50
Free Exchange: If Economists Agree on Something, the Public Will Almost Certainly Think Differently, THE
ECONOMIST, Jan. 12, 2013, at 66, and at www.economist.com/news/finance-and-economics/21569378-if-economistsagree-something-public-will-almost-certainly-think.
51
Martin A. Sullivan, The Simple Economics of Like-Kind Exchanges, 148 TAX NOTES 491, 493 (2015).
52
See id. (criticizing the tax preference for like kind exchanges, discussed in Chapter 12). See also Martin A. Sullivan,
Benefits of Boustany-Neal Patent Box Vary Widely, 148 TAX NOTES 707 (2015) (criticizing a proposed tax subsidy to
certain income obtained from intellectual property and related activities).
53
www.economist.com/economics-a-to-z/r.

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profit to the economy as a whole. A common example of illegal rent-seeking behavior is blackmail,
but much rent-seeking behavior is legal, if inefficient. One example from the popular press is the
increase in price charged by Turing Pharmaceuticals for a decades-old drug that Turing merely
acquired, raising the price overnight from $13.50 to $750 per pill. 54 Economists Lucian Bebchuk,
Jesse Fried, and David Walker have provocatively argued that the very dramatic increases seen in
U.S. executive compensation packages over the last several decades are a result of rent-seeking
behavior, with the cross-fertilization on corporate boards of these executives blessing each others’
escalating pay packages at the expense of workers and shareholders. 55 If true, a penalty tax on
executive compensation exceeding a stipulated threshold (such as § 162(m), discussed in Chapter
19) could be defended even by champions of a vigorous free market.
Economic rents in the tax context can be described as wealth accessions enjoyed by a person
that would not have occurred in a perfectly competitive and transparent economy but rather arise
by gaming the system, as in Profiteer’s rent-seeking behavior described in Chapter 2. The aftertax profit that Profiteer could command by purchasing tax-exempt § 103 bonds paying 4% interest
with borrowed money charging 5% interest that is deductible (absent effective application of §
265(a)(2)) represents not some daring entrepreneurial activity that created new wealth but, rather,
a simple transfer from the Federal Treasury, funded with tax dollars paid by you and me, to
Profiteer. Profiteer is a “rentier.”
Supply-side economics
Supply-side economics is simply one way to describe the most strident form of Chicago-school
style economics. It heavily influenced tax policy debates in the Reagan administration and remains
controversial today. Detractors of supply-side economics dismiss it as “trickle-down economics.”
The opposite of supply-side economics is a demand-side policy prescription in the face of
lackluster growth that often is referred to as Keynesian stimulus after the early 20th century
economist John Maynard Keynes.
Economic growth is generally dependent on both the available supply of goods and services
for sale in the marketplace and the demand for those goods and services from customers able and
willing to buy them. Economic growth can be dampened from either the supply side (e.g., a lack
of physical, human, or financial capital to create the goods or services that buyers want) or the
demand side (e.g., the lack of money in the hands of the consuming public with which to buy the
proffered goods and services). If lack of capital (supply) is the problem, one response can be to
reduce the tax rates on capital returns or at the top of the income spectrum so that more money is
in the hands of the suppliers of goods and services to meet the previously unmet demand, which
will, in turn, increase the number of jobs and the (taxable) wages of workers sufficiently to partly
offset the revenue loss from the supply-side tax cuts.
If lack of demand is the problem because consumers’ buying power is depressed (through, say,
increased unemployment or stagnant wages), one response can be to reduce taxes at the lower end
of the income scale so that broad swaths of consumers have more after-tax income left to purchase
goods and services. This increased demand will, in turn, increase the number of jobs and the
(taxable) wages of workers sufficiently to partly offset the revenue loss from the demand-side tax
54

See, e.g., Julie Creswell & Andrew Pollack, The Bad Boy of Pharmaceuticals Hits Back,
at www.nytimes.com/2015/12/06/business/martin-shkreli-the-bad-boy-of-pharmaceuticals-hits-back.html?_r=0.
55
Lucian Bebchuk, Jesse Fried, and David Walker, Managerial Power and Rent Extraction in the Design of Executive
Compensation, 69 U. CHI. L. REV. 751 (2002).

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cut. (An example of a demand-side move purely in the private sector was when Henry Ford more
than doubled the wages of his workers on the factory floor so that they could purchase the cars that
they were manufacturing. Ford’s revenue loss—from more than doubling his workers’ wages—
was partly offset by the increased profits he realized by being able to sell more automobiles.)
Whether a supply-side stimulus or a demand-side (Keynesian) stimulus is successful is, of
course, a matter of empirical inquiry, but empirical inquiry is muddied by the inability to isolate
easily any one factor in measuring the effect on economic growth of these tax changes.
Nevertheless, it is worth noting that top rates are now so low by historical standards that any
supply-side effect from further reduction is, even if present, likely diminished. The reductions in
the top rate from 91% to 70% (Kennedy administration) and from 70% to 28% (Reagan
administration) were dramatic. Further dramatic reductions are unlikely.
Moreover, recall the material in Part A. regarding how economic growth rates were much higher
from the post-WWII era to the mid-1970s (when the top marginal rate was much higher than today)
and have been notably lower since then (with much lower top marginal rates), even though the
amount collected in aggregate income tax as a percentage of GDP has remained remarkably
constant at the individual level and has been reduced substantially at the corporate level throughout
this period. The robust growth rates in the post WWII era, however, may have had more to do with
the devastated state of Japan and Europe (particularly Britain, Germany, and France) after the war
and the quiescence of China and India, which were not major economic powers, resulting in the
U.S. being a major net exporting nation during this period (whereas today the U.S. is a net
importing nation). Moreover, the more evenly distributed gains from growth in the three decades
after WWII demonstrated in Part A.—with the bottom 80% of the income spectrum garnering a
bit more of the gains from growth than those at the top—may have had more to do with the much
larger presence and strength of private-sector labor unions and such government spending
programs as the GI bill (which allowed many to be the first in their families to attend college) than
the tax rate structure. In short, these are empirical questions that are difficult to untangle and easy
assumptions (often made by partisans with a particular point of view to forward) should be met
with skepticism. The tax code may have much less power to affect these matters than is often
assumed without sufficient evidence.
In addition, many economists assumed in the past that the growing wealth and income
inequality seen in recent decades was merely a function (and unavoidable cost) of a vigorous,
growing economy. Today, however, many are abandoning that assumption, with more recent
evidence showing that significant wealth and income inequality in fact contributes meaningfully
to sluggish economic growth rates in the first place because of the demand-side drag when the
middle class has less discretionary income to spend. 56
A more subtle aspect of supply-side argumentation (separate from advocating a reduction in the
top marginal rates on all income) is that it supports the switch in tax base from income to
consumption, as suggested earlier. To review, the argument is this. Suppliers of goods and services
need more cheap capital to invest, to create these goods and services. By cheap capital I mean, for
example, the ability to raise corporate capital by selling corporate bonds at a low interest rate.
56

See, e.g., Annie Lowry, Income Inequality May Take Toll on Growth, at
www.nytimes.com/2012/10/17/business/economy/income-inequality-may-take-toll-on-growth.html?pagewanted=all
(summarizing studies); Annie Lowrey, Obama Adopts Catchphrase to Describe Proposed Recipe for Economic
Revival, at www.nytimes.com/2013/07/23/us/politics/president-adopts-catchphrase-to-describe-proposed-recipe-foreconomic-revival.html?_r=0.

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What brings interest rates down? The argument is that if we just save more and thereby increase
the pool of available capital interest rates will necessarily go down under the laws of supply and
demand because interest rates go down when there is a lot of capital (savings) chasing productive
investments. If capital is scarce, in contrast, savers can demand higher interest rates, and businesses
have a harder time raising capital at a cost-effective price.
So the argument is that we can increase the pool (and thus lower the cost) of available capital
that can be productively invested by businesses if we tax only consumption and not savings. 57 The
gains from this ensuing increase in economic growth would then be shared by both labor (wages)
and capital, increasing living standards for all. Again, this view is reflected in the quotation from
Congressman Ryan’s tax-reform plan quoted earlier in this chapter.
Is it a convincing argument? The argument assumes many things. The argument first assumes
that there is a dearth of savings available to U.S. business so that interest rates are high, making it
difficult for businesses to form and expand. But that assumption appears to be not just untrue but
glaringly, obviously untrue. Interest rates are at historic lows, with lots of talk of a “global savings
glut” looking for places to invest. Indeed, the global savings glut has been blamed in part for our
repeated stock and asset bubbles since the late 1990s. “[T]hese aren’t just a series of unrelated
accidents. Instead, what we’re seeing is what happens when too much money is chasing too few
investment opportunities…. [W]hat’s important now is that policy makers take seriously the
possibility, I’d say the probability, that excess savings … is the new normal.” 58 And corporations
are sitting on literally trillions of undistributed profits—a huge pool of untapped capital. But, for
the sake of argument, let’s assume that we need to increase the savings rates of Americans to
increase available capital for businesses to start and expand.
The argument that a consumption tax would meaningfully increase the savings rates of
Americans relies on the “substitution effect” described earlier, except now it refers not to
substituting untaxed leisure for (taxable) work effort but rather substituting savings behavior
(which would be free of tax under a consumption tax until spent on consumption) for spending
behavior (immediately taxed). In other words, if we tax all savings at a zero rate—the argument
goes—the average consumer will increase his savings rate (the percentage of income saved),
interest rates will fall as the pool of capital enlarges, and this increased pool of cheap capital can
be exploited by business to generate more goods and services to sell to the public to meet unmet
demand. Is that true?
Recall that offsetting the substitution effect is the “income effect,” which (in this context) means
that the taxpayers with fixed goals or “targets” for savings can decrease the percentage of income
that they save (i.e., decrease their savings rate) and still meet their target. To illustrate, assume that
Bill has the target of saving $100,000 by the time that Junior reaches college or $1 million by the
time that he retires and that Bill has determined that he must save 20% of his pre-tax income each
year if savings are taxed under an income tax. If the income tax is replaced by a consumption tax
so that savings are not taxed, Bill may be able to save less than 20% of his income each year and
still reach his targets.
As with the effect of income taxes on work effort, empirical evidence has been unable to
57

Another way of framing the same issue is that, by taxing capital income, an income tax encourages current
consumption over future consumption (and so is non-neutral), whereas a consumption tax treats current and future
consumption the same. For empirical doubts about this assumption, see Chris William Sanchirico, Do Capital Income
Taxes Hinder Growth?, at https://publicpolicy.wharton.upenn.edu/issue-brief/v1n2.php.
58
Paul Krugman, A Moveable Glut, at www.nytimes.com/2015/08/24/opinion/a-moveable-glut.html.

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determine precisely which effect predominates with respect to savings behavior, but the evidence
tends to show that the vast majority of middle-class taxpayers are largely target savers (sometimes
called “lifecycle savers”), while the wealthy tend to save at far higher rates for reasons unrelated
to anticipated future consumption costs (or even planned future bequests). 59 Thus, for the vast
majority of Americans, the income effect may predominate. If that is true, substituting a
consumption tax for the income tax can have the counterintuitive effect of decreasing the
percentage of pre-tax income that most Americans save. Indeed, savings rates began to decrease
notably just after the introduction and widespread adoption of the IRA and § 401(k) account in the
late 1970s and early 1980s, which are accorded consumption tax treatment, although (once again)
correlation is not causation. For example, this decrease in savings rates occurred just about at the
same time that income inequality began to accelerate and middle-class wages began to stagnate.
Was the decrease in discretionary income remaining after meeting consumption needs behind the
trend toward decreased savings rates? Again, these effects are difficult to disentangle.
Finally, it is worth noting that the major savings of most middle-class taxpayers are already
taxed under consumption tax principles: (1) tax-preferred retirement accounts (such as qualified
pension plans, IRAs and § 401(k) plans), (2) the built-in gain in personal residences (which is
mostly or entirely tax-free under § 121, considered in Chapter 17), and (3) the inside build-up of
life-insurance policies, which are tax-free to the insured while living and tax-free to the recipient
(under § 101) when the proceeds are paid by reason of the death of the insured (considered in
Chapter 7). A fair description of the current Internal Revenue Code is that it already operates
mostly as a consumption tax for middle-class households (above a tax-free amount representing
subsistence consumption) but as an income tax for wealthier households, whose savings exceed
the limits that can be protected from taxation under our hybrid income-consumption tax. The most
significant deviations from SHS income taxation for the wealthy are (1) not taxing property
appreciation until realized (and completely forgiving tax at death, as described in Chapter 7) and
(2) effectively not fully taxing capital gains (by taxing realized gains at a reduced tax rate). For
this reason, a move to consumption taxation would move the tax burden down the income scale.
The limits of economic theory
While neoclassical economists view a vigorous free market with both parties bargaining on
price at arm’s length and with full information as maximizing societal wealth as a whole, they
cannot argue that the resulting distribution of wealth or income is “fair” or that it allocates wealth
and income according to “just desserts” (i.e., that those who garner disproportionate wealth or
income “deserve” that share). As retired law Professor Alan Gunn once memorably put it:
As a fan of a market economy, I am amazed at the number of people who think that
prices (including wages) are supposed to measure what people “deserve.” Prices are
determined by supply and demand, period (absent government intervention, to be
sure). Markets do what they do—mainly, putting information to use—very well. But
one of the things they don’t do is give people what they deserve. Complaining about
this makes about as much sense as complaining that the laws of physics are unfair. 60
Two public finance economists put it this way:
59

See, e.g., Christopher D. Carroll, Why Do the Rich Save So Much?, in DOES ATLAS SHRUG?: THE ECONOMIC
CONSEQUENCES OF TAXING THE RICH (Joel B. Slemrod ed. 2000) at 465.
60
Alan Gunn, e-mail submission to Taxprof, a closed, Internet discussion group for tax law professors at AALSaccredited law schools, April 24, 2002 (copy on file with author).

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[E]conomists have often proclaimed at congressional hearings and in the press that
one tax system is superior to another. To make such a judgment, the economist is
implicitly introducing his or her own values into the choice, values that Congress or
the majority of Americans may not share. For this reason, in principle any panel of
economists offering their opinions on the best tax system should be followed by a
panel of philosophers or ethicists who offer their views on the ethics …. In practice,
of course, we do not convene such a panel every time an adjustment in the pattern of
tax liabilities is considered, and we rely on the political system to make these kinds of
choices. 61
Finally, within the proper realm of economic evidence, we must take care regarding the limits
of economic models premised on assumed behavior that may not reflect real-world behavior.
Neil Buchanan, who is both an economist and a law professor, put it this way in the course of
discussing the work of two other economists who did an empirical review of the literature on
several of the topics discussed above. 62
This deference to economists, of course, is hardly limited to legal scholars.
Journalists, including business journalists, tend to regurgitate a standard set of
statements about the world that are, in fact, nothing more than unexamined conclusory
statements that the journalists have heard from orthodox economists. As one of many
examples, the top economics writer for The New York Times confidently claimed a
few years ago that “higher tax rates discourage work and investment, two crucial
ingredients for economic growth. But higher taxes on consumption don’t have nearly
the same effect as taxes on incomes or companies. If anything, consumption taxes
encourage savings, which lifts investment.” How did he know any of this? The author
did not even feel the need to justify his assertions. Apparently, he felt that he was
saying nothing more controversial than claiming that the sun rises in the East.
Such assertions of cause and effect are part of what many public finance economists
are happy to tell us are “known results” from economic theory. After hearing these
claims by economists, legal scholars who study taxation have, at least by my
observation, generally (and quite erroneously) concluded that those results must be
backed up by evidence and are uncontroversial among people who “know the
economics.” Those claims are, many people seem to believe, simply the Economic
Truth. Other statements of supposed truth include the “double distortion” argument
and the claim that inefficiency rises as the square of the tax rate, which are used to
support the ideas, respectively, that we should not tax capital income, and that
increases in marginal tax rates are increasingly harmful to the economy.
Similarly, it is often taken as received truth that subsidizing poorer people’s wages
creates a disastrous work disincentive. If a person believes that statement to be true,
he can then insist that he does not want to ignore the plight of the poor, but that
61
JOEL SLEMROD & JON BAKIJA, TAXING OURSELVES: A CITIZEN’S GUIDE TO THE GREAT DEBATE OVER TAX REFORM
(2d ed. 2000) 53.
62
What Legal Scholars Need to Know About Economic Research on Taxation: The Evidence Thoroughly Debunks the
Conventional Wisdom, at http://tax.jotwell.com/what-legal-scholars-need-to-know-about-economic-research-ontaxation-the-evidence-thoroughly-debunks-the-conventional-wisdom (reviwing Peter Diamond & Emmanuel Saez,
The Case for a Progressive Tax: From Basic Research to Policy Recommendations, 25 JOURNAL OF ECONOMIC
PERSPECTIVES 165 (Fall 2011)). Reprinted with permission.

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“economic theory tells us” that indulging our soft hearts by helping the poor would be
pure folly.
The problem is that none of those cause-and-effect relationships is established by
economic evidence—and, for most of them, the evidence leads to precisely the
opposite conclusions….
What I had not done, and what I had not seen from any other scholar, was to
summarize the state of knowledge—both theoretical and empirical—about taxes and
their effects on important social outcomes, to show that there is no “there there” to
back up these oft-heard claims. Luckily, Diamond and Saez decided to do that difficult
and important work. In the Fall 2011 issue of the Journal of Economic Perspectives,
they summarized the best available research and, based on that evidence, made three
specific recommendations:
(1) “Very high earnings should be subject to rising marginal rates and higher rates than
current U.S. policy for top earners,”
(2) “Tax (and transfer) policy toward low earners should include subsidization of
earnings and should phase out the subsidization at a relatively high rate,” and
(3) “Capital income should be taxed.”
These recommendations are not the personal opinions of the authors. They are the
conclusions that can be drawn from the existing body of economic research. In short,
three of the key assumptions that too many public finance economists have
successfully exported into legal tax policy research, and that legal scholars had no
particular reason (or standing) to question, are unsupported by the evidence….
Notably, Diamond and Saez do not merely say that the evidence is lacking to
support the conventional superstitions about taxes, but that the evidence supports the
opposite conclusions: that marginal tax rates on high incomes should be increased, that
lower incomes should be subsidized, and that capital income should be taxed.
Diamond and Saez are not writing on a blank slate. They are debunking received
wisdom, exposing shibboleths that legal scholars need to un-learn if scholarship in
taxation is to move forward, fulfilling its promise to guide policymakers toward wise
decisions. For legal scholars with interests in tax policy, this is the essential article to
read.
Tax expenditures
The term “tax expenditures” was first coined by then-Assistant Secretary for Tax Policy Stanley
Surrey in the 1960s. The topic is a critical one in tax policy debates, and it is one that deeply
implicates both strands of tax policy analysis that we have been considering—fairness and
efficiency—thus providing an apt topic to end this chapter.
A “tax expenditure” deviates from core, normative concepts underlying the tax base in a
way that implements nontax social or economic policy by providing either an incentive (to
change behavior) or a subsidy (a transfer to a worthy recipient), or both, through the tax
system. Tax expenditures are the functional equivalent of a direct-spending program, and
they can be in the form of special deductions, exclusions, credits, or tax rates.
Assume, for example, that Congress adopts a pure SHS income tax, with no non-normative

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departures (except for the realization requirement). Under a pure SHS income tax (or a
consumption tax, for that matter), no deductions are allowed for personal consumption costs. Now
assume that Congress decides that it wants to, say, defray the costs of childcare for working
parents. Whether or not that decision is wise as a social policy matter, Congress has a choice
regarding how to implement this decision, once made. It can leave the income tax alone (under
which childcare costs would be nondeductible), collect the revenue under that tax, and use some
of that revenue on a direct-spending program that sends checks to working parents (or a childcare
agency) at a cost of, say, $100 billion each year. Alternatively, it could enact a tax expenditure,
creating a childcare deduction (or credit) that reduces the revenue collected in the first place by
$100 billion each year—but only if the amount that would otherwise be taxed is spent by the
taxpayer on a qualified childcare program. Both options can be seen as government spending, but
one is done via a direct-spending program while the other is done indirectly through a tax provision
that deviates from a normative SHS income tax.
A direct-spending program may work better than the tax expenditure in achieving the desired
behavior because of the impact, once again, of behavioral responses to the two types of programs.
For example, a direct spending childcare program may increase employment of mothers more than
a tax subsidy for child-care costs. If you would like to explore further, read the following article:
www.nytimes.com/2014/12/18/upshot/nordic-nations-show-that-big-safety-net-can-allow-forleap-in-employment-rate-.html?_r=0&abt=0002&abg=0
Tax expenditures are non-neutral on their face; they can cause changes in behavior. Examples
include buying a larger home than you otherwise might (instead of, say, investing in the stock
market) because of all the tax preferences for personal residences or providing compensation to
employees in the form of health care instead of cash because of the exclusion for employerprovided health care.
Moreover, with some tax expenditures at least, it is problematic if they do not result in changed
behavior because, in that case, the tax expenditure results in nothing more than an economically
inefficient windfall loss—tax revenue that Congress need not have given up because
taxpayers would have engaged in the behavior even without the tax expenditure. Rewarding
behavior that would have been engaged in without the tax benefit loses revenue that must be made
up with tax rates that are higher than they otherwise would have to be on, say, wages to raise $X.
In other words, these base-narrowing provisions are (1) not costless and (2) affect all taxpayers,
even those who cannot take advantage of the tax expenditure but whose tax rates are higher to
make up the revenue loss.
Tax expenditures have exploded in recent decades, rising to $1.2 trillion in 2019 ($1 trillion
under the income tax and $200 billion under the payroll taxes). 63 Revenue collected under the
individual income was $1.5 trillion in 2018. In other words, the revenue that goes uncollected each
year because of tax expenditures is only slightly less than the annual revenue collected under the
individual income tax. Here are a few of the more notable tax expenditures under the income tax
aimed at individuals and their anticipated revenue costs for 2018 and for the five-year period from
2018 to 2022 (in billions). 64
63

CONGRESSIONAL BUDGET OFFICE, The Distribution of Major Tax Expenditures in 2019,
https://www.cbo.gov/publication/57413 [hereinafter CBO Tax Expenditures].
64
www.jct.gov/publications.html?func=fileinfo&id=5149. These revenue estimates do not incorporate the revenue
loss under the payroll taxes (Social Security and Medicare) for the exclusions for employer-provided health care and

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Employer-provided pension plans and IRAs
Exclusion of employer-provided health care
Reduced rate on net capital gain and qualified dividends
Child Tax Credit
Earned Income Tax Credit
Step-up in basis at death
Capital gains exclusion for sales of primary residences
Deduction of mortgage interest on owner-occupied residences

Chapter 3

2018

2018-2022

$239.1
146.1
128.7
103.8
70.1
37.4
34.6
33.7

1,306.0
869.6
655.7
595.7
363.6
204.4
186.5
163.2

Tax expenditures aimed at business activity, such as accelerated (and so-called bonus)
depreciation and the 20% deduction for qualified business income earned by certain sole
proprietors and owners of pass-through entities, are not listed above. (The latter, for example, will
lose $33.2 billion in 2018 and $259 billion between 2018 and 2022.)
Tax expenditures, particularly in the form of a deduction or exclusion (as opposed to a credit
against tax owed) can have perverse effects in that some are upside-down benefits that
disproportionately provide more benefits to those at upper-income levels than to those at the lower
end of the income scale, which often is inconsistent with what might have been enacted under a
direct-spending program equivalent.
For example, a taxpayer in the 37% tax bracket saves 37% cents in tax for every $1 of employerprovided health care excluded under § 106 (examined in Chapter 17), a taxpayer working for the
same employer at a lower salary saves 24 cents for that same $1 of employer-provided healthcare
if the excluded dollar would otherwise fall in the 24% bracket, and someone whose employer does
not provide health care does not benefit at all from this tax expenditure. If you were to think about
how Congress might have crafted a direct-spending program equivalent aimed at subsidizing
health care costs, you might understandably doubt that it would have chosen to subsidize highly
paid employees more generously than lower-paid employees and would have chosen no subsidy
at all for the employee whose employer fails to provide health care benefits. But this exactly
describes the effect of the § 106 exclusion. Indeed, Jacob Hacker, a political scientist at Yale
University, argues that the amount of social spending in the United States is not significantly lower
than in the so-called welfare states in Europe but that the U.S. does far more of its social spending
via tax expenditures, with these resulting upside-down effects. 65
The upside-down nature of tax expenditures is shown in the CBO charts below. 66

retirement savings.
65
See generally JACOB HACKER, THE DIVIDED WELFARE STATE: THE BATTLE OVER PUBLIC AND PRIVATE SOCIAL
BENEFITS IN THE UNITED STATES (2002).
66
CBO Tax Expenditures, supra note 63.

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While direct spending programs and tax expenditures can be seen as economic equivalents, the
beneficiaries of indirect spending (tax expenditures) often do not perceive themselves as benefiting
from government programs, which clearly skews political debate. If you would like to explore
further, read the following article:
www.nytimes.com/2015/10/08/opinion/we-all-get-free-stuff-from-the-government.html?_r=0
Those interested in reading more about tax expenditures at this point can also take a sneak
preview of Chapter 16, Part A., and the introduction to Chapter 17.
Final Thoughts
Now that you have a basic grasp of the horizontal equity and ability to pay fairness norms, as
well as the neutrality economic norm and the harms arising from rent-seeking behavior, you should
be better situated to appreciate that—at a minimum—the tax system should strive to tax wage
income and capital income similarly. This observation is particularly pungent after learning that—
taxes entirely aside—the pre-tax return on capital has exceeded the rate of economic growth for
decades, which means that the pre-tax return on labor has been less than the rate of economic
growth. The tax system should not exacerbate this pre-tax inequality by taxing wage income more
heavily than capital income. Unfortunately, current law sometimes does just that, further
exacerbating the income and wealth inequality that would occur in a no-tax world.
With few exceptions for fringe benefits (particularly the tax-free receipt of employer-provided
health care), wages are fully taxed. In other words, the tax base is not very leaky with respect to
the wage income of employees. Yet, you have already learned in Chapter 1 that capital income in
the form of property gain is taxed more lightly than the same amount of wage income because of
both (1) the realization requirement (deferring taxation—without an interest charge for the time
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value of money—of the wealth increase from property appreciation until a realization event) and
(2) the possibility that even realized § 1001 gain may be taxed at a lower rate than an equivalent
amount of wages to the extent it satisfies the definition of “net capital gain.”
As you move through this course, you will learn that current law permits significant amounts
of capital income to be taxed more lightly than wage income, to escape taxation completely, or
even to create negative tax (which can reduce tax on unrelated income that would otherwise be
fully taxed). In short, the tax base is very leaky with respect to capital income, which means that
rates are higher on wage income than they would otherwise have to be to raise the same amount
of tax revenue. It also means that the economy is less efficient, with the tax system encouraging
taxpayers to invest in assets or activities that, taxes aside, they would not otherwise pursue.
As you move through the course, be on the lookout for ways in which current law understates
capital income or otherwise taxes it more lightly (or even raises tax arbitrage possibilities). Here
are just a few examples, though you will not be able to fully appreciate them at this point:
• Sections 1031 and 1033 (and many similar provision studied in upper-level tax courses)
permit even realized property gain to be deferred until a future realization event, unless the
property is held until death, leading to ….
• Built-in property gain that has been deferred throughout life, often by taking advantage of
the provisions referred to in the first bullet, is completely wiped out under the income tax
(never taxed to anyone) at death under § 1014.
• Depreciation deductions are accelerated substantially, with significant amounts of capital
expenditures deducted immediately in the purchase year, which mis-measures capital
income under an income tax.
• Interest should be nondeductible if paid with respect to loans used to make capital
expenditures that are permitted (contrary to an income tax) to be deducted in the purchase
year (rather than depreciated over time), or else it creates tax arbitrage profits (negative tax),
but many property owners are nevertheless permitted to do just this.
• Depreciation deductions offset high-taxed ordinary income, so gain on later sale of the
depreciated property should be treated as high-taxed ordinary income to the extent merely
recouping the prior (too fast) depreciation, yet taxpayers owning commercial real estate are
permitted to create tax arbitrage profits by having so-called depreciation recapture taxed at
lower rates.
• Section 121, like § 103, permits a capital return (this time gain on the sale of a principal
residence) to go untaxed (not merely deferred).
• Not only “net capital gain” but also “qualified dividends” are subject to a reduced tax rate.
And much more.

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Chapter 4: The Contours of Capital
Expenditure v. Expense (or Current Depreciation)
In Chapter 1, you learned that business and investment outlays that qualify as current
“expenses” can be immediately deducted under §§ 162 and 212, respectively. In contrast, outlays
that are categorized as “capital expenditures” are nondeductible (regardless of whether incurred in
business, investment, or personal consumption activity) but create basis that can reduce the tax
base in the future (via depreciation or amortization deductions if the asset so qualifies or via
reduced gain or increased loss under § 1001 on a realization event). The common way to describe
why the distinction between an expense and a capital expenditure is important is because of the
time value of money; a dollar deducted today is worth more than a dollar that reduces the tax base
in a future year. The more specific or nuanced reason why this distinction is important is that the
capitalization principle is the defining difference between an SHS income tax and a consumption
tax, as you learned in Chapter 2. If Chris purchases shares of corporate stock for $10,000, he cannot
deduct that outlay under an SHS income tax because it is a capital expenditure. The basis thereby
created will reduce his tax base only in the future. Under a cash-flow consumption tax, in contrast,
he would be able to deduct immediately that addition to his savings in the purchase year, and we
have seen that consumption tax treatment is more favorable for Chris. Indeed, under the E. Cary
Brown yield-exemption phenomenon, the asset’s return, while nominally included in his tax base
in the future when withdrawn from investment, is effectively free from tax (to the extent not
exceeding the expected normal return) because earned on pre-tax dollars. Stated differently, if
Chris is permitted to deduct his $10,000 cost immediately, the tax consequences can be the same
as if he were not permitted to deduct that $10,000 immediately (as under an income tax) but were
permitted to exclude the investment’s return from tax (unlike under an income tax) between the
time that he (prematurely) deducted the outlay and the time that he should have been permitted
deduction.
For these reasons, the issue of which outlays should properly be categorized as capital
expenditures is much more important than one of mere timing, as you sometimes read in court
opinions. Characterizing an outlay as a current “expense” that should properly be characterized as
a “capital expenditure” can provide inadvertent consumption tax treatment through the back door.
Congress has shown that it knows well how to enact consumption tax provisions when it wants
to do so. Chapter 2 contained a list of some of those provisions. These provisions are conscious
deviations from the SHS income tax norm, which otherwise provides the default position regarding
the core structure of the Internal Revenue Code. Because Congress knows how to deviate from
SHS principles when it wants to do so, one can argue that administrators of the statute and courts
should be careful to protect income tax values by applying a strong capitalization principle (in
ambiguous circumstances) to avoid providing consumption tax treatment inadvertently through
the manipulation of doctrine, without the blessing of Congress.
The issue becomes even more important if borrowed money is used to make the outlay at issue.
You learned in Chapter 2 that business and investment interest (generally deductible under an
income tax) should be nondeductible under a cash-flow consumption tax. In other words, the tax
arbitrage possibilities of combining the income tax rules pertaining to debt (an interest deduction)
with respect to an investment that is otherwise accorded consumption tax treatment (where interest

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would not be deductible) would provide a tax outcome that is more favorable than would occur
under either a pure SHS income tax or cash-flow consumption tax. Because the stakes are so high,
the issue of which outlays must be capitalized has been highly litigious, particularly during the
time surrounding the INDOPCO decision, below.
This chapter will begin in Part A. by considering outlays pertaining to the acquisition or creation
of an intangible asset (typically referred to merely as an “intangible”). The Supreme Court’s 1992
INDOPCO decision made tax headlines and caused Treasury to open a new regulations project to
revamp completely the capital expenditure regulations in an effort to bring more certainty to this
area. Treasury divided the project into two phases, with the first devoted to intangibles (at issue in
INDOPCO itself) and the second devoted to tangible assets. The intangibles regulations were
finalized in December 2003. The regulations pertaining to tangible assets, considered in Part B.,
took much longer. The final regulations were made effective as of January 1, 2014.
Part C. will then consider the related issue pertaining to which indirect costs (such as labor
expenses, state taxes other than income taxes, production-period interest, and depreciation)
incurred in the process of creating an asset must be capitalized into the basis of that newly created
asset rather than immediately deducted. The Supreme Court’s 1974 decision in Idaho Power led
Congress to enact § 263A in 1986, which codified more precise rules to implement the idea
illustrated in Idaho Power.

A. Outlays pertaining to intangibles
For a pre-INDOPCO case involving the purchase of an intangible, consider Commissioner v.
Boylston Market Association, 1 in which the taxpayer purchased and paid for, in Year 1, insurance
coverage for his business that would last for three years. The taxpayer sought to deduct the entire
premium payment in Year 1 as a § 162 business expense, but the court agreed with the government
that the purchase of insurance coverage that lasted three years was a nondeductible capital
expenditure, not a current expense, because the coverage lasted substantially beyond the end of
Year 1. Rather than a current wealth decrease, the payment represented merely a change in the
form in which wealth was held when the company purchased an intangible (insurance coverage)
that lasted well beyond the year of payment. Whether the basis created on the making of that
nondeductible capital expenditure is amortizable over the three-year period of insurance coverage
under the depreciation provisions is a separate question from the issue of whether the outlay is, in
the first instance, a capital expenditure or expense. We shall study the depreciation provisions in
Chapter 13. Right now, we are interested solely in exploring the threshold capitalization question.
INDOPCO involved the proper treatment of the costs incurred by National Starch (renamed
INDOPCO after the transaction) in the course of the acquisition of its stock by another corporation,
Unilever. While such facts (a corporate acquisition) appear to be far afield of the typical facts
found in a course devoted to the taxation of the individual, the way in which the court analyzed
the capital expenditure issue goes far beyond the fact pattern before it. You need not understand
the underlying structure (or tax consequences) of the acquisition transaction, itself, to appreciate
the discrete issue analyzed here: whether the legal and investment banking fees incurred by
National Starch/Indopco (the target corporation) in connection with the acquisition of its stock by
Unilever should be categorized as a current business expense (deductible under § 162) or as a
1

131 F.2d 966 (1st Cir. 1942).

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nondeductible capital expenditure (creating basis). 2
INDOPCO, INC. v. COMMISSIONER
503 U.S. 79 (1992)
JUSTICE BLACKMUN delivered the opinion of the Court.
Petitioner INDOPCO, Inc., formerly named National Starch and Chemical Corp., manufactures
adhesives, starches, and specialty chemical products. In October 1977, representatives of Unilever
U.S., Inc. expressed interest in acquiring National Starch, which was one of its suppliers, through
a friendly transaction. National Starch at the time had outstanding over 6,563,000 common shares
held by approximately 3,700 shareholders. The stock was listed on the New York Stock Exchange.
Frank and Anna Greenwall were the corporation’s largest shareholders and owned approximately
14.5% of the common. The Greenwalls, getting along in years and concerned about their estate
plans, indicated that they would transfer their shares to Unilever only if a transaction tax-free for
them could be arranged.
Lawyers representing both sides devised a “reverse subsidiary cash merger” that they felt would
satisfy the Greenwalls’ concerns. In November 1977, National Starch’s directors were formally
advised of Unilever’s interest and the proposed transaction. At that time, Debevoise, Plimpton,
Lyons & Gates, National Starch’s counsel, told the directors that under Delaware law they had a
fiduciary duty to ensure that the proposed transaction would be fair to the shareholders. National
Starch thereupon engaged the investment banking firm of Morgan Stanley & Co., Inc., to evaluate
its shares, to render a fairness opinion, and generally to assist in the event of the emergence of a
hostile tender offer.
Although Unilever originally had suggested a price between $65 and $70 per share, negotiations
resulted in a final offer of $73.50 per share, a figure Morgan Stanley found to be fair. Following
approval by National Starch’s board and the issuance of a favorable private ruling from the IRS
that the transaction would be tax-free for those National Starch shareholders who exchanged their
stock for preferred stock [of a Unilever subsidiary], the transaction was consummated in August
1978 [and National Starch continued to exist as a corporate subsidiary of Unilever].
Morgan Stanley charged National Starch a fee of $2,200,000, along with $7,586 for out-ofpocket expenses and $18,000 for legal fees. The Debevoise firm charged National Starch
$490,000, along with $15,069 for out-of-pocket expenses. National Starch also incurred expenses
aggregating $150,962 for miscellaneous items—such as accounting, printing, proxy solicitation,
and Securities and Exchange Commission fees—in connection with the transaction. No issue is
raised as to the propriety or reasonableness of these charges.
The Tax Court, in an unreviewed decision, ruled that the expenditures were capital in nature
and therefore not deductible under § 162(a) in the 1978 return as “ordinary and necessary
expenses.” The court based its holding primarily on the long-term benefits that accrued to National
Starch from the Unilever acquisition. The United States Court of Appeals for the Third Circuit
affirmed, upholding the Tax Court's findings that “both Unilever’s enormous resources and the
2

For those who do go on to the tax course considering mergers and acquisitions, however, you will read an important
Revenue Ruling pertaining to the underlying tax structure of the transaction in this case. See Rev. Rul. 84-71, 1984-1
C.B. 106 (consistent with the private letter ruling obtained by the tax lawyers in this deal). The tax lawyers made this
deal work. Tax lawyers rock!

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possibility of synergy arising from the transaction served the long-term betterment of National
Starch.” In so doing, the Court of Appeals rejected National Starch’s contention that, because the
disputed expenses did not “create or enhance … a separate and distinct additional asset,” see
Comm’r v. Lincoln Savings & Loan Assn., 403 U.S. 345, 354 (1971), they could not be capitalized
and therefore were deductible under § 162(a). We granted certiorari to resolve a perceived conflict
on the issue among the Courts of Appeals.
The Court also has examined the interrelationship between the Code’s business expense and
capital expenditure provisions. In so doing, it has had occasion to parse § 162(a) and explore
certain of its requirements. For example, in Lincoln Savings, we determined that, to qualify for
deduction under § 162(a), “an item must (1) be ‘paid or incurred during the taxable year,’ (2) be
for ‘carrying on any trade or business,’ (3) be an ‘expense,’ (4) be a ‘necessary’ expense, and (5)
be an ‘ordinary’ expense." See also Comm’r v. Tellier, 383 U.S. 687, 689 (1966) (the term
‘necessary’ imposes ‘only the minimal requirement that the expense be ‘appropriate and helpful’
for ‘the development of the [taxpayer's] business,’” quoting Welch v. Helvering, 290 U.S. 111,
113 (1933)); Deputy v. Du Pont, 308 U.S. at 495 (to qualify as “ordinary,” the expense must relate
to a transaction “of common or frequent occurrence in the type of business involved”). The Court
has recognized, however, that the “decisive distinctions” between current expenses and capital
expenditures “are those of degree and not of kind,” Welch v. Helvering, 290 U.S. at 114, and that
because each case “turns on its special facts,” Deputy v. Du Pont, 308 U.S. at 496, the cases
sometimes appear difficult to harmonize. See Welch v. Helvering, 290 U.S. at 116.
National Starch contends that the decision in Commissioner v. Lincoln Savings & Loan Assn.,
403 U.S. 345, 354 (1971), changed these familiar backdrops and announced an exclusive test for
identifying capital expenditures, a test in which “creation or enhancement of an asset” is a
prerequisite to capitalization. In Lincoln Savings, we were asked to decide whether certain
premiums, required by Federal statute to be paid by a savings and loan association to the Federal
Savings and Loan Insurance Corporation (FSLIC), were ordinary and necessary expenses or
capital expenditures. We found that the “additional” premiums, the purpose of which was to
provide FSLIC with a secondary reserve fund in which each insured institution retained a pro rata
interest recoverable in certain situations, “serve to create or enhance for Lincoln what is essentially
a separate and distinct additional asset.” “[A]s an inevitable consequence,” we concluded, “the
payment is capital in nature and not an expense, let alone an ordinary expense.”
Lincoln Savings stands for the simple proposition that a taxpayer’s expenditure that serves “to
create or enhance a separate and distinct” asset should be capitalized. It by no means follows,
however, that only expenditures that create or enhance separate and distinct assets are to be
capitalized. We had no occasion in Lincoln Savings to consider the tax treatment of expenditures
that did not create or enhance a specific asset, and thus the case cannot be read to preclude
capitalization in other circumstances. In short, Lincoln Savings holds that the creation of a separate
and distinct asset well may be a sufficient but not a necessary condition to classification as a capital
expenditure.
Nor does our statement in Lincoln Savings that “the presence of an ensuing benefit that may
have some future aspect is not controlling” prohibit reliance on future benefit as a means of
distinguishing an ordinary business expense from a capital expenditure. Although the mere
presence of an incidental future benefit—“some future aspect”—may not warrant capitalization, a
taxpayer’s realization of benefits beyond the year in which the expenditure is incurred is
undeniably important in determining whether the appropriate tax treatment is immediate deduction

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or capitalization. See U.S. v. Mississippi Chemical Corp., 405 U.S. 298 (1972) (expense that “is of
value in more than one taxable year” is a capital expenditure); Central Texas Savings & Loan Assn.
v. U.S., 731 F.2d 1181 (CA5 1984) (“While the period of the benefits may not be controlling in all
cases, it nonetheless remains a prominent, if not predominant, characteristic of a capital item.”).
Indeed, the text of the Code’s capitalization provision, § 263(a)(1), which refers to “permanent
improvements or betterments,” itself envisions an inquiry into the duration and extent of the
benefits realized by the taxpayer.
In applying the foregoing principles to the specific expenditures at issue in this case, we
conclude that National Starch has not demonstrated that the investment banking, legal, and other
costs it incurred in connection with Unilever’s acquisition of its shares are deductible as ordinary
and necessary business expenses under § 162(a).
Although petitioner attempts to dismiss the benefits that accrued to National Starch from the
Unilever acquisition as “entirely speculative” or “merely incidental,” the Tax Court’s and the
Court of Appeals’ findings that the transaction produced significant benefits to National Starch
that extended beyond the tax year in question are amply supported by the record. For example,
National Starch’s 1978 “Progress Report” observed that the company would “benefit greatly from
the availability of Unilever’s enormous resources, especially in the area of basic technology.”
Morgan Stanley’s report to the National Starch board noted that National Starch management
“feels that some synergy may exist with the Unilever organization given a) the nature of the
Unilever chemical, paper, plastics and packaging operations ... and b) the strong consumer
products orientation of Unilever U.S.”
In addition to these anticipated resource-related benefits, National Starch obtained benefits
through its transformation from a publicly held, freestanding corporation into a wholly owned
subsidiary of Unilever. The Court of Appeals noted that National Starch management viewed the
transaction as “swapping approximately 3,500 shareholders for one.” Following Unilever’s
acquisition of National Starch’s outstanding shares, National Starch was no longer subject to what
even it terms the “substantial” shareholder-relations expenses a publicly traded corporation incurs,
including reporting and disclosure obligations, proxy battles, and derivative suits.
Courts long have recognized that expenses such as these, “incurred for the purpose of changing
the corporate structure for the benefit of future operations are not ordinary and necessary business
expenses.” General Bancshares Corp. v. Comm’r, 326 F.2d 712, 715 (CA8 1964).
______________________________________
Though not relevant to the resolution of this case (because the outlays were held to be capital
expenditures rather than expenses), note the language in the opinion that describes the several,
separate § 162 elements that must be satisfied (in addition to being an expense) before an outlay
can be deducted under § 162. What does ordinary mean, according to the Court? Necessary? We
shall explore this issue in more detail in Chapter 19.
Post-INDOPCO developments
The “substantial future benefits test” enunciated in INDOPCO makes sense as a theoretical
matter. After all, your appreciation of the difference between an income tax and consumption tax
shows that the major feature distinguishing between a current expense and a nondeductible capital
expenditure should be whether the outlay contributes chiefly to creating only this year’s Gross
Income (expense) or contributes meaningfully to creating income in future years (capital

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expenditure). If the outlay contributes meaningfully to future income, the investment should be
made with after-tax dollars in order to ensure effective taxation of that future income. If an
investment producing future income is made with pre-tax dollars, in contrast, the return (though
nominally included on the tax return) can be seen as effectively free from tax between the time the
investment producing that return was prematurely deducted and the time it would have been
deducted under a pure SHS income tax, as you learned in Chapter 2.
While understandable as a theoretical matter, the future benefits test announced in INDOPCO
was immediately controversial. Many outlays that had been routinely treated as expenses by the
government before INDOPCO, such as the cost of a routine commercial TV spot advertising a
product, could conceivably be reconsidered under this opinion. The IRS first calmed the waters by
issuing several Revenue Rulings to reassure the tax community. For example, Rev. Rul. 92-803
concluded that ordinary business advertising expenses generally remain deductible after
INDOPCO, even if they create goodwill lasting beyond the current year, and Rev. Rul. 96-62 4
concluded that employee training costs remain generally deductible immediately as expenses,
notwithstanding the future benefits obtained from training the employee in new skills.
At the same time, however, the government began litigating cases under the future benefits test.
For example, Wells Fargo & Co. v. Commissioner, 5 like INDOPCO, involved an acquisition of a
Target corporation by another corporation. The government maintained that Target employee
salary costs must be capitalized to the extent that the employees’ time was spent working on the
acquisition. The 8th Circuit Court of Appeals disagreed, however, distinguishing INDOPCO by
noting that the relevant Target employees had been hired to work in the Target’s general business
operations before the acquisition became a possibility, that their compensation was not increased
as a result of their work on the acquisition, and that they would have been paid their established
salaries even if the acquisition had not occurred.
Finally, Treasury announced and then issued new Treasury Regulations that provide greater
clarity regarding when an outlay pertaining to acquiring or creating an intangible must be
capitalized, which are found primarily in Treas. Reg. § 1.263(a)-4 and -5. The drafters stated that
they used the “substantial future benefits” test to inform the new regulations but that the
government would no longer cite the substantial future benefits test—alone—as justification for
capitalization without prior notice published in the Federal Register. 6
Outline of the regulations pertaining to intangibles
The Treasury Regulations pertaining to intangibles are found at Treas. Reg. § 1.263(a)-4, and
those regulations at -4(b)(1), (c), and (d) confirm that taxpayers must capitalize amounts paid to
acquire an intangible from another or to create an intangible, including ownership interests in
business entities, a financial instrument (such as a bond, futures contracts, or foreign currency
contract), a lease, a patent, a copyright, a trademark, goodwill, a customer list, software, and more.
For example, a $250,000 loan made by National Bank to client A is a nondeductible capital
expenditure because it creates a debt instrument (an intangible), 7 and the purchase of a patent from
the inventor is similarly a nondeductible capital expenditure. Such amounts include transaction
costs incurred to investigate or facilitate the transaction, as well, unless the aggregate of such costs
3

1992-2 C.B. 57.
1996-2 C.B. 9.
5
224 F.3d 874 (8th Cir. 2000).
6
See Treas. Reg. §§ 1.263(a)-4(b)(1)(iv) and -(4)(b)(2).
7
See Treas. Reg. §§ 1.263(a)-4(d)(2)(i)(B) and (d)(2)(vi), Ex. (1).
4

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is de minimis, defined as not exceeding $5,000. 8 In addition, costs incurred to defend or perfect
title to an intangible already owned must be capitalized. 9 Subject to the 12-month exception (more
below), prepaid expenses must be capitalized. 10 Drawing directly from Boylston Market, supra,
for example, Treas. Reg. § 1.263(a)-4(d)(3)(ii), Ex. (1), provides that a taxpayer who pays $10,000
to obtain three years of insurance protection must capitalize the cost. Similarly, amounts paid to
obtain membership or privileges in an organization or to obtain rights from a governmental
organization or state must be capitalized, including the cost of hospital privileges paid by a
physician and of bar admission paid by a lawyer, subject to the 12-month rule. 11
The 12-month rule is a significant change in law. Before the promulgation of this regulation,
an outlay made in December of Year 1 to purchase a 12-month intangible benefit (such as
insurance coverage) would have to be capitalized, as the bulk of the benefit was realized after the
close of the taxpayer year in which the benefit was purchased. Under Treas. Reg. § 1.263(a)4(f)(1), in contrast, “a taxpayer is not required to capitalize under this section amounts paid to
create … any right or benefit for the taxpayer that does not extend beyond the earlier of (i) 12
months after the first date on which the taxpayer realizes the right or benefit, or (ii) [t]he end of
the taxable year following the taxable year in which the payment is made.” For an example, see
Treas. Reg. § 1.263(a)-4(f)(8), Ex. (1) & (2). To prevent gamesmanship, Treas. Reg. § 1.263(a)4(f)(5) provides that “the duration of a right includes any renewal period if all of the facts and
circumstances in existence during the taxable year in which the right is created indicate a
reasonable expectancy of renewal.”
Treas. Reg. § 1.263(a)-5 generally provides that the costs incurred to rearrange the capital
structure of a corporation, such as the costs incurred in the acquisition of National Starch by
Unilever in INDOPCO, must be capitalized.
Problems
1. Mary, who uses the calendar year as her taxable year, owns a coffee shop. She purchases
insurance coverage that protects against damage to the building, as well as personal liability
coverage in case a customer sues. Instead of paying for coverage monthly, Mary pays the entire
contract amount on September 1 of Year 1. Can Mary deduct her payment as an expense under §
162 in the year of payment, or must she capitalize the cost under § 263, instead?
a. On September 1 of Year 1, she pays $12,000 for 24-month coverage, effective on that date
and extending to August 31 of Year 3? See Treas. Reg. § 1.263(a)-4(f)(1).
b. On September 1 of Year 1, she pays $6,000 for 12-month coverage, effective on that date
and extending to August 31 of Year 2?
c. On September 1 of Year 1, she pays $6,000 for 12-month coverage, effective February 1 of
Year 2 and extending to January 31 of Year 3?
d. Same as b., except that the contract has a renewal clause that entitles Mary to renew the
contract for a second 12-month period at the same price? See Treas. Reg. § 1.263(a)-4(f)(5).

8

Treas. Reg. § 1.263(a)-4(e).
Treas. Reg. § 1.263(a)-4(d)(9).
10
Treas. Reg. § 1.263(a)-4(d)(3).
11
See Treas. Reg. §§ 1.263(a)-4(d)(4) and (5).
9

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2. Sally, an inventor, owns an exclusive patent on a new technology. Saul sues Sally (say that
three times fast), alleging that he is the true owner of the patent. To settle the lawsuit, Sally pays
$10,000 to Saul in exchange for Saul’s release of all future claims against Sally regarding the
patent. Can Sally deduct the payment as an expense under § 162 in the year of payment, or must
she capitalize the cost under § 263, instead? See Treas. Reg. § 1.263(a)-4(d)(9).
3. On November 1 of Year 1, Matthew enters into negotiations with Martin to lease commercial
property from Martin for 25 years. Matthew pays Susan, one of his outside legal counsel, $4,000
on November 15 of Year 1 to assist in the negotiations of the lease terms with Martin. Matthew
and Martin come to an agreement in January of Year 2, and Matthew pays Larry, a second outside
legal counsel, $2,000 to draft the lease agreement. Can Matthew deduct the $4,000 paid to Susan
in Year 1 and the $2,000 paid to Larry in Year 2 as expenses under § 162, or must he capitalize
the costs to his lease agreement under § 263, instead? See Treas. Reg. § 1.263(a)-4(e). Would the
result be the same if Susan and Larry were full-time, in-house counsel (i.e., employees) in
Matthew’s business?

B. Outlays pertaining to tangible assets
The Treasury Regulations pertaining to tangible property are chiefly found at Treas. Reg. §
1.263(a)-2. Subject to two mutually exclusive exceptions—a de minimis rule and a rule pertaining
to “materials and supplies”—the costs to acquire, produce, or improve tangible assets, such as
land, buildings, and business equipment, must be capitalized. 12 On the flip side of the coin,
amounts incurred to sell property must also be capitalized, and capitalization occurs by reducing
the “amount realized” under § 1001(b) in determining gain or loss. Selling costs incurred by dealers
selling inventory, however, can be deducted immediately as ordinary and necessary business
expenses under § 162. 13 Just as in the case of intangibles, costs incurred to defend or perfect title
to real or personal 14 tangible property must also be capitalized. 15
As with intangibles, costs incurred to facilitate or investigate the acquisition of tangible business
or investment property must generally be capitalized (creating basis) rather than deducted as
current expenses, even if the property is not purchased. 16 If the property is not purchased after the
investigation, the basis created by the capitalized cost can be deducted as a “loss” under § 165.
(Recall from Chapter 1, Part A., that the definition of a “loss” in the tax sense is unrecovered
basis.) Because no “sale or exchange” occurs, this loss deduction would be ordinary, unhampered
by § 1211(b), even if the property would have been a capital asset if purchased.
In the case of real property only, however, costs incurred in the course of deciding whether to
purchase real property and which real property parcel to purchase need not be capitalized
(commonly referred to in the tax community as the “whether and which” rule for real property),
unless the item is on the list of “inherently facilitative costs,” which must always be capitalized. 17
The list of inherently facilitative costs is found at Treas. Reg. § 1.263(a)-2(f)(2)(ii) and includes,
12

Treas. Reg. § 1.263(a)-2(d)(1).
Treas. Reg. § 1.263(a)-1(e).
14
The use of the word “personal” here does not refer to personal-use property but rather non-real estate in the property
law sense.
15
Treas. Reg. § 1.263(a)-2(e).
16
Treas. Reg. § 1.263(a)-2(f)(3).
17
Treas. Reg. § 1.263(a)-2(f)(2)(iii).
13

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for example, appraisal costs, the cost of negotiating the acquisition terms or obtaining tax advice
in connection with the acquisition, sales and transfer taxes, title registration costs, and brokers’
commissions.
Two mutually exclusive de minimis elections
Recall that the intangible regulations had a simple $5,000 de minimis rule. For tangible
property, the de minimis rules are more complex. Treas. Reg. § 1.263(a)-1(f) contains alternative
elective de minimis rules, depending on whether or not the taxpayer has an “applicable financial
statement” within the meaning of Treas. Reg. § 1.263(a)-1(f)(4). First, taxpayers that have an
applicable financial statement can elect to treat amounts paid to acquire, produce, or improve
tangible property as current expenses (rather than capital expenditures) if:
•

the taxpayer has written accounting procedures in place at the beginning of the tax year in
question that treats outlays (i) costing less than a stipulated amount or (ii) having an
economic useful life of 12 months or less as current expenses for nontax purposes;

•

the taxpayer treats the outlay in question as an expense on its applicable financial statement
consistent with its written procedures; and

•

the amount paid does not exceed $5,000 per invoice or (as substantiated by the invoice) per
item (or some other amount announced in the Federal Register in the future).

An “applicable financial statement” is defined as (i) a financial statement required to be
submitted to the Securities and Exchange Commission (SEC); (ii) a certified audited financial
statement that is accompanied by a report of an independent CPA and that is used for reports to
shareholders or partners, for credit purposes, or for any other nontax purpose; or (iii) a financial
statement (other than a tax return) that is required to be submitted to a state or Federal government
or agency other than the SEC. Notice that such statements must be used for nontax, public purposes
to qualify under this de minimis rule, chiefly to provide public information to owners, lenders, and
regulators regarding the health of the business. The outlay allowed to be treated as a current
expense for tax purposes under this de minimis rule must also be treated as a current expense on
the financial statement, thus reducing financial statement current-year profits. The inherent tension
in requiring the business to publicly show a reduced profit for financial reporting purposes to
owners and lenders (because of the current expense deduction on the financial statement) is thought
to provide a built-in safeguard against misuse of the de minimis rule for tax purposes.
Small businesses are unlikely to satisfy the requirements of an “applicable financial statement”
within the meaning of the regulation, so the first set of proposed regulations contained no de
minimis rule for such taxpayers. After receiving criticism for this omission, Treasury added an
additional de minimis rule to the final regulations for those taxpayers who do not have an applicable
financial statement. Such taxpayers can elect to treat amounts paid to purchase, produce, or
improve tangible property as a current expense—not to exceed $2,500 per item (or invoice) 18—if
they have in place at the beginning of the taxable year accounting procedures treating costs less
than a specified dollar amount (or having a useful life of 12 months or less) as current expenses
for nontax purposes and record the items on their nontax books and records as expenses.
To make either de minimis election, the taxpayer must attach a statement that he is making the

18

The final regulations contained a $500 cap, but this amount was increased in November 2015 to $2,500 in Notice
2015-82, 2015-2 C.B. 859, for taxable years beginning in 2016.

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election to a timely filed tax return. 19 In no case can either of the de minimis rules described above
apply to the acquisition of land or inventory.
The § 162 deduction for materials and supplies
Finally, only taxpayers who do not elect to use the de minimus safe harbors described above
can use the companion § 162 regulation pertaining to “materials and supplies,” the cost of which
can be treated as an expense rather than a capital expenditure. Treas. Reg. § 1.162-3(c) identifies
as materials and supplies not only fuel, lubricants, and spare parts pertaining to other property but
also a “unit of property” with an economic useful life of 12 months or less or a “unit of property”
costing $200 or less (increased from $100 in the proposed regulations). Taxpayers making either
of the de minimis safe harbor elections described above must account for such costs under those
safe harbors, instead of the materials and supplies rule in Treas. Reg. § 1.162-3(c). 20
Property that is expensed (either under the de minimis rule or materials and supplies rule) has a
zero basis, which means that if the property is sold, the taxpayer will certainly realize a gain. This
gain must be treated as ordinary gain, even if the asset otherwise qualifies as a capital asset or §
1231 property (considered in Chapter 14). 21
Problems
1. Ringo does not have an “applicable financial statement” but does have in place before the
beginning of the taxable year an accounting procedure to treat capital expenditures of $2,500 or
less pertaining to tangible property as current expenses. Ringo decides that he wants to relocate
his music business to a larger building. He pays $5,000 to a real estate broker to find a suitable
building for his purposes. After she locates a suitable building, Ringo hires a contractor to perform
an inspection for termites and other potential problems, paying $3,000. After a good report, Ringo
purchases the building for $1,000,000. Can he deduct any of these payments as expenses under §
162, or must he capitalize the costs under § 263, instead?
2. Paul does not have an “applicable financial statement” but does have in place before the
beginning of the taxable year an accounting procedure to treat capital expenditures of $2,500 or
less pertaining to tangible property as current expenses. Paul owns a retail store in City A. He
wishes to explore the feasibility of expanding by opening a new store in city B. In October of Year
1, he pays $10,000 to a real estate development firm to study the retail environment in city B and
to perform market surveys, evaluate zoning requirements, and provide preliminary
recommendations on site selection. In December of Year 1, Paul hires an appraiser and pays to her
$2,000 to appraise a property for possible purchase. Must he capitalize these costs? What if the
appraiser charges $3,000? What if Paul decides in March of Year 2 not to acquire the property?
3. George, a landscaper, does not have an “applicable financial statement” and (unlike Ringo
and Paul) does not have in place before the beginning of the taxable year an accounting procedure
to treat capital expenditures of $2,500 or less pertaining to tangible property as current expenses.
He pays $90 for a new handsaw, which should last for 24 months, for use in his landscaping
business. He also pays $250 for a new edge trimmer, which typically lasts only 9 months for
19

See Treas. Reg. § 1.263(a)-1(f)(5).
See Treas. Reg. §§ 1.263(a)-1(f)(1)(ii) and (iii).
21
See Treas. Reg. §§ 1.263-1(f)(3)(ii) and (iii).
20

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George. Must he capitalize these costs? (Ignore the possible applicability of other Code sections,
such as § 179. Consider only the initial capitalization question.)
4. John sells Blackacre, A/B of $600,000, for $900,000. In so doing, he incurs 41,000 in legal
fees, as well as a $9,000 sales commission to a broker. Must he capitalize these costs? How does
one do that in connection with a sale of property? What if John is a real estate dealer?
_______________________________________________
The difficult distinction between repair (expense) and improvement (capital expenditure)
The capitalization issue that has produced the most litigation over the years with respect to
tangible property has been whether an outlay constitutes a mere “repair” (an expense under Treas.
Reg. § 1.162-4(a)), on the one hand, or an “improvement” (a capital expenditure), on the other.
For example, in American Bemberg Corp. v. Commissioner, 22 the taxpayer built a factory in 1925
through 1928 near a river. Twelve years later (in 1940), portions of the floor caved in, creating
holes as deep as 42 feet. The taxpayer engaged a well-known engineering firm to recommend a
remedy, but additional cave-ins occurred in 1941. The taxpayer hired a second firm with expertise
in subsoil engineering, and it recommended “an elaborate program of drilling and grouting and
making some replacements,” which the taxpayer had to do or “abandon its plant.” The taxpayer
expended nearly $1 million (more than $17 million in current dollars) to complete the required
work, which fixed the problems.
The taxpayer immediately deducted the cost as a mere repair expense, but the government
argued that the outlay constituted an improvement or betterment of the factory building and, thus,
a nondeductible capital expenditure.
The Tax Court majority, in a reviewed decision, examined “the purpose, the physical nature,
and the effect of the work” in distinguishing between a repair and an improvement.
In connection with the purpose of the work, [the outlays were] intended [to] avert a
plant-wide disaster and avoid forced abandonment of the plant. The purpose was not
to improve, better, extend, or increase the original plant, nor to prolong its original
useful life. Its continued operation was endangered; the purpose of the expenditures
was to continue in operation not on any better scale, but on the same scale and as
efficiently as it had operated before. The purpose was not to rebuild or replace the
plant, but to keep it as it was and where it was.
In connection with the physical nature of the work, the drilling and grouting was not a
work of construction nor the creating of anything new. While the amount of grout
introduced was large, it by no means represented a large percentage of the tremendous
cube of earth standing between the plant floor and the bedrock which lay at an average
depth of over 50 feet below the plant floor. The work could not successfully have been
of smaller scope.
In connection with the effect of the work, the accomplishment of what was done
forestalled imminent disaster and gave petitioner some assurance that major cave-ins
would not occur in the future. The original geological defect has not been cured; rather
its immediate consequences have been dealt with.
22

10 T.C. 361 (1948), aff’d, 177 F.2d 200 (6th Cir. 1949) (per curiam).

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Thus, the majority held in favor of the taxpayer. The dissent, in contrast, argued:
These large expenditures created a substantial underground structure, a part of the
plant, which did not exist, had no previous counterparts, and was not a part of the
petitioner’s capital previously. Its life and benefits would last for considerably more
than one year. The expenditures were capital in their nature and should be recovered
ratably over its useful life.
In light of the underlying tax values at stake described at the beginning of this chapter, which
is the better approach? Many contradictory court decisions on similar facts contributed to the need
for Treasury to amend the regulations pertaining to this troublesome distinction. Today,
regulations found at Treas. Reg. § 1.263(a)-3 provide a detailed roadmap to the analysis that
effectively supersedes this large body of contradictory case law.
Improvement: betterment, restoration, or adapting the property to a new use
Treas. Reg. § 1.263(a)-3(d) now provides that outlays must be treated as capital expenditures if
they “improve” the unit of property, and property is considered improved if the costs (1) result in
a betterment to the unit of property, (2) restore the unit of property, or (3) adapt the unit of property
to a new or different use (unless the alternative de minimis exceptions are satisfied).
Betterment results if the outlay (i) ameliorates a “material condition or defect” existing prior to
the taxpayer’s acquisition of the unit of property or one that arose during its production (whether
or not the taxpayer was aware of the defect), (ii) results in a “material addition,” e.g., physical
enlargement, expansion, or extension, or (iii) results in a “material increase in productivity,
efficiency, strength, quality, or output” of the unit of property. 23 Outlays incurred to correct
“normal wear and tear” do not result in betterment. 24
An amount is paid to restore property if it replaces a component, the basis of which was
deducted as a loss under § 165 or was reduced (such as in the case of certain casualty losses). 25
Alternatively, a restoration returns the property to its “ordinarily efficient operating condition if
the property has deteriorated to a state of disrepair and is no longer functional for its intended use,”
results in rebuilding the unit of property to “like new” condition, or replaces “a part or a
combination of parts that comprise a major component or a substantial structural part of a unit of
property.” 26 A “major component” is one that “performs a discrete and critical function in the
operation of the unit of property,” and a “substantial structural part” is one that “comprises a large
portion of the physical structure of the unit of property.” 27
An amount is used to adapt the property to a new or different use if “the adaptation is not
consistent with the taxpayer’s ordinary use of the unit of property at the time originally placed in
service by the taxpayer.” 28
In contrast, outlays constitute a mere repair (expense)—rather than in improvement (capital
expenditure)—if they are “necessitated by normal wear and tear or damage to the unit pf property
that occurred during the taxpayer’s use of the unit and of property” and “correct the effects of
normal wear and tear to the unit of property that occurred during the taxpayer’s use of the unit of
23

See Treas. Reg. § 1.263(a)-3(j)(1).
See Treas. Reg. § 1.263(a)-3(j)(2)(iv).
25
Treas. Reg. § 1.263(a)-3(k)(1)(i)-(iii).
26
Treas. Reg. § 1.263(a)-3(k)(1)(iv)-(vi) and (k)(5)-(6).
27
Treas. Reg. § 1.263(a)-3(k)(6)(B).
28
Treas. Reg. § 1.263(a)-3(l)(1).
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property.” 29
Determining the unit of property
The threshold task in making the improvement determination is to establish the “unit of
property” that should be the focus of the inquiry. With respect to real property, each building,
including its structural components and significant systems, is considered to be a single unit of
property, but the improvement standard is then applied separately to (i) the building structure and
its structural components (e.g., roof, walls, and floor), and (ii) each of the buildings systems, such
as HVAC (heating, ventilation, and air conditioning), plumbing systems, electrical systems, all
escalators, all elevators, fire protection and alarm systems, security systems, gas distribution
systems, and any other structural components identified in published guidance. 30 In an example of
the latter, the regulations posit a retail building owned by B with two elevator banks in different
parts of the building, with three elevators in each bank (a total of six elevators in the building), and
concludes “if an amount paid by B for work on the elevators is an improvement (for example, a
betterment) to the elevator system, B must treat this amount as an improvement to the building.” 31
In the case of property other than buildings, the regulations adopt a “functional interdependent
test” to determine the unit of property. 32 “Components of property are functionally interdependent
if the placing in service of one component by the taxpayer is dependent on the placing in service
of the other component by the taxpayer.” 33 In an example, the regulations conclude that a computer
and printer put into service in a law office constitute two separate units of property (rather than a
single unit of property) because “the computer and the printer are not components that are
functionally interdependent (that is, the placing in service of the computer is not dependent on the
placing in service of the printer).” 34
Routine maintenance safe harbor
One of the most important innovations of the new regulations is the creation of a new “safe
harbor” for routine maintenance with respect to both buildings and other tangible property. 35 With
respect to buildings, routine maintenance consists of the “recurring activities that a taxpayer
expects to perform as a result of the taxpayer’s use … to keep the building structure or each
building system in its ordinarily efficient operating condition,” including “the inspection, cleaning,
and testing of the building structure or each building system, and the replacement of damaged or
worn parts with comparable and commercially available replacement parts.” 36 Whether the
activities qualify as “routine” depends on “the recurring nature of the activity, industry practice,
manufacturers’ recommendations, and the taxpayer’s experience with similar or identical
property.” 37 At a minimum, however, the taxpayer must reasonably expect to perform the activities

29

Treas. Reg. § 1.263(a)-3(j)(iv)(A)-(B).
See Treas. Reg. §§ 1.263(a)-3(e)(1) and (2).
31
Treas. Reg. § 1.263(a)-3(e)(6), Ex. (2).
32
Special unit-of-property rules apply to plant property, network assets, and leased property, which are not described
here.
33
Treas. Reg. § 1.263(a)-3(e)(3).
34
Treas. Reg. § 1.263(a)-3(e)(6), Ex. (9).
35
See Treas. Reg. § 1.263(a)-3(i). A “safe harbor” is a provision of a statute or a regulation that specifies that certain
well-defined conduct will be deemed either to come within or not to violate a given rule.
36
Treas. Reg. § 1.263(a)-3(i)(1)(i).
37
Id.
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more than once every 10 years. 38
The rules are similar for property other than buildings, except that the taxpayer must reasonably
expect to perform the maintenance activities more than once during the property’s “class life”
(essentially, the useful life over which the taxpayer may depreciate the property under the
provisions studied in Chapter 13). For an example, see Treas. Reg. § 1.263(a)-3(i)(6), Ex. (1)
(pertaining to engine maintenance for airplanes). Routine maintenance costs do not qualify for the
safe harbor if they are done at the same time as a betterment, however. 39
Small business safe harbor election for building improvements
Finally, for small taxpayers, the final regulations added a safe harbor election for building
property held by taxpayers with annual average gross receipts (over three years) of $10 million or
less. They can elect to avoid capitalizing a building improvement (without regard to the unit-ofproperty analysis described above) if the total amount paid during the tax year for repairs,
maintenance, improvements, and similar activities performed on the eligible building does not
exceed the lesser of $10,000 or 2% of the unadjusted basis of the building. 40 Eligible building
property must have an unadjusted basis of $1 million or less. 41 This election is independent of the
de minimis safe harbor election described earlier, and a separate election must be made with respect
to each building by attaching the election to a timely filed return. 42
Problems
1. In Year 1, Danielle purchases a store on a parcel of land that includes underground gasoline
storage tanks. Though she was not aware of the defect when she purchased the land, the storage
tanks had leaks, which contaminated the soil. When Danielle discovers the problem in Year 2, she
incurs $10,000 to remediate the spillage. Must she capitalize the costs, or can she deduct them
immediately as business expenses under § 162?
2. David has long owned a meat processing plant and was used to periodic inspections by
Federal meat inspectors. On the most recent inspection, they find oil seeping through the concrete
walls of the plant, creating a fire hazard, and order David to correct the problem or they will close
the plant down. David spends $10,000 to add a concrete lining to the walls and floors, which
corrects the problem. Must he capitalize the cost?
3. Mark owns an office building whose roof needs new shingles. Mark spends $10,000 in
replacing the old wooden shingles with asphalt shingles of comparable quality. Must he capitalize?
What if the roof inspection reveals that a major portion of the sheathing and rafters has rotted and
the entire roof, including the decking, insulation, membrane and shingles, needs to be replaced?
4. Rhonda owns a tugboat, and the tugboat manufacturer recommends inspection and cleaning
of the engine every three years, with replacement of worn parts, as necessary. In Year 3, Rhonda
spends $6,000 for scheduled maintenance, which includes cleaning, inspecting, reconditioning,
and the replacement of minor parts. Must she capitalize the cost? In Year 6, when the next
38

Id.
See Treas. Reg. § 1.263(a)-3(i)(6), Ex. (10).
40
See Treas. Reg. § 1.263(a)-3(h)1).
41
See Treas. Reg. § 1.263(a)-3(h)(4).
42
See Treas. Reg. § 1.263(a)-3(h)(6).
39

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scheduled maintenance occurs, Rhonda decides to upgrade the engines to increase their
horsepower and propulsion, allowing her to pull heavier loads. The amount that she pays ($15,000)
includes the replacement of some parts with upgraded components to achieve the increased power
that she desires but also the usual cleaning, inspecting, reconditioning, and the replacement of
minor parts, which benefit the upgrades. Must she capitalize?

C. Indirect costs of producing inventory (and other property)
There is no question that the utility in Idaho Power, below, is constructing property, the costs
of which must be capitalized into basis. But which costs should be counted?
COMMISSIONER v. IDAHO POWER CO.
418 U.S. 1 (1974)
MR. JUSTICE BLACKMUN delivered the opinion of the Court.
For many years, the taxpayer has used its own equipment and employees in the construction of
improvements and additions to its capital facilities [power lines and related facilities]. During 1962
and 1963, taxpayer owned a wide variety of automotive transportation equipment, including cars,
trucks, power-operated equipment, and trailers. The equipment was used in part for operation and
maintenance and in part for the construction of capital facilities having a useful life of more than
one year. For Federal income tax purposes, the taxpayer claimed as a deduction all the year’s
depreciation on the transportation equipment, using a life of 10 years.
The Commissioner disallowed the deduction for the construction-related depreciation. He
added the amount of the depreciation so disallowed to the taxpayer’s adjusted basis in its capital
facilities.
The issue comes down to a question of timing, that is, whether the construction-related
depreciation is to be amortized over the shorter life of the equipment or, instead, over the longer
life of the facilities constructed. Our primary concern is with the necessity to treat constructionrelated depreciation in a manner that comports with accounting and taxation realities. Over a period
of time [an] asset is consumed and, correspondingly over that period, its theoretical value and
utility are thereby reduced. Depreciation is an accounting device which recognizes that the
physical consumption of [an] asset is a true cost, since the asset is being depleted. When the asset
is used to further the taxpayer’s day-to-day business operations, a current depreciation deduction
is an appropriate offset to Gross Income currently produced. It is clear, however, that different
principles are implicated when the consumption of the asset takes place in the construction of other
assets that, in the future, will produce income themselves. In this latter situation, the cost
represented by depreciation is related to the future and is appropriately allocated as part of the cost
of acquiring an income-producing asset.
Established tax principles require the capitalization of the cost of acquiring an asset. This
principle has obvious application to the acquisition of an asset by purchase, but it has been applied,
as well, to the costs incurred in a taxpayer’s construction of capital facilities.
There can be little question that other construction-related expense items, such as tools,
materials, and wages paid construction workers, are to be treated as part of the cost of acquisition
of a capital asset. The taxpayer does not dispute this. Of course, reasonable wages paid in the

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carrying on of a trade or business qualify as a deduction from Gross Income. § 162(a)(1). But when
wages are paid in connection with the construction or acquisition of [an] asset, they must be
capitalized and are then entitled to be amortized over the life of the asset so acquired. Constructionrelated depreciation is not unlike expenditures for wages for construction workers. The significant
fact is that the exhaustion of construction equipment does not represent the final disposition of the
taxpayer’s investment in that equipment; rather, the investment in the equipment is assimilated
into the cost of the asset constructed.
An additional pertinent factor is that capitalization of construction-related depreciation by the
taxpayer who does its own construction work maintains tax parity with the taxpayer who has its
construction work done by an independent contractor. The depreciation on the contractor’s
equipment incurred during the performance of the job will be an element of cost charged by the
contractor for his construction services, and the entire cost must be capitalized by the taxpayer
having the work performed. The Court of Appeals’ holding would lead to disparate treatment
among taxpayers because it would allow the firm with sufficient resources to construct its own
facilities and obtain a current deduction, whereas another firm without such resources would be
required to capitalize its entire cost charged to it by the contractor.
Finally, the priority-ordering directive of § 161—or, for that matter, § 261 of the Code—
requires that the capitalization provision of § 263(a) take precedence, on the facts here, over
§ 167(a). The clear import of § 161 is that, with stated exceptions set forth either in § 263 itself or
provided for elsewhere, none of which is applicable here, an expenditure incurred in acquiring
assets must be capitalized even when the expenditure otherwise might be deemed deductible under
Part VI.
[Dissenting opinion of JUSTICE DOUGLAS omitted.]
____________________________________
When Baker Bob owns a delivery truck and uses it to deliver baked goods to restaurants around
town, Bob would currently deduct the depreciation allowable on the truck under §§ 167 and 168,
as that depreciation is a cost of producing this year’s Gross Income (only). In contrast, when
Developer Diana owns a backhoe that she uses in constructing other property—a building for her
own use or for sale to others, for example—the depreciation otherwise allowable on the backhoe
during the construction period must be added to the basis of the constructed building, instead of
being currently deducted. If the building is going to be used by Developer Diana in her own
business, the building’s basis (which includes the construction-period depreciation on the backhoe)
would be depreciated over the much longer life of the building. If Developer Diana is, instead,
going to sell the building, the basis (which includes the construction-period depreciation on the
backhoe) would be offset against the § 1001(b) amount realized on sale.
§ 263A codification
Congress enacted § 263A in 1986, which provides greater clarity regarding which indirect costs
of the type illustrated in Idaho Power must be capitalized. These rules trump any rules found in
the Treasury regulations under § 263. While they contain quite a bit of detail, some of the more
important rules are described below.
Section 263A generally applies to real or personal property produced by the taxpayer or
acquired for resale, except that it does not apply to personal property acquired for resale by
taxpayers whose average annual gross receipts for the prior three years did not exceed $10

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million.43 Section 263A(a) requires that the “direct costs” and an allocable share of “indirect costs”
be capitalized into the property produced or acquired, but exceptions apply to the production of
animals and plants by farmers, 44 as well as to any “qualified creative expense” incurred by
professional writers, photographers, and artists. 45
While interest is usually considered to be a current expense, production-period interest is an
indirect cost that must generally be capitalized into the produced property rather than deducted
currently under § 163. 46 Other indirect costs that must be capitalized generally include labor costs,
storage costs, depreciation, rent, state sales and property taxes, insurance, utilities, repairs and
maintenance, engineering and design costs, licensing fees, and more. 47 Indirect costs specifically
excepted from capitalization include selling and distribution costs, research and experimental
costs, and amounts permitted to be deducted under § 179. 48 The Treasury regulations under §
1.263A are lengthy and detailed, but this short description gives you a flavor. (Chocolate.)

43

§ 263A(b)(2)(B).
§ 263A(d).
45
§ 263A(h).
46
See § 263A(f).
47
See Treas. Reg. § 1.263A-1(e)(3)(ii).
48
Treas. Reg. § 1.263A-1(e)(3)(iii).
44

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Unit II:
Two Types of Gross Income:
Compensation and Residual Gross Income
Introduction to Chapters 5 and 6
In Chapter 1, you learned that § 61(a) of the Code lists several items of Gross Income, including,
among other items, interest, rent, dividends, and “gains derived from dealings in property.” In
connection with that last item, you learned that gain was a precise term of tax art, defined in §
1001(a) as the excess of § 1001(b) amount realized over the property’s adjusted basis. You will
further explore the concept of § 1001 realized and recognized gain in Chapter 12. This unit
explores more closely two other types of § 61 gross income: § 61(a)(1) compensation for services
rendered and so-called residual gross income.
Chapter 5 will consider the scope of the compensation inclusion under § 61(a)(1). As you will
learn, all compensation for services rendered must be included in gross income under § 61(a)(1)
unless an express statutory exclusion applies. Though there were a few common law doctrines that
developed in the early days of the income tax, which allowed some forms of compensation paid in
kind to escape taxation (such as the convenience-of-the-employer doctrine that was eventually
codified in § 119 in 1954), Congress made its intent absolutely clear in 1984 when it enacted §
132 that no common law exclusions remain. To exclude compensation from gross income, the
payee must satisfy an express statutory exclusion.
The most important compensation exclusions today are (1) the exclusion for employer-provided
health care in §§ 105 and 106 (among the most expensive tax expenditures in the Code) and (2)
the exclusion for contributions to certain retirement accounts, which are accorded consumptiontax treatment, such as IRAs, qualified pension plans, and § 401(k) plans. The former will be
discussed in Chapter 17, and the details of the latter are beyond the basic income taxation course,
though they will be mentioned again in connection with the cash method of accounting in Chapter
21. With our limited time, Chapter 5 will consider two statutory exclusions provisions, §§ 119 and
132, as well as the rules in § 83 that apply to property paid in kind as compensation that is subject
to a substantial risk of forfeiture. The interested student who wishes to learn about other
compensation exclusions can explore the exclusions for the rental value of parsonages (§ 107),
certain combat zone compensation of members of the Armed Forces (§ 112), so-called Cafeteria
Plans (§ 125), dependent-care assistance programs (§ 129), adoption assistance programs (§ 137),
employer-provided life insurance (§ 79), and more. (Alas, there are only so many classroom hours
in the basic tax course!)
Chapter 6 will then explore the contours of that terribly vague language found in what we can
call the “residual clause” in § 61: “Gross Income means all income from whatever source derived.”
We know that this language must contain positive content, i.e., that items of includable Gross
Income must be described by that language, because the parenthetical in § 61—“(including but not
limited to)”—states that the listed items do not exhaust the universe of Gross Income items. The
very vagueness of that language, however, means that both the administrators of the statute and
the courts appear to have more leeway to conclude that a receipt does—or does not—constitute

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Gross Income. How should they decide which items should be included in Gross Income under
the residual clause? Which analytical tools should they use? Are these judgments merely arbitrary?
Can the underlying tools of tax policy that you learned in Chapter 3 and the core concepts
underlying SHS income that you learned in Chapter 1 inform the adjudicator, whether that
adjudicator is the IRS issuing guidance or a court confronting that vague language in a tax dispute?

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Chapter 5: § 61(a)(1) Compensation
As just described in the introduction to this unit, this chapter will consider the general contours
of the compensation inclusion under § 61(a)(1), two statutory exclusions pertaining to
compensation (§§ 119 and 132), and the rules in § 83 that apply to property paid in kind as
compensation that is subject to a substantial risk of forfeiture. The most important compensation
exclusion (for employer-provided health care) will be examined in Chapter 17 (pertaining to the
personal consumption tax expenditures), certain education fringe benefits will be addressed in
Chapter 16 (addressing the acquisition of human capital), and an introductory consideration of
compensation paid to tax-preferred retirement accounts will be considered in Chapter 21 (in
connection with the cash method of accounting). The employer’s § 162(a)(1) deduction for
compensation paid is also briefly considered here.
A payment made by an employer to an employee (or made by a services recipient to an
independent contractor services provider) is expressly listed as Gross Income in the very first listed
item in § 61(a)(1). Notice how broad the language found there is: “compensation for services,
including fees, commissions, fringe benefits, and similar items.” The name attached to the payment
is irrelevant to the taxation of that payment. And the payment need not necessarily ever touch the
employee’s or independent contractor’s hands, as illustrated in the relatively early Supreme Court
case below.
OLD COLONY TRUST CO. v. COMMISSIONER
279 U.S. 716 (1929)
MR. CHIEF JUSTICE TAFT delivered the opinion of the Court.
William M. Wood was president of the American Woolen Company during the years 1918,
1919 and 1920. In 1918 he received as salary and commissions from the company $978,725 [more
than $18 million in current dollars], which he included in his Federal income tax return for 1918.
In 1919 he received as salary and commissions from the company $548,132.27 [more than $8.6
million in current dollars], which he included in his return for 1919.
August 3, 1916, the American Woolen Company had adopted the following resolution, which
was in effect in 1919 and 1920:
Voted: That this company pay any and all income taxes, State and Federal, that may
hereafter become due and payable upon the salaries of all the officers of the company,
including the president, William M. Wood, to the end that said persons and officers
shall receive their salaries or other compensation in full without deduction on account
of income taxes, State or Federal, which taxes are to be paid out of the treasury of this
corporation.
Pursuant to these resolutions, the company paid to the collector of internal revenue Mr. Wood's
Federal income and surtaxes due to salary and commissions paid him by the company, as follows:
taxes paid for 1918: $681,169.88 [effective tax rate 69.5%]; taxes paid for 1919: $351,179.20
[effective tax rate 64%].
The decision of the Board of Tax Appeals here sought to be reviewed was that the income taxes
paid by the company for Mr. Wood were additional income to him for the years 1919 and 1920.

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[W]e think the question presented is whether a taxpayer, having induced a third person to pay
his income tax or having acquiesced in such payment as made in discharge of an obligation to him,
may avoid the making of a return thereof and the payment of a corresponding tax. We think he
may not do so. The payment of the tax by the employers was in consideration of the services
rendered by the employee and was a gain derived by the employee from his labor. The form of the
payment is expressly declared to make no difference. Section 213, Revenue Act of 1918, c. 18, 40
Stat. 1065 [current § 61(a)(1)]. It is therefore immaterial that the taxes were directly paid over to
the Government. The discharge by a third person of an obligation to him is equivalent to receipt
by the person taxed. The certificate shows that the taxes were imposed upon the employee, that
the taxes were actually paid by the employer and that the employee entered upon his duties in the
years in question under the express agreement that his income taxes would be paid by his employer.
This is evidenced by the terms of the resolution passed August 3, 1916, more than one year prior
to the year in which the taxes were imposed. The taxes were paid upon a valuable consideration,
namely, the services rendered by the employee and as part of the compensation therefor. We think
therefore that the payment constituted income to the employee.
Nor can it be argued that the payment of the tax was a gift. The payment for services, even
though entirely voluntary, was nevertheless compensation within the statute.
It is next argued against the payment of this tax that if these payments by the employer constitute
income to the employee, the employer will be called upon to pay the tax imposed upon this
additional income, and that the payment of the additional tax will create further income which will
in turn be subject to tax, with the result that there would be a tax upon a tax. This it is urged is the
result of the Government’s theory, when carried to its logical conclusion, and results in an
absurdity which Congress could not have contemplated.
In the first place, no attempt has been made by the Treasury to collect further taxes, upon the
theory that the payment of the additional taxes creates further income, and the question of a tax
upon a tax was not before the Circuit Court of Appeals and has not been certified to this Court.
We can settle questions of that sort when an attempt to impose a tax upon a tax is undertaken, but
not now. It is not, therefore, necessary to answer the argument based upon an algebraic formula to
reach the amount of taxes due. The question in this case is, “Did the payment by the employer of
the income taxes assessable against the employee constitute additional taxable income to such
employee?” The answer must be “Yes.”
________________________________
Note the Court’s rejection of exclusion by Mr. Wood as a “gift.” In 1986, Congress amended §
102 by adding subsection (c), which expressly denies exclusion of payments made by an employer
to an employee as a gift. Section 102(c)(2), however, helpfully reminds us that other statutory
exclusions may apply, such as exclusion as a de minimis fringe under § 132(e) (considered below)
or as an employee achievement award under § 74(c).
Although the case does not use the words, you can think of Old Colony Trust as one of the first
cases to apply the very important “substance over form” doctrine in tax. Under the substance
over form doctrine, a transaction is taxed according to its underlying economic substance if
its form does not fairly reflect that underlying substance. In form, cash went directly from the
company to the IRS, not to Mr. Wood as compensation. In substance, however, the cash implicitly
went first to Mr. Wood (includable compensation) and then from Mr. Wood to the IRS and to his
state’s treasury. Or this could case could illustrate another common law doctrine: the step

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transaction doctrine. In form, one step occurs (the payment of money by the corporation to the
IRS), but in substance two steps occur: the payment of cash to Mr. Wood (step 1), followed the
payment of that cash by Mr. Wood to the IRS and his state’s treasury (step 2). The portion deemed
paid by him to the IRS would be nondeductible under § 275(1), but the portion deemed paid by
Mr. Wood to his state’s treasury could be deductible under § 164(a)(3) today, subject to a $10,000
cap, though it would be an Itemized Deduction, as described in Chapter 1, Part B.
Mr. Wood’s includable salary thus had to be grossed up by the amount of the taxes paid on his
behalf directly to Federal and state authorities by Mr. Wood’s company. Whether any additional
tax owed under Old Colony Trust on the gross-up, itself, would be paid by the company is, of
course, a matter of the employment contract between the executive and the company. Some
contracts may provide that only the first level of income tax owed would be paid by the company
(which would be the largest chunk) and that any additional tax owed (under Old Colony Trust
principles) by reason of the payment is the executive’s responsibility. Other employment contracts
may provide for a full gross-up, meaning that any additional tax owed by reason of the first tax
payment would also be paid by the company, and the additional tax owed on that second payment
would also be paid by the company, and so on, until the additional compensation reaches zero.
Executive compensation experts have the algebraic formula in hand that allows them to compute
what a full gross-up would end up costing the company.
Even in the case of a full gross-up, this practice does not affect the total tax collected by
Treasury. For example, assume a combined Federal and state income tax rate of 45% on $1 million
of compensation for the sake of simplicity. Whether the corporation contracts with Executive Ed
to pay $1.82 million with no gross-up or $1 million with a full Federal and state gross-up, Ed will
have approximately $1 million in hand after taxes are paid, and the Federal and state Treasuries
will collect roughly $820,000 in aggregate tax. Let’s see why that statement is true.
A payment of $1.82 million with no gross-up would cause Ed to pay $819,000 to the Treasury
directly ($1.82 million x .45), leaving him with slightly more than $1 million cash in hand. In
contrast, if Ed’s employment contract requires a salary of $1 million net of Federal and state
income tax, the company will pay $450,000 tax ($1 million x .45) in the first round. That $450,000
payment made on Ed’s behalf constitutes additional income to Ed under Old Colony Trust
principles, resulting in a second tax of $202,500 ($450,000 x .45), resulting in additional tax owed
of $91,125 ($202,500 x .45), and so on until a total of slightly more than $819,000 is paid by the
company on Ed’s behalf.
While the total tax paid is not affected, tax gross-ups raise transparency concerns for
shareholders regarding the total compensation paid by a company to its executives. As a 2005 Wall
Street Journal article observed, “[d]etails of the little-known payments, called ‘tax gross-ups,’ are
often buried in impenetrable footnotes or obscure filings.” 1 If shareholders read that the
executive’s compensation package amounts to $1 million, they may infer that the executive would
owe Federal and state income tax on that $1 million, leaving less in the executive’s hands after
taxes are taken into account. They may not appreciate that the executive’s before-tax salary is
really $1.82 million. In 2009 the Wall Street Journal reported that some companies were beginning
to scale back on tax gross-ups as more light has been shed on them by advocacy groups. 2

1

See Mark Maremont, Latest Twist in Corporate Pay: Tax-Free Income for Executives, at
http://online.wsj.com/news/articles/SB113521937434129170.
2
Cari Tuna, Firms End Key Benefit for Executives, at http://online.wsj.com/news/articles/SB123999269099029747.

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The issue illustrated in Old Colony Trust goes far beyond tax gross-ups, however. What if Sue
is the CEO of Realty, Inc., and Realty pays CEO Sue’s gym membership for her at a cost of $1,000
each year? Under Old Colony Trust, she must include that $1,000 in her Gross Income under §
61(a)(1), even if the payment goes directly from Realty to the gym. Because gym membership is
a personal expense, she cannot deduct the payment that she is deemed to have made. § 262(a).
Mr. Wood’s tax payment in Old Colony Trust and CEO Sue’s gym membership were both paid
in cash, but compensation need not be paid in cash to be cognizable for tax purposes.
Compensation paid in the form of property received in kind or in the form of services received in
kind is also includable (absent application of §§ 119 or 132, below).
For example, assume that Realty, Inc., sells to CEO Sue Blackacre, which is worth $100,000,
for only $10,000. CEO Sue must include the $90,000 worth of Blackacre that she received in kind
(for free) in her Gross Income as compensation. 3 What should be CEO Sue’s basis in Blackacre
under SHS principles? Recall from Chapter 1 the two most common ways for basis to be created:
(1) through the making of a nondeductible capital expenditure and (2) through an income inclusion
with respect to property. Sue creates $10,000 of basis when she pays $10,000 for Blackacre, a
nondeductible capital expenditure under § 263. She also creates $90,000 of basis when she
includes $90,000 in her Gross Income under § 61(a)(1) on receipt of the property as
compensation. 4 The sum of $10,000 (paid by Sue) and $90,000 (included by Sue) results in a
$100,000 Blackacre basis, its full fair market value. Recall that basis is generally a running record
of previous taxed dollars to ensure that we do not tax the same taxpayer twice on the same dollars.
When Sue is denied a deduction for her $10,000 capital expenditure, that amount remains in her
tax base and is implicitly taxed. When Sue includes $90,000 of compensation in her Gross Income,
the $90,000 is explicitly taxed. Sue needs a $100,000 Blackacre basis to ensure that she is not
taxed on any part of that $100,000 a second time when she sells Blackacre in the future.
Ditto with respect to services (as opposed to property) received in kind, as illustrated in the
revenue ruling below.
REVENUE RULING 79-24
1979-1 C.B. 60
Certain members of barter clubs must include in income the fair market value of services
received in exchange for services rendered. Likewise, the owner of an apartment building who
receives a work of art created by a professional artist in return for the rent-free use of an apartment
must include in income the fair market value of the work of art, and the artist must include the fair
rental value of the apartment.
FACTS
Situation 1. In return for personal legal services performed by a lawyer for a housepainter, the
housepainter painted the lawyer’s personal residence. Both the lawyer and the housepainter are
members of a barter club, an organization that annually furnishes its members a directory of
members and the services they provide. All the members of the club are professional or trades
3

See Treas. Reg. § 1.61-2(d)(1). In the very next chapter, you will learn that a bargain purchase between strangers
does not result in realized gross income at the time of purchase for the buyer, as the benefit of the bargain does not
represent a substitute for a clearly includable item, such as compensation, in that case. Stay tuned.
4
See Treas. Reg. § 1.61-2(d)(2).

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persons. Members contact other members directly and negotiate the value of the services to be
performed.
Situation 2. An individual who owned an apartment building received a work of art created by
a professional artist in return for the rent-free use of an apartment for six months by the artist.
LAW
The applicable sections of the Internal Revenue Code and the Income Tax Regulations
thereunder are 61(a) and 1.61-2, relating to compensation for services.
Section 1.61-2(d)(1) of the regulations provides that if services are paid for other than in money,
the fair market value of the property or services taken in payment must be included in income. If
the services were rendered at a stipulated price, such price will be presumed to be the fair market
value of the compensation received in the absence of evidence to the contrary.
HOLDINGS
Situation 1. The fair market value of the services received by the lawyer and the housepainter
are includible in their Gross Incomes under section 61 of the Code.
Situation 2. The fair market value of the work of art and the six months fair rental value of the
apartment are includible in the Gross Incomes of the apartment-owner and the artist under section
61 of the Code.
_______________________________________
The Associated Press reported that the NBC broadcasting network once gave matching silver
Boxster sports cars (worth $40,000 at the time) to Eric McCormack, Debra Messing, Sean Hayes,
and Megan Mullaly, the four stars of the “Will & Grace” television show. “It was a nice way for
us to say thank you for a great first season,” said Dave Bartus, an NBC vice president. “We walked
out into the parking lot and said, ‘There’s one for each of you.’ They seemed truly shocked.” 5 Of
course, the TV stars had to include in their Gross Incomes the fair market value (FMV) of the cars
under § 61(a)(1).
Here is another example:
Phil Lubin, chief executive of Evernote, turned to his wife last year and asked if she
had suggestions for how the software company might improve the lives of its
employees and their families. His wife, who also works at Evernote, didn’t miss a beat:
housecleaning.
Today, Evernote’s 250 employees—every full-time worker, from receptionist to top
executive—have their homes cleaned twice a month, free.
It is the latest innovation from Silicon Valley: the employee perk is moving from the
office to the home…. Stanford School of Medicine is piloting a project to provide
doctors with housecleaning and in-home dinner delivery. Genentech offers take-home

5

ASSOCIATED PRESS, “Will & Grace” Stars Get Porsches, at www.apnewsarchive.com/1999/-Will-Grace-Stars-GetPorsches/id-f4d340339fe0455e7a8313f73f664701. Eric McCormack then auctioned off the Porsche, with the
proceeds benefiting Project Angel Food, a charity that delivers meals to those with debilitating illnesses. See Jessica
Gold Haralson, Erik McCormack auctioning Will & Grace Porsche, at
www.people.com/people/article/0,,20223342,00.html.

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dinners …. 6
As with the TV stars, the Evernote employees must include in their Gross Incomes the FMV of
these services.
Why would employers go to the bother of paying compensation in the form of property or
services in kind—rather than cash—if employees (or independent contractors) must include the
FMV of the property or services in Gross Income (absent application of an exclusion provision,
such as §§ 119 and 132)? After all, paying cash is clearly easier for employers. A cash economy
is also much more efficient than a barter economy. Indeed, perhaps the employee does not really
want that particular property or service and would have preferred the cash, instead, so that she
could buy something that she really wants.
Richard Thaler is one of the leading economists in the behavioral economics movement
introduced in Chapter 3, which explores behavior that appears irrational on its surface. If you’d
like to explore further, please click and read the following article:
www.nytimes.com/1999/06/30/opinion/the-gasoline-powered-raise.html. (Come this holiday
season, do not say that I never taught you anything practical.)
In sum, do not assume that an employer would never bother to arrange paying compensation in
kind if it were going to be includable in any event, as would cash. Nevertheless, some
compensation paid in kind (either with property or with services) is excludable under either § 119
or § 132, addressed in Parts A. and B., respectively.

A. Section 119
Section 119 had its start in the common law under the “convenience of the employer” doctrine,
created by some courts and affirmed by the IRS in the early days of the income tax. A
straightforward example was the food and bed afforded to an army major at Fort Monroe in
Virginia in Jones v. United States. 7 Should the value of the food and bunk provided in kind to the
major be includable in Gross Income as compensation under § 61(a)(1)? The Jones court said “no”
in 1925 because the food and lodgings were provided for the convenience of the employer (the
U.S. Army) in order for the employee to perform his duties properly, not to provide remuneration
to the employee. 8 As early as 1919, the IRS agreed that a seaman away on the high seas need not
include the value of meals and lodgings provided by his employer on the ship (or boat). 9 Treasury
memorialized this position in a 1920 regulation. 10 The doctrine was codified in 1954 when
Congress enacted § 119, but it did not take long for taxpayers far afield of army majors and
fishermen to argue that meals and lodgings should be excluded under § 119. 11
Note each, separate requirement listed in § 119 that must be satisfied in order for meals or
lodgings to qualify for exclusion. Does lunch money (cash) constitute “meals”? What are “the
6

Matt Richtel, Housecleaning, Then Dinner? Silicon Valley Perks Come Home,
at www.nytimes.com/2012/10/20/us/in-silicon-valley-perks-now-begin-at-home.html?pagewanted=all.
7
60 Ct. Cl. 552 (1925).
8
See also Benaglia v. Comm’r, 36 B.T.A. 838 (1937); Diamond v. Sturr, 221 F.2d 264 (2d Cir. 1955); Comm’r v.
Doak, 234 F.2d 704 (4th Cir. 1956); Papineau v. Comm’r, 16 T.C. 130 (1951); Ellis v. Comm’r, 6 T.C. 138 (1946).
9
O.D. 265, 1 C.B. 71 (1919).
10
T.D. 2992, 2 C.B. 76 (1920).
11
Today, the exclusion of military housing is afforded under § 134. A “minister of the gospel” can exclude the value
of housing provided in kind under § 107(1) and can exclude a cash housing allowance under § 107(2).

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business premises of the employer” of state troopers? The entire state? Private restaurants along
the public highways? If the requirements of § 119 are not satisfied, did the common law,
convenience-of-the-employer doctrine survive the 1954 enactment of § 119 so that amounts failing
to satisfy the new statutory provision might nevertheless be excludable?
COMMISSIONER v. KOWALSKI
434 U.S. 77 (1977)
MR. JUSTICE BRENNAN delivered the opinion of the Court.
Respondent is a police trooper employed by the State of New Jersey. During 1970 he received
a base salary of $8,740, and an additional $1,698 designated as an allowance for meals. Under the
meal allowance system, troopers remain on call in their assigned patrol areas during their midshift
break. Otherwise, troopers are not restricted in any way with respect to where they may eat in the
patrol area. Troopers are not required to spend their meal allowances on their midshift meals, nor
are they required to account for the manner in which the money is spent.
In the absence of a specific exemption, respondent’s meal-allowance payments are income
within the meaning of [§ 61(a)(1)].
Respondent contends, however, that § 119 can be construed to [exclude] the meal-allowance
payments. By its terms, § 119 covers meals furnished by the employer and not cash
reimbursements for meals. The Senate Report is very clear: “Section 119 applies only to meals or
lodging furnished in kind.” See also Reg. § 1.119-1(c)(2). Accordingly, respondent’s meal
allowance payments are not subject to exclusion under § 119.
Alternatively, respondent argues a specific exemption may be found in a line of lower-court
cases and administrative rulings which recognize that benefits conferred by an employer on an
employee “for the convenience of the employer” are not income. In 1920 a convenience-of-theemployer section was added to the regulations, which as modified stated:
When living quarters such as camps are furnished to employees for the convenience
of the employer, the value need not be added to the cash compensation of the
employee, but where a person receives as compensation for services rendered a salary
and in addition thereto living quarters, the value to such person of the quarters
furnished constitutes income subject to tax.
O.D. 514, 2 C.B. 90 (1920), extended the convenience-of-the-employer doctrine to cash
payments for “supper money.” ….
Even if we assume that respondent’s meal-allowance payments could have been excluded from
income pursuant to the doctrine we have just sketched, we must nonetheless inquire whether such
an implied exclusion survives the 1954 recodification. Two provisions of the 1954 Code are
relevant to this inquiry: § 119 and § 120, now repealed.
In enacting § 119, Congress was determined to “end the confusion as to the tax status of meals
and lodging furnished an employee by his employer.” The House proposed to exclude meals from
income “if they [were] furnished at the place of employment and the employee [was] required to
accept them as a condition of his employment.” The House view [entailed] complete disregard of
the convenience of-the-employer doctrine. The Senate, however, was of the view that the doctrine
had at least a limited role to play. The Senate Report states:

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Your committee has provided that the basic test of exclusion is to be whether the meals
or lodging are furnished primarily for the convenience of the employer.
In a technical appendix, the Senate Report further elaborated that:
Section 119 applies only to meals or lodging furnished in kind. Therefore, any cash
allowances for meals or lodging received by an employee will continue to be
includible in Gross Income to the extent that such allowances constitute compensation.
After conference, the House acquiesced in the Senate’s version of § 119.
As the last step in its restructuring of prior law, the Senate adopted an additional restriction
created by the House and not theretofore a part of the law, which required that meals subject to
exclusion had to be taken on the business premises of the employer. Thus, § 119 comprehensively
modified the prior law, both expanding and contracting the exclusion for meals and lodging
previously provided, and it must therefore be construed as its draftsmen obviously intended it to
be—as a replacement for the prior law, designed to “end [its] confusion.”
Because § 119 replaces prior law, respondent’s further argument that the technical appendix in
the Senate Report recognized the existence under § 61 of an exclusion for a class of noncompensatory cash payments is without merit.
Finally, respondent argues that it is unfair that members of the military may exclude their
subsistence allowances from income while respondent cannot. While this may be so, arguments of
equity have little force in construing the boundaries of exclusions and deductions from income
many of which, to be administrable, must be arbitrary. In any case, Congress has already
considered respondent’s equity argument and has rejected it in the repeal of § 120 of the 1954
Code. That provision as enacted allowed state troopers like respondent to exclude from income up
to $5 of subsistence allowance per day. Section 120 was repealed after only four years, however,
because it was “inequitable, since there are many other individual taxpayers whose duties also
require them to incur subsistence expenditures regardless of the tax effect.” H.R. Rep. No. 775.
MR. JUSTICE BLACKMUN, with whom THE CHIEF JUSTICE joins, dissenting.
I have no particular quarrel with the conclusion that the payments received by the New Jersey
troopers constituted income to them under § 61. I disagree with the Court’s conclusion that the
payments are not excludable under § 119. The Court draws an in-cash or in-kind distinction. This
has no appeal or persuasion for me because the statute does not speak specifically in such terms.
It does no more than refer to “meals furnished on the business premises of the employer,” and
from those words the Court draws the in-kind consequence. I am not so sure. In any event, for me
the business premises of the State of New Jersey are wherever the trooper is on duty in that State.
_______________________________________

What does “convenience of the employer” mean? Treas. Reg. § 1.119-1(a)(2) provides that the
meals and lodgings must be provided by the employer for a “substantial noncompensatory business
reason” (emphasis added), as opposed to a “means of providing additional compensation.” The
“mere declaration” by the employer that the meals or lodgings are provided for a noncompensatory
business reason is not sufficient; rather, all the facts and circumstances must be examined in
making this determination. Note the several examples provided in the regulations that will
constitute a substantial noncompensatory business reason, such as having the employees available
for emergency call during meals. Also note the provision near the end of that regulation; providing
meals merely to boost employee morale is not a substantial noncompensatory business reason.
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Assume that a hospital provides meals in kind to all employees for free at the hospital cafeteria
and that the doctors and nurses are not infrequently called back to their wards during meals. Can
you see why each of the requirements for § 119 exclusion are met for them? Can the ward janitors,
who are not often called back to the ward for emergencies, exclude their free meals? Could you
imagine the reaction if the low-paid employees were told that their free meals must be valued and
included in their Gross Incomes but that the better-paid doctors and nurses need not include the
value of their free meals in their Gross Incomes? Likely to counteract such perceptions of
unfairness, Congress enacted § 119(b)(4) in 1998.
Note that the statute imposes an additional requirement for the value of lodgings provided in
kind to be excludable under § 119 (not required for meals): that “the employee is required to accept
such lodging … as a condition of employment.” What does that additional requirement mean?
Does it mean only that the employer stipulate in the employment contract that the employee must
accept the lodgings provided on the business premises? What employer would refuse to add such
a provision in the contract at the request of the employee once the employer agreed to provide such
free lodgings in any event? See Treas. Reg. § 1.119-1(b). As described in the regulation, can you
think of any fact pattern where the convenience of the employer requirement would be satisfied
but the condition of employment requirement would not be (or vice versa)?
What does the “business premises of the employer” mean? See Treas. Reg. § 1.119-1(c)(1).
LINDEMAN v. COMMISSIONER
60 T.C. 609 (1973)
JUDGE FEATHERSTON: [Jack B. Lindeman was the general manager of the Beach Club Hotel
in Fort Lauderdale, Florida. For many years, he and his family were provided a free four-room
suite in the hotel in which to live, but his employer decided that the suite could be more profitably
rented to guests. His employer purchased a house across a 50-foot-wide street from the hotel and
allowed Mr. Lindeman to live there rent-free. The government sought to include the fair rental
value of the home in Mr. Lindeman’s Gross Income under § 61(a)(1).]
As a general rule, all remuneration for services is Gross Income, and an employee’s
remuneration includes the value of lodging or living quarters furnished by his employer. See
Treas. Reg. sec. 1.61-2(d)(1). However, section 119 excludes from an employee’s Gross Income
the value of lodging furnished to him by his employer if three conditions are met: (1) The lodging
is furnished for the convenience of the employer; (2) the employee is required to accept the
lodging as a condition of his employment; and (3) the lodging is “on the business premises” of
the employer. The sole issue in the instant case is whether the house in which petitioner and his
family lived during 1968 and 1969 was “on the business premises” of Beach Club Hotel.
These deceptively simple words—“on the business premises” of the employer—have been
the subject of extended judicial opinions with varying results. See, e.g., Comm’r v. Anderson,
371 F.2d 59 (C.A. 6, 1966), reversing 42 T.C. 410 (1964), and Gordon S. Dole, 43 T.C. 697
(1965), affirmed per curiam 351 F.2d 308 (C.A. 1, 1965). We examine anew the legislative
history of section 119 insofar as it bears on the issue presented for decision.
The requirement of section 119 that, to be excludable from Gross Income, lodging must be
furnished and accepted “on the business premises” of the employer was first adopted as part of
the 1954 Code. As passed by the House of Representatives, the section used the term “place of

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employment” rather than “business premises.” H. Rept. No. 1337, to accompany H.R. 8300 (Pub.
L. No. 591), 83d Cong., 2d Sess., pp. 18, A39 (1954). The Senate changed the term to “business
premises,” but the accompanying report explained that “[u]nder both bills meals and lodging are
to be excluded from the employee's income if they are furnished at the place of employment and
the employee is required to meet certain other conditions.” S. Rept. No. 1622, to accompany H.
R. 8300 (Pub. L. No. 591), 83d Cong., 2d Sess., pp. 19, 190-191 (1954).
The Senate version was adopted with the following explanation in Conf. Rept. No. 2543, 83d
Cong., 2d Sess., p. 27 (1954):
The term “business premises of the employer” is intended, in general, to have the same
effect as the term “place of employment” in the House bill. For example, lodging
furnished in the home to a domestic servant would be considered lodging furnished on
the business premises of the employer. Similarly, meals furnished to a cowhand while
herding his employer’s cattle on leased lands, or on national forest lands used under a
permit, would also be regarded as furnished on the business premises of the employer.
***
As in the case of other exclusions from Gross Income, this one is subject to abuse, and the
statutory language must be construed with this thought in mind. Accordingly, the term “on” in
relation to the employer’s business premises does not mean “in the vicinity of” or “nearby” or
“close to” or “contiguous to” or similar language, but is to be read literally. Comm’r v. Anderson,
supra at 67. If the lodging is furnished at a location some distance from the place where the
employee works, the lodging is not furnished on his employer’s business premises.
In determining what are the employer’s “business premises,” Congress quite obviously
intended a commonsense approach. Read literally, the statutory language ordinarily would not
permit any exclusion for lodging furnished a domestic servant, since a servant’s lodging is rarely
furnished on “the business premises of his employer”; yet the committee report, quoted above,
shows a clear intention to allow the exclusion where the servant’s lodging is furnished in the
employer’s home. Similarly, the section, as a condition to the exclusion, does not require that the
meals or lodging be furnished at any particular location on the employer’s property; thus, the same
committee report clearly states that meals provided for a cowhand are excludable even though they
are furnished on leased lands or on lands used under a permit.
These illustrations in the committee report, moreover, demonstrate that section 119 does not
embody a requirement that the meals or lodging be furnished in the principal structure on the
employer’s business premises. Thus, the committee report makes it explicitly clear that a
cowhand’s meals and lodging need not be furnished at the ranch headquarters. And surely the right
of a domestic servant to the section 119 exclusion cannot be made to turn on whether his lodging
is furnished in the family residence or in servants’ quarters located elsewhere on the estate. Indeed,
in Boykin v. Commissioner, 260 F.2d 249 (C.A. 8, 1958), affirming in part and reversing in part
29 T.C. 813 (1958), the Commissioner at least implicitly conceded that a physician’s living
quarters, located on the grounds of a Veterans Administration Hospital, were on his employer’s
business premises even though he performed none of his employment services in his living
quarters. Similarly, the Commissioner has ruled that meals furnished at branch offices of an
employer, as well as at a central dining facility, meet the requirements of the section. Rev. Rul.
71-411, 1971-2 C.B. 103.
The issue as to the extent or the boundaries of the business premises in each case is a factual

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issue, and in resolving that question consideration must be given to the employee’s duties as well
as the nature of the employer’s business. The section 119 exclusion applies where the lodging is
furnished at a place where the employee performs a significant portion of his duties or on the
premises where the employer conducts a significant portion of his business. Comm’r v. Anderson,
371 F.2d at 67. Or, in the words of this Court in Gordon S. Dole, 43 T.C. at 707, “the phrase should
be construed to mean either (1) living quarters that constitute an integral part of the business
property or (2) premises on which the company carries on some of its business activities.”
We think petitioner has shown that the house which his employer furnished him during 1968
and 1969 was part and parcel of the “business premises” of Beach Club Hotel. In reaching this
conclusion, we think it apparent that the business premises of the hotel are not limited to 3100
North Ocean Boulevard, where the hotel building is located, but include both parking lots and the
house furnished to petitioner.
There is a large parking lot on the property where the hotel building is located, but it is by no
means adequate to meet the needs of the hotel guests. The parking lot situated across Oakland Park
Boulevard is used by hotel guests and employees and is essential to the operation of the hotel
business. Even though these lots are across a street from the hotel building, they are obviously as
much a part of the “business premises” of the hotel as the parking area located on the lot at 3100
North Ocean Boulevard.
Similarly, we think the house in which petitioner resides is part of the business premises of the
hotel. These lots were acquired to alleviate a chronic shortage of parking spaces in connection with
the operation of the hotel and to provide the hotel general manager with living quarters that were
more economical to the hotel.
Moreover, the nature of the Beach Club Hotel business is such as to require the general manager
to live where he is immediately accessible at all hours, and the house meets this need. It is
stipulated that:
In 1963, after a cost study, Beach Hotel Corporation determined it should be more
profitable to purchase or rent accommodations [sic] for * * * [petitioner] and his family
as close to the hotel as possible and have the suite of four rooms he was occupying
available to be rented.
Thereupon, [the house was acquired by the Beach Club Hotel] to provide housing for petitioner
and his family. This was a business decision based on business considerations, and there is no
suggestion in the record that it was prompted by any other factors or that it involves an abuse of
the section 119 exclusion.
The house is so situated and so used that it is part of the hotel plant. While petitioner’s office is
located in the business area of the hotel building (as it was while he occupied the suite of rooms
as his residence), he is subject to call 24 hours a day, and he is as readily accessible for the frequent
calls by direct telephone as he was in the suite located in the hotel building. He often returns to the
hotel building several times in an evening. People dealing with him through the direct telephone
line have no way of knowing whether he is in the hotel building or his home. Moreover, from the
house he can observe the entire south half of the building and can “tell if there is a disturbance of
any kind, see if lights are on or off, if the night lights don’t come on early enough,” and the like.
While petitioner does most of his management work in his office in the hotel building, he also
has an office in the house. In this latter office in his home, he receives calls from the hotel personnel
or guests on the direct telephone line from the hotel while he is not on regular duty. He also uses
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this office when he is working on new brochures or rate structures and when he is planning a
program for future hotel activities, such as “cook-outs, games, picnics on the beach, cocktail
parties, and this sort of thing.” In addition, he occasionally entertains a guest of the hotel. [5]
In our view, these facts demonstrate that the lodging furnished petitioner is, within the meaning
of section 119, “on the business premises of his employer” or, within the meaning of the
accompanying committee reports, “at the place of employment.” The house in which he lives is an
indispensable and inseparable part of the hotel plant, and it is within the perimeter of the hotel
property. Since it is part of the premises where petitioner performs the duties required in his job
and where his employer carries on its business, we hold that petitioner is entitled to the section 119
exclusion.
Commissioner v. Anderson, 371 F.2d 59 (C.A. 6, 1966), on which respondent relies, is factually
distinguishable. In that case, the housing furnished the employee was “two short blocks” from the
facility being managed by the taxpayer (p. 61), and the Court of Appeals did not conclude, as we
do here, that the living quarters of the employee-taxpayer were an integral part of the business
property. Accordingly, the Court of Appeals held that the requirements of the statute were not met.
In the instant case, the premises of the business managed by petitioner include the house in which
his lodging was furnished.
______________________________________
The Lindeman case noted the servant and cow hand examples in the regulations, which were
drawn from the legislative history. (Are they particularly helpful examples in the 21st century?)
Do the chosen examples imply that the employer must have some sort of ownership interest in the
premises, such as a lease or a fee interest? If that is the case, the private restaurants along the public
highways in New Jersey could not have been the “business premises of the employer” in the
Kowalski case, notwithstanding Justice Blackmun’s dissenting opinion to the contrary. Moreover,
even if the servant is considered to be on the business premises of the employer, does she satisfy
the “convenience of the employer” requirement?
One of the common law cases pre-dating codification in § 119 of the convenience of the
employer doctrine was Benaglia v. Commissioner, 12 which one tax professor 13 described thusly:
In Benaglia, a hotel manager was permitted to exclude the value of a posh hotel suite
and equally extravagant meals on the ground that his presence was necessary to attend
to the “numerous, varied, and unpredictable” demands of the filthy rich patronizing
the establishment—i.e., for the convenience of the employer. 36 B.T.A. at 840. Any
benefit to the manager was “merely an incident of the performance of his duty.” Id.
The favorable tax treatment, some commentators have noted, “apparently runs with
the land.” The manager of the same hotel, forty years after Benaglia, continued the
tax-free receipt of meals and lodging, “although he admitted to an enterprising tax
professor that he had never handled a nighttime emergency.” Byrnes & McIntyre,
[5]
Seeking a decision on the broader ground that the house was located “at the place of employment,” petitioner
deemphasizes the duties which he performs in this home office. However, under the meaning of the term “on the
business premises,” discussed above, we think his work at his home office as well as its proximity to the hotel building
are factors to be taken into account.
12
36 B.T.A. 838 (1937).
13
Erik M. Jensen, Food for Thought and Thoughts About Food: Can Meals and Lodging Provided to Domestic
Servants be for the Convenience of the Employer?, 65 IND. L.J. 639 (1990).

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Famous Events in Tax History, 1 TAX NOTES INT’L 260 (1989).
Is Mr. Benaglia’s exclusion—very different from the soldiers and sailors at sea with which the
common law doctrine originated—consistent with the standard of living fairness norm discussed
in Chapter 3? These sorts of observations bring us to the tax policy issues underlying excludable
compensation received in the form of consumption provided in kind. Under the Old Colony Trust
two-step, the employee would be treated as receiving cash compensation (includable in Gross
Income under § 61(a)(1)), which she then uses to purchase the meals or lodgings (nondeductible
personal expenses under § 262). If an employer provides meals or lodgings to an employee that
satisfies each of the requirements of § 119, however, the employee can exclude from Gross Income
the FMV of the meals or rental value of the lodgings, notwithstanding Old Colony Trust. What
factors justify departure from the Old Colony Trust two-step? What tax policy tools does Congress
draw on in crafting the lines between includable and excludable compensation paid in the form of
consumption provided in kind? And can these tax policy tools help to inform how the requirements
provided in the exclusion provisions ought to be interpreted by judges and the administrators of
the statute in the case of ambiguity?
One possible tax policy tool is horizontal equity, but the usual problems with that standard
(discussed in Chapter 3) are also implicated here. Sam is provided $100 in cash salary and
purchases his own $10 meal, which is a nondeductible personal expense under § 262. His Taxable
Income is $100, including the amount expended on the meal that he ate. Sally is provided $90 in
cash salary and is provided a free $10 meal by her employer that is excludable under § 119. Her
Taxable Income is $90. At the end of the day, both Sam and Sally have $90 of cash in hand and
have eaten a meal, but Sam’s Taxable Income is $10 higher than Sally’s. Does this situation violate
the horizontal equity norm that similarly situated taxpayers should be taxed alike? But are they
similarly situated? Why or why not? Does your reasoning have any impact on how broadly or
narrowly § 119 ought to be construed (and § 132, in a moment)?
How about this line of reasoning? In Old Colony Trust, it was easy to see why the employer’s
payment of Mr. Wood’s Federal income tax should be construed as though (1) Mr. Wood received
additional cash compensation (a clearly includable wealth accession), which (2) he then sent to the
IRS as Federal income tax (a nondeductible payment under § 275(1)). It was easy to see because
Mr. Wood’s payment of Federal income tax was mandatory, so we can be comfortable in assuming
that had he, in fact, received additional cash compensation (equal to the tax payment) he would
have used that cash in the very manner in which his employer used it—to pay his Federal income
tax. In enacting § 119 (or in construing whether one or more of the requirements imposed by § 119
is satisfied), is it helpful for Congress, a court, or the IRS to consider how likely it is that the
employee would have bought precisely the same meal or rented precisely the same premises if she
had been provided cash compensation instead? After all, if we can determine that the employee
would have bought precisely the same consumption, we can be comfortable in assuming that
having it provided in kind is the equivalent of (1) receiving additional cash compensation (clearly
includable), which was then (2) used to purchase the nondeductible personal consumption.
Of course, such an inquiry (how likely is it that the taxpayer would have chosen to purchase
precisely the same meal or rent precisely the same premises?) would not be administrable as a
statutory test in the real world, which is why Congress must come up with proxy tests (such as
convenience of the employer) to get at the same underlying question indirectly. If there is a strong
noncompensatory business reason why the employer provided the meals or lodgings (relevant to
the ability of the employee to perform his or her job duties properly), perhaps we can be less sure

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that the employee would have used an equivalent amount of cash compensation to purchase the
same meals or lodgings and thus should be wary of applying the Old Colony Trust two-step.
The more certain we are that the meals and lodgings are of the same sort that the taxpayer would
have purchased, the more reasonable it is to deem an intermediate cash receipt à la Old Colony
Trust, which clearly represents ability to pay. Along the same lines, the Kowalski Court rejected
broadly interpreting the word “meals” to include cash (used to buy meals chosen by the employee).
Finally, as you will learn very shortly in Part B., below, the same reasoning underlies the refusal
to allow cash (or a cash equivalent) to be excluded as a de minimis fringe under § 132(e) (with one
narrow exception for “supper money”). Notice that this sort of analysis is premised on the ability
to pay fairness norm rather than the standard of living fairness norm.
Taking the analysis one step further, does not the receipt of free meals and free lodgings in
kind—even if they are different from the type of meals or lodgings that the employee would
otherwise have purchased—nevertheless free the taxpayer from having to spend some amount on
meals and lodging? After all, we all have to eat and to find shelter. In Chapter 19, we shall consider
the deductibility of cash spent on meals as a business expense (rather than the inclusion of free
meals received in kind as compensation). For example, when John travels to another city for a
business meeting, he will incur meal costs on the road, which are generally deductible under §
162(a)(2). In 1986, however, Congress enacted § 274(n)(1), which generally reduces John’s § 162
business expense deduction for meals to 50% of the cost. The idea is that, even though business
reasons support deduction of a portion of his meal costs while traveling on business, the meal
nevertheless also provides nourishment because John must eat in any event. In effect, § 274(n)(1)
allocates 50% of the cost to nourishment (nondeductible personal consumption) and 50% to the
business purpose underlying the meal (deductible). 14 So here is the question: even if business
reasons justify some exclusion for meals and lodgings provided in kind for the convenience of the
employer, should Congress have similarly amended § 119 in 1986 to limit the exclusion of the
meals or lodgings to 50% of the value received (with the remaining 50% included) on the theory
that the employee would have had to buy food and shelter (nondeductible personal consumption)
in any event?
The House version of the TCJA would have capped the § 119 exclusion to $50,000 and would
have phased it out for employees with compensation income exceeding $120,000. The Senate had
no comparable provision, and the House provision was not enacted as part of the TCJA.

B. Section 132
In the late 1970s, Treasury decided to issue additional regulations under § 61(a)(1) to clarify
what other kinds of in-kind compensation (other than meals and lodgings provided for the
convenience of the employer under § 119) could be excluded from Gross Income, notwithstanding
§ 61(a)(1), because complaints had arisen that different employers were given varying IRS advice
regarding the same sorts of items. Congress responded by imposing a moratorium in 1978 on new
Treasury regulations pertaining to this issue, providing Congress some time to enact new statutory
provisions. Finally, in 1984, Congress enacted § 132 and added the language regarding “fringe
benefits” to § 61(a)(1), making it clear that no common law exclusions exist with respect to
compensation. Absent explicit statutory authority to exclude, all compensation—whether paid in
14

The 50% reduction that normally applies to meal expenses in § 274(n)(1) does not apply to restaurant meals
through 2022, thanks to § 274(n)(2)(D).

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cash or in kind—must be included in Gross Income under § 61(a)(1).
Excerpt from General Explanation of the Revenue Provisions
of the Deficit Reduction Act of 1984 15
Reasons for Change
In providing statutory rules for exclusion of certain fringe benefits for income and payroll tax
purposes, the Congress struck a balance between two competing objectives. First, the Congress
was aware that in many industries, employees may receive, either free or at a discount, goods and
services which the employer sells to the general public. In many cases, these practices are long
established, and generally have been treated by employers, employees, and the Internal Revenue
Service as not giving rise to taxable income.
[W]here an employer has only one line of business, the fact that the selection of goods and
services offered in that line of business may be limited in scope makes it appropriate to provide a
limited exclusion, when such discounts are generally made available to employees …. By contrast,
allowing tax-free discounts for all lines of business of a conglomerated organization, where the
employee might have unlimited choices among many products and services which individuals
normally consume or use on a regular basis, would be indistinguishable in economic effect from
allowing tax-free compensation in the form of cash or gift certificates. Also, the noncompensatory
element involved in providing discounts on the particular products or services that the employee
sells to the public may be marginal or absent where an employer offers discounts across all lines
of business.
…
The second objective of the new statutory rules is to set forth clear boundaries for the provision
of tax-free benefits…. Congress was concerned that without any well-defined limits on the ability
of employers to compensate their employees tax-free by providing noncash benefits having
economic value to the employee, new practices will emerge that could shrink the income tax base
significantly. This erosion of the income tax base results because the preferential tax treatment of
fringe benefits serves as a strong motivation to employers to substitute more and more types of
benefits for cash compensation. A similar shrinkage of the base of the social security payroll tax
could also pose a threat to the viability of the social security system above and beyond the adverse
projections which the Congress addressed in the Social Security Amendments of 1983. In addition,
continuation of the dramatic growth in noncash forms of compensation—at a rate exceeding the
growth in cash compensation—could further shift a disproportionate tax burden to those
individuals whose compensation is in the form of cash.
Finally, an unrestrained expansion of noncash compensation would increase inequities among
employees in different types of businesses, because not all employers can or will provide
comparable compensation packages…. [A]n unlimited exclusion for noncash benefits
discriminates among employers. For example, if tax-free discounts were allowed across all lines
of business of an employer, a large employer with many types of businesses (e.g., department
store, hotel, airline, etc.) would be given a favorable edge by the tax system in competing for
employees as compared with a small firm having one line of business (e.g., a specialty clothing

15

STAFF OF THE JOINT COMM. ON TAX’N, GENERAL EXPLANATION OF THE REVENUE PROVISIONS OF THE DEFICIT
REDUCTION ACT OF 1984, JCS-41-84, 840-42 (Dec. 31, 1984).

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store)….
Accordingly, the Congress determined that specific rules of exclusion should be set forth in the
Code, with limitations on the availability, applicability, and scope of these statutory exclusions.
These general limitations include a nondiscrimination rule, the line of business limitation, and the
limitation on exclusions to benefits provided to the employee and the employee’s spouse and
dependent children….
The nondiscrimination rule is an important common thread among the types of fringe benefits
which are excluded under the Act from income and employment taxes. Under the Act, most fringe
benefits may be made available tax-free to officers, owners, or highly compensated employees
only if the benefits are also provided on substantially equal terms to other employees. The
Congress believed that it would be fundamentally unfair to provide tax-free treatment for economic
benefits that are furnished only to highly paid executives. Further, where benefits are limited to
the highly paid, it is more likely that the benefit is being provided so that those who control the
business can receive compensation in a nontaxable form; in that situation, the reasons stated above
for allowing tax-free treatment would not be applicable….
These amendments made clear that any fringe benefit that does not qualify for exclusion under
a specific Code provision is includable in the recipient’s Gross Income, and in wages for
withholding and other employment tax purposes, at the excess of the fair market value of the
benefit over any amount paid by the recipient for the benefit.
__________________________________________
Note the concern repeatedly stated in the legislative history excerpt about possible damage to
the tax base if consumption provided in kind (as compensation) were broadly excludable. A broad
exclusion would encourage the substitution of in-kind compensation (excludable) for cash
compensation (includable). Such a substitution would be inefficient, causing a tax-motivated
change in behavior, as it is easier for most employers to pay compensation in cash rather than in
kind. Moreover, always remember that tax-base-narrowing provisions are never costless; the
resulting reduction in tax base would require tax rates to be higher than they would otherwise need
to be to raise $X, raising additional efficiency concerns.
The original version of § 132 enacted in 1984 contained only the provisions now listed in §
132(a)(1) through (4), pertaining to the no additional cost service, the qualified employee discount,
the working condition fringe, and the de minimis fringe, as well as the exclusion for qualified
tuition reductions for employees of educational institutions, added to the Code in § 117(d)
(considered in Chapter 16). Subsequent acts have since expanded § 132.
Compensation excludable for Federal income tax purposes under § 132 is also not taxed as
“wages” under the payroll taxes (Social Security and Medicare).
The employer is typically the party that seeks to determine whether an item is includable or
excludable because, if the item is includable, the employer must (1) withhold and send to Treasury
the estimated income tax, as well as payroll taxes, owed by the employee from remaining cash
wages, (2) pay its employer share of the payroll taxes on these amounts, and (3) include those
amounts in the year-end Form W-2 that is sent to the employee. The IRS may choose to conserve
resources by pursuing fringe benefit issues primarily with employers.

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For example, in American Airlines, Inc. v. United States, 16 American Airlines gave to every
employee a $50 American Express “Be My Guest” voucher that could be used like cash at any
establishment that accepted American Express credit cards as a gesture of appreciation for the
employees’ extra work effort during a labor dispute at a competing airline that substantially
increased American’s passenger load. American Airlines decided on the voucher in lieu of a firmwide banquet. The face amount of the vouchers totaled $4,250,000, and more than 97% were
redeemed. American did not include the vouchers in the employees’ Gross Incomes for income
and payroll tax purposes and did not pay the employer share of payroll taxes on the amount,
arguing that the vouchers could be excluded as a de minimis fringe within the meaning of §
132(e)(1). While a firm-wide banquet would have been excludable as a de minimis fringe under
Treas. Reg. § 1.132-6(e)(1), which provides exclusion authority for “occasional cocktail parties,
group meals, or picnics for employees and their guests” (emphasis added), the vouchers were held
not to be excludable because they constituted “cash equivalent fringe benefits” within the meaning
of Treas. Reg. § 1.132-6(c). Notice that the IRS pursued this issue with the employer, not the
numerous employees.
Suppose that you rack up frequent flier miles on business trips reimbursed by your employer
and that you subsequently use those frequent flier miles to take a personal trip. That personal trip
was, in substance, paid for by your employer because the miles used to take the trip were compiled
on travel paid for by your employer. Nevertheless, the IRS has announced that it will not seek to
tax the use of such frequent flier miles unless the employee is able to convert them to cash, 17 as
occurred in Charley v. Commissioner. 18

C. The Employer’s Business Expense Deduction for Compensation
While we have been focusing primarily on the employee’s § 61(a)(1) Gross Income inclusion
for compensation, it’s worth mentioning that employers can generally deduct the payment of
compensation paid to employees as an ordinary and necessary business expense under § 162(a)(1).
The employee’s inclusion and the employer’s deduction, especially with respect to cash, is
typically the same amount, but there are exceptions. For example, § 162(m) forbids deduction of
employee compensation to certain executives in excess of $1 million each year. Prior to the TCJA,
§ 162(m) contained a gaping exception for “performance-based compensation,” but the TCJA
repealed it. If an executive negotiates an annual salary of $10 million, the executive must include
the entire $10 million in his Gross Income under § 61(a)(1), but the employer is permitted to deduct
no more than $1 million each year under §§ 162(a) (1) and (m).
For services provided in kind to employees as compensation, the employer’s § 162 deduction
generally equals the actual cost incurred by the employer to provide the service, not the FMV of
the service. Moreover, the employer’s deduction is not generally affected by whether the employee
can exclude the FMV of the free or discounted service under statutory authority. For example, an
employee working in one line of business may not be able to exclude as a § 132(b) no additional
cost service the FMV of a free service provided in a second line of business operated by the
employer because the employee does not work in that second line of business. If the FMV of the
free service is $150, the employee must include $150 in Gross Income under § 61(a)(1). If the
16

204 F.3d 1103 (Fed. Cir. 2000).
See Announcement 2002-18, 2002-1 C.B. 621.
18
91 F.3d 72 (9th Cir. 1996).
17

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employer incurs no cost in providing the free service to the employee (e.g., free use of a hotel room
that would otherwise not be occupied), the employer has incurred no expense to deduct under §
162. On the other hand, if an employer’s cost in providing a free service exceeds the FMV of the
service included in Gross Income by certain employees, the employer generally cannot deduct the
cost in excess of the amount included by the employee. 19
With respect to compensation paid in the form of property, return to the CEO Sue example prior
to Revenue Ruling 79-24 earlier in this chapter. Recall that Realty, Inc., sells Blackacre to its CEO
for $10,000 when it is worth $100,000. Under the Old Colony Trust two-step, in substance CEO
Sue received an additional $90,000 in cash salary from Realty, which she uses (along with $10,000
from her savings) to purchase Blackacre from Realty for $100,000. CEO Sue must include the
$90,000 discount (why isn’t the discount excludable as a qualified employee discount under §
132(c)?), and she takes a basis equal to the sum of (1) her $10,000 nondeductible capital
expenditure and (2) the $90,000 that she includes under § 61(a)(1). Review Treas. Reg. §§ 1.612(d)(1) and (2). Now let’s add another layer to the analysis. What are Realty’s tax consequences if
its basis in Blackacre is, say, $70,000?
First, under the same Old Colony Trust two-step described above, Realty realizes a $30,000 §
1001 gain ($100,000 A/R less $70,000 A/B)—as though it did, in fact, receive $100,000 from
Sue—not a $60,000 loss ($10,000 A/R less $70,000 A/B). In short, Realty’s amount realized (from
which basis is subtracted) is $100,000, not $10,000.
Second, Realty can also deduct $90,000 of compensation paid to Sue (the $90,000 worth of
Blackacre paid as compensation for services rendered) as a business expense under § 162(a)(1),
which is another reason why we know that Realty must include Blackacre’s $30,000 built-in gain
as though it were sold to Sue for $100,000. You learned in Chapter 1, Part A., that deductions must
usually be supported by basis—generally, previously taxed dollars—or else the taxpayer would
enjoy a double tax benefit for the same dollars (both exclusion and deduction of the same dollars).
Because Realty can deduct the $90,000 of Blackacre’s value paid as compensation under § 162,
Realty must also include the $30,000 built-in gain in Blackacre, as though Realty paid Sue an
additional $90,000 in deductible (from Realty’s perspective) cash salary, which she combined with
$10,000 of her savings to buy the land for its $100,000 FMV, i.e., as though Realty received
$100,000 in cold, hard cash for Blackacre, not merely $10,000.
Finally, § 274(n)(1) has long provided that only 50% of the cost of food and beverages that are
otherwise deductible as business expenses can be deducted. Prior to the TCJA, an exception
permitted employers to deduct 100% of the cost incurred to provide discounted meals in an eating
facility described in § 132(e)(2). The TCJA now limits the employer’s deduction to 50% for costs
incurred before 2025 and disallows deduction of 100% of both §§ 132(e)(2) and 119 meal costs
after 2025. 20 The TCJA also repealed the employer deduction for the costs of providing most
transportation fringe benefits that are excludable by the employee under § 132(f). 21 These
deduction denials may discourage employers from providing these benefits.
Problems
These problems provide an opportunity for close parsing of the statute and regulations. While
19

See Treas. Reg. § 1.274-9(a).
See § 274(o).
21
See § 274(l)(1).
20

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I sometimes provide helpful Treasury regulations, always start with the statutory language at issue
in each problem before turning to the cited regulations. In particular, before embarking on the
problems, carefully read § 132(a), (b), (c), (d), (e), (f), (j)(1), and (h)(2)(A), (h)(3).
Section 132(h)(3) was added in 1985. Why would Congress specify that use by parents qualify
as use by employees only in the case of airline transportation? The Chairman of the House Ways
and Means Committee, where all tax legislation originates, was Dan Rostenkowski, who sponsored
the 1985 legislation. I understand that his two daughters worked for an airline that provided free
air travel on a space-available basis for parents of employees (in addition to spouses and
dependents). As my nieces and nephews commonly observe, “just sayin.”
1. Holly works as a flight attendant on Hilarity Airlines, owned by Conglomerate, Inc., which
also owns Hooyacht Hotels. Conglomerate allows all of its employees, as well as their spouses and
children, to fly for free (Hilarity Airlines) or stay for free (Hooyacht Hotels) on their vacations on
a space-available basis. Holly and her husband Hal use this perk to fly at no cost to Hawaii (FMV
$600 each for a total FMV of $1,200), where they stay for free in a room at the Hooyacht Hotel in
Honolulu for 5 nights (FMV $2,000 for all 5 nights). On the flight to Hawaii, they ate free meals
and drank beverages. At the Hooyacht Hotel, the maid serviced their room each day, cleaning their
room while there were on the beach. Which fringe benefit exclusion might apply to the facts? What
are the separate and independent requirements that must be satisfied for the exclusion provision to
apply? After isolating possible statutory issues, see Treas. Reg. §§ 1.132-2(a)(5)(ii) and -4(a)(1)(i)
for help in resolving them.
2. Same as 1. except that Holly is an Executive Vice President of Hilarity Airlines rather than
a flight attendant, and only executives are allowed to fly for free on Hilarity Airlines or stay for
free in Hooyacht Hotels on a space-available basis. All employees other than executives get a 50%
discount for flying or staying in the hotel on a space-available basis. On the same flight that Holly
and her husband took, non-executives would have had to pay $300 each for the flight seats (worth
$600 each). See Treas. Reg. § 1.132-8(a)(2).
3. Same as 1. (where Holly was a flight attendant), except that, in addition to being able to fly
for free on Hilarity Airlines on a space-available basis, Holly is provided annually one voucher
that allows her to make advanced reservations for confirmed seats for herself, her spouse, and her
children. She uses this voucher to purchase two seats (for herself and her husband Hal) to fly to
Paris (FMV $1,500 each for a total FMV of $3,000) for free. See Treas. Reg. § 1.132-2(a)(2); 3(e).
4. Jack works as a salesperson at Jock Shoes, where he sells the latest designer athletic shoes.
All employees are permitted to buy shoes for personal use (not for friends) at a 40% discount. Jack
purchases for $60 shoes that are sold to customers for $100. During the year, Jock Shoes has $1
million in total sales and $700,000 in cost of goods sold.
5. Sam works for Gold Unlimited, which buys and sells gold. All employees are permitted to
buy gold at a 10% discount from the price at which gold is selling on that day. Sam purchases a
quantity of gold for $900 on a day that gold is selling for $1,000 for the quantity that he purchased.
During the year, Gold Unlimited has $1 billion in total sales and $900 million in cost of goods
sold. In addition to § 132(c)(4), read Treas. Reg. § 1.132-3(a)(2)(ii).

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6. Sally is in-house corporate counsel (instead of a flight attendant) for Conglomerate, Inc., the
owner of Hilarity Airlines and Hooyacht Hotels, described above. In addition to the perks noted
above, Conglomerate purchases a laptop for Sally’s use at home to be used exclusively for
business, and Conglomerate does not have an “accountable plan” in place for such equipment
purchases. (Review Treas. Reg. §§ 1.62-1(c)(4) and (5) from Chapter 1, Part B.) In addition, Sally
and her husband take advantage of the space-available policy noted above for flights and rooms to
fly at no cost to Hawaii (FMV $600 each for a total FMV of $1,200), where they stay for free in a
room at the Hooyacht Hotel in Honolulu for 5 nights (FMV $2,000 for all 5 nights). Sally does
corporate work for both the Hilarity and Hooyacht lines of business. See Treas. Reg. § 1.1324(a)(1)(iii), (iv).
7. Conglomerate, Inc., supports the local theater complex that hosts touring Broadway shows.
Conglomerate provides to Jacob, an executive, one set of free theater tickets (FMV $250) to attend
a touring company performance of a hot Broadway show for himself and his spouse. Only
executives are provided such tickets. What if, instead, Conglomerate provides Jacob with $250 in
cash to use in purchasing the tickets, rather than provides the tickets in kind? See Treas. Reg. §
1.132-6(e)(1) and -6(c).
8. Conglomerate, Inc., reimburses Jacob for the cost of his dinner approximately four nights
each month when he works late at the office. Conglomerate does not reimburse dinner costs for
non-executives who must work late. See Treas. Reg. § 1.132-6(d)(2).
9. Conglomerate, Inc., has a cafeteria in its headquarters building that is open to all employees.
The cafeteria charges low prices (substantially less than the FMV of the meals) in order to just
break even in running the cafeteria. Must the employees include the difference between the FMV
of the meals and the price paid for them? Assume that § 119 is not satisfied on the facts. See §
132(e)(2). What if the facility is an Executive Dining Room open only to Executives?
10. Conglomerate, Inc., reimburses Jacob for his parking costs in a garage close to the office
building at a cost of $150 each month. Only executives’ parking costs are reimbursed.

D. Section 83
Recall Mary from Chapter 1, Part A., who was a CEO of a mid-size corporation receiving $1
million in annual compensation. We considered then the case in which she received her
compensation in the form of $500,000 in cash and shares of corporate stock with a FMV of
$500,000. We confirmed then that Mary must include the full $1 million of compensation in her
Gross Income under § 61(a)(1), including not only the cash but also the $500,000 FMV of the
corporate shares, under Treas. Reg. § 1.61-2(d)(1), and that she would take a $500,000 cost basis
in those shares (equal to the amount that she included in Gross Income with respect to their receipt)
under Treas. Reg. § 1.61-2(d)(2).
Let’s change the facts a bit. Suppose that a condition is attached to Mary’s retention of those
shares to the effect that, if Mary were to quit or be fired for cause before the end of Year 5, she
would have to forfeit those shares back to her corporate employer. You will sometimes hear such
shares referred to as “restricted stock” or “nonvested stock.” Should Mary still include the
$500,000 FMV of those shares on receipt in Year 1? If she includes their value in Year 1, can she

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reduce that value (to something less than $500,000) to take account of the forfeiture risk, i.e., the
potential that she might have to return the shares? Or should she wait to include the FMV of those
shares until the risk of forfeiture lapses at the end of Year 5 and include their FMV at that time,
which may be more or less than $500,000?
Congress enacted § 83 in 1969 to answer these questions. Under § 83(a), Mary would defer
inclusion of the FMV of her stock until the forfeiture risk lapses in Year 5 and the property vests
in Mary outright. She would include nothing in Year 1 on the receipt of the restricted stock. If it
were worth, say, $600,000 in Year 5 when the forfeiture risk lapses, she would include $600,000
of § 61(a)(1) compensation at that time (as ordinary income) and take a $600,000 cost basis,
reflecting the income inclusion. Any additional increase in value (or loss in value) would produce
capital gain or loss, as the case may be, when realized because the stock is a capital asset in Mary’s
hands within the meaning of § 1221. Under Treas. Reg. § 1.83-1(a), Mary’s corporate employer is
considered to be the owner of the shares until the forfeiture risk lapses. Therefore, if any dividend
is payable on the stock during the period before vesting, Mary would have no legal right to the
dividend. Nevertheless, many corporations pay an equal amount “in lieu of” the dividends to folks
like Mary, who must include these amounts as (ordinary) compensation income.
Under § 83(b), however, Mary can make an election (within 30 days of receipt) to include the
FMV of the restricted property in the year of receipt (creating a basis equal to that Gross Income
inclusion). The FMV is determined without regard to the forfeiture risk inherent in the stock. What
factors should Mary consider in deciding whether to make a § 83(b) election?
As you learned in Chapter 1, the deferral of an income inclusion benefits Mary because of (all
together now) the time value of money. All things being equal, Mary would like to defer an income
inclusion as long as possible. But sometimes all things are not equal. For example, what if Mary
believes that the top tax rate may increase beyond 37% before the stock vests in Year 5? She would
have to weigh two factors—possibly higher tax rates in the future and the time value of deferral—
against each other in determining whether deferral would be beneficial. Even though she would
lose the time value of money by giving up deferral and including the $500,000 now, that timevalue-of-money loss may be more than made up for by having that inclusion taxed at 37% today
if she believes that future tax rates will be significantly higher.
Even if tax rates remain absolutely unchanged between Year 1 and Year 5, Mary may still wish
to include the $500,000 FMV in Year 1 because the property received (stock) is a capital asset.
While the top tax rate applicable to ordinary income (such as compensation) is 37%, recall from
Chapter 1 that the top tax rate applicable to “net capital gain” is generally 15% for those with
Taxable Income of less than $400,000 ($450,000 for married couples filing jointly) or less and
20% for those with Taxable Income exceeding those thresholds. Suppose that Mary expects that
stock to be worth $600,000 in Year 5 when the forfeiture risk lapses. If she defers inclusion until
Year 5, she will include $600,000 of high-taxed ordinary income at that time. If, in contrast, she
makes a § 83(b) election in Year 1 and includes the $500,000 FMV of the stock in that year, she
will take a $500,000 cost basis. When the forfeiture risk lapses in Year 5 and she sells for its thenvalue of $600,000, she would realize $100,000 of low-taxed capital gain ($600,000 A/R less
$500,000 A/B). Which would be better? Once again, she would have to weigh the pain of losing
the time-value-of-money benefit against the reduction in tax rate that could potentially apply to
the $100,000 of expected future appreciation.
Suppose that Mary expects the stock (FMV of $500,000 on receipt in Year 1) to lose value to,
say, $200,000, before the forfeiture restriction lapses in Year 5. In that case, she clearly would not
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want to make the § 83(b) election to include $500,000 of high-taxed income now, creating a
$500,000 basis, only to realize a $300,000 capital loss when she later sells ($200,000 A/R less
$500,000 A/B). Not only would Mary lose the time value of money but, under the § 1211(b) capital
loss limitation rule to which you were introduced in Chapter 1, the capital loss may be difficult to
deduct in Year 5 if Mary does not realize substantial capital gain in that year (though she could
carry forward any undeducted capital loss under § 1212(b)). If, instead, she included nothing in
Year 1, she would include only the stock’s $200,000 Year-5 FMV (as ordinary compensation
income) when the forfeiture risk lapses (and would realize no loss). In this way, she enjoys both
the time value of money and avoids the capital loss deduction restrictions in § 1211(b).
How good is Mary’s crystal ball …?
Read the last sentence in § 83(b)(1). A downside of making the § 83(b) election (which, recall,
creates basis equal to the amount included) is that, should the forfeiture occur, Mary would be
denied deduction of her otherwise allowable $500,000 loss deduction (equal to her basis) under §§
165(b) and (c)(2). If Mary does not make a § 83(b) election and quits in Year 3, she would avoid
any income inclusion. If Mary does make a § 83(b) election and quits in Year 3, she would include
the $500,000 FMV in Year 1 on receipt (creating a $500,000 basis in the stock); when she quits in
Year 3 and must forfeit her stock to her employer, she could not deduct her $500,000 basis. Why
should Mary be denied a loss deduction equal to the basis of this lost investment? The legislative
history is silent with respect to this question. As a normative matter, it’s incorrect to deny her the
loss deduction for investment property.
The employer’s § 162 deduction for compensation paid is taken in the same year and in the
same amount as the employee’s compensation inclusion. 22 Both the timing and amount of the
employer’s deduction will depend on whether the employee makes a § 83(b) election.
While stock happens to be the most common property that triggers application of § 83, notice
that § 83 is not limited to stock. For example, recall CEO Sue from earlier in this chapter, who
purchased Blackacre for $10,000 from her employer when the property was worth $100,000. If the
retention of Blackacre is conditioned on CEO Sue not quitting or being fired for cause before the
end of Year 5, she would not (contrary to our earlier analysis) include the $90,000 received for
free in her Gross Income in Year 1, unless she chooses to do so by making a § 83(b) election.
Finally, what if Mary receives not stock but an option to buy stock? For example, Conglomerate
gives CEO Sue an option to buy Conglomerate stock for $100 per share at a time when the stock
is trading at $100 per share. That property right, even if not subject to a substantial risk of
forfeiture, would have a $0 value at the time of receipt, as it provides her no benefit that any other
buyer of the stock enjoys. So let’s change the facts and say that the option gives CEO Sue the
option to buy Conglomerate stock for $90 per share at a time when the stock is trading at $100 per
share. That property right surely has value to CEO Sue, but must she include something at the time
she receives this “in the money” option if it is not subject to a substantial risk of forfeiture?
Luckily for CEO Sue, Treas. Reg. § 1.83-7(b)(1) provides that an option like Sue’s must be
included on receipt as compensation only if it has a “readily ascertainable” FMV at that time,
which will generally be the case only if the option is “actively traded on an established market.”23
While some stock options are traded over established markets, the kind received by CEO Sue
22

See § 83(h).
Options that are not actively traded on an established market are considered to have a “readily ascertainable” FMV
only if certain conditions described in Treas. Reg. § 1.83-7(b)(2) are met, and they rarely are.
23

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rarely are. CEO Sue would include nothing in Gross Income as compensation on the receipt of this
in-the-money option. If she exercises that option, however, for $90 per share when the FMV of
the stock received is $100 per share, she would include the $10 received for free as ordinary
compensation income under §§ 61(a)(1) and 83(a). Her basis for each share would then equal the
$90 that she paid (a nondeductible capital expenditure that creates basis) plus the $10 that she
included as compensation income under §§ 61(a)(1) and 83(a) for a $100 total basis. If the stock
increases in value, and CEO Sue is able to sell it for, say, $120, her $20 realized gain ($120 A/R
less $100 A/B) would be capital gain. The longer she waits to exercise that option, the more hightaxed compensation income that she will realize if that stock continues to increase in value between
the time of the option receipt and its exercise. Sometimes the option grant may stipulate that the
exercise date can be no sooner than a particular date in the future in order to encourage the
executive to do everything in his or her power to increase the corporation’s future share price.24
Of course, if CEO Sue expects the stock’s FMV to fall below her $90 per share option price, she
would likely choose not to exercise her option, and she would realize no tax consequences.
Problems
What are the tax consequences for Employee Erin in each of the following?
1. In Year 1, Erin receives shares of corporate stock from her employer-corporation with a FMV
of $200 for no consideration (i.e., she pays nothing for the stock shares). No restrictions attach to
Erin’s receipt and continued ownership of those shares. The stock has a FMV of $300 at the end
of Year 3, but she does not sell until Year 5, when she sells for $500.
2. Same as 1., except that, should Erin quit or be fired for cause before the end of Year 3, she
must forfeit the stock back to her employer-corporation. Erin does not make the § 83(b) election.
The stock has a FMV of $300 at the end of Year 3, but she does not sell until Year 5, when she
sells for $500.
3. Same as 2., except that Erin decides to make the § 83(b) election. The stock has a FMV of
$300 at the end of Year 3, but she does not sell until Year 5, when she sells for $500. What if,
instead, the shares lose value and she is able to sell for only $100 in Year 5?
4. Same as 3., except that Erin is fired for cause in Year 2 before the stock vests, and she must
forfeit the stock at that time.
5. Based on the results in 2 through 4, above, what questions would you ask Erin in helping her
to decide whether or not to make a § 83(b) election?

24

Special rules apply to so-called incentive stock options (ISOs) in § 421 that differ from the rules prescribed here.
ISOs are uncommon.

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Chapter 6: § 61 Residual Gross Income
Section 61(a) provides that “Gross Income means all income from whatever source derived,
including (but not limited to) the following items ….” (Emphasis added.) Because of that
parenthetical, we know that items of Gross Income exist in the world that are not found among the
specifically listed items, but what are they? How should that vague residual clause be interpreted
by both courts and the administrators of the statute? That issue is what this chapter is all about.
In the early days of the income tax, interpreters often turned to the meaning of the term
“income” in other disciplines and contexts for help. For example, readers of 19th century English
novels (confession: Jane Austen fan here) often read that Lord Wembley has 30,000 pounds a year
in income on which to live. This income would come typically from land, such as rent from the
tenants on his estate. Under the social conventions of the time, Lord Wembley would never dream
of invading his capital—the land—to spend on personal consumption, invading his capital to live.
Rather, it was understood that Lord Wembley would live only on the periodic income produced
by his capital so that the capital, itself, could be passed intact to his first-born son. If a plot of land
proved to be inconveniently situated and he sold it, he would not view the cash sales proceeds (or
any profit from the sale) as available for consumption. Rather, he would use the sales proceeds to
improve his lands or purchase other capital, which would, in turn, produce income that he could
legitimately consume under the social conventions of the time.
Notice that capital returns, such as rent and interest, tend to be paid periodically, i.e., from time
to time or with regularity, such as monthly or quarterly. Similarly, returns on human capital in the
form of wages are also paid periodically. Some early interpreters concluded that income meant
only the periodic payments from invested capital (such as interest, dividends, rents, and royalties)
and the periodic return to human capital in the form of wages. Under this view, one-time, lumpsum payments were not considered “income” but rather “capital” receipts that, when invested,
would produce future income. For that reason, the gain realized on the sale of land was not
considered income under the early English income tax but rather the entire proceeds (including
any gain) were considered a tax-free capital receipt. If profit from one-time sales of land were
considered income and thus taxed, the wealth of the landed gentry might diminish over time when
that wealth needed to remain intact to be handed down to the first-born son.
Similarly, let’s return to an earlier example, under which Father died in the 19th century and,
under his will, instructed that the title to all of his land and other investment property be transferred
to a trust, with income from the trust to be paid to surviving Wife for the rest of her life. Upon her
death, his will instructed that the trust should be dissolved, with the trust capital or corpus
distributed to the first-born son. If the trustee sells land or another investment asset held in the trust
at a profit during Wife’s life, that profit (what we would call § 1001 gain today) would not be
distributed to Wife as income but rather would be considered a capital receipt that belongs to the
trust corpus and which would, when invested again by the trustee, produce future income to be
distributed to Wife. Because the profit was not a periodic return but rather a lump sum, it was not
considered to be income (available to spend on consumption) but rather a capital receipt that would
eventually be distributed to the first-born son on Wife’s death.
This all sounds quite odd to our 21st-century ears. Today, we do not view one-time, lump-sum
receipts as out of bounds for spending on personal consumption under any social convention

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(lottery winnings anyone?). And the term capital receipt would, to our ears, mean only a tax-free
return of basis—not the entire amount realized. Gain realized on the sale of an asset (the excess of
amount realized over basis) is similarly available to spend on personal consumption under 21stcentury mores. In the early 20th century, however, when the modern income tax was first enacted,
debate swirled regarding whether income within the meaning of the residual clause was limited to
the periodic receipts from invested financial or human capital so that gain on the sale of an
investment (capital gain) would not be considered income, just as under the English income tax. 1
In the 1920 Supreme Court decision in Eisner v. Macomber, 2 the Court said—when interpreting
the meaning of that vague residual clause—that “income may be defined as the gain derived from
capital, from labor, or from both combined, provided it to be understood to include profit gained
through a sale or conversion of capital assets.” If that last clause had not been added, we still might
have been unsure after Macomber whether § 1001 gain realized on the sale of an asset could
legitimately be considered income for tax purposes. 3
Pondering that Eisner v. Macomber definition of income for more than a moment, you realize
that some receipts would still escape the income label if the receipt could not be traced back to a
capital investment or to labor. What about lottery winnings, prizes, punitive damages, and other
windfalls? They are not compensation for services rendered (a return to labor), and they are not a
return on invested capital (§ 1001 gain on the sale of an asset, interest, dividends, rents, or
royalties). Does that mean that they are not income within the meaning of the residual clause?
It seems odd that the facts in the following case had to be litigated all the way up to the Supreme
Court, as the outcome seems so intuitive to modern readers. But you can see why the issue arose
when you appreciate the background described above.
COMMISSIONER V. GLENSHAW GLASS
348 U.S. 426, reh’g denied, 349 U.S. 925 (1955)
MR. CHIEF JUSTICE WARREN delivered the opinion of the Court.
This litigation involves two cases with independent factual backgrounds yet presenting the
identical issue. The two cases were consolidated for argument before the Court of Appeals for the
Third Circuit and were heard en banc. The common question is whether money received as
exemplary damages for fraud or as the punitive two-thirds portion of a treble-damage antitrust
recovery must be reported by a taxpayer as Gross Income under § 22(a) of the Internal Revenue
Code of 1939 [the predecessor to current § 61(a)]. In a single opinion, the Court of Appeals
affirmed the Tax Court’s separate rulings in favor of the taxpayers. Because of the frequent
recurrence of the question and differing interpretations by the lower courts of this Court’s decisions
bearing upon the problem, we granted the Commissioner of Internal Revenue’s ensuing petition
for certiorari.
The facts of the cases were largely stipulated and are not in dispute. So far as pertinent they are
as follows:
The Glenshaw Glass Company, a Pennsylvania corporation, manufactures glass bottles and
1

Capital gains have been regularly taxed under the English income tax only since 1965.
252 U.S. 189 (1920).
3
In case we were not sure of this result, the Court confirmed in the following year that even “occasional” capital gains
on the disposition of property constitute income. See Merchants’ Loan & Trust Co. v. Smietanka, 255 U.S. 509 (1921).
2

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containers. It was engaged in protracted litigation with the Hartford-Empire Company, which
manufactures machinery of a character used by Glenshaw. Among the claims advanced by
Glenshaw were demands for exemplary damages for fraud and treble damages for injury to its
business by reason of Hartford’s violation of the Federal antitrust laws. In December, 1947, the
parties concluded a settlement of all pending litigation, by which Hartford paid Glenshaw
approximately $800,000. Through a method of allocation which was approved by the Tax Court,
and which is no longer in issue, it was ultimately determined that, of the total settlement,
$324,529.94 represented payment of punitive damages for fraud and antitrust violations. Glenshaw
did not report this portion of the settlement as income for the tax year involved. The Commissioner
determined a deficiency. As previously noted, the Tax Court and the Court of Appeals upheld the
taxpayer.
William Goldman Theatres, Inc., a Delaware corporation operating motion picture houses in
Pennsylvania, sued Loew’s, Inc., alleging a violation of the Federal antitrust laws and seeking
treble damages. After a holding that a violation had occurred, the case was remanded to the trial
court for a determination of damages. It was found that Goldman had suffered a loss of profits
equal to $25,000 and was entitled to treble damages in the sum of $375,000. Goldman reported
only $125,000 of the recovery as Gross Income and claimed that the balance constituted punitive
damages and as such was not taxable. The Tax Court agreed, and the Court of Appeals, hearing
this with the Glenshaw case, affirmed.
It is conceded by the respondents that there is no constitutional barrier to the imposition of a
tax on punitive damages. Our question is one of statutory construction: are these payments
comprehended by § 22(a) [predecessor to current § 61(a)]?
The sweeping scope of the controverted statute is readily apparent:
SEC. 22. GROSS INCOME.
(a) GENERAL DEFINITION.—‘Gross Income’ includes gains, profits, and income
derived from salaries, wages, or compensation for personal service . . . of whatever
kind and in whatever form paid, or from professions, vocations, trades, businesses,
commerce, or sales, or dealings in property, whether real or personal, growing out of
the ownership or use of or interest in such property; also from interest, rent, dividends,
securities, or the transaction of any business carried on for gain or profit, or gains or
profits and income derived from any source whatever….
This Court has frequently stated that this language was used by Congress to exert in this field
“the full measure of its taxing power.” Helvering v. Clifford, 309 U.S. 331, 334; Helvering v.
Midland Mutual Life Ins. Co., 300 U.S. 216, 223; Douglas v. Willcuts, 296 U.S. 1, 9; Irwin v.
Gavit, 268 U.S. 161, 166. Respondents contend that punitive damages, characterized as
“windfalls” flowing from the culpable conduct of third parties, are not within the scope of the
section. But Congress applied no limitations as to the source of taxable receipts, nor restrictive
labels as to their nature. And the Court has given a liberal construction to this broad phraseology
in recognition of the intention of Congress to tax all gains except those specifically exempted.
Comm’r v. Jacobson, 336 U.S. 28, 49; Helvering v. Stockholms Enskilda Bank, 293 U.S. 84, 8791. Thus, the fortuitous gain accruing to a lessor by reason of the forfeiture of a lessee’s
improvements on the rented property was taxed in Helvering v. Bruun, 309 U.S. 461. Cf. Robertson
v. U.S., 343 U.S. 711; Rutkin v. U.S., 343 U.S. 130; U.S. v. Kirby Lumber Co., 284 U.S. 1. Such
decisions demonstrate that we cannot but ascribe content to the catchall provision of § 22(a), “gains

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or profits and income derived from any source whatever.” The importance of that phrase has been
too frequently recognized since its first appearance in the Revenue Act of 1913 to say now that it
adds nothing to the meaning of “Gross Income.”
Nor can we accept respondents’ contention that a narrower reading of § 22(a) is required by the
Court's characterization of income in Eisner v. Macomber, 252 U.S. 189, 207, as “the gain derived
from capital, from labor, or from both combined.” The Court was there endeavoring to determine
whether the distribution of a corporate stock dividend constituted a realized gain to the shareholder,
or changed “only the form, not the essence,” of his capital investment. It was held that the taxpayer
had “received nothing out of the company’s assets for his separate use and benefit.” The
distribution, therefore, was held not a taxable event. In that context—distinguishing gain from
capital—the definition served a useful purpose. But it was not meant to provide a touchstone to all
future Gross Income questions. Helvering v. Bruun, supra, at 468-469; U.S. v. Kirby Lumber Co.,
supra, at 3.
Here we have instances of undeniable accessions to wealth, clearly realized, and over which
the taxpayers have complete dominion. The mere fact that the payments were extracted from the
wrongdoers as punishment for unlawful conduct cannot detract from their character as taxable
income to the recipients. Respondents concede, as they must, that the recoveries are taxable to the
extent that they compensate for damages actually incurred. It would be an anomaly that could not
be justified in the absence of clear congressional intent to say that a recovery for actual damages
is taxable but not the additional amount extracted as punishment for the same conduct which
caused the injury. And we find no such evidence of intent to exempt these payments.
It is urged that re-enactment of § 22(a) without change since the Board of Tax Appeals held
punitive damages nontaxable in Highland Farms Corp., 42 B.T.A. 1314, indicates congressional
satisfaction with that holding. Re-enactment—particularly without the slightest affirmative
indication that Congress ever had the Highland Farms decision before it—is an unreliable indicium
at best. Helvering v. Wilshire Oil Co., 308 U.S. 90, 100-101; Koshland v. Helvering, 298 U.S. 441,
447. Moreover, the Commissioner promptly published his nonacquiescence in this portion of the
Highland Farms holding and has, before and since, consistently maintained the position that these
receipts are taxable. It therefore cannot be said with certitude that Congress intended to carve an
exception out of § 22(a)’s pervasive coverage. Nor does the 1954 Code’s legislative history, with
its reiteration of the proposition that statutory Gross Income is “all-inclusive,” give support to
respondents’ position. The definition of Gross Income has been simplified, but no effect upon its
present broad scope was intended. Certainly punitive damages cannot reasonably be classified as
gifts, cf. Comm’r v. Jacobson, 336 U.S. 28, 47-52, nor do they come under any other exemption
provision in the Code. We would do violence to the plain meaning of the statute and restrict a clear
legislative attempt to bring the taxing power to bear upon all receipts constitutionally taxable were
we to say that the payments in question here are not Gross Income. See Helvering v. Midland
Mutual Life Ins. Co., supra, at 223.
Reversed.
MR. JUSTICE DOUGLAS dissents. MR. JUSTICE HARLAN took no part in the consideration or
decision of this case.
_______________________________________
The language from § 22 quoted in the case is from the 1939 Internal Revenue Code. In 1954,

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Congress did a thorough rewrite of the Code—a “recodification”—including changing most Code
section numbers. Section 22 of the 1939 Code became § 61(a) in the 1954 Code. Although
Glenshaw Glass was decided in 1955, the tax years at issue predated the 1954 recodification, which
is why the Court quoted § 22 rather than § 61. Although the language in old § 22 looks slightly
different from that in current § 61 (with the residual clause appearing at the end of old § 22 instead
of at the beginning, as in current § 61), the two versions are not materially different. The Glenshaw
Glass Court’s interpretation of the scope of the residual clause in old § 22 applies equally to the
residual clause in current § 61. 4
Which statutory interpretation tools did the Glenshaw Glass Court use in deciding that punitive
damages fell within the residual clause? Did it look to common understandings of the term income
in 1913 under the notion that the meaning of that term as it was understood by the original enactors
of the statute should govern what that term means in 1955? Or did the Court effectively permit the
meaning of the term income to evolve over time? And what was the structure of the argument
pertaining to the Highland Farms case? Sometimes you will hear this argument referred to as the
“legislative reenactment doctrine.” Did you find it convincing?
Finally, the statutory interpretation canon referred to as ejusdem generis (Latin for “of the same
kind”) directs that, when a statute contains a list of persons or items with common characteristics
and then appends a general catch-all clause (such as the residual clause), the scope of the catch-all
clause should be limited to items with the same common characteristics of the specifically listed
items. For example, if a statute provides that a motor vehicle tax should apply to “automobiles,
trucks, motorcycles, and other motor-powered vehicles,” the word “vehicles” should not be
interpreted to include airplanes because the other items on the list all pertain to ground
transportation vehicles.
What common characteristics are shared by the specifically enumerated items in old § 22 quoted
in the opinion? Notice that all of the listed items could be traced back to labor or capital. If the
Court wanted, therefore, it could have chosen to invoke ejusdem generis to re-affirm Eisner v.
Macomber’s approach to the residual clause, which would mean that receipts not traced back to
labor or capital (such as windfalls and punitive damages) would not constitute Gross Income
within the meaning of the residual clause. But the Court did not do that. Indeed, the Court gave
new meaning to the residual clause by replacing the Macomber language—which looked
backward by asking whether today’s receipt could be traced back to labor or capital—with
language that asks only whether the taxpayer has been enriched by the receipt: “undeniable
accessions to wealth, clearly realized, over which the taxpayer[] ha[s] complete dominion.”
Whether the receipt can be traced back to labor or capital is irrelevant; we ask only whether the
taxpayer is wealthier by reason of the receipt or event.
Where did the Supreme Court find this new perspective? There is no direct evidence that the
Supremes ever read the works of Henry Simons, Robert Haig, or Georg Schanz, but their work in
attempting to articulate a tax-specific meaning of the term income had by 1955 become widely
discussed—at least in the academic world. Henry Simons’s book (quoted in Chapter 1) was
published in 1938. Moreover, the Government’s Brief in Glenshaw Glass explicitly referred to the
4

The Tax Reform Act of 1986 also resulted in a recodification of the Internal Revenue Code, but most of the Code
section numbers remained unchanged. The current Internal Revenue Code comprises Title 26 of the U.S. Code and is
properly referred to as the “The Internal Revenue Code of 1986, as amended,” with that last phrase inserted to account
for the virtually annual changes made to the Code by Congress.

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concept. 5 At the least, dated Victorian notions about not spending lump-sum, non-periodic
windfalls on consumption had gone by the wayside. When you recall my simplified restatement
of the SHS notion of income from Chapter 1—wealth increases less wealth decreases that are not
spent on personal consumption—you can appreciate how Glenshaw Glass can be seen as
effectively incorporating SHS notions into the modern interpretation of the residual clause. For
that reason, you can think of Glenshaw Glass as an example of what some refer to as “dynamic
statutory interpretation,” under which the meaning of unamended statutory language can change
over time, including the meaning of the term income in the § 61 residual clause. 6
Section A. examines the scope of wealth accessions within the meaning of Glenshaw Glass.
Section B. explores when a clear wealth accession is considered realized. The third Glenshaw
Glass factor (referring to “complete dominion”) will be important in considering attempts to shift
income among taxpayers, considered in Chapter 8.

A. What is an accession to wealth
within the meaning of Glenshaw Glass?
We move from the simple (cash) to the more ambiguous (consumption received in kind).
Cash receipts that are not basis recovery (or loan principal or excluded by statute)
Once the Court decided that the proper question to ask in Glenshaw Glass was whether the
taxpayer had enjoyed a wealth accession, the case before it became an easy one because a punitive
damage award—a cash receipt that clearly does not represent basis recovery—is new wealth that
has never been taxed before to this taxpayer. Glenshaw Glass clearly enjoyed an increase in its
wealth upon receipt of the punitive damages.
But do all cash receipts that are not basis recovery (or borrowed money or amounts that are
excludable under specific statutory authority, such as the § 102 gift exclusion) constitute § 61
Gross Income under the residual clause?
REVENUE RULING 76-131
1976-1 C.B. 16
Advice has been requested whether benefit payments received by individuals under the Alaska
Longevity Bonus Act, Alaska Statutes, Title 47, Chapter 45, sections 10 to 170, effective January
1, 1973, are includible in the Gross Income of the recipients pursuant to section 61 of the Internal
Revenue Code of 1954.
The Alaska Longevity Bonus Act grants a bonus of $100 per month to persons 65 years of age
and over who have maintained a continuous domicile in the territory or State of Alaska for 25
years. Such bonus will be paid only as long as an eligible person retains a domicile in Alaska.
The purpose of the statute as stated therein is to provide an incentive to continue uninterrupted
residence in the state and under no circumstances is to be considered a form, type or manner of
public relief. It is also stated that the bonuses are not predicated on need.

5
6

See Alice G. Abreu & Richard K. Greenstein, Defining Income, 11 FLA. TAX REV. 295, 306 (2011).
See, e.g., William N. Eskridge, Jr., Dynamic Statutory Interpretation, 135 U. PA. L. REV. 1479 (1987).

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Section 61 of the Code provides, in part, that Gross Income means all income from whatever
source derived unless otherwise excluded by law.
The Internal Revenue Service has consistently held that payments made under legislatively
provided social benefit programs for promotion of the general welfare are not includible in a
recipient’s Gross Income. See for example, Rev. Rul. 63-136, 1963-2 C.B. 19, concerning
payments under the Manpower Development and Training Act; Rev. Rul. 68-38, 1968-1 C.B. 446,
involving payments under Title II-A of the Economic Opportunity Act of 1964; and Rev. Rul. 72340, 1972-2 C.B. 31, concerning stipends paid by a city to unemployed or underemployed
probationers.
The Alaska Longevity Bonus is distinguished from welfare program payments in that the
benefits are payable to any Alaskan meeting the age and residency requirements regardless of
financial status, health, educational background, or employment status.
Accordingly, in the instant case, benefit payments received by individuals under the Alaska
Longevity Bonus Act are includible in the Gross Income of the recipients pursuant to section 61
of the Code.
_______________________________
In the 1990s, Congress replaced the Aid to Families with Dependent Children (AFDC) program
with the Temporary Assistance for Needy Families (TANF) program. AFDC payments were
excludable from Gross Income under the so-called general welfare doctrine, and the IRS was asked
whether TANF payments were similarly excludable from Gross Income because TANF requires
that specified percentages of individual recipients engage in work activities and imposes penalties
on the states for noncompliance with that requirement. “Work activities” was broadly defined,
however, to include a range of activities, such as engaging in job search and job readiness
assistance programs, community service programs, certain education programs, and the like. In
Notice 99-3, 7 the IRS ruled as follows:
Payments by a governmental unit to an individual under a legislatively provided
social benefit program for the promotion of the general welfare that are not basically
for services rendered are not includible in the individual’s Gross Income and are not
wages for employment tax purposes, even if the individual is required to perform
certain activities to remain eligible for the payments. See Rev. Rul. 71-425, 1971-2
C.B. 76; Rev. Rul. 75-246, 1975-1 C.B. 24. If, however, taking into account all the
facts and circumstances, payments by a governmental unit are basically compensation
for services rendered, even though some training is provided, then the payments are
includible in the individual’s Gross Income and are generally wages for employment
tax purposes. Rev. Rul. 75-246, 1975-1 C.B. 24.
Due to the flexibility TANF affords states to determine basic eligibility rules and
benefit amounts, a TANF payment may be made both for the promotion of the general
welfare and as compensation for services. In these cases, it is extremely difficult to
characterize the basic purpose of the payments. It is also not practically feasible to
determine the relative proportion of the payment each purpose represents.
In many of these cases, TANF payments are received in lieu of (and generally in
amounts no greater than) payments the individual formerly received or would have
7

1999-1 C.B. 271.

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received under AFDC based upon the individual’s personal and family subsistence
requirements. In these cases, the primary measure of the amount received is the
personal or family need of the individual recipient rather than the value of any services
performed.
In cases where the following three conditions are satisfied, TANF payments will be
treated as made for the promotion of the general welfare and therefore will not be
includible in an individual’s Gross Income and will not be wages for employment tax
purposes:
(1) The only payments received by the individual with respect to the work activity are
received directly from the state or local welfare agency (for this purpose, an entity with
which a state or local welfare agency contracts to administer the state TANF program
on behalf of the state will be treated as the state or local welfare agency);
(2) The determination of the individual’s eligibility to receive any payment is based
on need and the only payments received by the individual with respect to the work
activity are funded entirely under a TANF program (including any payments with
respect to qualified state expenditures …, and
(3) The size of the individual’s payment is determined by the applicable welfare law…
Neither the ruling nor the notice provide much analysis regarding the source of the so-called
general welfare doctrine. Can you construct one? Is Congress’s apparent intent to protect bare
subsistence income from taxation via the mechanisms studied in Chapter 1, Part B. (such as the
Standard Deduction and the suspended Personal and Dependent Exemption Deductions) relevant?
How about the “ability to pay” fairness norm that was most discussed when the income tax was
first adopted, as described in Chapter 3? Unemployment compensation payments are includable in
Gross Income under § 85, as they are considered substitutes for what would have been includable
compensation income under § 61(a)(1) had the taxpayer not lost her job.
What about Social Security payments? Unlike the TANF payments described above, Social
Security payments are not need-based and thus are not excludable under the general welfare
doctrine because they are payable regardless of financial status. Unlike the payments under the
Alaska Longevity Bonus, however, the recipient likely made earlier payments (in the form of
Social Security Tax payments) which, from one perspective, could be seen as investment in an
asset (creating basis) that generates this stream of payments. Let’s think about the issue from the
theoretical perspective first and then look at positive law.
The payment of Social Security tax under the payroll tax system (described in Chapter 3) during
one’s working life is not deductible under the income tax. As a theoretical matter, therefore, the
nondeduction for income tax purposes during one’s working life could conceivably be thought to
create basis in the future payment stream, which could offset those payments on receipt—if you
conceive of the system as similar to a personal retirement account. That conceptualization is
controversial, however, because the Social Security system is not truly an individualized pension
system but, rather, a current tax-and-transfer system. That is to say, current Social Security tax
payments fund payments to current retirees (as well as certain disability and other payments); they
are not set aside for the payee and invested on the payee’s account for a future stream of payments.
For that reason, they are more commonly considered to be expenses (which do not create basis). 8
8

See generally, Deborah A. Geier, Integrating the Tax Burdens of the Federal Income Tax and Payroll Taxes on

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If, however, we indulge in the notion that the payment of Social Security Tax and the receipt
of Social Security payments in retirement are related, the resulting creation of basis with the tax
payments would mean that Social Security payments would be includable in Gross Income only
to the extent exceeding that basis. For ease, we could allocate 100% of each payment received to
tax-free basis recovery until basis is exhausted and then include 100% of each payment thereafter.
Or we could allocate basis over the estimated remainder of the taxpayer’s life (using actuarial
tables) so that a portion of each payment is tax-free basis recovery and a portion of each payment
is includable, similar to the rules found in § 72 that apply to payments received under certain
annuity contracts (explored in Chapter 9). Because of the time value of money, the former system
would be of greater benefit to the Social Security recipient.
Under positive law, however, neither approach is taken. Prior to 1983, Social Security payments
were entirely excludable from Gross Income, perhaps on the simplifying assumption that the
receipts never exceeded our hypothetical basis. In 1983, however, Congress enacted § 86, which
now requires inclusion of a portion of Social Security payments received by those with Adjusted
Gross Income (AGI) exceeding certain thresholds. Today, anywhere between 0% and 85% of
Social Security payments can be includable under § 86, depending on AGI, filing status, and the
amount of Social Security payments received.
In 1983, research showed that most recipients of Social Security payments received
substantially more in lifetime benefits than they paid in taxes over their working lives. That is no
longer true for the most recent class of retirees if you view Social Security payments alone. If you
add in Medicare taxes paid and benefits received, however, it remains true. 9 Virtually everyone
today receives in kind many times more health care than they pay in Medicare Tax. For example,
a two-earner married couple pays, on average, approximately $120,000 in aggregate Medicare Tax
but receives Medicare services valued at $427,000. 10 This observation takes us to the next
question: whether the value of Medicare benefits (and other consumption benefits) received in
kind ought to be included in § 61 Gross Income under the residual clause.
Consumption received in kind
You learned in Chapter 1 that the taxation of personal consumption is accomplished primarily
through deduction denial. Personal consumption spending, although a wealth reduction, is not
deductible. Personal expenses are nondeductible under § 262(a), and the basis created on the
purchase of personal-use property cannot be depreciated under §§ 167 and 168 or be deducted as
a loss when the property is sold for less than basis. See § 165(c)(3). In this manner, purchased
personal consumption remains in the tax base via deduction denial, resulting in taxation.
Should consumption received in kind for free from another—rather than purchased by the
taxpayer—be valued and included in § 61 Gross Income? When I say “consumption received in
kind,” I generally mean the value of consumption services and consumer goods received in kind,
such as food, entertainment, gym memberships, health care, lodging, and the like. Some receipts—
even if considered Gross Income within the meaning of § 61—might nevertheless be excludable
under a specific Code section (such as § 102 pertaining to gifts or the fringe benefit exclusions for
certain forms of compensation received in kind considered in the last chapter). We are considering
Labor Income, 22 VA. TAX REV. 1 (2002).
9
C. Eugene Steuerle &Stephanie Rennane, Social Security Taxes and Benefits Over a Lifetime,
at www.urban.org/UploadedPDF/social-security-medicare-benefits-over-lifetime.pdf.
10
See Bruce Bartlett, Taxing Medicare Benefits, at http://economix.blogs.nytimes.com/2013/09/17/taxing-medicarebenefits/?_r=0 (using data from the Urban Institute).

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here only receipts that—if they do constitute § 61 Gross Income—would fail to qualify for
exclusion under another Code section.
In Glenshaw Glass terms, the question is whether free consumption increases the taxpayer’s
wealth. Free consumption certainly is unlike the cash punitive damages received by the Glenshaw
Glass Company, easily a wealth accession. After all, free consumption is illiquid; you cannot send
the free entertainment or health care to the IRS in payment of a tax. But we have seen in Chapter
5 that lack of liquidity does not prevent in-kind consumption from being treated like a wealth
accession if it is received as compensation for services rendered. In that case, the consumption
must be valued and included in Gross Income (absent application of an explicit statutory exclusion,
such as §§ 119 or 132).
But in the compensation context, you quite incisively reply, the in-kind consumption clearly
replaces what would otherwise clearly constitute a wealth increase—cash compensation. Most
compensation is, in fact, paid in cash. In situations where in-kind consumption can be considered
a substitute for something that would clearly constitute a wealth accession, we must be vigilant to
include that in-kind consumption in Gross Income to prevent undermining the tax base. Indeed,
the excerpt from the Joint Committee on Taxation reprinted in Chapter 5 expressed this very
concern when it described the enactment of § 132:
Congress was concerned that without any well-defined limits on the ability of
employers to compensate their employees tax-free by providing noncash benefits
having economic value to the employee, new practices will emerge that could
shrink the income tax base significantly. This erosion of the income tax base results
because the preferential tax treatment of fringe benefits serves as a strong
motivation to employers to substitute more and more types of benefits for cash
compensation. 11
Because of this concern, the receipt of free consumption by an employee that is not described in
§§ 119, 132, or another exclusion provision is reconstructed in substance as though (1) the
employee received cash (clearly a wealth accession), which (2) the employee then used to purchase
personal consumption (nondeductible under § 262) under Old Colony Trust.
In sum, one clear instance in which the receipt of consumption in kind is considered to rise to
the level of a wealth accession (and thus includable in § 61 Gross Income, absent a specific
statutory exclusion) is when the receipt is otherwise expressly listed as an item of Gross Income
in § 61 or elsewhere, outside the residual clause: e.g., compensation under § 61(a)(1), dividend
under § 61(a)(7), rent under § 61(a)(5), or a prize under § 74(a). In each case, the consumption
received in kind is clearly a substitute for cash, the most common forms of compensation,
dividends, rent, and prizes. Of course, the taxpayer wishing to avoid inclusion can always simply
decline the receipt and avoid the Gross Income inclusion. But if the receipt is accepted rather than
declined, Congress made its intent clear that these types of receipts are includable in Gross Income
by expressly listing them in the enumerated list of clearly includable Gross Income items, without
regard to whether the compensation, dividend, rent, or prize is paid in cash or in kind.
In the piece below, the goody bags provided to presenters were, in essence, either a prize or
compensation for services rendered. (You will read in the next chapter why exclusion as a gift was
not possible under the Federal income tax definition of that term.)
11

STAFF OF THE JOINT COMM. ON TAX’N, GENERAL EXPLANATION OF THE REVENUE PROVISIONS OF THE DEFICIT
REDUCTION ACT OF 1984, JCS-41-84, 840-42 (Dec. 31, 1984). (Emphasis added.)

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Oscar Freebies Balloon to $80K (Don’t Tell IRS) 12
Robert W. Wood
No matter who you are, it is somehow fun to receive free stuff. Perhaps it is less fun for the
truly wealthy, but it’s still fun, especially if the items are downright cool and are dropped in your
lap. It should be no surprise that companies flock to the celebrity appeal of the Oscars.
Who wouldn’t want to have Tom Hanks wearing your polo shirt, Sandra Bullock wearing your
watch, or Cate Blanchett snacking on your protein bar? The allure is too great not to try. All sorts
of products benefit from celebs giving them a try. So with a kind of effusive zeal, companies throw
expensive goodies at the nominees, and this year, the volume and value for the most elite offerings
has risen to over $80,000.
That’s about double the 2013 take, so the economy must be improving. Gift bags include such
essentials as:
•
•
•
•
•
•
•
•
•
•
•
•
•
•
•
•
•
•
•
•
•
•

$16,000 hair restoration procedure;
$15,000 walking tour around Japan;
$9,000 trip to Las Vegas;
$6,850 train trip in the Canadian Rockies;
$5,000 toward art from Gizara;
$5,000 toward laser hair removal and cosmetic surgery from Ideal Image;
$4,895 home water filtration system;
$3,300 resort stay at the Imanta’s Ocean Casa suite in Mexico;
$2,700 “O-Shot” procedure to stimulate a woman’s sex drive;
$2,560 home spa system from Steamist;
$2,000 five-night stay at the Koloa Landing Resort in Hawaii;
$1,572 pet supplies from Epic Pet Health;
$850 for 10 personal training sessions with Huntley Drive Fitness;
$500 lifetime membership to a meditation gym;
$290 Swiss-made watch from Slow Watch;
$280 portable camera from Narrative Clip;
$280 package of organic maple syrup from Rouge Maple;
$120 pink and camo pepper guns from Mace;
$39 in weight-loss products from Hydroxycut;
$35 six-pack of herbal tea lollipops from Dosha Pops;
$23 worth of reusable dry-cleaning bags from Green Garmento; and
$6 device keeps hair from clogging in the shower from DrainWig.

Sure, winning is better. Oscars don’t have a cash prize like Olympic medals. But still, taking
home an Academy Award means a recipient will make a lot more money in the future. But a gift
bag worth $80,000 is hardly inconsequential, not like a Thanksgiving turkey from your employer.
That means somebody has to pay tax on it. That makes the biggest winner of them all the IRS.
12

www.forbes.com/sites/robertwood/2014/03/01/oscar-freebies-balloon-to-80k-dont-tell-irs/. Reprinted
with permission of the author.

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In case the attendees “forget,” they will receive an IRS Form 1099 reporting the value of what they
took home. Form 1099 is that irksome piece of paper that tells the IRS you were paid….
For years, the entertainment industry and the IRS locked horns repeatedly over taxes…. But
eventually, the brouhaha was settled …. Now, IRS guidelines are clear. If you get a gift bag, you
generally have taxable income equal to its fair market value. Can’t you argue this was a “gift” and
you aren’t being paid? Nope, you lose. You must report it on your tax return.
What about gift certificates or vouchers for trips or personal services? If you redeem the
certificates or vouchers, you must include the fair market value of the trip or service on your tax
return.
If these are gifts, why are they income? They’re not gifts for tax purposes. The organizations
and merchants don’t give them solely out of affection or respect.
Can you take a charitable contribution deduction if you “regift” a gift bag? Yes, if you donate
the gift bag to a qualified charity. But the fair market value of the gifts must still be reported on
your tax return.
Are there third-party reporting requirements for gift bags? Yes. Organizations and vendors
distributing gift bags may have to issue Form 1099-MISC, Miscellaneous Income.
What if you make a selection in a free shopping room for participating in the show? The value
of your selection is income and you must report it.
_________________________________________
This brings us to the obvious next step in the analysis. Suppose the consumption received in
kind is not compensation for services rendered, a dividend, rent, a prize, or some other type of
explicitly listed Gross Income item. In that case, the only provision that could result in inclusion
in § 61 Gross Income is the residual clause, as interpreted by Glenshaw Glass: a wealth accession.
When should consumption received in kind for free that is not compensation, a dividend, etc., be
considered a wealth receipt? To the average taxpayer, “wealth” connotes property or cash,
representing ability to pay.
Suppose that you are a jazz fan, and you are walking down the street when you come across a
jazz saxophonist who opens his case and begins to play with the hope that passersby will throw
some cash into his case. You love jazz. Indeed, you went last night to a nightclub to hear a jazz
performer, paying $25 for the entrance ticket to hear him. You could not deduct that $25 ticket
price because it was a nondeductible personal expense. Must you value this free concert and
include that value in § 61 Gross Income, as though you received cash (a clear wealth accession)
followed by a nondeductible personal expense?
Of course not! But why not? In Chapter 1, we saw that Henry Simons described income as “the
algebraic sum of (1) the market value of rights exercised in consumption and (2) the change in the
value of the store of property rights between the beginning and end of the period in question.”13
One could argue that his reference to “rights exercised in consumption” implies that the taxation
of consumption under an income tax should primarily be accomplished via deduction denial, not
through a Gross Income inclusion if received in kind. That is to say, a taxpayer who freely chooses
to exercise his right to spend a prior wealth receipt on consumption in the marketplace should be
denied a deduction for that consumption under the ability to pay fairness norm described in Chapter
13

HENRY SIMONS, PERSONAL INCOME TAXATION 50 (1938).

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3, which defines the tax base according to the resources under the control of the taxpayer that are
available for contribution to the fisc. The Code denies deductions (wealth reductions) for personal
expenses, depreciation, and losses.
Under this deduction-denial route to taxing personal consumption, one can argue that we should
tax personal consumption received in kind under Glenshaw Glass’s wealth accession interpretation
of the residual clause only when we are fairly confident that, under the particular facts and
circumstances, the in-kind consumption is the equivalent of (1) the receipt of cash (clearly a wealth
accession) followed by (2) a free-spending choice on consumption (nondeductible). In other
words, if we are not confident that the taxpayer might have purchased the consumption at issue
with his own resources, perhaps it is not reasonable to interpose a deemed cash step (followed by
nondeduction of the personal consumption outlay), i.e., to equate the in-kind consumption receipt
with a wealth receipt representing ability to pay.
Notice that this is the same sort of reasoning that we explored in the last chapter in trying to
construct an analytical framework regarding where the lines are drawn in §§ 119 and 132 in the
compensation context. We suggested there, for example, that the convenience of the employer test
for meals and lodgings provided to an employee (i.e., substantial noncompensatory business
reason) could be seen as a more administrable proxy test for determining whether we can be fairly
confident that the taxpayer would have freely purchased the same consumption on his own.
If consumption is received in kind outside of a market transaction, such as the free jazz concert
enjoyed on the street by a passerby, we cannot be so sure that the consumption receipt is the
equivalent of a cash receipt followed by a free-spending choice to purchase the personal
consumption. Similarly, the lack of a marketplace transaction means that the value of self-provided
services does not produce Gross Income, even though economists sometimes count this value as
income. When you grow your own vegetables to consume, you do not include the value of the
consumed vegetables in Gross Income. 14 Nor do you include the imputed rental income generated
by owner-occupied housing (considered further in Chapter 17), even though economists (and some
other countries) count it as income.
With this background, let’s return to the receipt of medical care received under the Medicare
program. Unlike the free jazz concert, the receipt of health care under the Medicare program is an
identifiable marketplace transaction, with the government paying for the services rendered to you.
Nevertheless, the government has never argued that the value of this in-kind consumption is
includable in § 61 Gross Income under the residual clause, even though the value of medical care
received under the Medicare and Medicaid programs is included by the CBO as economic income
in the denominator when describing effective Federal tax rates, as described in Chapter 3 (thus
reducing effective tax rates). As noted above, the value of medical care received by a retiree under
the Medicare system far exceeds the typical taxpayer’s payment of Medicare Tax over one’s
working life. Even if one did consider the payment of Medicare Tax as creating basis that could
be recovered tax-free when medical care is provided later in life, this fiction could not explain full
exclusion of the value received.
Is the receipt of the free medical care by the retiree the equivalent of (1) the receipt of cash that
was then used (2) to purchase medical care? How confident are we that the retiree would have
chosen to purchase the same medical care if it had not been provided for free? Should the answer
to this question turn on the taxpayer’s financial status? After all, even certain cash payments
14

See Morris v. Comm’r, 9 B.T.A. 1273 (1928).

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received under government programs is not considered includable residual Gross Income if the
payment satisfies the general welfare doctrine, described above—typically government payments
made on account of financial need. Similarly, § 86 requires wealthier retirees to include a portion
of Social Security payments received, as described above. Should this mean that Congress ought
to amend the statute to require wealthier retirees to include a portion of Medicare benefits received,
as well?
On the other hand, in the private medical insurance market, the payment of premiums entitle
the payor to specified benefits regardless of whether the value of medical care eventually received
under the contract exceeds the aggregate of premiums paid, and the excess value received does not
create includable § 61 Gross Income under the residual clause. Does this analogy explain why the
value of medical care received under the Medicare program is similarly not valued and included
in Gross Income (without regard to the financial status of the recipient or whether it exceeds or is
less than Medicare tax paid over one’s working life)? Perhaps what is purchased under an
insurance contract is not the actual future medical care received but rather risk shifting—the
shifting of financial risk to the insurance pool at large if the cost of your medical care proves to be
extraordinary in amount—so that whatever recoveries are received under the insurance contract
were fully purchased in that sense? Or do these examples merely represent the purchase of services
(at arm’s length between strangers) at a bargain price? Cf. Part B., below. Frankly, there are no
easy answers to these questions, but the IRS has never argued that the value of Medicare services
received is includable in Gross Income.
Next hypothetical: You hire a lawyer to pursue a litigation matter on your behalf. The lawyer
takes you and your spouse out to dinner to discuss the matter and pays the cost of all three meals
(the one for herself, as well as the ones for you and your spouse). We shall consider the possibility
of the lawyer’s deduction for her outlay in Chapter 19. Here we are concerned only with whether
you and your spouse must include in your § 61 Gross Incomes the value of the free meals that you
enjoyed. The meals clearly do not constitute compensation, a dividend, etc. If the value of the free
meals is to be included, therefore, it could be included only under the residual clause, as interpreted
by Glenshaw Glass. Is the receipt of the free meals in this context the equivalent of a cash receipt
(a clear wealth accession) followed by a free-spending choice to purchase nondeductible personal
consumption? What proxy tests are used in the following cases to arrive at the answer in a more
administratively feasible way?
In the case below, Mr. Gotcher was an employee of a Volkswagen car dealership who had been
identified as a good candidate to co-invest in the dealership as a principal. The 12-day, expensepaid trip described in the case was paid for mostly by Volkswagen Germany and Volkswagen of
America, though a small portion was paid by his employer. Nevertheless, even the small portion
paid by his employer was not analyzed as compensation because the purpose of the trip was to
entice Mr. Gotcher to invest in the dealership, itself, which is why the court does not discuss the
possibility of inclusion under § 61(a)(1). Rather, the FMV of this free trip could only be included
under the residual clause (or possibly as a § 74 prize). For that reason, Gotcher cannot be cited as
authority for § 61(a)(1) compensation to be excluded from Gross Income.
UNITED STATES v. GOTCHER
401 F.2d 118 (5th Cir. 1968)
Before JOHN R. BROWN, CHIEF JUDGE, and BELL AND THORNBERRY, CIRCUIT JUDGES.

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THORNBERRY, CIRCUIT JUDGE: In 1960, Mr. and Mrs. Gotcher took a twelve-day expense-paid
trip to Germany to tour the Volkswagen facilities there. The trip cost $1,372.30 [paid mostly by
Volkswagen of Germany and Volkswagen of America]. Upon returning, Mr. Gotcher bought a
twenty-five percent interest in Economy Motors, the Sherman, Texas Volkswagen dealership that
had been offered to him before he left. Today he is President of Economy Motors in Sherman and
owns fifty percent of the dealership. Mr. and Mrs. Gotcher did not include any part of the $1,372.30
in their 1960 income. The Commissioner determined that the taxpayers had realized income to the
extent of the $1,372.30 for the expense-paid trip and asserted a tax deficiency of $356.79, plus
interest. Taxpayers paid the deficiency, plus $82.29 in interest, and thereafter timely filed suit for
a refund. The district court, sitting without a jury, held that the cost of the trip was not income ….
We affirm the district court’s determination that the cost of the trip was not income to Mr. Gotcher
($686.15); however, Mrs. Gotcher’s expenses ($686.15) constituted income ….
Section 61 of the Internal Revenue Code of 1954 defines Gross Income as income from
whatever source derived and specifically includes fifteen items within this definition. The court
below reasoned that the cost of the trip to the Gotchers was not income because an economic or
financial benefit does not constitute income under section 61 unless it is conferred as compensation
for services rendered. This conception of Gross Income is too restrictive since it is well-settled that
section 61 should be broadly interpreted and that many items, including noncompensatory gains,
constitute Gross Income.
In determining whether the expense-paid trip was income within section 61, we must look to
the tests that have been developed under this section. The concept of economic gain to the taxpayer
is the key to section 61. H. Simons, Personal Income Taxation 51 (1938); J. Sneed, The
Configurations of Gross Income 8 (1967). This concept contains two distinct requirements: There
must be an economic gain, and this gain must primarily benefit the taxpayer personally….
In two cases, Rudolph v. U.S., 5th Cir. 1961, 291 F.2d 841, and Patterson v. Thomas, 5th Cir.
1961, 289 F.2d 108, this Court has examined expense-paid trips and held that the value of these
trips constituted income. Both of these cases involved conventions for insurance salesmen, and in
both it was evident that the trip was awarded as compensation for past services. The instant case
differs from Rudolph and Patterson in that there is no evidence in the record to indicate that the
trip was an award for past services since Mr. Gotcher was not an employee of VW of Germany
….
The trip was made in 1959 when VW was attempting to expand its local dealerships in the
United States. The “Buy American” campaign and the fact that the VW people felt they had a
“very ugly product” prompted them to offer these tours of Germany to prospective dealers. The
VW story was related by Mr. Horton, who is Manager of Special Events for VW of America. His
testimony was uncontradicted and unimpeached. He stated that VW operations were at first so
speculative that cars had to be consigned with a repurchase guarantee. In 1959, when VW began
to push for its share of the American market, its officials determined that the best way to remove
the apprehension about this foreign product was to take the dealer to Germany and have him see
his investment first-hand. It was believed that once the dealer saw the manufacturing facilities and
the stability of the “new Germany” he would be convinced that VW was for him. Furthermore,
VW considered the expenditure justified because the dealer was being asked to make a substantial
investment of his time and money in a comparatively new product. Indeed, after taking the trip,
VW required him to acquire first-class facilities. It was hoped that this would be accomplished by
following the international architectural plans that VW had for its dealerships. It was also hoped

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that the dealer would adopt VW’s international plan for the sales and services department. Mr.
Horton testified that VW could not have asked that this upgrading be done unless it convinced the
dealer that VW was here to stay. Apparently these trips have paid off since VW’s sales have
skyrocketed and the dealers have made their facilities top-rate operations under the VW
requirements for a standard dealership.
The activities in Germany support the conclusion that the trip was oriented to business. The
Government makes much of the fact that the travel brochure allocated only two of the twelve days
to the touring of VW factories. This argument ignores the uncontradicted evidence that not all of
the planned activities were in the brochure. There is ample support for the trial judge’s finding that
a substantial amount of time was spent touring VW facilities and visiting local dealerships. VW
had set up these tours with local dealers so that the travelers could discuss how the facilities were
operated in Germany. Mr. Gotcher took full advantage of this opportunity and even used some of
his “free time” to visit various local dealerships. Moreover, at almost all of the evening meals VW
officials gave talks about the organization and passed out literature and brochures on the VW story.
Some of the days were not related to touring VW facilities, but that fact alone cannot be
decisive. The dominant purpose of the trip is the critical inquiry and some pleasurable features will
not negate the finding of an overall business purpose. See Patterson v. Thomas, supra. Since we
are convinced that the agenda related primarily to business and that Mr. Gotcher’s attendance was
prompted by business considerations, the so-called sightseeing complained of by the Government
is inconsequential. See Peoples Life Ins. Co. v. U.S., U.S. Ct. Cl. 1967, 179 Ct. Cl. 318, 373 F.2d
924, 930. Indeed, the district court found that even this touring of the countryside had an indirect
relation to business since the tours were not typical sightseeing excursions but were connected to
the desire of VW that the dealers be persuaded that the German economy was stable enough to
justify investment in a German product. We cannot say that this conclusion is clearly erroneous.
Nor can we say that the enthusiastic literary style of the brochures negates a dominant business
purpose. It is the business reality of the total situation, not the colorful expressions in the literature,
that controls. Considering the record, the circumstances prompting the trip, and the objective
achieved, we conclude that the primary purpose of the trip was to induce Mr. Gotcher to take out
a VW dealership interest.
The question, therefore, is what tax consequences should follow from an expense-paid trip that
primarily benefits the party paying for the trip. In several analogous situations the value of items
received by employees has been excluded from Gross Income when these items were primarily for
the benefit of the employer. Section 119 excludes from Gross Income of an employee the value of
meals and lodging furnished to him for the convenience of the employer. Even before these items
were excluded by the 1954 Code, the Treasury and the courts recognized that they should be
excluded from Gross Income. Thus it appears that the value of any trip that is paid by the employer
or by a businessman primarily for his own benefit should be excluded from Gross Income of the
payee on similar reasoning. See Disney v. U.S., C.D. Calif. 1967, 267 F. Supp. 1; Comm’r v. Riss,
1967, 1967 T.C. Memo 258, 26 T.C.M. 1334.
In the recent case of Allen J. McDonnell, 26 T.C.M. 115, Tax Ct. Mem. 1967-18, a sales
supervisor and his wife were chosen by lot to accompany a group of contest winners on an expensepaid trip to Hawaii. In holding that the taxpayer had received no income, the Tax Court noted that
he was required by his employer to go and that he was serving a legitimate business purpose though
he enjoyed the trip. The decision suggests that in analyzing the tax consequences of an expensepaid trip one important factor is whether the traveler had any choice but to go. Here, although

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taxpayer was not forced to go, there is no doubt that in the reality of the business world he had no
real choice. The trial judge reached the same conclusion. He found that the invitation did not
specifically order the dealers to go, but that as a practical matter it was an order or directive that if
a person was going to be a VW dealer, sound business judgment necessitated his accepting the
offer of corporate hospitality. So far as Economy Motors was concerned, Mr. Gotcher knew that
if he was going to be a part-owner of the dealership, he had better do all that was required to foster
goodbusiness relations with VW. Besides having no choice but to go, he had no control over the
schedule or the money spent. VW did all the planning. In cases involving noncompensatory
economic gains, courts have emphasized that the taxpayer still had complete dominion and control
over the money to use it as he wished to satisfy personal desires or needs. Indeed, the Supreme
Court has defined income as accessions of wealth over which the taxpayer has complete control.
Comm’r v. Glenshaw Glass Co., supra. Clearly, the lack of control works in taxpayer’s favor here.
McDonnell also suggests that one does not realize taxable income when he is serving a
legitimate business purpose of the party paying the expenses. The cases involving corporate
officials who have traveled or entertained clients at the company’s expense are apposite. Indeed,
corporate executives have been furnished yachts, Challenge Mfg. Co. v. Comm’r, 1962, 37 T.C.
650, taken safaris as part of an advertising scheme, Sanitary Farms Dairy, Inc., 1955, 25 T.C. 463,
and investigated business ventures abroad, but have been held accountable for expenses paid only
when the court was persuaded that the expenditure was primarily for the officer’s personal
pleasure. On the other hand, when it has been shown that the expenses were paid to effectuate a
legitimate corporate end and not to benefit the officer personally, the officer has not been taxed
though he enjoyed and benefited from the activity. Thus, the rule is that the economic benefit will
be taxable to the recipient only when the payment of expenses serves no legitimate corporate
purpose. See Comm’r v. Riss, 8th Cir. 1967, 374 F.2d 161. The decisions also indicate that the tax
consequences are to be determined by looking to the primary purpose of the expenses and that the
first consideration is the intention of the payor. The Government in argument before the district
court agreed that whether the expenses were income to taxpayers is mainly a question of the
motives of the people giving the trip. Since this is a matter of proof, the resolution of the tax
question really depends on whether Gotcher showed that his presence served a legitimate corporate
purpose and that no appreciable amount of time was spent for his personal benefit and enjoyment.
See United Aniline Co., 1962, 21 T.C.M. 327.
Examination of the record convinces us that the personal benefit to Gotcher was clearly
subordinate to the concrete benefits to VW. The purpose of the trip was to push VW in America
and to get the dealers to invest more money and time in their dealerships. Thus, although Gotcher
got some ideas that helped him become a better dealer, there is no evidence that this was the
primary purpose of the trip. Put another way, this trip was not given as a pleasurable excursion
through Germany or as a means of teaching taxpayer the skills of selling. He had been selling cars
since 1949. The personal benefits and pleasure were incidental to the dominant purpose of
improving VW’s position on the American market and getting people to invest money.
The corporate-executive decisions indicate that some economic gains, though not specifically
excluded from section 61, may nevertheless escape taxation. They may be excluded even though
the entertainment and travel unquestionably give enjoyment to the taxpayer and produce indirect
economic gains. When this indirect economic gain is subordinate to an overall business purpose,
the recipient is not taxed. We are convinced that the personal benefit to Mr. Gotcher from the trip
was merely incidental to VW’s sales campaign.

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As for Mrs. Gotcher, the trip was primarily a vacation. She did not make the tours with her
husband to see the local dealers or attend discussions about the VW organization. This being so
the primary benefit of the expense-paid trip for the wife went to Mr. Gotcher in that he was relieved
of her expenses. He should therefore be taxed on the expenses attributable to his wife. See Disney
v. U.S., supra. Nor are the expenses deductible since the wife’s presence served no bona fide
business purpose for her husband. Only when the wife’s presence is necessary to the conduct of
the husband’s business are her expenses deductible under section 162. Acacia Mutual Life Ins. Co.
v. U.S., D. Md. 1967, 272 F. Supp. 188, 201. Also, it must be shown that the wife made the trip
only to assist her husband in his business. A single trip by a wife with her husband to Europe has
been specifically rejected as not being the exceptional type of case justifying a deduction. Warwick
v. U.S., E.D. Va. 1964, 236 F. Supp. 761; See also Silverman v. Comm’r, 8th Cir. 1958, 253 F.2d
849.
JOHN R. BROWN, CHIEF JUDGE (concurring): I concur in the result and in the opinion.
Attributing income to the little wife who was neither an employee, a prospective employee, nor a
dealer, for the value of a trip she neither planned nor chose still bothers me. If her uncle had paid
for the trip, would it not have been a pure gift, not income? Or had her husband out of pure separate
property given her the trip would the amount over and above the cost of Texas bed and board have
been income? I acquiesce now, confident that for others in future cases on a full record the wife,
as now does the husband, also will overcome.
_____________________________________
Is the Gross Income issue irrelevant to Mr. Gotcher because—if the court had decided that the
free trip constituted residual Gross Income—he would then have been permitted to deduct the
amount as a § 162 business expense, resulting in no bottom-line tax consequences? No. Recall
from Chapter 4 that investigative costs incurred in purchasing an intangible asset (like a dealer
franchise) are categorized as nondeductible capital expenditures instead of current expenses. The
same would be true if Mr. Gotcher had not been offered the free trip by VW Germany but rather
had simply decided on his own initiative to fly to Germany (at his own expense) to see for himself
whether investing in the dealership would be wise. His costs would not be deductible under § 162.
The nondeductibility of the costs is why the Gross Income issue is pivotal.
Problem
High-Tech Corp pays the cost of air fare, hotel, taxis, meals, and incidental expenses for Joseph
and Michael to fly from Cleveland, Ohio, to Palo Alto, California, so that Joseph can interview for
a position as a software engineer with High-Tech. The total cost of the expense-paid trip is $3,000
($1,500 for each). Michael, Joseph’s spouse, is a lawyer, and he uses the time in Palo Alto to
explore the local legal market and the potential for obtaining a lawyer position. Must Joseph,
Michael, or both include the value of the expense-paid trip in their Gross Incomes? Would it make
any difference if Michael were a stay-at-home spouse with three young children?
HAVERLY v. UNITED STATES
513 F.2d 224 (7th Cir. 1975)
Before HASTINGS, SENIOR JUDGE, and SWYGERT AND CUMMINGS, CIRCUIT JUDGES.
HASTINGS, SENIOR JUDGE: This case presents for resolution a single question of law which is of
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first impression: whether the value of unsolicited sample textbooks sent by publishers to a principal
of a public elementary school, which he subsequently donated to the school’s library and for which
he claimed a charitable deduction, constitutes Gross Income to the principal within the meaning
of Section 61 of the Internal Revenue Code of 1954, 26 U.S.C. § 61.
During the years 1967 and 1968 Charles N. Haverly was the principal of the Alice L. Barnard
Elementary School in Chicago, Illinois. In each of these years publishers sent to the taxpayer
unsolicited sample copies of textbooks which had a total fair market value at the time of receipt of
$400. The samples were given to taxpayer for his personal retention or for whatever disposition
he wished to make. The samples were provided, in the hope of receiving favorable consideration,
to give taxpayer an opportunity to examine the books and determine whether they were suitable
for the instructional unit for which he was responsible….
In 1968 taxpayer donated the books to the Alice L. Barnard Elementary School Library. The
parties agreed that the donation entitled the taxpayer to a charitable deduction under 26 U.S.C. §
170, in the amount of $400, the value of the books at the time of the contribution. The parties
further stipulated that the textbooks received from the publishers did not constitute gifts within the
meaning of 26 U.S.C. § 102 since their transfer to the taxpayer did not proceed from a detached
and disinterested generosity nor out of affection, respect, admiration, charity or like impulses.
Taxpayer’s report of his 1968 income did not include the value of the textbooks received, but
it did include a charitable deduction for the value of the books donated to the school library. The
Internal Revenue Service assessed a deficiency against the taxpayer representing income taxes on
the value of the textbooks received. Taxpayer paid the amount of the deficiency, filed a claim for
refund, and subsequently instituted this action to recover that amount.
Upon agreement of the parties, the case was submitted to the district court on the uncontested
facts and briefs for decision without trial. The district court issued a memorandum opinion which
held that receipt of the samples did not constitute income. Haverly v. U.S., N.D. Ill., 374 F. Supp.
1041 (1974). The court subsequently ordered, in accordance with its decision, that plaintiffs
recover from the United States the sum of $120.40 plus interest. The United States appeals from
that judgment. We reverse.
Section 61(a) of Title 26 of the United States Code provides: “Except as otherwise provided in
this subtitle, Gross Income means all income from whatever source derived, including (but not
limited to) the following items:” The section thereafter enumerates fifteen items none of which,
the government concedes, encompass the receipt of sample textbooks. The taxpayer concedes that
receipt of the books does not fall within any of the specific exclusions from Gross Income set out
in Sections 101 through 124 of Title 26. The only question remaining is whether the value of the
textbooks received is included within “all income from whatever source derived.”
The Supreme Court has frequently reiterated that it was the intention of Congress “to use the
full measure of its taxing power” and “to tax all gains except those specifically exempted.” James
v. U.S., 366 U.S. 213, 218-219, 6 L. Ed. 2d 246, 81 S. Ct. 1052 (1961). The Supreme Court has
also held that the language of Section 61(a) encompasses all “accessions to wealth, clearly realized,
and over which the taxpayers have complete dominion.” Id. at 219; Comm’r v. Glenshaw Glass
Co., 348 U.S. 426, 431, 99 L. Ed. 483, 75 S. Ct. 473 (1955).
There are no reported cases which have applied these definitions of income to the question of
the receipt of unsolicited samples. The parties have cited to the court a number of cases applying
income definitions to other fact situations. We have considered these cases, but we find them of

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no particular assistance in resolving the question before us. In view of the comprehensive
conception of income embodied in the statutory language and the Supreme Court’s interpretation
of that language, we conclude that when the intent to exercise complete dominion over unsolicited
samples is demonstrated by donating those samples to a charitable institution and taking a tax
deduction therefor, the value of the samples received constitutes Gross Income.
The receipt of textbooks is unquestionably an “accession to wealth.” Taxpayer recognized the
value of the books when he donated them and took a $400 deduction therefor. Possession of the
books increased the taxpayer’s wealth. Taxpayer’s receipt and possession of the books indicate
that the income was “clearly realized.” Taxpayer admitted that the books were given to him for his
personal retention or whatever disposition he saw fit to make of them. Although the receipt of
unsolicited samples may sometimes raise the question of whether the taxpayer manifested an intent
to accept the property or exercised “complete dominion” over it, there is no question that this
element is satisfied by the unequivocal act of taking a charitable deduction for donation of the
property.
The district court recognized that the act of claiming a charitable deduction does manifest an
intent to accept the property as one’s own. It nevertheless declined to label receipt of the property
as income because it considered such an act indistinguishable from other acts unrelated to the tax
laws which also evidence an intent to accept property as one’s own, such as a school principal
donating his sample texts to the library without claiming a deduction. We need not resolve the
question of the tax consequences of this and other hypothetical cases discussed by the district court
and suggested by the taxpayer. To decide the case before us we need only hold, as we do, that
when a tax deduction is taken for the donation of unsolicited samples the value of the samples
received must be included in the taxpayer’s Gross Income.
This conclusion is consistent with Revenue Ruling 70-498, 1970-2 C.B. 6, in which the Internal
Revenue Service held that a newspaper’s book reviewer must include in his Gross Income the
value of unsolicited books received from publishers which are donated to a charitable organization
and for which a charitable deduction is taken. This ruling was issued to supersede an earlier ruling,
Rev. Rul. 70-330, 1970-1 C.B. 14, that mere retention of unsolicited books was sufficient to cause
them to be Gross Income.
The Internal Revenue Service has apparently made an administrative decision to be concerned
with the taxation of unsolicited samples only when failure to tax those samples would provide
taxpayers with double tax benefits. It is not for the courts to quarrel with an agency’s rational
allocation of its administrative resources.
In light of the foregoing, the judgment appealed from is reversed and the case is remanded to
the district court with directions to enter judgment for the United States.
__________________________________
Problem
You receive in the mail a free sample of a new brand of coffee from Coffee A Go-Go. As a
coffee lover, you immediately use the new sample to brew and enjoy a pot of coffee. Must you
include the value of the free sample in Gross Income?

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B. When is a wealth accession clearly
realized within the meaning of Glenshaw Glass?
Even if a wealth accession is obvious, as in the case of valuable property received for free,
Glenshaw Glass also requires the wealth accession to be “clearly realized” before it is included in
§ 61 Gross Income under the residual clause. In this manner, the Supreme Court blessed the
realization requirement as a general matter, although Congress has deviated from it in §§ 475 and
1256, pertaining to mark-to-market taxation for certain securities and futures contracts. Barbara’s
purchase of Blackacre in March of Year 1 for its $100 FMV is a nondeductible capital expenditure,
and she takes a $100 cost basis under § 1012 in the property. If Blackacre increases in value to,
say, $150 by the end of Year 1, Barbara has experienced a $50 wealth increase, satisfying the first
requirement under Glenshaw Glass. Nevertheless, that wealth increase is ignored until a realization
event occurs, such as a sale, exchange, destruction, theft, etc., under the second requirement.
The bargain purchase rule
What if, instead, Barbara is able to purchase property at a price that is less than FMV, which
means that Barbara is wealthier immediately at the time of purchase (equal to the amount received
for no consideration) rather than only later, as the purchased property appreciates in value above
its original purchase price? Is that clear wealth increase “realized” at the time of purchase—a
marketplace event—or may she ignore the immediate wealth increase until a later realization
event, just as she can ignore the post-purchase increases in value until a realization event?
The answer depends on the surrounding facts. Recall, for example, CEO Sue from Chapter 5,
who is an employee of Realty, Inc., and who purchases Blackacre from Realty for $10,000 when
its FMV is $100,000. We saw that CEO Sue must include the $90,000 Blackacre value that she
receives in kind as compensation under § 61(a)(1) immediately upon the purchase and takes,
therefore, a $100,000 cost basis ($10,000 nondeductible capital expenditure plus $90,000 income
inclusion) under Treas. Reg. § 1.61-2(d)(1) and (2). 15 We also saw, however, that if Blackacre’s
continued ownership is subject to a substantial risk of forfeiture, § 83 allows CEO Sue to avoid
including the bargain purchase element until the forfeiture risk lapses. Section 83 treatment matters
because of both (1) the time value of money and (2) the characterization (ordinary versus capital)
of the wealth accession.
Unlike with CEO Sue’s bargain purchase, where the bargain element is disguised
compensation, neither Congress nor the IRS has sought to tax the bargain purchase between
unrelated parties in the marketplace under the residual clause, where the benefit of the bargain is
not a substitute for otherwise includable compensation, a dividend, rent, a prize, or some other
specifically listed type of includable Gross Income.
Problem
Charles, a surgeon, is a knowledgeable art lover, and he browses the flea markets and garage
sales in the hope of finding an undiscovered treasure. At a garage sale in May of Year 1, Charles
sees a small painting that he believes may well be the work of the 15th-century French artist Jean
Fouquet, who is credited with inventing the portrait miniature. Many of his early works were
15

Recall that real estate is not “qualified property” within the meaning of § 132(c)(4), so Sue could not exclude any
part of the discount as a qualified employee discount.

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believed to have been lost in the French Revolution, but a few have since been found in unexpected
places. Charles bargains down the price from the $150 marked price to $100. After the purchase,
he enlists the help of the world’s foremost expert of Jean Fouquet’s work, who confirms in
December of Year 1 that the work is authentic and has a likely market value of $1 million. Charles
properly insures the work and hangs it on his wall to enjoy. In Year 4, however, Charles decides
that he would rather have the cash and sells the painting through an art auction house for $3 million.
Describe his tax consequences with respect to the purchase in Year 1 and the sale in Year 4.
_________________________________
Commercial rebates
What about the receipt of a cash rebate from the manufacturer of a product? Notice that the
rebate comes from a third party (the manufacturer) rather than the seller, so the transaction cannot
be recharacterized in substance as simply a bargain purchase between the buyer and a seller.
REVENUE RULING 76-96
1976-1 C.B. 23
Advice has been requested whether, under the circumstances described below, the rebates
received by qualifying retail customers are includible in their Gross Incomes under section 61 of
the Internal Revenue Code of 1954….
M, a manufacturer of automobiles, instituted a program whereby it pays 40x dollar rebates to
all qualifying retail customers who purchase or lease a new automobile. M also pays 5x dollar
rebates to all qualifying retail customers who purchase a new automobile and trade in a specified
type of vehicle. For purposes of the rebate program, a qualifying retail customer is one who
independently negotiates, at arm’s length, with one of M’s dealers to arrive at a purchase or lease
price for an automobile. The automobile must be a type specified by M and the purchase or lease
must be made within a prescribed period. The rebates are made subsequent to the delivery of the
automobile.
Section 61 of the Code provides that Gross Income means all income from whatever source
derived, unless specifically excluded by law.
Section 1012 of the Code provides that the basis of property shall be the cost of such property
with exceptions not pertinent here.
Section 1016 of the Code provides, in pertinent part, that proper adjustment in respect of the
property shall in all cases be made for expenditures, receipts, losses, or other items, properly
chargeable to capital account….
In the case of a purchase, at the time qualifying retail customers conclude negotiations with M’s
dealer, section 1012 of the Code establishes a basis for the automobiles. Assuming there are no
trade-in automobiles involved, the actual purchase price of the new automobiles will be their basis.
The rebate represents a reduction in the purchase price of the automobile. Thus, when the
qualifying retail customers each receive the 40x dollar rebate, section 1016 requires a downward
adjustment to the basis of the automobiles.
Accordingly, the 40x dollar rebates paid by M to qualifying retail customers who purchase …
a new automobile are not includible in the qualifying retail customers’ Gross Incomes.

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Also, the qualifying retail customers who purchase a new automobile and trade in a specified
type of vehicle and receive the 5x dollar trade-in rebates are not in receipt of Gross Income.
However, under section 1016 of the Code, a downward adjustment to the basis of a new purchased
automobile is required.
_____________________________________
When you receive a cash payment that is contingent on the ownership of underlying property,
the cash receipt must be categorized as either:
(1) an income receipt with respect to the property, or
(2) a return of the underlying investment, itself.
If the receipt falls within category (1), it is includable in Gross Income under § 61(a)(4), (5),
(6), or (7), respectively. The basis of the underlying property remains unchanged because the
income inclusion, itself, immediately creates basis to attach to the cash, so we need not take basis
from the underlying property to attach to the cash. 16
If, in contrast, the receipt falls within category (2), the receipt is tax-free to the extent of basis
in the underlying property, with basis reduced, dollar for dollar, under § 1016. Once basis is
exhausted, any further cash receipt will produce gain because there is no more basis to take from
the underlying property to attach to the cash. In other words, the cash receipt is tax-free in category
(2) cases only because it can take basis from the underlying property to attach to the cash, which
necessarily must always have a basis equal to the face amount of the cash.
The property owner is not free to simply elect to treat the payment as falling within either
category as (1) includable income or (2) tax-free basis recovery. The surrounding objective facts
will determine the nature of the cash payment. If Landlord purchases Blackacre for $100,000 and
enters into a lease with a tenant farmer that stipulates a yearly rent of $5,000, Landlord, upon
receiving the first payment of $5,000, cannot elect to treat the payment as tax-free basis recovery,
reducing his basis in the land from $100,000 to $95,000 and excluding the $5,000 payment. Rather,
their lease agreement indicates that the payment is for the use of the land and will be treated as
rent, includable under § 61(a)(5), with Blackacre basis remaining unchanged at $100,000.
In Rev. Rul. 76-96, above, the receipt of cash from the manufacturer was treated as tax-free
basis recovery (category (2)) rather than the receipt of Gross Income (category (1)) with respect to
the car. If it had been treated as a category (1) receipt, it would have been includable under the
residual clause, as interpreted by Glenshaw Glass, because cash would clearly constitute a wealth
accession if it is not basis recovery. Because it was treated as basis recovery, however, the receipt
is excludable, but the car’s initial cost basis must be reduced by the tax-free receipt.
Those of you who go on to study the taxation of business entities under Subchapters C, S, and
K will see a more complex elaboration of this concept, but the rebate context is a simple example.
Problem
James purchases a fancy DSLR camera for $1,000. The camera store retains the full $1,000,
16

Of course, one exception to this analysis is interest received on § 103 bonds, as described in Chapter 2. Though the
interest is excluded from Gross Income, basis in the underlying bond is not taken to attach to the cash interest payment.
The bond’s basis remains intact and the interest is excludable: the best of both worlds! Remember, however, that §
103 is a tax expenditure provision that intentionally deviates from SHS normative analysis for nontax policy reasons.

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but his purchase entitles James to a $100 rebate from the camera’s manufacturer. James submits
the required documentation, and he receives a $100 cash payment from the manufacturer. How
does James treat the receipt?
____________________________________
Lessee improvements that are not rent
The case below predates Glenshaw Glass but nevertheless remains relevant for its discussion
of realization. If the lessee improvement described in the case constituted in-kind rent, the FMV
of the building would be includable by the landlord as it was built because rent is specifically listed
as an item of Gross Income in § 61(a)(5). The Bruun Court concluded, however, that the lessee
improvement was not intended by the parties to constitute rent. Read Treas. Reg. § 1.61-8(c).
When the lease terminated prematurely, however, and the lessor gained ownership and
possession of the valuable lessee improvement, the landlord became immediately wealthier. But
was that wealth accession clearly realized upon regaining possession of the land? Why or why
not? Is the landlord like Charles, our bargain purchaser? What are the tax stakes for the landlord?
HELVERING v. BRUUN
309 U.S. 461 (1940)
MR. JUSTICE ROBERTS delivered the opinion of the Court.
The controversy had its origin in the petitioner’s assertion that the respondent realized taxable
gain from the forfeiture of a leasehold, the tenant having erected a new building upon the premises.
The court below held that no income had been realized. Inconsistency of the decisions on the
subject led us to grant certiorari.
The cause was submitted upon a stipulation of facts. From this it appears that on July 1, 1915,
the respondent, as owner, leased a lot of land and the building thereon for a term of ninety-nine
years.
The lease provided that the lessee might, at any time, upon giving bond to secure rentals
accruing in the two ensuing years, remove or tear down any building on the land, provided that no
building should be removed or torn down after the lease became forfeited, or during the last three
and one-half years of the term. The lessee was to surrender the land, upon termination of the lease,
with all buildings and improvements thereon.
In 1929 the tenant demolished and removed the existing building and constructed a new one
which had a useful life of not more than fifty years. July 1, 1933, the lease was cancelled for default
in payment of rent and taxes and the respondent regained possession of the land and building.
The parties stipulated “that as at said date, July 1, 1933, the building which had been erected
upon said premises by the lessee had a fair market value of $64,245.68 and that the unamortized
cost of the old building, which was removed from the premises in 1929 to make way for the new
building, was $12,811.43, thus leaving a net fair market value as at July 1, 1933, of $51,434.25,
for the aforesaid new building erected upon the premises by the lessee.”
On the basis of these facts, the petitioner determined that in 1933 the respondent realized a net
gain of $51,434.25. The Board overruled his determination and the Circuit Court of Appeals
affirmed the Board’s decision.
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The course of administrative practice and judicial decision in respect of the question presented
has not been uniform. In 1917 the Treasury ruled that the adjusted value of improvements installed
upon leased premises is income to the lessor upon the termination of the lease. The ruling was
incorporated in two succeeding editions of the Treasury Regulations. In 1919 the Circuit Court of
Appeals for the Ninth Circuit held in Miller v. Gearin, 258 F. 225, that the regulation was invalid
as the gain, if taxable at all, must be taxed as of the year when the improvements were completed.
The regulations were accordingly amended to impose a tax upon the gain in the year of
completion of the improvements, measured by their anticipated value at the termination of the
lease and discounted for the duration of the lease. Subsequently the regulations permitted the lessor
to spread the depreciated value of the improvements over the remaining life of the lease, reporting
an aliquot part each year, with provision that, upon premature termination, a tax should be imposed
upon the excess of the then value of the improvements over the amount theretofore returned.
In 1935 the Circuit Court of Appeals for the Second Circuit decided in Hewitt Realty Co.
v. Comm’r, 76 F.2d 880, that a landlord received no taxable income in a year, during the term of
the lease, in which his tenant erected a building on the leased land. The court, while recognizing
that the lessor need not receive money to be taxable, based its decision that no taxable gain was
realized in that case on the fact that the improvement was not portable or detachable from the land,
and if removed would be worthless except as bricks, iron, and mortar. It said (p. 884): “The
question as we view it is whether the value received is embodied in something separately
disposable, or whether it is so merged in the land as to become financially a part of it, something
which, though it increases its value, has no value of its own when torn away.”
This decision invalidated the regulations then in force.
In 1938 this court decided M. E. Blatt Co. v. U.S., 305 U.S. 267. There, in connection with the
execution of a lease, landlord and tenant mutually agreed that each should make certain
improvements to the demised premises and that those made by the tenant should become and
remain the property of the landlord. The Commissioner valued the improvements as of the date
they were made, allowed depreciation thereon to the termination of the leasehold, divided the
depreciated value by the number of years the lease had to run, and found the landlord taxable for
each year’s aliquot portion thereof. His action was sustained by the Court of Claims. The judgment
was reversed on the ground that the added value could not be considered rental accruing over the
period of the lease; that the facts found by the Court of Claims did not support the conclusion of
the Commissioner as to the value to be attributed to the improvements after a use throughout the
term of the lease; and that, in the circumstances disclosed, any enhancement in the value of the
realty in the tax year was not income realized by the lessor within the Revenue Act.
The circumstances of the instant case differentiate it from the Blatt and Hewitt cases; but the
petitioner’s contention that gain was realized when the respondent, through forfeiture of the lease,
obtained untrammeled title, possession and control of the premises, with the added increment of
value added by the new building, runs counter to the decision in the Miller case and to the
reasoning in the Hewitt case.
The respondent insists that the realty—a capital asset at the date of the execution of the lease—
remained such throughout the term and after its expiration; that improvements affixed to the soil
became part of the realty indistinguishably blended in the capital asset; that such improvements
cannot be separately valued or treated as received in exchange for the improvements which were
on the land at the date of the execution of the lease; that they are, therefore, in the same category

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as improvements added by the respondent to his land, or accruals of value due to extraneous and
adventitious circumstances. Such added value, it is argued, can be considered capital gain only
upon the owner’s disposition of the asset….
We hold that the petitioner was right in assessing the gain as realized in 1933.
We might rest our decision upon the narrow issue presented by the terms of the stipulation. It
does not appear what kind of a building was erected by the tenant or whether the building was
readily removable from the land. It is not stated whether the difference in the value between the
building removed and that erected in its place accurately reflects an increase in the value of land
and building considered as a single estate in land. On the facts stipulated, without more, we should
not be warranted in holding that the presumption of the correctness of the Commissioner’s
determination has been overborne.
The respondent insists, however, that the stipulation was intended to assert that the sum of
$51,434.25 was the measure of the resulting enhancement in value of the real estate at the date of
the cancellation of the lease. The petitioner seems not to contest this view. Even upon this
assumption we think that gain in the amount named was realized by the respondent in the year of
repossession.
The respondent cannot successfully contend that the definition of Gross Income in § 22 (a) of
the Revenue Act of 1932 is not broad enough to embrace the gain in question…. [The respondent]
emphasizes the necessity that the gain be separate from the capital and separately disposable….
While it is true that economic gain is not always taxable as income, it is settled that the
realization of gain need not be in cash derived from the sale of an asset. Gain may occur as a result
of exchange of property, payment of the taxpayer’s indebtedness, relief from a liability, or other
profit realized from the completion of a transaction. The fact that the gain is a portion of the value
of property received by the taxpayer in the transaction does not negative its realization.
Here, as a result of a business transaction, the respondent received back his land with a new
building on it, which added an ascertainable amount to its value. It is not necessary to recognition
of taxable gain that he should be able to sever the improvement begetting the gain from his original
capital. If that were necessary, no income could arise from the exchange of property; whereas such
gain has always been recognized as realized taxable gain.
Judgment reversed.
_____________________________________
The real estate lobby responded immediately by petitioning Congress to reverse the result in
Bruun for future landlords. Congress responded by enacting §§ 109 and 1019. Section 109 may
have been understandable in the 1930s in view of the extreme financial dislocations caused by the
Great Depression, with many lessees defaulting and landlords regaining possession at a time when
they may not have had the liquidity to pay the resulting tax liability under Bruun because banks
were not lending (i.e., Mr. Bruun might not have been able to mortgage his property to obtain the
cash with which to pay tax on his clear wealth accession). Is § 109 still defensible today in light
of your better understanding of the difference between income taxation and consumption taxation
(explored in Chapter 2)? Consider the following.
Plots X and Y are identical plots of land situated near each other. In Year 1, Maria purchases
Plot X and Mario purchases Plot Y, with each paying $100,000.

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Maria does not want the bother of building a commercial building on the land herself, so she
immediately rents the land to Ronald Realty, a real estate developer, for a lease term of 30 years.
Under their lease, Realty will pay to Maria rent of $1,000 per year for the raw land (its fair rental
value as undeveloped land), increased only by the rate of inflation under the consumer price index
each year. Realty then shoulders the costs of building the commercial rental building on the land.
After the construction period, Realty will be able to rent the commercial building to others and
keep the resulting rental payments for the duration of the 30-year lease term, at the end of which
Maria will be entitled to obtain the land back with the building. She then will be in a position to
continue to rent the commercial building to others.
In Year 3, however, shortly after the building is constructed, Ronald Realty becomes insolvent
and defaults on the lease, and Maria regains possession of the land with the newly constructed
building worth $10 million. She properly excludes the building’s FMV under § 109 and
immediately rents it to tenants at an aggregate rent of $200,000 per year, the market rate for similar
buildings in the location.
In contrast, after his purchase Mario builds a commercial building very similar to Maria’s at a
cost of $10 million. When the construction is completed in Year 3, he immediately rents it to
tenants. He, too, can charge no more than the market rent of $200,000 per year for the area.
Both Maria and Mario must include in Gross Income the $200,000 rent that each receives under
§ 61(a)(5). But are they really treated similarly for tax purposes? Recall from Chapter 2 the two
requirements that must be present for an investment to be taxed under income tax principles: (1)
the investment must be made with after-tax dollars (not pre-tax dollars) and (2) the investment’s
return must be included in the tax base. Are both requirements satisfied for both Maria and Mario?
Which investment is being taxed under income tax principles, which investment is being taxed
under cash-flow consumption tax principles, and why? Does § 109 violate horizontal equity?
Treasure trove
Treasure trove is includable in residual Gross Income in the year found or, if ownership is
disputed, in the year reduced to undisputed possession. 17 When Mr. and Mrs. Cesarini purchased
an old piano at auction for $15 in 1957 and found nearly $4,500 hidden inside it when they cleaned
the piano in 1964, the treasure trove was includable in Gross Income in the year found (1964). 18
Similarly, if Lindsey is beachcombing in Hawaii and finds a diamond ring or a gold bullion brick
washed ashore from some old shipwreck, she must include the item’s FMV in her residual Gross
Income in the year reduced to her undisputed possession.
Should valuable home run baseballs that set important Major League baseball records be
included in Gross Income under the § 61 residual clause in the year snagged by a fan? Is the wealth
accession realized when caught under Bruun or realized only on later sale? Is the wealth accession
excludable in the year caught under the bargain purchase rule, i.e., does the cost of purchasing the
ticket also necessarily include any caught baseballs so that the wealth accession is not realized
until the ball is later sold? Does or should public perceptions regarding implementation of the
residual clause affect the analysis?
This issue was hotly debated as Mark McGwire and Sammy Sosa competed in 1998 to break
the previous record of 61 home runs hit in a single season (by Roger Maris in 1961) and again
17
18

See Treas. Reg. § 1.61-14.
Cesarini v. U.S., 428 F.2d 812 (6th Cir. 1970).

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when Barry Bonds broke McGwire’s record by hitting 73 home runs in 2001. Once again, what
are the tax stakes here?
Excerpt from DEFINING INCOME 19
Alice G. Abreu & Richard K. Greenstein
The breadth of the Glenshaw Glass definition appears to be nearly co-extensive with the Haig–
Simons definition of income, which is widely accepted as providing the theoretical foundation for
the income tax. Accordingly, many tax professionals interpret the language in section 61 and
Glenshaw Glass solely in light of the economic principles reflected in the Haig–Simons definition.
The analytical structure for determining what is income appears clear and is generally treated as
immutable. The analysis begins with the broad mandate of section 61 and Glenshaw Glass. As
long as there is a realized accession in the economic sense within the taxpayer’s dominion,
Glenshaw Glass would seem to provide that there is income unless, pursuant to the very first words
of section 61, there is an exclusion in the statute. From the time they are introduced to the tax law,
students are taught this analytical structure, and by the time they become practitioners and then
judges or scholars, it is second nature.
The apparent breadth of the Glenshaw Glass formulation seems to give the Internal Revenue
Service (IRS) wide authority to tax accessions to wealth. Nevertheless, the IRS has sometimes
taken the position that a particular accession is income, only to be rebuffed by a trial or appellate
court and then abandon its position. Other times the IRS has chosen not to take the position that a
particular accession is income at all…. For example, … courts have held that … an expense-paid
trip to Germany to inspect VW facilities provided to a [potential] VW dealer to induce him to
make an … investment in the dealership [was not] income, and the IRS acknowledges that cash
welfare payments are not income either. Sometimes, as in the case of “swag bags” given to
nominees and presenters at the Academy Awards, the IRS has taken a position consistent with the
apparent breadth of Glenshaw Glass, but other times, as in the case of less valuable free samples
received by ordinary people, child support, government transfer payments, government-funded
benefits (such as public education and medical care), or even record-breaking baseballs caught by
baseball fans, it has not.
While such instances reflect the IRS’s and the courts’ reluctance to attempt to implement the
full apparent breadth of the Glenshaw Glass definition of income, neither the courts, nor tax
scholars, nor the IRS have articulated a comprehensive theory that explains all of these specific
outcomes. Perhaps in reaching these conclusions the courts and the IRS are being lawless,
deliberately ignoring the apparent mandate of Glenshaw Glass. Or maybe they simply do not
understand the breadth of the Glenshaw Glass definition and are therefore incompetently failing
to effectuate it.
We believe that neither lawlessness nor incompetence explains the apparent inconsistency
between the breadth of the Glenshaw Glass definition and the narrower interpretation adopted by
the courts and the IRS. We subscribe, rather, to a third explanation: that the rulings of the courts
and the IRS reflect a widespread uncertainty and disagreement about what counts as the kind of
“accession to wealth” that should be taxed—that is, widespread uncertainty and disagreement
about what the language in the Internal Revenue Code and Glenshaw Glass means.
19

11 FLA. TAX REV. 295 (2011) (footnotes omitted).

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Our thesis is that what explains the inconsistency and the uncertainty and disagreement is that
economics—at least Haig–Simons economics—is not everything. Although the Glenshaw Glass
definition of income is largely consistent with the Haig-Simons definition, and thus with
economics, it fails to take into account other values that count for the people who are subject to
the tax and must buy into it, at least to some degree, for the tax to be administrable.
The IRS, the agency charged with administering the tax law, sometimes understands this. While
the IRS rarely acknowledges these noneconomic values explicitly—perhaps for fear of unmooring
tax from economics and being left rudderless on a turbulent sea—it does give itself some slack,
taking into account competing, noneconomic values, and finding no income when Glenshaw Glass
could be read to suggest otherwise. And in those instances when the IRS misunderstands the
competing values, courts or Congress provide the slack, rebuffing the IRS without explicitly
recognizing the departure from strict economic values and thereby retaining an anchor to prevent
excessive drift….
Even individuals who agree on the essential need for taxation will differ on what ought to be
subject to tax, and those differences are not only deep but are often unexplored. Tax may be
different from other areas of the law in at least two ways. First, self-interest can affect tax values
in ways that are less evident in other areas of law. Ex ante, an individual might not know what
kind of contract or tort rules she might favor because she would not know whether she would be
likely to be a breaching promisor or a disappointed promisee, or the driver of the vehicle or the
pedestrian who was hit. In tax, however, self-interest will almost always move an individual
toward a conclusion of no income. Sides are more easily taken, even in the abstract.
Second, putting self-interest to one side, while socialization produces in most individuals a
shared morality and sense of right and wrong, socialization does not typically produce in
individuals a sense of what ought, or ought not, be taxed. Those who teach tax know that until
students take the introductory income tax course, few have given much thought to the subject.
They may know that there is an obligation to pay tax, as do most people, but like most people, they
expect the tax law to consist of a set of mechanical rules unmoored from values. Students expect
that the subject will be artificial, unlike, for example, constitutional law, which they know will
involve the clash of deeply felt values.
That perceived artificiality complicates the clash of values. People who have not thought much
about the values of equity and efficiency in taxation but care about baseball may well think that a
caught record-breaking baseball ought to bring nothing but joy to its catcher. There is almost
certainly a greater national consensus about baseball than about what ought to be taxed and it is
likely that most baseball fans would agree with former IRS Commissioner Rossotti that the lucky
fan who catches the record-breaking ball deserves “a round of applause, not a tax bill.”
Commissioner Rossotti’s account of his reaction to the caught baseball tax controversy … is
worth detailing because it illustrates perfectly the clash of values we have identified.
Commissioner Rossotti was the first Commissioner in a very long time who was not a tax
professional. He had founded and run a large information technology corporation and was brought
in to head the IRS at a time when the agency was in great turmoil and the approach of Y2K raised
the specter of the possible collapse of its computer systems. That he was not a lawyer, much less
a tax lawyer, is important because it means he brought to the position of Commissioner the
reactions and sensibilities of a member of the public, not of someone whose professional training
began at the knee of section 61 and Glenshaw Glass. In his reflections on his time as Commissioner
he recounted the events that began the baseball tax controversy: a New York Times reporter asked
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“a hypothetical question about gift tax due from a fan who might catch [Mark McGwire’s] recordbreaking baseball and give it back to McGwire.” When an IRS spokesperson answered the question
by saying that tax would be due, a firestorm of controversy erupted. As Rossotti explains:
More than innocent-spouse cases, more than small-business owners losing their
businesses, more than ITS modernization failures, the prospect of the IRS taxing
this hypothetical good-hearted fan unleashed the fury of the American people, not
to mention their representatives in Congress. This was what people thought of when
they talked about a faceless bureaucracy.
The firestorm of controversy erupted because even if most people had not thought much about
what ought to be taxed, it seemed obvious to them that a ball caught at a park should not be. In the
words of White House spokesman Mike McCurry, taxing the baseball was “about the dumbest
thing I’ve ever heard in my life.”
It is telling that tax professionals, those who had been inculcated with the structure that begins
with section 61 and proceeds to Glenshaw Glass, were unanimous in their view that catching the
baseball and keeping it produces income. Commissioner Rossotti was fortunate in not having to
answer that question. The IRS Chief Counsel was able to respond to the catch-and-return
hypothetical by analogy to disclaimers and thus conclude that there would be no tax. A subsequent
IRS Chief Counsel, himself a baseball fan, had no such easy out. When asked the income question
directly, he covered his head with his hands and declined to respond.
Commissioner Rossotti is justifiably proud of his handling of the situation, reporting that
the press grudgingly gave us credit for not being so pinheaded after all. I was told one
of the television commentators read my quote “Sometimes pieces of the tax code can
be as hard to understand as the infield fly rule. All I know is that the fan who gives
back the home run ball deserves a round of applause, not a big tax bill” to the national
audience at the beginning of the game in which McGwire hit his sixty-second homer.
By the skin of our teeth, we had turned a potential public relations disaster into
something that made it seem as if real people worked at the IRS, even people who
knew what the infield fly rule was.
Commissioner Rossotti’s account of the IRS response to the controversy captures the importance
of the IRS’s role in resolving clashes of values in defining income. It is significant that, in
Commissioner Rossotti’s words, “real people work at the IRS.”
…
Practicing tax lawyers may not consciously experience the full force of the clash because their
duty to represent their client’s interest will usually cause them to want to find no income and they
will attribute any IRS desire to find income to rapaciousness born of the duty to collect revenue.
Law trains us to think in adversarial terms. But tax lawyers who work for the IRS, particularly
those in its Office of Chief Counsel, have a more difficult task. Those tax lawyers would probably
agree that equity and efficiency point toward taxing the value of the baseball (because it is an
accession to wealth clearly realized within the taxpayer’s dominion if she keeps it), and the Chief
Counsel who covered his head with his hands and pleaded not to be asked the question probably
reflects that. But as lawyers working for the IRS they understand the difficulty of administering
such a conclusion, not only because of the difficulty of valuation but also because it necessarily
implies taxing all caught baseballs, including those of relatively little value. Such a result, while
equitable and efficient, is unadministrable, not only because people would rebel but also because

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it would be impossible for the IRS to enforce it. Administrability encompasses noneconomic
values, which affect the IRS’s ability to enforce the law, as well. Equity, efficiency, and
administrability thus clash in this case as they do in those involving free samples, because the free
sample of shampoo mailed to an individual’s house is logically indistinguishable from the one
included in the Oscar swag bag. A rule based on administrability could be an invitation to
circumvention and would lack the flexibility to address similar but unforeseen iterations of the
same issue by weighing noneconomic values that affect public perception and enforceability. In
the case of income, a standard is therefore most apt.
But if we cannot rely on a shared consensus regarding tax values to render the Glenshaw Glass
standard apt, what is the substitute? The answer is ad hoc intervention by the IRS. The IRS has
specified on a case-by-case basis what counts as an accession to wealth for purposes of income
taxation, and it has generally done so in a manner that respects the values of equity and efficiency,
along with the equally important value of administrability. The Glenshaw Glass standard will
produce the right result in those cases where the values align, so salary will be income because
treating it as such promotes both equity and efficiency and is highly administrable. But in cases
where the values point in different directions, such as the case of the client who is taken to lunch
by her lawyer, the IRS can weigh equity and efficiency, both of which would point to income, but
allow administrability to outweigh them, leaving itself open to argue income when it senses abuse,
either because the value of the lunch is excessive or because it suspects some non-business
motivation on the part of the lawyer. Moreover, with a standard the IRS can take into account
noneconomic values that are not central to tax law but emerge as important in specific situations—
like reverence for the game of baseball.
The use of a standard, as exists in the administered definition of income, respects equity and
efficiency. At the same time, the standard allows for the crucial value of administrability by giving
the agency charged with administering the tax law, the IRS, the ability to weigh the relative values,
including noneconomic values, and make decisions that reflect current circumstances. The very
cloudiness of the definition thus becomes its strength….
What we propose, that the definition of income be acknowledged to be a standard that should
be interpreted in light of the values—including noneconomic values—that animate the field of
income taxation, may sound heretical or even incoherent to the contemporary scholarly ear, but it
is not revolutionary when viewed in historical context. It has a long and distinguished pedigree
that dates to the period shortly before the Court’s decision in Glenshaw Glass and that was
contained in scholarship that was cited by the Government to the Court in that case.
Professors Surrey and Warren understood that even the Macomber formulation was “a
generalization rather than a definition” that failed to answer questions such as whether the “act of
picking up found money [was] ‘labor’” which would be captured by the Macomber formulation of
income as “gain derived from capital, from labor, or from both combined.” They acknowledged
that the Haig-Simons definition was too broad to be administrable and concluded instead that
the concept of income is a flexible one, with the result in a particular case being
determined by the interplay of common usage, accounting concepts, administrative
goals, and finally judicial reaction to these forces. Each force and judicial reaction in
turn reflects an underlying judgment as to what types of receipts should be subject to
a tax imposed on “income.”
…

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In the income tax, as in other complex legislation, the need is for a standard which will
project our present aims into the future and serve as the vehicle for solving the
unforeseen cases as they arise. The legislative function is not denied or thwarted when
other branches of the Government are relied upon by Congress to perform substantial
tasks in the application of statutes. Administration and judicial interpretation are
necessary parts of the overall process of legislation. The income tax is no exception.
We couldn’t agree more.
Because the Surrey and Warren article was cited in the Government’s brief in Glenshaw Glass
and because its discussion of the definition of income implicated precisely the issue facing the
Court—expansion of the Macomber definition—and was prominent, having been placed at the
very beginning of the piece, we believe that it is likely that the Court considered it, and took it to
heart in the formulation it adopted in that case. We think that history has proven Professors Surrey
and Warren … right. While a definition of income that is acknowledged to be a standard does not
fit the desire for technical precision that seems to be the hallmark of so much tax legislation, it is
not for that reason inapt. Acknowledging that the Glenshaw Glass formulation is not a rule but a
standard will not land the tax system in a quagmire but will instead … allow a deliberate
examination of whether a particular item ought to be included in the tax base.
In law, as in baseball, there are rules and there are standards. The infield fly rule is a rule, but
the strike zone is a standard. In law, apparently crystalline rules can turn into muddy standards as
they are applied to situations in which competing values clash. The Glenshaw Glass definition of
income may seem to provide a rule, but it is actually a standard, and the IRS is its umpire. Unlike
the umpire, the IRS generally does not have the last word. However, the IRS does call the balls
and strikes within the zone. In doing so it weighs numbers of factors and tries to reach the right
result: a tax system that is equitable, efficient, and administrable. By exploring the IRS’s role in
defining income and by dissecting the factors that make it so difficult to articulate a clear, precise,
and accurate definition of the income that is taxed, we have tried to illuminate the penumbral area
where income becomes no-income. In that area, economics are important, but noneconomic values
also count. Economics is not everything.
_______________________________________
For the record, and contrary to the article’s claim that “[t]here was unanimity of opinion on the
part of tax professionals, for whom it was clear that the baseball was income when caught …,” not
everyone concurred. Fishermen, whether for profit or for pleasure, don’t immediately include the
fish they catch in their Gross Income. Only on sale will they include income. 20 While the baseball
was a clear wealth accession, the issue was one of realization. The public’s perception of the fair
administration of the tax law, which can affect taxpayer confidence in the system and willingness
to participate in everyday compliance, can be a legitimate consideration when the IRS calls this
close case regarding when realization occurs on facts like these. Waiting to tax until the fan sells
the ball is likely more consistent with what the average taxpayer reading the newspaper about this
story expects regarding the timing of the tax event. 21 Having a zero basis in the ball, the fan would
20

See also Lawrence A. Zelenak & Martin J. McMahon, Jr., Taxing Baseballs and Other Found Property, 84 TAX
NOTES 1299 (1999).
21
Similarly, I do not think that a routine foul ball or homerun ball can be properly categorized as a “prize,” which
would be includable immediately under § 74. The lucky fan’s personal use of the baseball will generate no income,
but if he can find a buyer for this non-record-setting baseball, § 1001 will then apply. In contrast, if fans are informed
that their purchase of a ticket entitles them to be entered into a drawing for a new car worth $20,000 during the seventh-

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realize a § 1001 gain on later sale that would equal the entire amount realized. If he waits more
than a year, therefore, the gain would contribute to low-taxed net capital gain. If the ball were
income on receipt, instead, the included value would be high-taxed ordinary income. In other
words, the stakes were the same as those at issue for our bargain purchaser and for Mr. Bruun!
Nevertheless, this article excerpt suggests that the very opaqueness of the language in the
residual clause that might drive law students nuts—“Gross Income means all income from
whatever source derived”—may in fact be a good thing because, as a standard rather than a rule,
it effectively allows both the administrator of the statute and courts to use external norms to decide
whether the matter at issue meets Glenshaw Glass’s requirement that the event results in a realized
wealth accession—or not.
For example, if we can be fairly sure after examining the surrounding facts that the noncash
receipt (which is not compensation, a dividend, or a prize) is not the equivalent of a cash receipt
followed by a free-spending choice to purchase personal consumption, we can be comfortable in
concluding that the receipt of in-kind consumption is not a wealth accession under the residual
clause, as in Gotcher or the case of the clients who are treated to a meal by their lawyer as they
discuss their case with her. If, on the other hand, we are convinced that the accepted (rather than
declined) receipt is a substitute for cash that the taxpayer would otherwise have received or that
the taxpayer would likely have purchased the same consumption in any event, we can be much
more comfortable in concluding that the receipt constitutes a realized wealth accession
representing ability to pay, as in the case of our Oscar presenters. And even the anticipated reaction
of the public at large (as in the case of the home run baseball) could conceivably be a legitimate
consideration in applying these norms by a tax administration concerned with public perceptions
about the legitimacy of the tax system overall.
If the fan who catches the record-breaking home run baseball is not required to include the
value of the baseball immediately in the year of receipt, when will that value be taxed under the
income tax if the fan dies before selling the ball? Great segue to Unit III!

inning stretch, the lucky fan whose ticket is drawn clearly must include the $20,000 FMV of the car on receipt under
§ 74. Context is everything!

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Unit III:
The Possibilities for Income Shifting
Introduction to Chapters 7 and 8
This unit consists of two chapters that explore the possibilities for shifting income from one to
another or splitting income between two (or more) taxpayers. Because of the progressive rate
structure in § 1, the total tax paid can sometimes be lowered if income is shifted to another in a
lower marginal rate bracket or if income is split between two taxpayers, with the ensuing ability
to use the lower rate brackets twice.
Chapter 7 starts with an examination of both inter vivos gifts during life and death-time bequests
because the § 1015 basis rule for inter vivos gifts, in particular, carries with it the possibility to
shift built-in gain from one taxpayer to another.
Chapter 8 then considers other income-shifting possibilities within both the intact and fractured
families, including the assignment-of-income doctrine under the common law and related statutory
provisions, as well as divorce.

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Chapter 7: Gifts and Bequests
Recall from Chapter 1 that a fundamental precept of an income tax is that the same dollars
should not be taxed to the same taxpayer more than once and that we use basis as the tool to keep
track of previously taxed dollars to implement this precept.
Do not be lulled into thinking that the same dollars cannot be taxed to the same taxpayer more
than once under two separate tax systems, however. It happens routinely. For example, the same
dollar of labor income is commonly taxed twice to the same taxpayer at the Federal level: once
under the payroll taxes (the Social Security and Medicare Taxes described in Chapter 3) and once
under the income tax.
Moreover, even if we limit our focus to the Federal income tax itself, the same dollar is
commonly taxed to more than one taxpayer as it is transferred from taxpayer to taxpayer in the
economy. For example, Doris earns wages from her job as a store clerk, and she includes those
wages in her Gross Income under § 61(a)(1). Doris then pays some of her after-tax dollars to her
window washer, David, for washing the windows of her home. They are after-tax dollars because,
as a personal expense, Doris cannot deduct the outlay, which means that the amount that she pays
to David effectively remains in her tax base and is taxed to her. David cannot claim that his receipt
should be free of Federal income tax in his hands because those dollars were already taxed once
(to Doris) under the Federal income tax. The same dollars are includable in Gross Income by both
Doris and David and are taxed twice under the income tax as they move from Doris to David.
What if, however, Doris simply makes a gift of those dollars to David during life or leaves a
bequest to David at her death instead of paying them as wages to him?
Possible taxation approaches to the transfer and receipt of gifts and bequests
When we think about gratuitous transfers, whether an inter vivos gift (during life) or a deathtime bequest, we have two taxpayers to consider—the donor and the donee—and we have two
possible tax systems to consider at the Federal level: the Federal income tax and the Federal wealth
transfer taxes, which are excise taxes imposed on the donor on certain wealth transfers and which
consist of an integrated system composed of the estate tax, the gift tax, and the generation-skipping
transfer tax, each of which is legally imposed on the donor. Unlike wealth taxes, which tax the fair
market value of assets year after year (doubly taxing the same dollars), the wealth transfer taxes
are excise taxes imposed (on the donor) only once—on the act of transfer—whether during life or
at death. The wealth transfer taxes are the subject of a separate tax course but are nevertheless
briefly described here only because their mere existence may help us to think about how gratuitous
transfers should be treated under the income tax—our focus.
For example, should the income tax treatment for the donee of inter vivos gifts and death-time
bequests be integrated with the wealth transfer taxes possibly imposed on the donor so that the
same dollars are not taxed under both Federal tax systems? If the answer to that is “yes,” should
the payroll taxes (Social Security Tax and Medicare Tax) on wages be integrated with the income
tax on wages so that the same dollars are not taxed under both Federal tax systems, as well? 1 If the
answer to the latter is “no” because the income tax and payroll taxes serve different purposes,
should the answer to the former also be “no” for the same reason? Should the income and wealth
1

See, e.g., Deborah A. Geier, Integrating the Tax Burdens of the Federal Income and Payroll Taxes on Labor Income,
22 VA. TAX REV. 1 (2002).

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transfer tax systems ensure that a dollar is taxed at least once between the two systems rather than
escaping tax entirely under both? The latter outcome is common today because of the combination
of the realization requirement, the high estate tax exemption, and § 1014, described below.
Under the Federal income tax—viewed alone and without regard to any possible treatment
under the estate tax—should amounts transferred as inter vivos gifts or bequests be effectively
taxed to both the donor and the donee, just as both David (the window washer) and Doris were
effectively taxed on the same dollars under the income tax when she paid them to David as wages?
The making of a gift is clearly a personal expense of the donor, so it would generally be
nondeductible (unless contributed to a charity, considered in Chapter 17). The issue boils down to
whether it ought to be included in the donee’s Gross Income when received. And what if property
(instead of cash) is transferred, and the property has unrealized built-in gain at the time of transfer?
Should the gift or bequest qualify as a § 1001 realization event? At what basis should the donee
take the property?
To help us to think about these questions, consider this story appearing in the Los Angeles Times
in 2010, which reported that Christie’s New York sold Pablo Picasso’s 1932 portrait of his mistress
entitled “Nude, Green Leaves and Bust” for $106.5 million. Bidders came from all over the world,
including Asia, the U.S., Europe, and Russia, although the winning bidder (by telephone) was not
identified. The article relates the following:
The painting came from the estate of Frances Brody, the Los Angeles arts patron who
died last year [2009] at age 93. Her husband Sidney, a real estate developer, died in
1983. The estate consigned this Picasso to Christie’s along with some 80 other
artworks. The most valuable pieces, including sculptures by Alberto Giacometti, went
up for auction Tuesday night; the remainder are slated for Wednesday morning…. The
Brodys originally bought “Nude, Green Leaves and Bust” in January 1951 from Paul
Rosenberg’s New York gallery for $19,800 (about $166,000 in today’s dollars). 2
When an individual dies, a new taxpayer automatically springs into existence called an “estate,”
which in essence takes the place of the decedent. The estate owes income tax on any income
realized by it during its existence, using the rate schedule found in § 1(e) (reprinted in Chapter 8).
For example, when the estate receives an interest payment on a corporate bond that the decedent
owned before death, the estate must include that interest payment in its Gross Income under §
61(a)(4), just as the decedent would have included it had she lived. At some point, the estate will
distribute all of its (after-tax) cash and other assets to the estate beneficiaries as described in the
decedent’s will or under the laws of intestacy and cease to exist. The cash collected by the Brody
estate on the sale described above, as well as any other cash and property owned by the estate, less
any income tax (and estate tax, if any) owed, would be distributed to Mrs. Brody’s beneficiaries.
What are the possible ways that the events described above could be taxed, considering both
2

Jori Finkel, Picasso Sets Record Sales Price, http://articles.latimes.com/2010/may/05/entertainment/la-et-brodypicasso-20100505. At the time, this sale represented the highest price ever obtained for an artwork. That record has
since been broken multiple times, most recently in 2017, when a work attributed (though not unequivocally) to
Leonardo da Vinci sold at auction for $450.3 million. See Robin Pogrebin & Scott Reyburn, Leonardo da Vinci
Painting Sells for $450.3 Million, Shattering Auction Highs,
at https://www.nytimes.com/2017/11/15/arts/design/leonardo-da-vinci-salvator-mundi-christies-auction.html. Trivia
tidbit: After Frances Brody’s death, the talk show host Ellen DeGeneres bought the house from the estate for $40
million before it officially was listed for sale. See Steven Kurutz, The Unsettling Thing About Ellen,
atwww.nytimes.com/2014/04/24/garden/the-unsettling-thing-about-ellen.html?hpw&rref=garden.

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the income tax and the estate tax? There are various possibilities that we could construct, from the
least-taxed combination to the most-taxed combination.
Least taxed possibility: The automatic transfer of the painting by the decedent to this new
taxpayer (the estate) is not a § 1001 realization event for income tax purposes. Nevertheless, the
estate steps up the basis of the painting from the $19,800 cost basis that it had in the hands of
Frances to its fair market value (FMV) at her death, which is determined by the sale, itself, to be
$106,500,000. While the sale by the estate of the painting is a § 1001 realization event for income
tax purposes, the sale produces no gain because the A/R and A/B are the same—$106,500,000—
so no income tax is owed by the estate on the sale. No wealth transfer tax is imposed on Frances’s
estate when that $106,500,000 and other property are transferred to her daughter. Her daughter
does not include the cash from the sale or the FMV of other property received in her Gross Income
for Federal income tax purposes. Notice that, under this approach, we have laundered out the
$106,480,200 built-in gain in the painting, which is never taxed to anyone.
Most taxed possibility: The transfer of the painting from Frances to her estate on her death is a
§ 1001 realization event so that the $106,480,200 built-in gain is taxed on her final individual
income tax return, payable by the estate. In addition, the after-tax cash from the sale, plus the FMV
of any other property held by the estate, is taxed to her estate under the estate tax (to the extent
that it exceeds any applicable exemption amount) before transfer to her daughter. Her daughter
includes the cash (after the estate’s payment of income and estate taxes) plus the FMV of any other
property that she receives from the estate in her Gross Income for income tax purposes on receipt
because they are wealth accessions for her.
And, of course, we could construct various degrees between those two extremes. We could
provide that the deemed transfer to the estate is a realization event for income tax purposes but
that no wealth transfer tax applies. We could provide that the receipt by her daughter is includable
for income tax purposes as a wealth accession—with or without an estate tax. Or we could provide
that the bequest is not a realization event but that the full $106,500,000 FMV is taxed to her estate
under a wealth transfer tax. Her daughter could exclude the painting under the income tax but take
the same basis that her mother had so that the built-in gain is not laundered out.
And so on.
Before turning to positive law, your thoughts? Remember your tax policy tools from Chapter
3. How may these decisions regarding how to tax (or not tax) these events affect taxpayer behavior
under the neutrality norm? Any fairness concerns? And remember that $X (the aggregate amount
collected in tax each year) stays about the same as a percentage of GDP so that the narrower the
tax base, the higher the marginal rates need to be to raise $X, and the broader the base, the lower
the rates need to be to raise $X. In other words, when (or whether) we tax the painting’s built-in
gain, whether we tax the transfer of wealth, and whether we require gifts and bequests received by
the donee to be included in Gross Income for income tax purposes affect not only the parties
directly involved but also the rest of the taxpaying public, whose tax rates are inevitably affected
by these decisions. In short, they are not costless decisions.
A brief description of positive law
What follows is a brief description of both the history and current law regarding the wealth
transfer taxes imposed on the donor and the income tax treatment of wealth transfers received by
donee. While we are interested here primarily in the income taxation of gifts and bequests, as noted
above, the existence of the wealth transfer taxes imposed on donors may, for some, be an important

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consideration in deciding the appropriate income tax treatment of gifts and bequests for the donee.
The original estate tax was enacted in 1916 (three years after the enactment of the income tax)
and was intended to “reallocate the costs of underwriting a modern state across the geographical
regions and socioeconomic classes.” 3 In other words, it was intended primarily to raise revenue
from those best able to pay. But an important secondary reason was to combat the ill effects of
rapidly advancing wealth concentration at the time, including political influence peddling that can
harm democratic values, the consolidation of monopoly power in business, etc. As described by
the Joint Committee on Taxation, the new estate tax was viewed as “preventing undue
concentrations of wealth and complementing the income tax to fulfill the goal of the progressive
tax system.” 4 This view was common in early 20th century political and economic thought. For
example, in a 1910 speech former (Republican) President Theodore Roosevelt said:
The absence of effective State, and, especially, national restraint upon unfair moneygetting has tended to create a small class of enormously wealthy and economically
powerful men, whose chief object is to hold and increase their power…. The really big
fortune, the swollen fortune, by the mere fact of its size acquires qualities which
differentiate it in kind as well as in degree from what is possessed by men of relatively
small means. Therefore, I believe in a graduated income tax on big fortunes, and in
another tax which is far more easily collected and far more effective—a graduated
inheritance tax on big fortunes, properly safeguarded against evasion, and increasing
rapidly in amount with the size of the estate. 5
To combat avoidance of the estate tax through lifetime gifts, a gift tax was enacted in 1924,
repealed in 1926, and reintroduced in 1932. The generation-skipping transfer tax was added in
1976, and the estate, gift, and generation-skipping transfer taxes were effectively integrated into a
single, unified system at that time.
In 1987, the estate tax exemption amount (the cumulative amount that could be transferred
during life and at death without tax) was $600,000, effectively $1.2 million for a married couple,
and marginal tax rates ranged from 18% to 55% on very large estates. If these exemption amounts
had been merely indexed for inflation, they would stand at nearly $1.5 million today ($3 million
for a married couple. As part of the tax reductions that occurred in 2001 in the George W. Bush
administration, the estate tax exemption amount was gradually increased each year until it reached
$3.5 million ($7 million for a married couple) in 2009, and the top marginal tax rate was gradually
reduced each year until it reached 45% in 2009. (Because Mrs. Brody died in 2009, her estate
would have been taxed using these figures.) For tax year 2010, the estate tax was fully repealed
for that year only (because of the 2010 sunset for that legislation, described in Chapter 3), which,
as you can imagine, created all sorts of late-night jokes about pushing grandma off the train in
2010. At least four billionaires died in 2010, avoiding estate tax, including George Steinbrenner,
the irascible owner of the New York Yankees. 6
For 2011—when the estate tax otherwise would have reverted to 2000 levels—Congress acted
3

AJAY MEHOTRA, MAKING THE MODERN AMERICAN FISCAL STATE 27 (2014).
JOINT COMMITTEE ON TAXATION, DESCRIPTION OF GIFT AND ESTATE TAX MATTERS, JCS-30-83, June 27, 1983, at
15.
5
http://teachingamericanhistory.org/library/document/new-nationalism-speech/.
6
The other four were Janet Morse Cargill of the family that founded Cargill, Inc., the Texas pipeline magnate Daniel
Duncan, and the California real estate mogul Walter Shorenstein. “By rough calculation, their deaths in 2010 have
cost the government some $6.5 billion.” www.elderlawanswers.com/Resources/Article.asp?ID=8454.
4

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to increase the exemption amount to $5 million ($10 million for a married couple), to reduce the
top tax rate to 35%, and to index the exemption amount for inflation. Absent further Congressional
action, the estate tax exemption amount was scheduled to be reduced to $1 million ($2 million for
a married couple), with a top tax rate of 55%, in 2013.
The American Taxpayer Relief Act of 2012, however, made permanent the $5 million 2010
exemption ($10 million for a married couple), indexed for inflation, and reduced the top tax rate
from 55% to 40%, which the Joint Committee on Taxation estimated would collect $369 billion
less revenue over the decade ending in 2023 than if Congress had retained the 2001 law. The 2017
TCJA essentially doubled the exemption to $11.18 million for 2018 ($22.36 million for a married
couple), indexed for inflation thereafter. For 2022, the amount is $12,060,000 ($24,120,000 for a
married couple). According to the Tax Policy Center, of the 2.8 million people expected to have
died in 2020, only about 1,400 will owe estate tax, about .05% of decedents (five one-hundredths
of one percent). 7 The high point of taxable estates was 1976 at 139,000. 8
Under the integrated estate and gift tax system, transfers during life that would otherwise trigger
gift tax for the donor can avoid gift tax but reduce the donor’s estate tax exemption amount at
death. But not all gifts reduce the donor’s estate tax exemption amount. Each individual donor can
transfer $16,000 (as of 2022) to each donee during life without either incurring gift tax or reducing
the cumulative estate tax exemption amount. For example, a married couple with two children can
transfer $64,000 each year (with each spouse giving $16,000 to each of their two children) without
incurring gift tax or using any of their estate tax exemption amount, which means that they can
transfer at least $640,000 over ten years to their children without tax and without reducing their
estate tax exemption amount at death. I say “at least” because the $16,000 figure is also adjusted
for inflation over time, allowing more than $640,000 to be transferred without tax or reducing the
estate tax exemption amount. In 2005, for example, the gift tax annual exclusion was $11,000, in
2012 it was $13,000, in 2017 it was $14,000, and in 2021 it was $15,000. Moreover, education
and health costs paid directly to the provider on behalf of another do not count toward the $16,000
annual gift tax exclusion. In short, a good deal of wealth can be transferred during life and at death
without transfer tax, even with the estate and gift tax in place.
As for the income tax, in the U.S., the making of a gift, whether during life or at death, is
not a § 1001 realization event for the donor. The built-in gain in property owned at death (the
difference between the property’s FMV and its A/B) is not taxed under the income tax to the
decedent (on her final income tax return) in the United States.
With respect to the donee’s receipt under the income tax, read § 102(a). Both inter vivos gifts
and bequests are fully excluded from the Gross Income of the donee for income tax purposes,
with no cap on the amount that can be excluded. In contrast, the 1894 income tax (which was
ruled unconstitutional under the apportionment clause, as you read in Chapter 3) included in the
tax base “money and the value of all personal property acquired by gift or inheritance” (leaving
out real property). 9 While the entire 1894 income tax was controversial, this provision was subject
to particular scrutiny, as described by tax historian Joseph Thorndike. 10 By the time the income
7

TAX POLICY CENTER, Briefing Book, at www.taxpolicycenter.org/briefing-book/how-many-people-pay-estate-tax.
Patricia Callahan, James Bandler, Justin Elliott, Doris Burke & Jeff Ernsthausen, The Great Inheritors: How Three
Families Shielded Their Fortunes From Taxes for Generations, https://www.propublica.org/article/the-greatinheritors-how-three-families-shielded-their-fortunes-from-taxes-for-generations.
9
See Joseph J. Thorndike, When Estates Were (Almost) Taxed as Income, 147 TAX NOTES 483 (2015).
10
Id.
8

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tax was enacted again in 1913 (after ratification of the 16th amendment), all gifts and bequest were
excluded by the recipient under the predecessor to § 102(a).
Why the change of heart between 1894 and 1913? There is no legislative history explaining it.
The 1913 exclusion could not have been premised on the notion that the gift or bequest would be
taxed to the donor under the estate tax and should not therefore be included by the donee under the
income tax, as there was no estate tax in 1913. Moreover, even with an estate tax now in place, the
gift exclusion cannot be premised on the notion that the estate tax and the income tax treatment of
gifts are integrated to avoid double taxation (albeit under two separate tax systems) because the
income tax exclusion for gifts was not repealed when the estate tax was repealed for 2010. The
cash bequests of George Steinbrenner and other billionaires who died in 2010 were taxed under
neither the estate tax (to the donor) nor the income tax (to the donee).
Recall the discussion from Chapter 6 regarding Victorian notions distinguishing between (1)
lump sum, nonperiodic capital receipts and (2) periodic income receipts. The 1913 exclusion likely
had its roots in such notions. In a treatise published just a year after the 1913 income tax was
enacted with the gift exclusion in place, E.R.A. Seligman stated this notion explicitly when
describing the defunct 1894 income tax: “If anything is irregular and unperiodic, it is an
inheritance. The income from the inheritance is indeed regular, but the [1894] law taxed not only
the income from the inheritance but the inheritance itself.” He implied that inclusion of gifts or
bequests as income was wrong under theoretical notions of what that term meant at the time.
By 1938, however, Henry Simons was elucidating the meaning of income for uniquely tax
purposes (as opposed to its meaning for financial or trust accounting purposes, where the periodic
gloss was strong), and he saw gifts and bequests as clear wealth accessions for the donee reflecting
ability to pay tax. Receiving a large gift or bequest increases one’s ability to pay just as much as
receiving a large salary (or prize) does. On horizontal equity grounds, do we want to treat people
who work hard for a living (and whose wages are includable under the income tax) worse than we
do those who are lucky enough to live off of transferred wealth from gramps? Simons said:
The income tax is not a tax upon income but a tax upon persons according to their
respective incomes; and, subject to the requirement of adherence to simple, general
rules, the objective of policy must be fairness among persons, not fairness among kinds
of receipts (whatever that might be construed to mean)….
Considerations of equity surely afford little ground for excluding (or including)
particular receipts according to the intentions of the second parties…. Thus, as regards
donees, current income-tax practices as to gifts find no sanction in considerations of
fairness; and they do involve a distinction between gifts and compensation which
introduces serious administrative difficulties and which, moreover, invites the
dressing-up of real exchanges in the guise of one-sided transfers. 11
So why does the unlimited gift exclusion in § 102(a) remain in the 21st century? Congress could
cap the exclusion to some reasonable amount (either annually or for the donee’s lifetime) to ensure
that ordinary birthday and holiday gifts remain excludable but that substantial gifts and bequests
in excess of the cap are includable. If the § 102 exclusion were capped, repeal of the estate tax
would be more defensible (and the § 1014 step up in basis, considered in the next section, might
be defensible).
11

HENRY C. SIMONS, PERSONAL INCOME TAXATION at 128, 134-35 (1938).

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Perhaps Congress believes that a mere transfer, without rendering services (such as in the case
of David, the window washer, and Doris), should result in only one level of taxation between the
two taxpayers under the income tax. Because the donor is denied deduction of personal expenses
under § 262 (and so is implicitly taxed on the transfer), the only way to ensure only a single layer
of income tax between the two is to permit the donee to exclude gifts and bequests, notwithstanding
horizontal equity concerns between donees and workers like David. Convincing?

A. The basis of property received
in kind as a gift or bequest (and related rules)
If an inter vivos gift or death-time bequest is received in kind rather than in cash, at what basis
does the donee take the property? Carefully read both §§ 1014(a)(1) and 1015(a) before
considering the following problems. With respect to inter vivos gifts, pay particular attention to
the language in § 1015(a) after the words “except that”: if and only if the property has a built-in
loss at the time of the gift, the donee uses the donor’s basis in computing later realized gain but
the lower gift-time FMV in computing later realized loss. In addition, note §§ 1223(1) and (9)
regarding the deemed holding period of property obtained by inter vivos gift or death-time bequest.
Problems
1. Jonathan purchased land many years ago for $100,000, which is rented to tenant farmers who
pay Jonathan an annual rent of $5,000. Today, the land is worth $400,000. Jonathan has just
learned that he is terminally ill and does not have much longer to live. Do you advise Jonathan to:
a. sell the land now to a buyer for $400,000 and provide a bequest in his will for the cash
proceeds to be transferred to his good friend Jill;
b. give the land to Jill now and let her sell it; or
c. provide a bequest in his will for the land to go to Jill after his death?
2. Same as 1., except that the land, which Jonathan purchased for $100,000, is now worth only
$75,000. Should Jonathan:
a. sell the land now to a buyer for $75,000 and provide a bequest in his will for the cash proceeds
to be transferred to his good friend Jill;
b. give the land to Jill now and let her sell it; or
c. provide a bequest in his will for the land to go to Jill after his death?
3. Notwithstanding your advice, Jonathan gave the land described in 2. to Jill before he died.
Rather than sell immediately, Jill held the land for several years. What is her § 1001 realized gain
or loss in each case if she eventually sells for:
a. $60,000;
b. $110,000; or
c. $80,000? See Treas. Reg. § 1.1015-1(a)(2).

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4. During the years of Jill’s ownership of the land in 3. before sale, must she include in her
Gross Income the rent that she receives from the tenant farmers, or can she exclude the rent under
§ 102(a) on the theory that the rent is all a part of Jonathan’s gift of the land? See § 102(b)(1).
5. Cindy recently died, and her will contains bequests for both Carl and Candy. Cindy’s will
directs that land that she owns should be transferred to Carl. The land was purchased by Cindy
years ago for $80,000, and it has a FMV of $120,000 on Cindy's death. Her will also directs,
however, that the rent paid by the tenant farmers working the land should be paid to Candy (rather
than Carl) until the current lease term ends in two years. When Candy receives the first lease
payment of $2,000, she asks you whether she can exclude the receipt under § 102(a), as she
received this rent as a bequest under Cindy’s will. While § 102(b)(1) does not apply on these facts
because Candy did not receive (and exclude) the land on which the rent was paid, see § 102(b)(2).
6. Hal and Helen are the proud parents of Hallie, who is a 24-year-old medical student whom
they continue to support through her studies in medical school. Hallie works part-time as a lab
technician in a hospital, but she does not earn much above minimum wage. Hal and Helen pay
Hallie’s medical school tuition directly, but they also plan to sell shares of corporate stock that
they bought for $2,000 in order to contribute toward Hallie’s living expenses this year. The stock
is now worth $16,000. Do you have any advice for Hal and Helen?
7. Jacob bought land many years ago for $7,000, and it was appraised at $20,000 just before he
sold it to his cousin Caleb for $10,000. In other words, Jacob sold the land at a deep discount to
his cousin! What are Jacob’s tax consequences? At what basis does Caleb take the land? The
theoretically correct answer is that Jacob sold 50% of the land (worth $10,000) for $10,000 and
made a gift of the remaining 50% (worth $10,000), which means that 50% of the basis ($3,500)
would be allocated to the sale transaction and 50% to the gift transaction. Under that approach,
Jacob would recognize a $6,500 § 1001 gain ($10,000 A/R less $3,500 allocated basis) with respect
to the 50% interest that he sold. Caleb would take a $10,000 cost basis (under § 1012) in the 50%
portion that he purchased and a $3,500 carryover basis (under § 1015(a)) in the 50% portion that
he received as a gift for a total basis of $13,500. But that is not the approach taken by the
regulations in the case of a “part gift/part sale” transaction. What are the results to both Jacob
and Caleb under Treas. Reg. §§ 1.1001-1(e) and 1.1015-4? How would your answers change if
Jacob’s basis in the land had been $12,000 instead of $7,000?
____________________________________
Historical development of the basis rules
While the original 1913 revenue act provided authority to exclude gifts and bequests, it
provided no special basis rule for such receipts received in kind rather than in cash. The only basis
rule in the Code at that time was the predecessor to current § 1012, providing that the basis of
property was equal to its “cost.” When the Treasury was asked what the cost basis of property
received by gift or bequest would be, it responded with FMV—probably on the analogy that when
property is purchased at arm’s length the cost basis typically equals FMV. Recall that in 1913, a
tax-specific meaning of “income” was yet to evolve, and the concept of basis was not yet fully
understood in its modern role of keeping track of previously taxed dollars.
It did not take long for propertied families to figure out that they could launder out any
unrealized gain by making intra-familial gifts before a sale to an unrelated third party for cash at

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no further gain. For example, Papa bought land in 1913 for $100, taking a cost basis of $100. By
1917, the land had increased in value to $120, so Papa gave it as a gift to Daughter, who took a
cost basis of $120 in the land, even though the gift was not a realization event for Papa and even
though she was permitted to exclude the value of the land from her Gross Income under the
predecessor to § 102. In 1920, the land had further increased in value to $130, so Daughter gave
the land to Sibling, who excluded the $130 value from his Gross Income and who took a $130 cost
basis in the land before selling it to Stranger for its $130 FMV, generating no § 1001 gain ($130
A/R less $130 A/B).
Congress finally responded to this scenario by enacting the predecessor to § 1015 in 1921, but
the taxpayer in Taft v. Bowers 12 soon claimed that the new carryover (or transferred) basis rule
was unconstitutional. The taxpayer’s brief depended on the antiquated capital receipt notion
described above and in the last chapter, as recounted in this excerpt.
The taxpayer’s counsel made the argument that the receipt of the gift was a ‘‘capital’’
receipt that must, under the Constitution, take an FMV basis to prevent any part of the
value from creating gain (and thus income) when converted to cash:
Until the Revenue Act of 1921 became effective, the Department [of
the Treasury] laid down the rule that gain on the sale of property
acquired by gift could be computed only by taking into [account as
basis] the value of the gift when it was acquired. This was an express
recognition by the Treasury Department that a gift is a capital
transaction … and that the donee can have ‘‘gain’’ only to the extent
that the proceeds in his hands exceed the value of his capital at the time
of acquisition.
And later:
The corpus of the gift is capital in the hands of the donee at the time of
its receipt. But the mere conversion of such capital into money does not
constitute income…. An amount sufficient to restore the capital value
that existed at the commencement of the taxing period must be
withdrawn from the gross proceeds in order to determine whether there
has been a gain or loss, and the amount of the gain, if any.
But the Court upheld the constitutionality of the new basis rule [in Taft v. Bowers],
even though it was inconsistent with early notions of income and capital that were
borrowed from business and trust accounting. The term ‘‘capital’’ was permitted to
evolve as a tax concept that protected tax values. The new rule meant that ‘‘capital’’
was synonymous with ‘‘basis,’’ a tax-free return of capital meant only a tax-free return
of basis, and basis meant previously taxed dollars. Thus, the Sixteenth Amendment
does not require that basis must equal FMV that can be recovered tax-free just because
in 1913 it was commonly thought so. Rather, Congress is empowered to change the
basis rule to ensure that it reflects only previously taxed dollars; the Sixteenth
Amendment is no bar. 13
Is § 1014 justified? If not, which alternative would be better?
12
13

278 U.S. 470 (1929).
Deborah A. Geier, Murphy and the Evolution of “Basis,” 113 TAX NOTES 576, 581 (2006) (footnotes omitted).

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Notably, when Congress enacted the predecessor to § 1015 for inter vivos gifts, it left intact
the FMV basis rule for property received at death, now memorialized in § 1014. Why? The old
capital receipts notion continued to hold powerful sway at the time, as evidenced by the treatment
of damage awards to compensate for the loss of human capital, considered in Chapter 16. While
change was forced in the inter vivos gift context because of the abuse that had come to light,
perhaps Congress believed that enacting § 1015 was sufficient to stop that immediate problem.
Unlike the inter vivos gifts described above, a transfer at death happens only once in a lifetime, so
built-in gain can be laundered out only once in a lifetime. Is that a satisfying reason to keep § 1014
alive today, with our better understanding of the role of basis?
As shown in the chart in Chapter 3, 1014 is expected to lose more than $200 billion in revenue
between 2018 and 2022. As always, this revenue loss must be made up with higher tax rates on
everyone else, such as wage earners. Section 1014 benefits only those owning property who
enjoyed significant untaxed wealth accessions during life (property appreciation) because of the
realization requirement—a rule of administrative convenience. What rationale justifies never
taxing that gain under the income tax? Section 1014 is the first significant provision that we have
encountered that violates the fundamental rule that basis generally represents dollars that have
been previously taxed under the income tax (if not to the donee, at least to the donor).
When the estate tax was fully repealed for one year in 2010, Congress replaced § 1014 with
new (and now repealed) § 1022, which provided a carryover (or transferred) basis similar to §
1015, except that the basis of up to $1.3 million worth of property selected by the executor would
be stepped up to FMV (plus another $3 million worth of property if it went to a surviving spouse).
The realization requirement, itself, is often criticized by economists for violating the neutrality
norm, encouraging taxpayers to hold on to property that could be more efficiently used by another.
You will hear this phenomenon referred to as the “lock-in effect,” discussed in Chapter 14
(pertaining to capital gains and losses). Section 1014 turbo-charges the lock-in effect because
owners will not merely defer the tax on built-in gain to enjoy the time value of money but eliminate
it entirely—if and only if they hold on to the property until death. A mark-to-market system (briefly
explored in Chapter 1) would eliminate the lock-in effect because gains would be taxed as they
accrue each year. While a mark-to-market system might be impractical for all but publicly traded
securities because of the administrative difficulty of valuing property each year, why not make
death a realization event, as such a rule would require valuation only once? Indeed, § 1014 already
requires valuation of property at death so that the donee can take that FMV basis!
That’s exactly what happened in 1989 in Canada, which repealed its estate tax in the same
legislation. If Frances Brody and her daughter, described in the earlier article excerpt, had lived in
Canada, the built-in gain in the Picasso painting would have been taxed to Frances (unlike here in
the U.S.), no wealth transfer tax would have applied, and her daughter would, as in the U.S., be
permitted to exclude the cash or property received in kind from her mother’s estate under Canada’s
income tax. Because the built-in gain would be taxed under the income tax on her mother’s final
income tax return, her daughter would appropriately take a stepped-up, FMV basis in the property.
Such a system makes the behavioral decision to sell to a third party (who might be able to put the
property to better use) or give to an heir less tax sensitive, as the transfer is going to be a realization
event either way, which means that economists prefer it as more behaviorally neutral than the U.S.
system. Because death is not a realization event under § 1001 in the U.S., whereas a sale is,
behavior is skewed, reducing economic efficiency.
As implied earlier, yet another approach would be to keep the transfer a nonrealization event
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for the donor (no § 1001 gain on Mrs. Brody’s final income tax return), repeal the estate tax, but
amend § 102(a) to require her daughter to include substantial gifts and bequests in excess of a
reasonable exemption amount ($100,000? $ 1 million? Annul or a cumulative lifetime exclusion?).
As Henry Simons said, the income tax is not a tax on income, per se, but a tax on persons, as
measured by their income because their wealth accessions best reflect their ability to pay tax.
The effect of the Internal Revenue Code on racial wealth inequities
The emasculation of the estate tax and step up in basis at death are significant contributors to
wealth inequality and has a particularly pernicious effect on black families. In advocating an
inheritance tax (as opposed to an estate tax on the donor), Professor Lily Batchelder has written:
A massive transfer of wealth is underway and will accelerate in the coming
years. Baby boomers and the generation that preceded them currently own $84
trillion, or 81 percent of all U.S. household wealth—wealth that will before long be
inherited by their children and other beneficiaries. This extraordinary transfer of
resources will further cement the economic inequality that plagues the United States
because this wealth is tightly concentrated in the hands of a few. And it will be
passed on as taxes on such transfers are at historic lows.
Among high-income countries, the United States has one of the lowest levels of
intergenerational economic mobility, meaning that a child’s economic future is
heavily influenced by his or her parents’ income. We have the second-highest level
of income inequality after taxes and government transfers, and the highest level of
wealth inequality. These disparities are sharply skewed by race. Median black
household wealth is only 9 percent that of white households, a racial wealth gap
that is even larger than in 1968. New research suggests the pandemic will further
increase wealth inequality, as the affluent save more and the poor earn less.
Effectively addressing these system inequalities will require many things. But
increasing the taxation of inheritances is one vital component.
This year, Americans will inherit about $765 billion. People who were already
rich will inherit a lot more than people who weren’t wealthy. So will white
households; they are twice as likely as black households to receive an inheritance,
and receiving an inheritance is associated with an increase in wealth that is 26 times
larger for white families than for black families….
Roughly 40 percent of all household wealth stems from inheritances. This means
that 40 percent of why some Americans are extraordinarily well off has nothing to
do with smarts, hard work, frugality, lucky gambles or entrepreneurial ingenuity. It
is simply because they were born to rich parents.
Inheritances compound over generations, one reason societies often choose to
tax them as a way to combat rising inequality and level the playing field. Our tax
system has always been one of our most potent tools for expressing and acting upon
our values. But in this area, it is failing and only getting worse. 14

14

Lily Batchelder, Tax the Rich and Their Heirs; How to Tax Inheritances More Fairly, at
www.nytimes.com/2020/06/24/opinion/sunday/inheritance-tax-inequality.html

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The initial version of President Biden’s Build Back Better plan would have ended the § 1014
tax-free step up in basis, among other provisions aimed particularly at the very wealthy, 15 but it
was stripped from the bill before the House of Representatives passed it in November 2021.
Professor Dorothy Brown 16 penned an op-ed lamenting the move, and she did so on explicitly
racial grounds, writing: “The United States has a huge racial wealth gap…. One of the hidden
drivers of this gap is tax policy, which has accelerated wealth-building by White families, while
excluding most Black families. Congress recently had an opportunity to reform at least one lever
of that inequality—only to reject it.” 17
She observed that § 1014 applies mainly to protect the wealth of the top 1% from taxation and
that this group is disproportionately white. “While 15 percent of White Americans are millionaires,
only 2 percent of Black Americans are millionaires.” She describes research showing that “White
Americans were five times as likely as Black Americans to receive an inheritance and that they
received about 10 times as much wealth as Black Americans.” Moreover, of every dollar of
inherited wealth, 91 cents could be saved by White families, contributing to generational wealth,
compared to 20 cents by Black families because the latter were more likely to need to use the
inheritance for the support of extended family members.
The backlash against the repeal of § 1014 relied on the oft-repeated argument that family farms
and ranches would have to be sold to pay the tax, ignoring the exception in the proposal for such
family businesses that remain in the family. Moreover, Professor Brown notes that this argument
conveniently ignores data showing “the reality of the racial demographics of farming in the 21st
century.” Today, 95 percent of farmers are White, with 3.3 percent Hispanic and less than 2 percent
Black. Ironically, the Federal government is responsible in part for that racial disparity. “In 1920,
14 percent of farmers were Black,” and the decrease is attributable in part to historic discrimination
in the Agriculture Department’s administration of farm loans. “The farmers who would benefit
from the stepped-up basis would overwhelmingly be White. Indeed, any tax break for farmers is
an almost perfect race-based subsidy for White Americans.” Finally, she recites similar statistics
to rebut the argument that § 1014 repeal would harm Black entrepreneurs.
In December 2020, Deputy Treasury Secretary Wally Adeyemo and Assistant Secretary for Tax
Policy Lily Batchelder announced that the Treasury Department will initiate studies, which will
be ongoing, of the distribution of tax benefits and the impact of tax administration efforts by race,
starting with an examination of the pandemic relief payments to families. 18 The For those
interested in reading more about the racial inequities in the tax system, the Univeristy of California

15

Another provision would mark to market publicly traded securities owned by those with $1 billion in assets or who
earned more than $100 million in 3 consecutive years. Non-publicly traded assets would remain subject to the
realization rule, but an interest charge would be assessed at realization to account for the time value of money during
the ownership period during which the gain accrued but was not taxed. See https://www.finance.senate.gov/chairmansnews/wyden-unveils-billionaires-income-tax. More than 200 economists and law professors signed a letter to the
Senate in support of the proposals. See https://taxprof.typepad.com/taxprof_blog/2021/12/219-economists-lawprofessors-urge-congress-to-include-the-billionaires-income-tax-in-build-back-bet.html. In the interest of fiull
disclosre, I am one of the signatories.
16
See also DOROTHY BROWN, THE WHITENESS OF WEALTH: HOW THE TAX SYSTEM IMPOVERISHES BLACK
AMERICANS—AND HOW WE CAN FIX IT (2021).
17
Dorothy Brown, Congress is Passing Up a Chance to Close a Tax Loophole—and the Racial Wealth Gap, WASH.
POST, Sept. 16, 2021, https://www.washingtonpost.com/outlook/2021/09/16/stepped-up-basis-race/.
18
Wally Adeyemo and Lily Batchelder, Advancing Equity Analysis in Tax Policy,
https://home.treasury.gov/news/featured-stories/advancing-equity-analysis-in-tax-policy.

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at Irvine School of Law maintains and updates
https://www.law.uci.edu/gradtax/race-tax-resources/.

Chapter 7
a

website

on

the

topic

at

Section 1014 is one of the provisions mentioned at the end of Chapter 3 illustrating how those
who earn capital income (as opposed to wage income) enjoy tax preferences that significantly mismeasure (understate) their income. And recall that (1) property income is heavily concentrated in
upper-income households and (2) the pre-tax return on capital has exceeded the rate of economic
growth for decades, exacerbating income and wealth inequality, which means that § 1014 applies
to wipe out the gains of those who most benefited from these trends. “[O]ld people have most of
the money. Thirty years ago, households headed by those over sixty-five were ten times as wealthy
as those under thirty-five; now they’re fifty times as wealthy.” 19 Moreover, as described above,
the substantial TCJA increase in the estate tax exemption ensures that most of this untaxed gain is
escapes tax under the estate tax, as well. Young workers pay the price for this failure to measure
capital income properly by having their wages taxed at rates higher than would otherwise be
required to raise the revenue lost under the provisions that enable capital income to escape tax.

B. What is a gift within the meaning of § 102(a)?
The lack of clear understanding regarding the modern rationale underlying the gift exclusion
makes it difficult for courts to give meaning and scope to the word “gift.” Indeed, the sheer number
of separate opinions in Duberstein, below, illustrates this fact. What was the government’s
preferred approach in defining the term, found in footnote 6? In carefully considering the words
in § 102(a)—“gift, bequest, devise, or inheritance”—can you construct a statutory interpretation
argument justifying the government’s interpretation? Under the statutory interpretation canon
noscitur a sociis (Latin for “it is known from its associates”), the meaning of one word in a list of
similar words should be informed by the common features among the words. 20 How did the Court’s
approach differ? Which do you think is the better approach in this particular context? Why? Would
Stanton’s case arise today? Review § 102(c), added in 1986.
COMMISSIONER v. DUBERSTEIN
363 U.S. 278 (1960)
MR. JUSTICE BRENNAN delivered the opinion of the Court.
These two cases concern the provision of the Internal Revenue Code which excludes from the
Gross Income of an income taxpayer “the value of property acquired by gift.” They pose the
frequently recurrent question whether a specific transfer to a taxpayer in fact amounted to a “gift”
to him within the meaning of the statute. The importance to decision of the facts of the cases

19

Tad Friend, Getting On, THE NEW YORKER, Nov. 20, 2017, at 47-48.
Compare this canon with ejusdem generis, discussed in Chapter 6 in connection with the § 61 residual clause.
Ejusdem generis can apply when a list of items is followed by a generic catch-all clause and instructs that the items
within the catch-all clause should be limited to those with the same common characteristics of the specifically listed
items. For example, if a statute provides that a motor vehicle tax should apply to “automobiles, trucks, motorcycles,
and other motor-powered vehicles,” the word “vehicles” in the catch-all clause should not be interpreted to include
airplanes because the other items on the list all pertain to ground transportation vehicles. Noscitur a sociis, in contrast,
pertains to the meaning of one word nestled among others in a list. Rather pedantic, I know. See, e.g., Babbitt v. Sweet
Home Chapter of Communities for a Great Oregon, 515 U.S. 687, 720-21 1995) (Scalia, J., dissenting).
20

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requires that we state them in some detail.
No. 376, Comm’r v. Duberstein. The taxpayer, Duberstein, was president of the Duberstein Iron
& Metal Company, a corporation with headquarters in Dayton, Ohio. For some years the
taxpayer’s company had done business with Mohawk Metal Corporation, whose headquarters
were in New York City. The president of Mohawk was one Berman. The taxpayer and Berman
had generally used the telephone to transact their companies’ business with each other, which
consisted of buying and selling metals. The taxpayer testified, without elaboration, that he knew
Berman “personally” and had known him for about seven years. From time to time in their
telephone conversations, Berman would ask Duberstein whether the latter knew of potential
customers for some of Mohawk’s products in which Duberstein’s company itself was not
interested. Duberstein provided the names of potential customers for these items.
One day in 1951 Berman telephoned Duberstein and said that the information Duberstein had
given him had proved so helpful that he wanted to give the latter a present. Duberstein stated that
Berman owed him nothing. Berman said that he had a Cadillac as a gift for Duberstein, and that
the latter should send to New York for it; Berman insisted that Duberstein accept the car, and the
latter finally did so, protesting however that he had not intended to be compensated for the
information. At the time Duberstein already had a Cadillac and an Oldsmobile, and felt that he did
not need another car. Duberstein testified that he did not think Berman would have sent him the
Cadillac if he had not furnished him with information about the customers. It appeared that
Mohawk later deducted the value of the Cadillac as a business expense on its corporate income tax
return.
Duberstein did not include the value of the Cadillac in Gross Income for 1951, deeming it a
gift. The Commissioner asserted a deficiency for the car’s value against him, and in proceedings
to review the deficiency the Tax Court affirmed the Commissioner’s determination. It said that
“The record is significantly barren of evidence revealing any intention on the part of the payor to
make a gift…. The only justifiable inference is that the automobile was intended by the payer to
be remuneration for services rendered to it by Duberstein.” The Court of Appeals for the Sixth
Circuit reversed.
No. 546, Stanton v. U.S.. The taxpayer, Stanton, had been for approximately 10 years in the
employ of Trinity Church in New York City. He was comptroller of the Church corporation, and
president of a corporation, Trinity Operating Company, the church set up as a fully owned
subsidiary to manage its real estate holdings, which were more extensive than simply the church
property. His salary by the end of his employment there in 1942 amounted to $22,500 a year.
Effective November 30, 1942, he resigned from both positions to go into business for himself. The
Operating Company’s directors, who seem to have included the rector and vestrymen of the
church, passed the following resolution upon his resignation: “BE IT RESOLVED that in
appreciation of the services rendered by Mr. Stanton … a gratuity is hereby awarded to him of
Twenty Thousand Dollars, payable to him in equal installments of Two Thousand Dollars at the
end of each and every month commencing with the month of December, 1942….”
The Operating Company’s action was later explained by one of its directors as based on the fact
that, “Mr. Stanton was liked by all of the Vestry personally. He had a pleasing personality. He had
come in when Trinity’s affairs were in a difficult situation. He did a splendid piece of work, we
felt. Besides that … he was liked by all of the members of the Vestry personally.” And by another:
“We were all unanimous in wishing to make Mr. Stanton a gift. Mr. Stanton had loyally and
faithfully served Trinity in a very difficult time. We thought of him in the highest regard. We
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understood that he was going into business for himself. We felt that he was entitled to that evidence
of good will.”
On the other hand, there was a suggestion of some ill-feeling between Stanton and the directors,
arising out of the recent termination of the services of one Watkins, the Operating Company’s
treasurer, whose departure was evidently attended by some acrimony. At a special board meeting
on October 28, 1942, Stanton had intervened on Watkins’s side and asked reconsideration of the
matter. The minutes reflect that “resentment was expressed as to the ‘presumptuous’ suggestion
that the action of the Board, taken after long deliberation, should be changed.” The Board adhered
to its determination that Watkins be separated from employment, giving him an opportunity to
resign rather than be discharged. At another special meeting two days later it was revealed that
Watkins had not resigned; the previous resolution terminating his services was then viewed as
effective; and the Board voted the payment of six months’ salary to Watkins in a resolution similar
to that quoted in regard to Stanton, but which did not use the term “gratuity.” At the meeting,
Stanton announced that in order to avoid any such embarrassment or question at any time as to his
willingness to resign if the Board desired, he was tendering his resignation. It was tabled, though
not without dissent. The next week, on November 5, at another special meeting, Stanton again
tendered his resignation which this time was accepted.
The “gratuity” was duly paid. So was a smaller one to Stanton’s (and the Operating Company’s)
secretary, under a similar resolution, upon her resignation at the same time. The two corporations
shared the expense of the payments.
The Commissioner asserted a deficiency against the taxpayer after the latter had failed to
include the payments in question in Gross Income. After payment of the deficiency and
administrative rejection of a refund claim, the taxpayer sued the United States for a refund in the
District Court for the Eastern District of New York. The trial judge, sitting without a jury, made
the simple finding that the payments were a “gift,” and judgment was entered for the taxpayer. The
Court of Appeals for the Second Circuit reversed.
The Government, urging that clarification of the problem typified by these two cases was
necessary, and that the approaches taken by the Courts of Appeals for the Second and the Sixth
Circuits were in conflict, petitioned for certiorari in No. 376, and acquiesced in the taxpayer’s
petition in No. 546. On this basis, and because of the importance of the question in the
administration of the income tax laws, we granted certiorari in both cases.
The exclusion of property acquired by gift from Gross Income under the Federal income tax
laws was made in the first income tax statute passed under the authority of the Sixteenth
Amendment, and has been a feature of the income tax statutes ever since. The meaning of the term
“gift” as applied to particular transfers has always been a matter of contention. Specific and
illuminating legislative history on the point does not appear to exist. Analogies and inferences
drawn from other revenue provisions, such as the estate and gift taxes, are dubious.... The meaning
of the statutory term has been shaped largely by the decisional law. With this, we turn to the
contentions made by the Government in these cases.
First. The Government suggests that we promulgate a new “test” in this area to serve as a
standard to be applied by the lower courts and by the Tax Court in dealing with the numerous cases
that arise. [6] We reject this invitation. We are of opinion that the governing principles are
[6]

The government’s proposed test is stated: “Gifts should be defined as transfers of property made for personal as
distinguished from business reasons.”

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necessarily general and have already been spelled out in the opinions of this Court, and that the
problem is one which, under the present statutory framework, does not lend itself to any more
definitive statement that would produce a talisman for the solution of concrete cases. The cases at
bar are fair examples of the settings in which the problem usually arises. They present situations
in which payments have been made in a context with business overtones—an employer making a
payment to a retiring employee; a businessman giving something of value to another businessman
who has been of advantage to him in his business. In this context, we review the law as established
by the prior cases here.
The course of decision here makes it plain that the statute does not use the term “gift” in the
common-law sense, but in a more colloquial sense. This Court has indicated that a voluntary
executed transfer of his property by one to another, without any consideration or compensation
therefor, though a common-law gift, is not necessarily a “gift” within the meaning of the statute.
For the Court has shown that the mere absence of a legal or moral obligation to make such a
payment does not establish that it is a gift. And, importantly, if the payment proceeds primarily
from “the constraining force of any moral or legal duty,” or from “the incentive of anticipated
benefit” of an economic nature, Bogardus v. Comm’r, 302 U.S. 34, 41, it is not a gift. And,
conversely, “where the payment is in return for services rendered, it is irrelevant that the donor
derives no economic benefit from it.” Robertson v. U.S., 343 U.S. 711, 714. 7 A gift in the statutory
sense, on the other hand, proceeds from a “detached and disinterested generosity, “ Comm’r v.
LoBue, 351 U.S. 243, 246; “out of affection, respect, admiration, charity or like impulses.”
Robertson v. U.S., supra, at 714. And in this regard, the most critical consideration, as the Court
was agreed in the leading case here, is the transferor’s “intention.” Bogardus v. Comm’r, 302 U.S.
34, 43. “What controls is the intention with which payment, however voluntary, has been made.”
Id., at 45 (dissenting opinion).
The Government says that this “intention” of the transferor cannot mean what the cases on the
common-law concept of gift call “donative intent.” With that we are in agreement, for our
decisions fully support this. Moreover, the Bogardus case itself makes it plain that the donor’s
characterization of his action is not determinative—that there must be an objective inquiry as to
whether what is called a gift amounts to it in reality. It scarcely needs adding that the parties’
expectations or hopes as to the tax treatment of their conduct in themselves have nothing to do
with the matter.
Second. The Government’s proposed “test,” while apparently simple and precise in its
formulation, depends frankly on a set of “principles” or “presumptions” derived from the decided
cases, and concededly subject to various exceptions; and it involves various corollaries, which add
to its detail. Were we to promulgate this test as a matter of law, and accept with it its various
presuppositions and stated consequences, we would be passing far beyond the requirements of the
cases before us, and would be painting on a large canvas with indeed a broad brush. The
Government derives its test from such propositions as the following: That payments by an
employer to an employee, even though voluntary, ought, by and large, to be taxable; that the
concept of a gift is inconsistent with a payment’s being a deductible business expense; that a gift
involves “personal” elements; that a business corporation cannot properly make a gift of its assets.
The Government admits that there are exceptions and qualifications to these propositions. We
think, to the extent they are correct, that those propositions are not principles of law but rather
maxims of experience that the tribunals which have tried the facts of cases in this area have
enunciated in explaining their factual determinations. Some of them simply represent truisms: it
doubtless is, statistically speaking, the exceptional payment by an employer to an employee that
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amounts to a gift. Others are overstatements of possible evidentiary inferences relevant to a factual
determination on the totality of circumstances in the case: it is doubtless relevant to the over-all
inference that the transferor treats a payment as a business deduction, or that the transferor is a
corporate entity. But these inferences cannot be stated in absolute terms. Neither factor is a
shibboleth. The taxing statute does not make nondeductibility by the transferor a condition on the
“gift” exclusion; nor does it draw any distinction, in terms, between transfers by corporations and
individuals, as to the availability of the “gift” exclusion to the transferee. The conclusion whether
a transfer amounts to a “gift” is one that must be reached on consideration of all the factors.
The major corollary to the Government’s suggested “test” is that, as an ordinary matter, a
payment by a corporation cannot be a gift, and, more specifically, there can be no such thing as a
“gift” made by a corporation which would allow it to take a deduction for an ordinary and
necessary business expense. As we have said, we find no basis for such a conclusion in the statute;
and if it were applied as a determinative rule of “law,” it would force the tribunals trying tax cases
involving the donee’s liability into elaborate inquiries into the local law of corporations or into the
peripheral deductibility of payments as business expenses. The former issue might make the tax
tribunals the most frequent investigators of an important and difficult issue of the laws of the
several States, and the latter inquiry would summon one difficult and delicate problem of Federal
tax law as an aid to the solution of another…. These considerations, also, reinforce us in our
conclusion that while the principles urged by the Government may, in nonabsolute form as
crystallizations of experience, prove persuasive to the trier of facts in a particular case, neither
they, nor any more detailed statement than has been made, can be laid down as a matter of law.
Third. Decision of the issue presented in these cases must be based ultimately on the application
of the fact-finding tribunal’s experience with the mainsprings of human conduct to the totality of
the facts of each case. The nontechnical nature of the statutory standard, the close relationship of
it to the data of practical human experience, and the multiplicity of relevant factual elements, with
their various combinations, creating the necessity of ascribing the proper force to each, confirm us
in our conclusion that primary weight in this area must be given to the conclusions of the trier of
fact. Baker v. Texas & Pacific R. Co., 359 U.S. 227; Comm’r v. Heininger, 320 U.S. 467, 475;
U.S. v. Yellow Cab Co., 338 U.S. 338, 341; Bogardus v. Comm’r, supra, at 45 (dissenting opinion).
This conclusion may not satisfy an academic desire for tidiness, symmetry and precision in this
area, any more than a system based on the determinations of various fact-finders ordinarily does.
But we see it as implicit in the present statutory treatment of the exclusion for gifts, and in the
variety of forums in which Federal income tax cases can be tried. If there is fear of undue
uncertainty or overmuch litigation, Congress may make more precise its treatment of the matter
by singling out certain factors and making them determinative of the matter.
Doubtless diversity of result will tend to be lessened somewhat since Federal income tax
decisions, even those in tribunals of first instance turning on issues of fact, tend to be reported, and
since there may be a natural tendency of professional triers of fact to follow one another’s
determinations, even as to factual matters. But the question here remains basically one of fact, for
determination on a case-by-case basis.
One consequence of this is that appellate review of determinations in this field must be quite
restricted. Where a jury has tried the matter upon correct instructions, the only inquiry is whether
it cannot be said that reasonable men could reach differing conclusions on the issue. Where the
trial has been by a judge without a jury, the judge’s findings must stand unless “clearly erroneous.”
Fed. Rules Civ. Proc., 52 (a). “A finding is ‘clearly erroneous’ when although there is evidence to
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support it, the reviewing court on the entire evidence is left with the definite and firm conviction
that a mistake has been committed.” U.S. v. U.S. Gypsum Co., 333 U.S. 364, 395. The rule itself
applies also to factual inferences from undisputed basic facts, id., at 394, as will on many occasions
be presented in this area. Cf. Graver Tank & Mfg. Co. v. Linde Air Products Co., 339 U.S. 605,
609-610. And Congress has in the most explicit terms attached the identical weight to the findings
of the Tax Court. I. R. C., § 7482 (a).
Fourth. A majority of the Court is in accord with the principles just outlined. And, applying
them to the Duberstein case, we are in agreement, on the evidence we have set forth, that it cannot
be said that the conclusion of the Tax Court was “clearly erroneous.” It seems to us plain that as
trier of the facts it was warranted in concluding that despite the characterization of the transfer of
the Cadillac by the parties and the absence of any obligation, even of a moral nature, to make it, it
was at bottom a recompense for Duberstein’s past services, or an inducement for him to be of
further service in the future. We cannot say with the Court of Appeals that such a conclusion was
“mere suspicion” on the Tax Court’s part. To us it appears based in the sort of informed experience
with human affairs that fact-finding tribunals should bring to this task.
As to Stanton, we are in disagreement. To four of us, it is critical here that the District Court as
trier of fact made only the simple and unelaborated finding that the transfer in question was a
“gift.” To be sure, conciseness is to be strived for, and prolixity avoided, in findings; but, to the
four of us, there comes a point where findings become so sparse and conclusory as to give no
revelation of what the District Court’s concept of the determining facts and legal standard may be.
Such conclusory, general findings do not constitute compliance with Rule 52‘s direction to “find
the facts specially and state separately . . . conclusions of law thereon.” While the standard of law
in this area is not a complex one, we four think the unelaborated finding of ultimate fact here
cannot stand as a fulfillment of these requirements. It affords the reviewing court not the semblance
of an indication of the legal standard with which the trier of fact has approached his task. For all
that appears, the District Court may have viewed the form of the resolution or the simple absence
of legal consideration as conclusive. While the judgment of the Court of Appeals cannot stand, the
four of us think there must be further proceedings in the District Court looking toward new and
adequate findings of fact. In this, we are joined by MR. JUSTICE WHITTAKER, who agrees that
the findings were inadequate, although he does not concur generally in this opinion.
Accordingly, in No. 376, the judgment of this Court is that the judgment of the Court of Appeals
is reversed, and in No. 546, that the judgment of the Court of Appeals is vacated, and the case is
remanded to the District Court for further proceedings not inconsistent with this opinion.
MR. JUSTICE HARLAN concurs in the result in No. 376. In No. 546, he would affirm the judgment
of the Court of Appeals for the reasons stated by MR. JUSTICE FRANKFURTER.
MR. JUSTICE WHITTAKER, agreeing with Bogardus that whether a particular transfer is or is not
a “gift” may involve “a mixed question of law and fact,” 302 U.S., at 39, concurs only in the result
of this opinion.
MR. JUSTICE DOUGLAS dissents, since he is of the view that in each of these two cases there was
a gift under the test which the Court fashioned nearly a quarter of a century ago in Bogardus v.
Comm’r, 302 U.S. 34.
MR. JUSTICE BLACK concurring and dissenting.
I agree with the Court that it was not clearly erroneous for the Tax Court to find as it did in No.
376 that the automobile transfer to Duberstein was not a gift, and so I agree with the Court’s
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opinion and judgment reversing the judgment of the Court of Appeals in that case.
I dissent in No. 546, Stanton v. United States. The District Court found that the $20,000
transferred to Mr. Stanton by his former employer at the end of ten years’ service was a gift and
therefore exempt from taxation under I. R. C. of 1939, § 22 (b)(3) (now I. R. C. of 1954, § 102
(a)). I think the finding was not clearly erroneous and that the Court of Appeals was therefore
wrong in reversing the District Court’s judgment. While conflicting inferences might have been
drawn, there was evidence to show that Mr. Stanton’s long services had been satisfactory, that he
was well liked personally and had given splendid service, that the employer was under no
obligation at all to pay any added compensation, but made the $20,000 payment because prompted
by a genuine desire to make him a “gift,” to award him a “gratuity.” Cf. Comm’r v. LoBue, 351
U.S. 243, 246-247. The District Court’s finding was that the added payment “constituted a gift to
the taxpayer, and therefore need not have been reported by him as income . . . .” The trial court
might have used more words, or discussed the facts set out above in more detail, but I doubt if this
would have made its crucial, adequately supported finding any clearer. For this reason I would
reinstate the District Court’s judgment for petitioner.
MR. JUSTICE FRANKFURTER, concurring in the judgment in No. 376 and dissenting in No. 546.
As the Court’s opinion indicates, we brought these two cases here partly because of a claimed
difference in the approaches between two Courts of Appeals but primarily on the Government’s
urging that, in the interest of the better administration of the income tax laws, clarification was
desirable for determining when a transfer of property constitutes a “gift” and is not to be included
in income for purposes of ascertaining the “Gross Income” under the Internal Revenue Code. As
soon as this problem emerged after the imposition of the first income tax authorized by the
Sixteenth Amendment, it became evident that its inherent difficulties and subtleties would not
easily yield to the formulation of a general rule or test sufficiently definite to confine within narrow
limits the area of judgment in applying it. While at its core the tax conception of a gift no doubt
reflected the non-legal, non-technical notion of a benefaction unentangled with any aspect of
worldly requital, the diverse blends of personal and pecuniary relationships in our industrial
society inevitably presented niceties for adjudication which could not be put to rest by any kind of
general formulation.
Despite acute arguments at the bar and a most thorough re-examination of the problem on a full
canvass of our prior decisions and an attempted fresh analysis of the nature of the problem, the
Court has rejected the invitation of the Government to fashion anything like a litmus paper test for
determining what is excludable as a “gift” from Gross Income. Nor has the Court attempted a
clarification of the particular aspects of the problem presented by these two cases, namely, payment
by an employer to an employee upon the termination of the employment relation and nonobligatory payment for services rendered in the course of a business relationship. While I agree
that experience has shown the futility of attempting to define, by language so circumscribing as to
make it easily applicable, what constitutes a gift for every situation where the problem may arise,
I do think that greater explicitness is possible in isolating and emphasizing factors which militate
against a gift in particular situations.
Thus, regarding the two frequently recurring situations involved in these cases—things of value
given to employees by their employers upon the termination of employment and payments
entangled in a business relation and occasioned by the performance of some service—the strong
implication is that the payment is of a business nature. The problem in these two cases is entirely
different from the problem in a case where a payment is made from one member of a family to
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another, where the implications are directly otherwise. No single general formulation appropriately
deals with both types of cases, although both involve the question whether the payment was a
“gift.” While we should normally suppose that a payment from father to son was a gift, unless the
contrary is shown, in the two situations now before us the business implications are so forceful
that I would apply a presumptive rule placing the burden upon the beneficiary to prove the payment
wholly unrelated to his services to the enterprise. The Court, however, has declined so to analyze
the problem and has concluded “that the governing principles are necessarily general and have
already been spelled out in the opinions of this Court, and that the problem is one which, under the
present statutory framework, does not lend itself to any more definitive statement that would
produce a talisman for the solution of concrete cases.”
The Court has made only one authoritative addition to the previous course of our decisions.
Recognizing Bogardus v. Commissioner, 302 U.S. 34, as “the leading case here” and finding
essential accord between the Court’s opinion and the dissent in that case, the Court has drawn from
the dissent in Bogardus for infusion into what will now be a controlling qualification, recognition
that it is “for the triers of the facts to seek among competing aims or motives the ones that
dominated conduct.” 302 U.S. 34, 45 (dissenting opinion). All this being so in view of the Court,
it seems to me desirable not to try to improve what has “already been spelled out” in the opinions
of this Court but to leave to the lower courts the application of old phrases rather than to float new
ones and thereby inevitably produce a new volume of exegesis on the new phrases.
Especially do I believe this when fact-finding tribunals are directed by the Court to rely upon
their “experience with the mainsprings of human conduct” and on their “informed experience with
human affairs” in appraising the totality of the facts of each case. Varying conceptions regarding
the “mainsprings of human conduct” are derived from a variety of experiences or assumptions
about the nature of man, and “experience with human affairs,” is not only diverse but also often
drastically conflicting. What the Court now does sets fact-finding bodies to sail on an illimitable
ocean of individual beliefs and experiences. This can hardly fail to invite, if indeed not encourage,
too individualized diversities in the administration of the income tax law. I am afraid that by these
new phrasings the practicalities of tax administration, which should be as uniform as is possible in
so vast a country as ours, will be embarrassed. By applying what has already been spelled out in
the opinions of this Court, I agree with the Court in reversing the judgment in Commissioner v.
Duberstein.
But I would affirm the decision of the Court of Appeals for the Second Circuit in Stanton v.
United States. I would do so on the basis of the opinion of Judge Hand and more particularly
because the very terms of the resolution by which the $20,000 was awarded to Stanton indicated
that it was not a “gratuity” in the sense of sheer benevolence but in the nature of a generous
lagniappe, something extra thrown in for services received though not legally nor morally required
to be given…. The business nature of the payment is confirmed by the words of the resolution,
explaining the “gratuity” as “in appreciation of the services rendered by Mr. Stanton as Manager
of the Estate and Comptroller of the Corporation of Trinity Church throughout nearly ten years,
and as President of Trinity Operating Company, Inc.” The force of this document, in light of all
the factors to which Judge Hand adverted in his opinion, was not in the least diminished by
testimony at the trial. Thus the taxpayer has totally failed to sustain the burden I would place upon
him to establish that the payment to him was wholly attributable to generosity unrelated to his
performance of his secular business functions as an officer of the corporation of the Trinity Church
of New York and the Trinity Operating Co. Since the record totally fails to establish taxpayer’s
claim, I see no need of specific findings by the trial judge.
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________________________________
Consequences of the Duberstein approach to gift
As noted earlier, the donor cannot deduct the value of a gift made to a friend or relative because
it is a personal expense under § 262, while the donee excludes the gift. This combination means
that the amount is taxed once between the donor/donee pair (through deduction denial for the
donor). The Court deferred to the trial court in Duberstein, concluding that Mr. Duberstein was
not entitled to exclude the Cadillac, only because of the trial court’s evaluation of the motive of
the donor established at trial. The Court knew, but appeared to be untroubled by the fact, that Mr.
Berman deducted the FMV of the Cadillac as a business expense under § 162, creating the
possibility that business income earned by Mr. Berman would go untaxed to anyone if the Cadillac
is also excluded by Mr. Duberstein. The government’s proposed rule would have avoided this
possibility, as it would have prevented exclusion by the recipient in the business context, ensuring
that—even with a business expense deduction by the donor—the amount would be taxed at leasdt
once between the two.
Congress reacted to Duberstein not by amending § 102 to prevent exclusion of business gifts
but by attempting to prevent deduction by the donor as a business expense by enacting § 274(b),
which you should read now. Section 274 is a Code section that does not authorize the taking of a
deduction (it does not contain the magic words “there shall be allowed as a deduction”) but rather
takes away an otherwise allowable deduction under some other Code section, such as § 162.
Section 274(b) would be unnecessary if the Duberstein Court had accepted the government’s
alternative interpretation of “gift” within the meaning of § 102.
Note that § 274(b) disallows a § 162 business expense deduction in excess of $25 for the
transferor only if the item is excludable by the transferee under § 102(a). 21 In the Duberstein
scenario, for example, § 274(b) is designed to try to ensure that Berman would effectively be taxed
on the value of the Cadillac by denying a deduction in excess of $25 if the transfer were truly a
“gift” that is excludable by Duberstein under § 102. But this outcome is not assured. There is no
joinder in tax. A donor like Berman might litigate before the Tax Court and convince the Tax
Court that the transfer was made to compensate for past services or as an incentive for future
economic benefits obtained from the recipient. At the same time, a recipient like Duberstein might
litigate before a District Court or the Court of Federal Claims and convince the trier of fact that
the donor’s intent was rooted in detached and disinterested generosity. The likelihood of the
government getting whipsawed is certainly reduced after enactment of § 274(b), but it is not
impossible. It has happened. 22
Are business donors likely to admit that they are making the transfer out of detached and
disinterested generosity, limiting themselves to a $25 deduction under § 274(b)? Will not the
Bermans of the world argue that the transfer is not a gift so that they can take a full § 162
deduction? How does this affect the ability of the donee to argue that the receipt is excludable
under § 102? Recall that the donor’s intention controls under Duberstein. If the donor refuses to
21

As an aside, the section is incoherently drafted because §§ 274(b)(1)(A) and (B) carves out from the term gift items
that could not qualify as gifts under the Duberstein test. Samples and promotional items are transferred for commercial
reasons, not out of detached and disinterested generosity, affection, respect, admiration, charity or like impulses.
22
Compare Estate of Carter v. Comm’r, 453 F.2d 61 (2d Cir. 1971) (allowing § 102(a) exclusion by the donee in a
year prior to enactment of § 274(b)) with Bank of Palm Beach & Trust Co. v. U.S., 476 F.2d 1343 (Ct. Cl. 1973)
(allowing a full business expense deduction for the donor on the same transfer).

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acknowledge that the transfer was a gift by limiting himself to a $25 deduction under §§ 162 and
274(b), can the donee persuasively argue that the donor’s intention was to make a gift?
On the other hand, how does the donee—or the trier of fact in the donee’s case—know whether
the donor took a full deduction? Personal tax return information is private and cannot be accessed
except in the taxpayer’s own litigation. And what if the donor is a tax-exempt entity, which does
not take tax deductions because it is exempt from paying income tax? Recall the facts in Stanton,
in which a church, which is a tax-exempt entity, made the payment.
Finally, notice that, in order for the § 274(b) deduction restriction to apply, the amount must
have been excluded by the recipient “under section 102, which is not excludable from his gross
income under any other provision of this chapter.” (Emphasis added.)
Problem
After turning age 65, Robert retired from his long-time job, and his employer presented him
with a gold watch at a retirement dinner. The watch cost the employer $200. While $200 might
not seem de minimis within the meaning of § 132(e), the 1984 legislative history accompanying
the enactment of § 132 gave as an example of an excludable de minimis fringe the gold watch
presented to an employee at his retirement, so Robert excludes the $200 value from his Gross
Income. How much can Robert’s employer deduct under § 162?
A Duberstein example and introduction of small tax case jurisdiction in the Tax Court
The case below arose under the Tax Court’s § 7463 “small tax case” jurisdiction. When a
deficiency of $50,000 or less, the taxpayer can elect to have the case heard under more informal
rules of procedure than otherwise apply. The cost of making this election is that the taxpayer
surrenders all appeal rights should she lose. 23 Many taxpayers using these simplified proceedings
represent themselves pro se, though not always. Ms. Yang was represented by counsel.
JUE-YA YANG v. COMMISSIONER
T.C. Summary Opinion 2008-156
GERBER, JUDGE: This case was heard pursuant to the provisions of section 7463 of the Internal
Revenue Code in effect when the petition was filed. Pursuant to section 7463(b), the decision to
be entered is not reviewable by any other court, and this opinion shall not be treated as precedent
for any other case. Respondent determined a $9,423 deficiency in Federal income tax and a $1,183
accuracy-related penalty under section 6662(a) for petitioner’s 2005 tax year. The deficiency
determination was based on unreported income adjustments of $40,000 and $10,500. Petitioner
conceded that the $40,000 amount was income, but she contends that the $10,500 amount was a
gift and not taxable as income. The sole issue for our consideration is whether the $10,500
petitioner received during 2005 was a gift or income.
Petitioner, Jue-Ya Yang, resided in California at the time her petition was filed. Petitioner met
Howard Shih through a mutual friend and they began dating. Mr. Shih earned his living as an artist
and calligrapher. Eventually, petitioner’s relationship with Mr. Shih became more intimate. She
moved into his home, and they cohabited. Petitioner did some housekeeping and cooking, but she
23

See § 7463(b).

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did not work for Mr. Shih under any form of written or oral contract for services. Petitioner did
not have any skill or experience in connection with Mr. Shih’s artistic endeavors.
During 2005 Mr. Shih gave petitioner checks totaling $10,500 to use for herself. Mr. Shih
reported to respondent by means of a Form 1099-MISC, Miscellaneous Income, that the $10,500
he paid to petitioner constituted wage income and, ostensibly, he deducted the payments for
purposes of computing his income for 2005. Relying on Mr. Shih’s filing of Form 1099-MISC,
respondent determined that petitioner had received income of $10,500.
The conclusion that a transfer amounts to a “gift” is one that must be reached on consideration
of all the factors and one that is left to the trier of facts. Comm’r v. Duberstein, 363 U.S. 278, 287289 (1960). In Duberstein, the Supreme Court set forth the following principles that underlie the
dichotomy between a gift and income:
This Court has indicated that a voluntarily executed transfer of his property by one
to another, without any consideration or compensation therefor, though a commonlaw gift, is not necessarily a “gift” within the meaning of the statute. For the Court has
shown that the mere absence of a legal or moral obligation to make such a payment
does not establish that it is a gift. And, importantly, if the payment proceeds primarily
from “the constraining force of any moral or legal duty,” or from “the incentive of
anticipated benefit” of an economic nature, it is not a gift. And, conversely, “[w]here
the payment is in return for services rendered, it is irrelevant that the donor derives no
economic benefit from it.” A gift in the statutory sense, on the other hand, proceeds
from a “detached and disinterested generosity,”; “out of affection, respect, admiration,
charity or like impulses.” And in this regard, the most critical consideration, as the
Court was agreed in the leading case here, is the transferor’s “intention.” * * *
Mr. Shih was romantically involved with Ms. Yang, and she moved into his home. There were
discussions of a formal engagement, and their relationship was intimate. Mr. Shih testified at the
trial and his testimony concerning his romantic relationship with Ms. Yang was evasive. Mr. Shih
was called by respondent and testified on direct examination that Ms. Yang had performed services
in his business in exchange for the payments made to her during 2005. On cross-examination,
however, after admitting that his relationship with Ms. Yang was more than a professional one,
Mr. Shih could not recall taking her out on dates or any intimacy in their relationship, even though
their relationship existed only a few years ago.
It is obvious that Mr. Shih and Ms. Yang have conflicting interests in the outcome of this
controversy and that their positions are diametrically opposed. Mr. Shih structured the payments
to Ms. Yang so that they appeared to be wages. He issued a Form W-2, Wage and Tax Statement,
and used the notation “salary” or “wages” on some of the checks used for payment. Ms. Yang,
however, was forthright in her testimony and answered all questions whether or not they favored
her position. On the other hand Mr. Shih professed to remember only those things that supported
his position that the payments were income to Ms. Yang. We find his testimony to be evasive and
untrue.
The facts show that Mr. Shih made payments totaling $10,500 to Ms. Yang with “detached and
disinterested generosity” out of his affection for her at the time of payment. We accordingly hold
that the $10,500 in payments made during 2005 was a gift and not reportable as income.
Ms. Yang conceded $40,000 in unreported income for 2005, and respondent has carried his
burden of production to establish that section 6662(a) applies with respect to that adjustment.

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Petitioner offered no evidence of reasonable cause with respect to her failure to report the $40,000
in income. Accordingly, we hold that petitioner is liable for an accuracy-related penalty under
section 6662(a) with respect to the $40,000 adjustment. Because we have decided that the $10,500
was a gift and not taxable, we need not address the accuracy-related penalty on that adjustment.
__________________________________
The Yang case also shows that an information return is not determinative of tax consequences.
Information returns are merely enforcement tools to alert the IRS of a possible understatement.
The possible limits of the Duberstein intent approach
Matthew is a veteran who lost a leg in Iraq. Wearing his uniform and telling his story in subway
stations in New York City, Matthew has learned that he can collect about $100,000 each year by
panhandling, and he has found that he enjoys this activity more than he would a 9 to 5 job. Even
if the motive of each and every person who gives him cash is “detached and disinterested
generosity,” should Matthew’s collected cash be excludable from Gross Income?
What about tips received by waiters in restaurants and so-called tokes received by casino dealers
in the Olk case, below? These amounts do not come from the employer but rather from customers
patronizing the establishment. Does Duberstein control the analysis of the receipt? Or is
Duberstein distinguishable? In what way? Should the motive or intent of the donor control when
receipts are not one-time events, as in Duberstein, but rather an expected part of the recipient’s
overall remuneration in making a living? If you were the appellate judge writing the opinion below,
could you have written it in a manner that reaches the same end result without struggling to fit the
facts within the confines of Duberstein? Is that struggle a bit artificial on these facts?
OLK v. UNITED STATES
536 F.2d 876 (9th Cir. 1976)
GOODWIN and SNEED, CIRCUIT JUDGES, and VAN PELT, DISTRICT JUDGE.
SNEED, CIRCUIT JUDGE: This is a suit to obtain a refund of Federal income taxes. The issue is
whether monies, called “tokes” in the relevant trade, received by the taxpayer, a craps dealer
employed by Las Vegas casinos, constitute taxable income or gifts within the meaning of section
102(a), INT. REV. CODE of 1954. The taxpayer insists “tokes” are non-taxable gifts. If he is right,
he is entitled to the refund for which this suit was brought. The trial court in a trial without a jury
held that “tokes” were gifts. The Government appealed and we reverse and hold that “tokes” are
taxable income.
There is no dispute about the basic facts, which explain the setting in which “tokes” are paid
and received. The district court's finding with respect to such facts which we accept are, in part, as
follows:
In 1971 plaintiff was employed as a craps dealer in two Las Vegas gambling casinos,
the Horseshoe Club and the Sahara Hotel. The basic services performed by plaintiff
and other dealers were described at trial. There are four persons involved in the
operation of the game, a boxman and three dealers. One of the three dealers, the
stickman, calls the roll of the dice and then collects them for the next shooter. The
other two dealers collect losing bets and pay off winning bets under the supervision of
the boxman. The boxman is the casino employee charged with direct supervision of

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the dealers and the play at one particular table. He in turn is supervised by the pit boss
who is responsible for several tables. The dealers also make change, advise the
boxman when a player would like a drink, and answer basic questions about the game
for the players.
Dealers are forbidden to fraternize or engage in unnecessary conversation with the
casino patrons and must remain in separate areas while on their breaks. Dealers must
treat all patrons equally, and any attempt to provide special service to a patron is
grounds for termination.
At times, players will give money to the dealers or place bets for them. The witnesses
testified that most casinos do not allow boxmen to receive money from patrons
because of their supervisory positions, although some do permit this. The pit bosses
are not permitted to receive anything from patrons because they are in a position in
which they can insure that a patron receives some special service or treatment.
The money or tokes are combined by the four dealers and split equally at the end of
each shift so that a dealer will get his share of the tokes received even while he is
taking his break. Uncontradicted testimony indicated that a dealer would be terminated
if he kept a toke rather than placed it in the common fund.
Casino management either required the dealers to pool and divide tokes or encouraged
them to do so. Although the practice is tolerated by management, it is not encouraged
since tokes represent money that players are not wagering and thus cannot be won by
the casino. Plaintiff received about $10 per day as his share of tokes at the Horseshoe
Club and an average of $20 per day in tokes at the Sahara. (footnotes omitted).
Additional findings of fact by the district court are that the taxpayer worked as a stickman and
dealer and at all times was under the supervision of the boxman who in turn was supervised by the
pit boss. Also the district court found that patrons sometimes give money to dealers, other players,
or mere spectators at the game but that between 90-95% of the patrons give nothing to a dealer.
No obligation on the part of the patron exists to give to a dealer and “dealers perform no service
for patrons which a patron would normally find compensable.” Another finding is that there exists
“no direct relation between services performed for management by a dealer and benefit or
detriment to the patron.”
There then follows two final “findings of fact” which taken together constitute the heart of the
controversy before us. These are as follows:
17. The tokes are given to dealers as a result of impulsive generosity or superstition
on the part of players, and not as a form of compensation for services.
18. Tokes are the result of detached and disinterested generosity on the part of a small
number of patrons.
These two findings, together with the others set out above, bear the unmistakable imprint of
Commissioner v. Duberstein, 363 U.S. 278 (1959) ….
The position of the taxpayer is simple. The above findings conform to the meaning of gifts as
used in section 102 of the Code. Duberstein further teaches, the taxpayer asserts, that whether a
receipt qualified as a non-taxable gift is “basically one of fact,” id. 363 U.S. at 290, and appellate
review of such findings is restricted to determining whether they are clearly erroneous. Because
none of the recited findings are clearly erroneous, concludes the taxpayer, the judgment of the trial
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court must be affirmed.
We could not escape this logic were we prepared to accept as a “finding of fact” the trial court's
finding number 18. We reject the trial court's characterization. The conclusion that tokes “are the
result of detached and disinterested generosity” on the part of those patrons who engage in the
practice of toking is a conclusion of law, not a finding of fact. Finding number 17, on the other
hand, which establishes that tokes are given as the result of impulsive generosity or superstition
on the part of the players is a finding of fact to which we are bound unless it is “clearly erroneous”
which it is not.
The distinction is between a finding of the dominant reason that explains the player’s action in
making the transfer and the determination that such dominant reason requires treatment of the
receipt as a gift. Finding number 17 is addressed to the former while number 18 the latter. A finding
regarding the basic facts, i.e., the circumstances and setting within which tokes are paid, and the
dominant reason for such payments are findings of fact, our review of which is restricted by the
clearly erroneous standard. Whether the dominant reason justifies exclusion from Gross Income
under section 102 as interpreted by Duberstein is a matter of law. Finding number 18 is a
determination that the dominant reason for the player’s action, as found in number 17, justifies
exclusion. This constitutes an application of the statute to the facts. Whether the application is
proper is, of course, a question of law.
Our view is supported by Judge Sobeloff's opinion in Poyner v. Commissioner, 301 F.2d 287
(4th Cir. 1962). He drew a line between the basic facts, the actual happenings, and a finding of the
“dominant reason” for the payments on the one hand and the determination whether the “dominant
reason” justified exclusion from Gross Income on the other. The latter requires an application of
the law to the facts and with respect to it the appellate court may make an independent judgment.
Id. at 290.
This is a sensible approach. Otherwise an appellate court’s inescapable duty of appellate review
in this type of case would be all but foreclosed by a finding, such as in number 18, in which the
resolution of the ultimate legal issue was disguised as a finding of fact. The error in insisting that
findings numbers 17 and 18 are both findings of fact with respect to the “dominant reason” is
revealed when the language of finding number 18 is compared with Duberstein's statement, “A
gift in the statutory sense, on the other hand, proceeds from a ‘detached and disinterested
generosity,’ Comm’r v. LoBue, 351 U.S. 243, 246; ‘out of affection, respect, admiration, charity
or like impulses.’” 363 U.S. at 285. Their similarity is not coincidental and demonstrates that
finding number 18 is but an application of the statutory definition of a gift to all previous findings
of fact including finding number 17. Number 18 merely characterizes all previous findings in a
manner that makes classification of the receipt as a gift inevitable. “Detached and disinterested
generosity” are, by reason of Duberstein, the operative words of the statutory definition of a gift.
To apply them to facts, including a finding with respect to “dominant motive,” is to apply the
statute to such facts. It is a conclusion of law.
Freed of the restraint of the “clearly erroneous” standard, we are convinced that finding number
18 and all derivative conclusions of law are wrong. “Impulsive generosity or superstition on the
part of the players” we accept as the dominant motive. In the context of gambling in casinos open
to the public such a motive is quite understandable. However, our understanding also requires us
to acknowledge that payments so motivated are not acts of “detached or disinterested generosity.”
Quite the opposite is true. Tribute to the gods of fortune which it is hoped will be returned
bounteously soon can only be described as an “involved and intensely interested” act.
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Moreover, in applying the statute to the findings of fact, we are not permitted to ignore those
findings which strongly suggest that tokes in the hands of the ultimate recipients are viewed as a
receipt indistinguishable, except for erroneously anticipated tax differences, from wages. The
regularity of the flow, the equal division of the receipts, and the daily amount received indicate
that a dealer acting reasonably would come to regard such receipts as a form of compensation for
his services. The manner in which a dealer may regard tokes is, of course, not the touchstone for
determining whether the receipt is excludable from Gross Income. It is, however, a reasonable and
relevant inference well-grounded in the findings of fact.
Our view of the law is consistent with the trend of authorities in the area of commercial
gratuities as well as with the only decision squarely in point, Lawrence E. Bevers, 26 T.C. 1218
(1956), and this Circuit's view of tips as revealed in Roberts v. Commissioner, 176 F.2d 221 (9th
Cir. 1949). Generalizations are treacherous but not without utility. One such is that receipts by
taxpayers engaged in rendering services contributed by those with whom the taxpayers have some
personal or functional contact in the course of the performance of the services are taxable income
when in conformity with the practices of the area and easily valued. Tokes, like tips, meet these
conditions. That is enough.
The taxpayer is not entitled to the refund he seeks. REVERSED.
____________________________________
The relationship between § 61 and exclusion provisions
The introductory language to § 61—“[e]xcept as otherwise provided by this subtitle”—reminds
us of the relationship between § 61 and provisions that authorize an exclusion from Gross Income.
Taxpayers need not search for an exclusion provision, such as § 102, if the receipt does not rise to
the level of § 61 Gross Income in the first place.
Recall Mr. Gotcher from Chapter 6, who received in-kind consumption that was not
compensation (specifically includable under § 61(a)(1)), a dividend (§ 61(a)(7)), rent (§ 61(a)(5)),
a prize (§ 74), or any other receipt that Congress specifically mandated must be included in Gross
Income without regard to the form taken (whether in cash or in kind). Whether the in-kind
consumption had to be valued and included in his Gross Income turned solely on whether it rose
to the level of Gross Income under the residual clause in § 61—“Gross Income means all income
from whatever source derived”—as construed in Glenshaw Glass. The Gotcher court concluded
that Mr. Gotcher’s trip did not constitute residual clause income because the trip primarily
benefited VW Germany, who was hoping to convince Mr. Gotcher to invest in a VW dealership.
In other words, VW Germany’s spending was in pursuit of its own business objectives. Notice,
therefore, that the very reasoning that permitted Mr. Gotcher to avoid a Gross Income inclusion
under § 61 would have prevented him from excluding the receipt as a gift under § 102 had the
receipt otherwise constituted Gross Income. VW Germany clearly did not provide the trip to Mr.
Gotcher out of detached and disinterested generosity. Rather, VW Germany provided the trip
because it hoped for an economic benefit by convincing Mr. Gotcher to invest in a VW dealership.
Similarly, recall the Oscar and Emmy goody bags provided to presenters, also described in
Chapter 6. As noted in the article, if the receipts rose to the level of Gross Income in the first place,
§ 102 exclusion surely would not be available, as the businesses providing those goodies to the
presenters did so because of the anticipated advertising effect that they would enjoy when the stars
paraded around wearing the jewelry and the like. If the provider is transferring the property and

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services for its own business reasons to the presenters, however, would not that mean that the
receipts fail to rise to the level of Gross Income in the first place under the residual clause? Perhaps
these outcomes are explained by concluding that what the stars received were simple prizes
(specifically includable under § 74) or compensation (specifically includable under § 61(a)(1)) so
that the residual clause and Gotcher are irrelevant.
What are we to make of the fact that § 102 provides exclusion authorization only for the receipt
of “property” (which would encompass cash) but makes no mention of services, such as a free
trip? If your friend pays for your birthday trip to Bruges, Belgium, out of detached and disinterested
generosity, do you lose the § 102 exclusion because the object of the gift was not property? Clearly
not. Under the Old Colony Trust two-step, the free trip is, in substance, analyzed as the deemed
receipt of cash (clearly property) followed by the donee’s purchase of the trip.
Final thoughts
Finally, recall from Chapter 1 that one difference between a pure wealth tax and a pure SHS
income tax is that the former taxes a dollar of wealth to the same taxpayer again and again while
the latter taxes a dollar of wealth to the same taxpayer only once—in the year realized. Under the
direct tax clause of Article 1, § 9, clause 4, which you read about in Chapter 3, an annual wealth
tax would be required to be apportioned among the states according to population. Because such
an apportionment would be unworkable, an annual wealth tax without apportionment would likely
require a constitutional amendment, making it improbable (if not impossible). 24 The estate and gift
taxes, which are not imposed annually but rather only once on the act of transferring wealth, are
indirect excise taxes (on the act of transfer) that escape the apportionment requirement. As noted
earlier, however, the combination of the realization requirement, § 1014, and the high estate and
gift tax exemption amount means that a good deal of wealth is never taxed to either the donor or
donee under either the income tax or wealth transfer taxes.

C. Life insurance proceeds received on death of the insured
Section 101(a)(1) generally excludes the proceeds of life insurance received by reason of the
death of the insured, even though the receipt is clearly a wealth accession for the recipient. Just as
a donor cannot deduct a gift because it is a personal expense under § 262, the person who pays life
insurance premiums generally cannot deduct this personal expense, though businesses who take
out a life insurance policy with respect to a key employee (such as the CEO) can usually deduct
the cost as a business expense under § 162. Indeed, the tax-free nature of the proceeds on death
has caused a dramatic expansion of this corporate practice, with some businesses taking out life
insurance policies on most or all of their employees—not just key employees—sometimes referred
to as “janitors” or “peasants” insurance. The company may collect only decades later when the
insured is no longer even employed by the company.
Is the § 101(a)(1) exclusion justified?
The rationale underlying the § 101(a)(1) exclusion is just as cloudy as that underlying § 102(a)
but was likely premised on the same dated “capital receipts” analysis discussed earlier. That is to
say, the lump sum, nonperiodic receipt was not considered income but rather a capital receipt that,
24

But see John T. Plecnik, The New Flat Tax: A Modest Proposal for a Constitutionally Apportioned Wealth Tax, 41
HASTINGS CONST. L.Q. 483 (2014) (describing a possible way to implement a wealth tax that could satisfy the
apportionment requirement).

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once invested, would produce future income under old-fashioned, Victorian-era analysis. Perhaps
it survives today by analogy to a bequest made through the vehicle of an insurance company. Does
the bequest-like nature ring true, however, in the case of janitors insurance?
Sales of life insurance policies to investors
Does the bequest-like nature ring true if an owner of a life insurance policy on his or her own
life sells it to Ian Investor—or a company formed by Ian Investor “at the forefront of a
controversial but rapidly growing industry,” as described below?
In an arrangement known as a “life settlement,” [the settlement company] pays the
holder a lump sum for the policy now, takes over paying the premiums for as long as
the insured person lives, then collects the benefits—generally worth far more—when
the person dies. [The company] keeps some of the policies in its own portfolio. It sells
others to institutional investors. From an investor’s standpoint, as a general rule, the
sooner these people die, the better.
…
The life-insurance market was once even more freewheeling. In 18th-century England,
people took out policies on prominent figures in ill health. The practice was eventually
deemed gambling. It led to laws like those in U.S. states today, which generally require
that the person who takes out a policy have an established relationship at the time with
the insured. Once purchased, however, the policy is considered property of the
policyholder, who is free within certain limits to use it at will. That includes selling to
someone else the rights to collect the benefits.
…
In conferences in recent years, investment banks and ratings agencies have discussed
bundling life-insurance policies into securities they can sell to pensions or hedge
funds, much as mortgages have been packaged for years. 25
When the policy purchaser receives the death benefits, can the purchaser exclude the entire
proceeds? See § 101(a)(2).
Problems
1. Bea owns a life insurance policy on which she paid premiums for many years. Upon her
death at age 89, her daughter Beulah collects $500,000. How much must Beulah include in Gross
Income?
2. At age 74, Bea needs money and sells her life insurance policy to Investor for $100,000, who
continues to pay premiums totaling $50,000 before Bea dies at age 89 and Investor collects
$500,000 (instead of Beulah). How much must Investor include in Gross Income?

25

Liam Pleven & Rachel Emma Silverman, An Insurance Man Builds a Lively Business in Death, at
http://online.wsj.com/news/articles/SB119604142916903531.

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Chapter 8: Income Shifting
in the Happy and Fractured Family
In Chapter 7, you learned that the making of a cash gift or bequest—funded from, say, wages
earned by the donor—does not succeed in shifting income tax liability from the donor to the donee.
The amount transferred by the donor is a nondeductible personal expense under § 262(a), and the
receipt by the donee is excludable from Gross Income under § 102(a). The wages earned to fund
the cash gift are effectively taxed to the donor at the donor’s tax rates (rather than to the donee at
the donee’s tax rates).
On the other hand, built-in gain (i.e., unrealized § 1001 gain) in property will be shifted to
another if the property is transferred by inter vivos gift because (1) the gift, itself, is not a realization
event for the donor and (2) § 1015 generally provides for a carryover basis in the hands of the
donee. Built-in gain will effectively be shifted to the donee and taxed at the donee’s (possibly
lower) marginal rate when realized (unless, of course, the donee retains the property until death,
at which time the built-in gain will be laundered out under § 1014). 1
This ability for propertied families to engage in income shifting more readily than families
whose chief source of income is from labor is a theme carried forward in this chapter, which
considers additional possibilities for income shifting or splitting in both the happy and fractured
family, as well as reactions by both Congress and the courts to such attempts.
Two reasons explain why income shifting or splitting can reduce the aggregate tax paid. First,
the income may be taxed at a lower rate if successfully shifted to a family member for whom the
income will be marginal (last) dollars in a rate bracket that is lower than the transferor’s marginal
rate bracket. Second, the ability to split income between two (or more) taxpayers for tax purposes
may mean that the lower brackets can effectively be used twice rather than only once, as would
occur if the entire amount must be included by only one taxpayer. Part A. considers income
splitting via the joint return, Part B. considers other income-shifting possibilities in the intact
family, and part C. considers the income-shifting possibilities in divorce, a context in which major
changes were made in the Tax Cuts and Jobs Act of 2017.

A. Income splitting via the joint return
The place to start is Lucas v. Earl.
LUCAS v. EARL
281 U.S. 111 (1930)
MR. JUSTICE HOLMES delivered the opinion of the Court.
This case presents the question whether the respondent, Earl, could be taxed for the whole of
the salary and attorney’s fees earned by him in the years 1920 and 1921, or should be taxed for
1

We also saw, however, that the § 1015 basis rule for inter vivos gifts prevents built-in loss from being effectively
shifted to a donee in a higher marginal rate bracket.

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only a half of them in view of a contract with his wife which we shall mention. The Commissioner
of Internal Revenue and the Board of Tax Appeals imposed a tax upon the whole, but their decision
was reversed by the Circuit Court of Appeals. A writ of certiorari was granted by this Court.
By the contract, made in 1901, Earl and his wife agreed “that any property either of us now has
or may hereafter acquire … in any way, either by earnings (including salaries, fees, etc.), or any
rights by contract or otherwise, during the existence of our marriage, or which we or either of us
may receive by gift, bequest, devise, or inheritance, and all the proceeds, issues, and profits of any
and all such property shall be treated and considered and hereby is declared to be received, held,
taken, and owned by us as joint tenants, and not otherwise, with the right of survivorship.”
The validity of the contract is not questioned, and we assume it to be unquestionable under the law
of the State of California, in which the parties lived. Nevertheless we are of opinion that the
Commissioner and Board of Tax Appeals were right.
The Revenue Act of 1918 approved February 24, 1919, c. 18, §§ 210, 211, 212 (a), 213 (a), 40
Stat. 1057, 1062, 1064, 1065, imposes a tax upon the net income of every individual including
“income derived from salaries, wages, or compensation for personal service … of whatever kind
and in whatever form paid,” § 213(a). The provisions of the Revenue Act of 1921, c. 136, 42 Stat.
227, in sections bearing the same numbers are similar to those of the above. A very forcible
argument is presented to the effect that the statute seeks to tax only income beneficially received,
and that taking the question more technically the salary and fees became the joint property of Earl
and his wife on the very first instant on which they were received. We well might hesitate upon
the latter proposition, because however the matter might stand between husband and wife he was
the only party to the contracts by which the salary and fees were earned, and it is somewhat hard
to say that the last step in the performance of those contracts could be taken by anyone but himself
alone. But this case is not to be decided by attenuated subtleties. It turns on the import and
reasonable construction of the taxing act. There is no doubt that the statute could tax salaries to
those who earned them and provide that the tax could not be escaped by anticipatory arrangements
and contracts however skillfully devised to prevent the salary when paid from vesting even for a
second in the man who earned it. That seems to us the import of the statute before us and we think
that no distinction can be taken according to the motives leading to the arrangement by which the
fruits are attributed to a different tree from that on which they grew.
Judgment reversed.
_________________________________
At the time of Lucas v. Earl, there was only one Federal income tax rate schedule that was used
by all taxpayers, including married individuals, who filed separate tax returns. If the attempted
assignment of income from Mr. Earl to Mrs. Earl of one-half of his wages had been successful for
income tax purposes, why would the aggregate tax paid between them have been lower than if, as
held, the attempted assignment of income had no effect for tax purposes?
While I sometimes edit opinions to make them shorter for student digestion, I did not edit Justice
Holmes’s opinion at all. Can you figure out why, precisely, Mr. Earl’s assignment of income to
his wife—while assumed to be valid under state contract law—did not shift the Federal income
tax burden on that assigned income to his wife? Could Guy Earl and his wife have executed the
contract with the intent of reducing their aggregate Federal income liability? When was this
contract signed? Recall from Chapter 3 that the 16th amendment was ratified in 1913 and that the
first income tax was enacted in the same year.

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Lucas v. Earl and Poe v. Seaborn, though decided in the very same term of Court, came to very
different outcomes. Why?
POE v. SEABORN
282 U.S. 101 (1930)
MR.JUSTICE ROGERTS delivered the opinion of the Court.
Seaborn and his wife, citizens and residents of the State of Washington, made for the year 1927
separate income tax returns. During and prior to 1927 they accumulated property comprising real
estate, stocks, bonds and other personal property. While the real estate stood in his name alone, it
is undisputed that all of the property real and personal constituted community property and that
neither owned any separate property or had any separate income.
The income comprised Seaborn’s salary, interest on bank deposits and on bonds, dividends, and
profits on sales of real and personal property. He and his wife each returned one-half the total
community income as Gross Income and each deducted one-half of the community expenses to
arrive at the net income returned.
The Commissioner of Internal Revenue determined that all of the income should have been
reported on the husband’s return, and made an additional assessment against him. Seaborn paid
under protest, claimed a refund, and on its rejection, brought this suit. The District Court rendered
judgment for the plaintiff; the Collector appealed, and the Circuit Court of Appeals certified to us
the question whether the husband was bound to report for income tax the entire income, or whether
the spouses were entitled each to return one-half thereof. This Court ordered the whole record to
be sent up.
The case requires us to construe Sections 210(a) and 211(a) of the Revenue Act of 1926 [the
predecessor to current § 1] and apply them, as construed, to the interests of husband and wife in
community property under the law of Washington. These sections lay a tax upon the net income
of every individual. The Act goes no farther, and furnishes no other standard or definition of what
constitutes an individual’s income. The use of the word “of” denotes ownership. It would be a
strained construction, which, in the absence of further definition by Congress, should impute a
broader significance to the phrase.
The Commissioner concedes that the answer to the question involved in the cause must be found
in the provisions of the law of the State, as to a wife’s ownership of or interest in community
property. What, then, is the law of Washington as to the ownership of community property and of
community income, including the earnings of the husband’s and wife’s labor?
The answer is found in the statutes of the State, and the decisions interpreting them. These
statutes provide that, save for property acquired by gift, bequest, devise or inheritance, all property
however acquired after marriage, by either husband or wife, or by both, is community property.
On the death of either spouse his or her interest is subject to testamentary disposition, and failing
that, it passes to the issue of the decedent and not to the surviving spouse. While the husband has
the management and control of community personal property and like power of disposition thereof
as of his separate personal property, this power is subject to restrictions which are inconsistent
with denial of the wife’s interest as co-owner. The wife may borrow for community purposes and
bind the community property (Fielding v. Ketler, 86 Wash. 194). Since the husband may not
discharge his separate obligation out of community property, she may, suing alone, enjoin

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collection of his separate debt out of community property (Fidelity & Deposit Co. v. Clark, 144
Wash. 520). She may prevent his making substantial gifts out of community property without her
consent (Parker v. Parker, 121 Wash. 24). The community property is not liable for the husband’s
torts not committed in carrying on the business of the community (Schramm v. Steele, 97 Wash.
309). The books are full of expressions such as “the personal property is just as much hers as his”
(Marston v. Rue, 92 Wash. 129); “her property right in it [an automobile] is as great as his” (92
Wash. 133); “the title of one spouse … was a legal title as well as that of the other” (Mabie v.
Whittaker, 10 Wash. 656, 663).
Without further extending this opinion it must suffice to say that it is clear the wife has, in
Washington, a vested property right in the community property, equal with that of her husband;
and in the income of the community, including salaries or wages of either husband or wife, or both.
A description of the community system of Washington and of the rights of the spouses, and of the
powers of the husband as manager, will be found in Warburton v. White, 176 U.S. 484.
The taxpayer contends that if the test of taxability under Sections 210 and 211 is ownership, it
is clear that income of community property is owned by the community and that husband and wife
have each a present vested one-half interest therein.
The Commissioner contends, however, that we are here concerned not with mere names, nor
even with mere technical legal titles; that calling the wife’s interest vested is nothing to the
purpose, because the husband has such broad powers of control and alienation, that while the
community lasts, he is essentially the owner of the whole community property, and ought so to be
considered for the purposes of Sections 210 and 211. He points out that as to personal property the
husband may convey it, may make contracts affecting it, may do anything with it short of
committing a fraud on his wife’s rights. And though the wife must join in any sale of real estate,
he asserts that the same is true, by virtue of statutes, in most States which do not have the
community system. He asserts that control without accountability is indistinguishable from
ownership, and that since the husband has this, quoad community property and income, the income
is that “of” the husband under Sections 210-211 of the income tax law.
We think, in view of the law of Washington above stated, this contention is unsound. The
community must act through an agent. This Court has said with respect to the community property
system (Warburton v. White, 176 U.S. 494) that “property acquired during marriage with
community funds became an acquet of the community and not the sole property of the one in
whose name the property was bought, although by the law existing at the time the husband was
given the management, control and power of sale of such property. This right being vested in him,
not because he was the exclusive owner, but because by law he was created the agent of the
community.”
In that case, it was held that such agency of the husband was neither a contract nor a property
right vested in him, and that it was competent to the legislature which created the relation to alter
it, to confer the agency on the wife alone, or to confer a joint agency on both spouses, if it saw
fit—all without infringing any property right of the husband.
The reasons for conferring such sweeping powers of management on the husband are not far to
seek. Public policy demands that in all ordinary circumstances, litigation between wife and
husband during the life of the community should be discouraged. Lawsuits between them would
tend to subvert the marital relation. The same policy dictates that third parties who deal with the
husband respecting community property shall be assured that the wife shall not be permitted to

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nullify his transactions. The powers of partners, or of trustees of a spendthrift trust, furnish apt
analogies.
The obligations of the husband as agent of the community are no less real because the policy
of the State limits the wife’s right to call him to account in a court. Power is not synonymous with
right. Nor is obligation coterminous with legal remedy. The law’s investiture of the husband with
broad powers, by no means negatives the wife’s present interest as a co-owner. We are of opinion
that under the law of Washington the entire property and income of the community can no more
be said to be that of the husband, than it could rightly be termed that of the wife….
The Commissioner urges that we have, in principal, decided the instant question in favor of the
Government. He relies on United States v. Robbins, 269 U.S. 315, and Lucas v. Earl, 281 U.S.
111.
In the Robbins case, we found that the law of California, as construed by her own courts, gave
the wife a mere expectancy and that the property rights of the husband during the life of the
community were so complete that he was in fact the owner. Moreover, we there pointed out that
this accorded with the executive construction of the Act as to California.
In the Earl case a husband and wife contracted that any property they had or might thereafter
acquire in any way, either by earnings (including salaries, fees, etc.), or any rights by contract or
otherwise, “shall be treated and considered and hereby is declared to be received held taken and
owned by us as joint tenants ….” We held that, assuming the validity of the contract under local
law, it still remained true that the husband’s professional fees, earned in years subsequent to the
date of the contract, were his individual income, “derived from salaries, wages, or compensation
for personal services” under §§ 210, 211, 212(a) and 213 of the Revenue Act of 1918. The very
assignment in that case was bottomed on the fact that the earnings would be the husband’s
property, else there would have been nothing on which it could operate. That case presents quite a
different question from this, because here, by law, the earnings are never the property of the
husband, but that of the community.
Finally the argument is pressed upon us that the Commissioner’s ruling will work uniformity
of incidence and operation of the tax in the various states, while the view urged by the taxpayer
will make the tax fall unevenly upon married people. This argument cuts both ways. When it is
remembered that a wife’s earnings are a part of the community property equally with her
husband’s, it may well seem to those who live in states where a wife’s earnings are her own, that
it would not tend to promote uniformity to tax the husband on her earnings as part of his income.
The District Court was right in holding that the husband and wife were entitled to file separate
returns, each treating one-half of the community income as his or her respective income, and its
judgment is
________________________________
Poe v. Seaborn is often criticized because the wife had almost no legal rights under the
community property law in Washington at the time except in the case of gross mismanagement by
the husband. Nevertheless, the decision remains good law for two propositions: (1) income earned
by an agent (the husband in this case) is properly allocable to the principal (the marital community)
and (2) state community property law governs the determination of the extent to which income is
considered to be community property for Federal income tax purposes, rather than the separate
property of one of the spouses.

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Recall that the Earls lived in California, which is also (like Washington) a community property
state. Under Poe v. Seaborn, therefore, should not the Earls have been permitted to split Guy Earl’s
labor earnings on their individual income tax returns? Note the Poe v. Seaborn Court’s description
of the Robbins case, which described California’s community property law at that time as creating
no more than a mere “expectancy” in the wife. Under proposition (2), above, we can now explain
more fully why the Lucas v. Earl Court prohibited income splitting even though the Earls lived in
a community property state: Mr. Earl’s salary income was considered to be his separate property
under California community property law at the time. So why did the Earls enter into their 1901
contract? Apparently, they did so as an estate planning device in an attempt to permit the property
to pass at death outside probate. 2
Another example of labor income that is properly allocable to the principal and not included in
the Gross Incomes of its agents is a fee earned for legal services provided by a supervising lawyer
and students working in a law school clinic. The IRS ruled in Revenue Ruling 74-581 3 that a
university’s law school attorney-faculty members and students are not required to include in their
Gross Incomes amounts earned with respect to their court-appointed representation of indigent
defendants while participating in the university’s clinical program. Under the clinic program, the
University had the legal right to these fees, not the faculty members or students. (Moreover,
because the university is a tax-exempt organization, the fees would not likely be taxed to the
principal on these facts, either.) In contrast, a nun working in a clinic as a nurse-midwife must
include her wages in Gross Income, even though she signs her paychecks over to her religious
order under her vow of poverty. 4 Both the Tax Court and 7th Circuit rejected her contention that
her work was performed as an agent of her religious order because the order had no day-to-day
control over her work and because her failure to insist on direct payment to her order undermined
her argument that she was working as an agent of the order. She accepted the paychecks as an
individual and then signed them over to the order. 5
Notice that the income in Poe v. Seaborn consisted not only of labor income, as in Earl, but
also of property income. Poe v. Seaborn also announced a third proposition: property income is
taxed to the owner of the property (here, the marital community). The Court further developed this
idea in subsequent cases, discussed in Part B.
Perhaps the real reason why the same court that decided Lucas v. Earl was comfortable with
the income splitting of the services income in Poe v. Seaborn is the pragmatic one that the income
splitting in the former resulted from arrangements made by the taxpayers—which looks
manipulative even though the particular arrangement in that case was not done for income tax
purposes—whereas the income splitting in the latter arose from a state law that had nothing to do
with taxes, regardless of whether the taxpayers wanted to split their income, etc.
Buttressing this inference is the Court’s 1944 decision in Commissioner v. Harmon. 6 Recall
2

My thanks go to Professor Patricia Cain for this information and insight.
1974-2 C.B. 25.
4
Schuster v. Comm’r, 800 F.2d 672 (7th Cir. 1986).
5
Because the nun had to include her wages in Gross Income, she would be entitled to deduct the amount contributed
to her order under § 170, pertaining to charitable contributions. As you will learn when we study § 170 in Chapter
17, however, no more than 60% of AGI can be offset by cash charitable contributions (50% at the time of this case).
Her failure to avoid inclusion under an agency theory meant that approximately half of her wages were subject to
income taxation, notwithstanding her contribution. If she had succeeded in her agency argument, none of the wages
would have been taxed because religious orders are also tax-exempt entities.
6
323 U.S. 44.
3

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from Chapter 3 that the income tax went from being a “class tax” paid mainly by the top 1% of
income earners to a “mass tax” paid by a majority of households with the skyrocketing revenue
needs of WWII. With many more households subject to the income tax, some common law states
(so called because they do not adopt the statutory community property legal regime) tried to garner
their residents the same income-splitting benefits enjoyed by married couples in community
property states by enacting an optional or elective community property regime. When Oklahoma
did so, the Harmon Court rejected the subsequent income splitting under the optional new law.
Here is an excerpt from that decision.
On July 29, 1939, Oklahoma adopted a community property law operative only if and
when husband and wife elect to avail of its provisions. In conformity to the
requirements of the statute, the respondent and his wife filed, October 26, 1939, a
written election to have the law apply to them. From November 1 to December 31,
1939, they received income consisting of his salary, dividends from his stocks,
dividends from her stocks, interest on obligations due him, distribution of profits of a
partnership of which he was a member, and oil royalties due to each of them. The Act
constitutes all of these receipts community income. The taxpayer and his wife filed
separate income tax returns for 1939 in which each reported one half of the November
and December income.
Under Lucas v. Earl an assignment of income to be earned or to accrue in the future,
even though authorized by state law and irrevocable in character, is ineffective to
render the income immune from taxation as that of the assignor. On the other hand, in
those states which, by inheritance of Spanish law, have always had a legal community
property system, which vests in each spouse one half of the community income as it
accrues, each is entitled to return one half of the income as the basis of Federal income
tax. Communities are of two sorts,—consensual and legal. A consensual community
arises out of contract. It does not significantly differ in origin or nature from such a
status as was in question in Lucas v. Earl, where by contract future income of the
spouses was to vest in them as joint tenants. In Poe v. Seaborn, supra, the court was
not dealing with a consensual community but one made an incident of marriage by the
inveterate policy of the State.
In Oklahoma, prior to the passage of the community property law, the rules of the
common law … represented the settled policy of the State concerning the relation of
husband and wife. A husband’s income from earnings was his own; that from his
securities was his own. The same was true of the wife’s income. Prior to 1939,
Oklahoma had no policy with respect to the artificial being known as a community.
Nor can we say that, since that year, the State has any new policy, for it has not
adopted, as an incident of marriage, any legal community property system. The most
that can be said is that the present policy of Oklahoma is to permit spouses, by contract,
to alter the status which they would otherwise have under the prevailing property
system in the State.
Such legislative permission cannot alter the true nature of what is done when husband
and wife, after marriage, alter certain of the incidents of that relation by mutual
contract. Married persons in many noncommunity states might, by agreement, make a
similar alteration in their prospective rights to the fruits of each other’s labors or
investments, as was done in Lucas v. Earl. This would seem to be possible in every

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State where husband and wife are permitted freely to contract with each other
respecting property thereafter acquired by either.
Thereafter, equal-income, one-earner married couples were treated very differently for Federal
income tax purposes, depending on whether they lived in a community property state or a common
law state. As already noted, before 1948, there was only one tax rate schedule applicable to all
filers, whether married or single. To illustrate, let’s assume (for the sake of simplicity) that this
rate schedule contained only two tax rates: 10% on income up to and including $40,000 and 20%
on income exceeding $40,000. Greg earned a $60,000 salary and was married to Greta, who did
not work outside the home. Because Greg and Greta lived in Washington State, the community
property state at issue in Poe v. Seaborn, each filed a tax return including $30,000, or one-half of
Greg’s aggregate $60,000 salary. Because they each were able to use the lower 10% rate bracket,
they each owed $3,000 in tax, for an aggregate tax liability between the two of them of $6,000.
George and Jenna, in contrast, lived in a common law state. As with Greg and Greta, George
earned a $60,000 salary and Jenna did not work outside the home. George was required to include
his entire $60,000 salary on his own return, and Jenna included nothing on hers. George owed
$8,000 in tax: $4,000 on the first $40,000 (10% of $40,000) and $4,000 on the remaining $20,000
(20% of $20,000). In short, George and Jenna owed $2,000 more in Federal income tax than did
Greg and Greta, even though both husbands earned the same $60,000 salary (and neither wife
earned income outside the home).
The resulting perceptions of unfairness led Congress to enact a second tax rate schedule in 1948
applicable to married couples filing jointly, which effectively provided couples in common law
states the same income-splitting benefits enjoyed by married couples in community property states.
The new 1948 joint return schedule was designed so that married couples would pay twice the tax
of a single taxpayer earning one-half of the couple’s aggregate taxable income. Under the new
joint return rate schedule, George and Jenna would owe the same $6,000 tax owed by Greg and
Greta, equal to twice the $3,000 tax that a single taxpayer would owe on $30,000 of taxable income
(one-half of the couple’s aggregate $60,000 income).
While the new rate schedule equalized the treatment among married couples with the same
aggregate income, regardless of whether they lived in a community property state or common law
state, it introduced a new “singles penalty” for individuals earning the same income as the oneearner spouse. While George and Jenna would owe only $6,000 in tax on George’s $60,000 salary
under the new joint return rate schedule, Jim would owe $8,000 in tax on the same $60,000 salary
(under the old rate schedule, now limited to unmarried individuals). Put another way, George and
Jenna enjoyed a “marriage bonus” that Jim was denied. The Jims of the world were unhappy.
Enter 1969. “As a result of this basic rate structure, by 1969, an individual with the same income
as a married couple could have had a tax liability as much as 40 percent higher than that of the
married couple. To address this perceived inequity, which was labeled a ‘singles penalty’ by some
commentators, a special rate schedule was introduced for single taxpayers (leaving the old
schedule solely for married individuals filing separate returns). The bracket breakpoints and
standard deduction amounts for single taxpayers were set at about 60 percent of those for married
couples filing joint returns.” 7 Whereas there was only one tax rate schedule applicable to all
taxpayers in 1947, after 1969 there were four: (1) unmarried individuals (enacted in 1969), (2)
married couples filing a joint return (enacted in 1948), (3) married filing separate returns (the pre7

JOINT COMMITTEE ON TAXATION, PRESENT LAW AND BACKGROUND RELATING TO PROPOSALS TO REDUCE THE
MARRIAGE TAX PENALTY, JCS-1-98 (Jan. 27, 1998), at www.jct.gov/publications.html?func=fileinfo&id=2935.

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1948 schedule) and (4) head of household. 8 Today, the tax schedule for married couples filing
separately contains rate bracket thresholds and ceilings that are precisely one-half those found in
the rate schedule for married couples filing jointly. 9
As no good deed goes unpunished, the new 1969 rate schedule for unmarried individuals
created a new “marriage penalty” for two-earner couples in which each spouse earned nearly
equivalent income. A married couple in which each of the husband and wife earned $30,000 owed
more in tax under the 1969 rate schedule for a married couple filing jointly (or under the schedule
for married couples filing separately) than would Jim, a single individual earning $60,000.
While two-earner married couples with equivalent incomes were rather rare in the 1960s, they
became increasingly common by the early 1980s. In 1981, therefore, Congress enacted a new
deduction for two-earner married couples equal to 10% of the lesser of (1) the lower-earning
spouse’s income or (2) $3,000, which means that the maximum deduction for two-earner couples
was $3,000. When rates were dramatically flattened in the Tax Reform Act of 1986 (with the top
marginal rate reduced from 50% to 28%, as described in Chapter 3), the two-earner deduction was
repealed, as the rate-flattening reduced the marriage penalty for two-earner couples substantially,
if not entirely, for most couples.
By 1997, however, marriage bonuses and penalties were the talk of the town again, with the top
marginal tax rate at 39.6%. Most commentary focused on the marriage penalty for two-earner
couples with substantially equivalent earnings, but more married couples enjoyed a marriage bonus
than suffered a marriage penalty, and more revenue was lost under the marriage bonus than was
paid under the marriage penalty. As a CBO study documented:
Measured as a percentage of income, marriage penalties and bonuses are largest for
low-income families and least for high-income families…. An estimated 42 percent of
couples incurred marriage penalties in 1996, 51 percent received bonuses, and 6
percent paid taxes unaffected by their marital status…. One-earner couples received
seven-eighths of the total of bonuses in 1996 but represented less than one-half of all
couples. 10
Across all married couples in 1996, for example, $28.8 billion was projected to be paid in marriage
penalties, while $32.9 billion was projected to be saved in marriage bonuses, for a net revenue loss
to the Treasury of slightly more than $4 billion compared to a system in which all taxpayers filed
8
Congress added this additional rate schedule in 1951, which provided to unmarried individuals with dependents
(often divorced women) approximately one-half of the benefit enjoyed by married couples via the joint return. This
rate schedule was sometimes referred to as providing a “divorce bonus.” See, e.g., JOINT COMMITTEE ON TAXATION,
THE INCOME TAX TREATMENT OF MARRIED COUPLES AND SINGLE PERSONS: A REPORT, JCS-17-80 (April 2, 1980), at
www.jct.gov/publications.html?func=startdown&id=3888. With the 1969 adoption of the more favorable rate
schedule for individuals, the Head of Household rate schedule was adjusted to provide approximately 75% of the
benefit of income-splitting via the joint return. See id.
9
Why would anyone file under the married filing separately schedule? A disadvantage of filing a joint return is that
each spouse is jointly and severally liable for any resulting tax deficiency, while those who file separately are not
responsible for a tax deficiency on their spouse’s return. See § 6013(d)(3). Under certain circumstances that are not
easy to satisfy, the “innocent spouse” on a joint return can appeal for relief from joint and several liability. See § 6015;
Rev. Proc. 2013-34, 2013-2 C.B. 397 (describing innocent spouse guidelines).
10
CONGRESSIONAL BUDGET OFFICE, FOR BETTER OR FOR WORSE: MARRIAGE AND THE FEDERAL INCOME TAX (June
1997) at xiv to xv. In addition to the rate schedules, the § 32 Earned Income Tax Credit and the Standard Deduction
suffered from notable marriage penalties before the 2001 amendments described in the text. The Earned Income Tax
Credit, in particular, continues to suffer from marriage penalties.

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as individuals, regardless of marital status. 11
The 2001 amendments (made permanent in 2012) significantly reduced the marriage penalty
for two-earner, middle class couples with substantially equivalent incomes (and thereby increased
the marriage bonus for one-earner couples) by increasing the Standard Deduction for a married
couple filing jointly to an amount precisely twice that for individuals (it had previously been
slightly less than double) and ensuring that the then-10% and 15% brackets were precisely twice
as wide as those for individual filers. (They had previously been less than twice as wide.) The point
at which higher brackets phase out for joint returns is not twice that of individuals, however, which
means that a marriage penalty can still apply at high levels of aggregate income for a dual-earner
couple with substantially equivalent incomes.
While many countries now use individual filing for income tax purposes to avoid these
difficulties, mandatory individual filing regardless of marital status with a statutory override for
Poe v. Seaborn (to prevent income splitting for Federal income tax purposes in community
property states) is highly unlikely in the U.S. For one thing, the IRS opposes the move because
eliminating the joint return today would significantly increase the aggregate number of returns that
it must process each year.
Registered domestic partnerships (RDPs) and civil unions
In United States v. Windsor, 12 the Supreme Court struck down the Defense of Marriage Act,
under which same-sex couples who legally married in those states that recognized such marriages
were nevertheless treated as unmarried individuals for purposes of Federal law, including Federal
tax law. The 2015 Supreme Court decision in Obergefell v. Hodges 13 held that the Due Process
and Equal Protection clauses of the 14th amendment provide to all same-sex couples the
fundamental right to marry. The Federal income tax treatment of same-sex married couples is the
same as for opposite-sex married couples today.
Several states, however, also recognize civil unions or registered domestic partnerships (RDPs),
both between opposite-sex and same-sex couples. 14 In Revenue Ruling 2013-17, 15 the IRS
announced: “For Federal tax purposes, the terms ‘spouse,’ ‘husband and wife,’ ‘husband,’ and
‘wife’ do not include individuals (whether of the opposite sex or same sex) who have entered into
a registered domestic partnership, civil union, or other formal relationship recognized under state
law that is not denominated as a marriage …, and the term ‘marriage’ does not include such formal
relationships.” In other words, members of a civil union or RDP must file as individuals for Federal
income tax purposes. This treatment differs from state law except in Colorado, which simply tracks
whatever Federal law says on this issue. For example, members of an RDP or civil union in
California file a joint income tax return for state income tax purposes but must file separate returns
under the Federal income tax.
Several states that recognize civil unions or RDPs are also community property states (including
California, Nevada, and Washington). How does Poe v. Seaborn apply to RDPs, whether the
partners are of the same or opposite sex?
11

Id. at xv.
133 S. Ct. 2675 (2013).
13
135 S. Ct. 2584 (2015).
14
For an updated list of the status of RDPs and civil unions in each state, consult www.nclrights.org/wpcontent/uploads/2013/07/Relationship_Recognition.pdf.
15
2013-2 C.B. 201.
12

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CHIEF COUNSEL ADVICE 201021050 16
May 5, 2010
On February 24, 2006, the Office of Associate Chief Counsel (Income Tax & Accounting)
issued Chief Counsel Advice (CCA) 200608038 concluding that an individual who is a registered
domestic partner in California must report all of his or her income earned from the performance of
personal services. In light of a change to California law, effective in 2007, you asked us whether
California registered domestic partners should each report half of the community income on their
Federal returns….
FACTS
In 2005, California law significantly expanded the rights and obligations of persons entering
into a California domestic partnership for state property law purposes, but not for state income tax
purposes. Specifically, the California Domestic Partner Rights and Responsibilities Act of 2003
(the California Act), effective on January 1, 2005, provided that “Registered domestic partners
shall have the same rights, protections, and benefits, and shall be subject to the same
responsibilities, obligations, and duties under law ... as are granted to and imposed upon spouses.”
However, the California Act provided that “earned income may not be treated as community
property for state income tax purposes.”
On September 29, 2006, California enacted Senate Bill 1827. Senate Bill 1827 repealed the
language of the California Act providing that earned income was not to be treated as community
property for state income tax purposes. Thus, effective January 1, 2007, the earned income of a
registered domestic partner must be treated as community property for state income tax purposes
…. As a result of the legislation, California, as of January 1, 2007, treats the earned income of
registered domestic partners as community property for both property law purposes and state
income tax purposes.
LAW AND ANALYSIS
Section 61(a)(1) of the Internal Revenue Code provides that Gross Income means all income
from whatever source derived including compensation for services such as fees, commissions,
fringe benefits, and similar items.
Federal tax law generally respects state property law characterizations and definitions. U.S. v.
Mitchell, 403 U.S. 190 (1971), Burnet v. Harmel, 287 U.S. 103, 1932-2 C.B. 210 (1932). In Poe
v. Seaborn, 282 U.S. 101, 1930-2 C.B. 202 (1930), the Supreme Court held that for Federal income
tax purposes a wife owned an undivided one-half interest in the income earned by her husband in
Washington, a community property state, and was liable for Federal income tax on that one-half
interest. Accordingly, the Court concluded that husband and wife must each report one-half of the
community income on his or her separate return regardless of which spouse earned the income.
United States v. Malcolm, 282 U.S. 792 (1931), applied the rule of Poe v. Seaborn to California’s
community property law.
California community property law developed in the context of marriage and originally applied
only to the property rights and obligations of spouses. The law operated to give each spouse an
equal interest in each community asset, regardless of which spouse is the holder of record. d’Elia
16

www.irs.gov/pub/irs-wd/1021050.pdf. See also PLR 201021048 (May 5, 2010).

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v. d’Elia, 58 Cal. App. 4th 415, 68 Cal. Rptr. 2d 324 (1997).
By 2007, California had extended full community property treatment to registered domestic
partners. Applying the principle that Federal law respects state law property characterizations, the
Federal tax treatment of community property should apply to California registered domestic
partners. Consequently, for tax years beginning after December 31, 2006, a California registered
domestic partner must report one-half of the community income, whether received in the form of
compensation for personal services or income from property, on his or her Federal income tax
return.
__________________________________
In summary, assignment of labor income by contract is generally not possible under Lucas v.
Earl. The joint return does permit income splitting between spouses, which effectively provides to
married couples living in common law states the income-splitting benefits enjoyed by married
couples living in community property states. Members of an RDP or civil union are not considered
married for Federal income tax purposes and must file separate returns. Such couples living in
community property states that recognize community property rights for members of an RDP or
civil union must nevertheless split their income on those separate returns (to the extent considered
community property under state law), just as did the married couple in Poe v. Seaborn.
Whew!

B. Income-shifting possibilities outside the joint return
The following problems should help you to think about the income-shifting possibilities outside
of the joint return. Some of these possibilities were suggested in the material in Part A. or prior
chapters, but most are suggested by the remaining material in this Part B. I include the problems
here (rather than at the end of Part B.) in the hope that reading them in advance and keeping them
in mind may help you to parse the remaining material more carefully as you move through it. Don’t
forget to return to the problems after you have finished the reading!
Problems
Ellen is a dentist whose marginal rate as defined in Part B. of Chapter 1 (the rate at which her
last, or marginal, dollar is taxed) is 32%, while her daughter Emma’s marginal rate is only 10%.
Which, if any, of the following strategies will successfully shift income from Ellen’s 32% bracket
to Emma’s 10% bracket?
1. Ellen transfers $5,000 in cash, funded by her dental practice, to Emma as a gift.
2. Ellen pays Emma $5,000 for cleaning the reception area and the office restroom in Ellen’s
dentist’s office on two Friday evenings in September. See Treas. Reg. § 1.162-7.
3. Ellen enters into a contract (enforceable under state law), which entitles Emma to 20% of
Ellen’s income arising from her dental practice from the moment that Ellen earns it.
4. Ellen’s grandmother died recently, and Ellen learned that she received a life interest in a trust
created under her grandmother’s will. The trust will be funded with stocks and bonds owned by

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her grandmother before her death. The will directs the trustee to distribute the annual income from
the trust to Ellen every December 15th for the rest of her life. At Ellen’s death, the trust will be
dissolved, and the stocks and bonds held by the trust will be distributed to Ellen’s nephew, Erik.
Review § 102(b)(2) from Chapter 7. Ellen immediately sends a document to the trustee informing
him that she is assigning 50% of her life interest in the trust for the rest of her life to Emma. On
December 15th of this year, each of Emma and Ellen receives $5,000 from the trustee.
5. Same as 4., except that, instead of assigning 50% of her life estate for the rest of her life,
Ellen assigns 50% of her life estate to Emma for this year only. On December 15th of this year,
each of Emma and Ellen receives $5,000 from the trustee.
6. Ellen owns a patent on a dental instrument that she invented which provides her with an
annual royalty of $5,000. Ellen assigns her right to receive this year’s royalty payment to Emma.
Alternatively, Ellen assigns her right to receive all royalty payments for the duration of her patent
ownership period to Emma. Emma receives this year’s $5,000 royalty payment.
7. Ellen transfers ownership of the patent, itself, to Emma. Emma receives this year’s $5,000
royalty payment. Does it matter whether Emma is 14 years old or 26 years old?
8. Ellen creates a trust, transferring ownership of the patent to it. Under the trust terms (1)
income from the trust will be distributed annually to Emma for the duration of the trust and (2)
Ellen retains the right to dissolve the trust at any time, with the patent distributed to herself, i.e.,
the trust is revocable. Emma receives this year’s $5,000 royalty payment. Assume that Emma is
26 years old. See § 676(a).
9. Same as 8., except that (1) the trust is irrevocable and (2) Ellen retains the right to designate
who will receive the distribution of trust income each year until Ellen’s death, at which time the
trust will dissolve and the patent will be distributed to Emma. For this year, Ellen designates Emma
as the beneficiary who will receive the trust income distribution, so Emma receives this year’s
$5,000 royalty payment. See § 674(a).
10. Same as 8., except that the trust is irrevocable for its duration but will dissolve after 20
years, at which time the patent will return to Ellen’s ownership. As the sole income beneficiary,
Emma receives this year’s $5,000 royalty payment. Assume that the value of Ellen’s reversionary
interest when the trust is created is 4%. See § 673(a).
__________________________________
In Chapter 7, you learned that “estates” are taxpayers that spring into being automatically when
an individual dies and that estates must file an income tax return with respect to any income earned
by it during its existence. Similarly, trusts can be taxpayers, too. The current income tax rules
pertaining to trusts as entities are found in Subchapter J of the Code and are studied in the Wealth
Transfer Tax course in more detail, as trusts are common vehicles used to transfer wealth from one
generation to the next. Nevertheless, we must get a taste of trust income taxation here in order to
consider the income-shifting possibilities that trusts may (or may not) provide.
First, let’s identify some nomenclature, as well as the potential taxpayers pertaining to a trust.
The taxpayer who forms a trust and funds it with cash or property is called the trust “grantor.” The
trust is administered by the “trustee” according to the terms of the trust document and trust law.
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The trust document will name the trust “beneficiaries” and describe their distribution rights. Some
trust beneficiaries may legally assign (to the extent permitted under the trust document and trust
law) all or a portion of their distribution rights to a third party. At some point in time, the trust will
end, and the trust’s “corpus” (the cash and property owned by the trust at that time) will be
distributed to the “remainder.” The remainder who obtains his trust interest as an inter vivos gift
or by bequest can exclude his or her receipt under § 102(a) when the trust is dissolved. But who
will include in Gross Income the trust’s annual income? The answer is never the trustee, as the
trustee is a mere agent of the trust, itself. (Remember Poe v. Seaborn in this regard.)
One possibility is the grantor of the trust if the trust’s existence is ignored for Federal income
tax purposes (as though it were never created and the grantor continued to own the trust property
directly) under rules that will be explored in a few pages. Such trusts are called “grantor trusts.”
But first let’s explore the rules pertaining to a trust that is recognized as an entity separate from
its grantor for tax purposes (a nongrantor trust). Under the statute, nongrantor trust income is
generally taxed only once: either to the trust’s beneficiaries (to the extent distributed to them)
or to the trust itself (to the extent retained by the trust). See § 61(a)(15).
Even though trust income is listed as an item of Gross Income, § 61’s introductory clause
(“except as otherwise provided in this subtitle”) reminds us that explicitly listed items can
nevertheless be excluded if a statutory exclusion applies. Even though compensation for services
rendered is listed as an item of Gross Income in § 61(a)(1), for example, you learned in Chapter 5
that compensation can be excluded under §§ 119 and 132 if their requirements are satisfied. Can a
trust distribution be excluded by a beneficiary under § 102(a) if the trust interest was received as
a gift or bequest from the grantor? No. As you learned in Chapter 7, § 102(b)(2) applies to negate
the § 102(a) exclusion in the case of a gift or bequest of income only. But what if the beneficiary
assigns his or her income distribution right to a third party before the distribution? Can the trust
beneficiary thereby shift the income to the third-party’s tax return?
In the case below, Mr. Blair’s father created a trust under his will, which was not a grantor trust.
Mr. Blair was a beneficiary with a life estate in the trust’s income. Under the rules described above,
therefore, Mr. Blair must generally include trust income distributions in his Gross Income. He
nevertheless escaped taxation of a portion of the trust’s income that he assigned (before the
distribution occurred) to his children. Precisely why was Mr. Blair’s assignment of income
successful for purposes of income taxation?
BLAIR v. COMMISSIONER
300 U.S. 5 (1937)
MR. CHIEF JUSTICE HUGHES delivered the opinion of the Court.
This case presents the question of the liability of a beneficiary of a testamentary trust for a tax
upon the income which he had assigned to his children prior to the tax years and which the trustees
had paid to them accordingly.
The trust was created by the will of William Blair, a resident of Illinois who died in 1899, and
was of property located in that State. One-half of the net income was to be paid to the donor’s
widow during her life. His son, the petitioner Edward Tyler Blair, was to receive the other onehalf and, after the death of the widow, the whole of the net income during his life. In 1923, after
the widow’s death, petitioner assigned to his daughter, Lucy Blair Linn, an interest amounting to

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$6000 for the remainder of that calendar year, and to $9000 in each calendar year thereafter, in the
net income which the petitioner was then or might thereafter be entitled to receive during his life.
At about the same time, he made like assignments of interests, amounting to $9000 in each calendar
year, in the net income of the trust to his daughter Edith Blair and to his son, Edward Seymour
Blair, respectively. In later years, by similar instruments, he assigned to these children additional
interests, and to his son William McCormick Blair other specified interests, in the net income. The
trustees accepted the assignments and distributed the income directly to the assignees.
The question first arose with respect to the tax year 1923 and the Commissioner of Internal
Revenue ruled that the income was taxable to the petitioner. The Board of Tax Appeals held the
contrary. The Circuit Court of Appeals reversed the Board, holding that under the law of Illinois
the trust was a spendthrift trust and the assignments were invalid. We denied certiorari.
[Subsequent litigation then settled that the trust was not a spendthrift trust under state law and
that Mr. Blair’s assignments were thus valid under trust law.] The Circuit Court of Appeals …
recognized the binding effect of the decision of the state court as to the validity of the assignments
but decided that the income was still taxable to the petitioner upon the ground that his interest was
not attached to the corpus of the estate and that the income was not subject to his disposition until
he received it.
Because of an asserted conflict with the decision of the state court, and also with decisions of
circuit courts of appeals, we granted certiorari.
In the face of this ruling of the state court it is not open to the Government to argue that the
trust “was, under the Illinois law, a spendthrift trust.” The point of the argument is that, the trust
being of that character, the state law barred the voluntary alienation by the beneficiary of his
interest. The state court held precisely the contrary. The ruling also determines the validity of the
assignment by the beneficiary of parts of his interest. That question was necessarily presented and
expressly decided.
The question remains whether, treating the assignments as valid, the assignor was still taxable
upon the income under the Federal income tax act. That is a Federal question.
Our decisions in Lucas v. Earl, 281 U.S. 111, and Burnet v. Leininger, 285 U.S. 136, are cited.
In the Lucas case the question was whether an attorney was taxable for the whole of his salary and
fees earned by him in the tax years or only upon one-half by reason of an agreement with his wife
by which his earnings were to be received and owned by them jointly. We were of the opinion that
the case turned upon the construction of the taxing act. We said that “the statute could tax salaries
to those who earned them and provide that the tax could not be escaped by anticipatory
arrangements and contracts however skillfully devised to prevent the same when paid from vesting
even for a second in the man who earned it.” That was deemed to be the meaning of the statute as
to compensation for personal service, and the one who earned the income was held to be subject
to the tax. In Burnet v. Leininger, supra, a husband, a member of a firm, assigned future partnership
income to his wife. We found that the revenue act dealt explicitly with the liability of partners as
such. The wife did not become a member of the firm; the act specifically taxed the distributive
share of each partner in the net income of the firm; and the husband by the fair import of the act
remained taxable upon his distributive share. These cases are not in point. The tax here is not upon
earnings which are taxed to the one who earns them. Nor is it a case of income attributable to a
taxpayer by reason of the application of the income to the discharge of his obligation. Old Colony
Trust Co. v. Comm’r, 279 U.S. 716. There is here no question of evasion or of giving effect to

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statutory provisions designed to forestall evasion; or of the taxpayer’s retention of control. Corliss
v. Bowers, 281 U.S. 376.
In the instant case, the tax is upon income as to which, in the general application of the revenue
acts, the tax liability attaches to ownership. See Poe v. Seaborn, supra.
The Government points to the provisions of the revenue acts imposing upon the beneficiary of
a trust the liability for the tax upon the income distributable to the beneficiary. But the term is
merely descriptive of the one entitled to the beneficial interest. These provisions cannot be taken
to preclude valid assignments of the beneficial interest, or to affect the duty of the trustee to
distribute income to the owner of the beneficial interest, whether he was such initially or becomes
such by valid assignment. The one who is to receive the income as the owner of the beneficial
interest is to pay the tax. If under the law governing the trust the beneficial interest is assignable,
and if it has been assigned without reservation, the assignee thus becomes the beneficiary and is
entitled to rights and remedies accordingly. We find nothing in the revenue acts which denies him
that status.
The decision of the Circuit Court of Appeals turned upon the effect to be ascribed to the
assignments. The court held that the petitioner had no interest in the corpus of the estate and could
not dispose of the income until he received it. Hence it was said that “the income was his” and his
assignment was merely a direction to pay over to others what was due to himself. The question
was considered to involve “the date when the income became transferable.” 83 F.2d, p. 662. The
Government refers to the terms of the assignment—that it was of the interest in the income “which
the said party of the first part now is, or may hereafter be, entitled to receive during his life from
the trustees.” From this it is urged that the assignments “dealt only with a right to receive the
income” and that “no attempt was made to assign any equitable right, title or interest in the trust
itself.” This construction seems to us to be a strained one. We think it apparent that the conveyancer
was not seeking to limit the assignment so as to make it anything less than a complete transfer of
the specified interest of the petitioner as the life beneficiary of the trust, but that with ample caution
he was using words to effect such a transfer. That the state court so construed the assignments
appears from the final decree which described them as voluntary assignments of interests of the
petitioner “in said trust estate,” and it was in that aspect that petitioner’s right to make the
assignments was sustained.
The will creating the trust entitled the petitioner during his life to the net income of the property
held in trust. He thus became the owner of an equitable interest in the corpus of the property. By
virtue of that interest he was entitled to enforce the trust, to have a breach of trust enjoined and to
obtain redress in case of breach. The interest was present property alienable like any other, in the
absence of a valid restraint upon alienation. The beneficiary may thus transfer a part of his interest
as well as the whole. See Restatement of the Law of Trusts, §§ 130, 132 et seq. The assignment of
the beneficial interest is not the assignment of a chose in action but of the “right, title and estate in
and to property.” See Bogert, Trusts and Trustees, vol. 1, § 183, pp. 516, 517; 17 Columbia Law
Review, 269, 273, 289, 290.
We conclude that the assignments were valid, that the assignees thereby became the owners of
the specified beneficial interests in the income, and that as to these interests they and not the
petitioner were taxable for the tax years in question. The judgment of the Circuit Court of Appeals
is reversed and the cause is remanded with direction to affirm the decision of the Board of Tax
Appeals.
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Instead of assigning specified interests in his life estate to his children for the rest of his life,
would Mr. Blair’s assignment have been successful for income tax purposes if he had assigned the
right to receive the income for, say, only the next year?
HARRISON v. SCHAFFNER
312 U.S. 579 (1941)
MR. JUSTICE STONE delivered the opinion of the Court.
In December, 1929, respondent, the life beneficiary of a testamentary trust, “assigned” to
certain of her children specified amounts in dollars from the income of the trust for the year
following the assignment. She made a like assignment to her children and a son-in-law in
November, 1930. The question for decision is whether, under the applicable 1928 Revenue Act,
45 Stat. 791, the assigned income, which was paid by the trustees to the several assignees, is
taxable as such to the assignor or to the assignees.
The Commissioner ruled that the income was that of the life beneficiary and assessed a
deficiency against her for the calendar years 1930 and 1931, which she paid. In the present suit to
recover the tax paid as illegally exacted the district court below gave judgment for the taxpayer,
which the Court of Appeals affirmed. We granted certiorari to resolve an alleged conflict in
principle of the decision below with those in Lucas v. Earl, 281 U.S. 111; Burnet v. Leininger, 285
U.S. 136, and Helvering v. Clifford, 309 U.S. 331.
Since granting certiorari we have held, following the reasoning of Lucas v. Earl, supra, that
one who is entitled to receive, at a future date, interest or compensation for services and who makes
a gift of it by an anticipatory assignment, realizes taxable income quite as much as if he had
collected the income and paid it over to the object of his bounty. Helvering v. Horst, 311 U.S. 112;
Helvering v. Eubank, 311 U.S. 122. Decision in these cases was rested on the principle that the
power to dispose of income is the equivalent of ownership of it and that the exercise of the power
to procure its payment to another, whether to pay a debt or to make a gift, is within the reach of
the statute taxing income “derived from any source whatever.” In the light of our opinions in these
cases the narrow question presented by this record is whether it makes any difference in the
application of the taxing statute that the gift is accomplished by the anticipatory assignment of
trust income rather than of interest, dividends, rents and the like which are payable to the donor.
Respondent, recognizing that the practical consequences of a gift by assignment, in advance, of
a year’s income from the trust, are, so far as the use and enjoyment of the income are concerned,
no different from those of the gift by assignment of interest or wages, rests his case on technical
distinctions affecting the conveyancing of equitable interests. It is said that since by the assignment
of trust income the assignee acquires an equitable right to an accounting by the trustee which, for
many purposes, is treated by courts of equity as a present equitable estate in the trust property, it
follows that each assignee in the present case is a donee of an interest in the trust property for the
term of a year and is thus the recipient of income from his own property which is taxable to him
rather than to the donor. See Blair v. Comm’r, 300 U.S. 5.
We lay to one side the argument which the Government could have made that the assignments
were no more than an attempt to charge the specified payments upon the whole income which
could pass no present interest in the trust property. See Scott on Trusts, §§ 10.1, 10.6, 29, 30. For

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we think that the operation of the statutes taxing income is not dependent upon such “attenuated
subtleties,” but rather on the import and reasonable construction of the taxing act. Lucas v. Earl,
supra, 114.
Section 22(a) of the 1928 Revenue Act provides, “’Gross Income’ includes gains, profits, and
income derived from . . . interest, rent, dividends, securities or the transactions of any business
carried on for gain or profit, or gains or profits, and income derived from any source whatever.”
By §§ 161(a) and 162(b) the tax is laid upon the income “of any kind of property held in trust,”
and income of a trust for the taxable year which is to be distributed to the beneficiaries is to be
taxed to them …. In construing these and like provisions in other revenue acts we have uniformly
held that they are not so much concerned with the refinements of title as with the actual command
over the income which is taxed and the actual benefit for which the tax is paid. See Corliss v.
Bowers, 281 U.S. 376; Lucas v. Earl, supra; Helvering v. Horst, supra; Helvering v. Eubank,
supra; Helvering v. Clifford, supra. It was for that reason that in each of those cases it was held
that one vested with the right to receive income did not escape the tax by any kind of anticipatory
arrangement, however skillfully devised, by which he procures payment of it to another, since, by
the exercise of his power to command the income, he enjoys the benefit of the income on which
the tax is laid.
Those decisions are controlling here. Taxation is a practical matter and those practical
considerations which support the treatment of the disposition of one’s income by way of gift as a
realization of the income to the donor are the same whether the income be from a trust or from
shares of stock or bonds which he owns. It is true, as respondent argues, that where the beneficiary
of a trust had assigned a share of the income to another for life without retaining any form of
control over the interest assigned, this Court construed the assignment as a transfer in praesenti to
the donee, of a life interest in the corpus of the trust property, and held in consequence that the
income thereafter paid to the donee was taxable to him and not the donor. Blair v. Comm’r, supra.
But we think it quite another matter to say that the beneficiary of a trust who makes a single gift
of a sum of money payable out of the income of the trust does not realize income when the gift is
effectuated by payment, or that he escapes the tax by attempting to clothe the transaction in the
guise of a transfer of trust property rather than the transfer of income, where that is its obvious
purpose and effect. We think that the gift by a beneficiary of a trust of some part of the income
derived from the trust property for the period of a day, a month or a year involves no such
substantial disposition of the trust property as to camouflage the reality that he is enjoying the
benefit of the income from the trust of which he continues to be the beneficiary, quite as much as
he enjoys the benefits of interest or wages which he gives away as in the Horst and Eubank cases.
Even though the gift of income be in form accomplished by the temporary disposition of the
donor’s property which produces the income, the donor retaining every other substantial interest
in it, we have not allowed the form to obscure the reality. Income which the donor gives away
through the medium of a short term trust created for the benefit of the donee is nevertheless income
taxable to the donor. Helvering v. Clifford, supra; Hormel v. Helvering, ante, p. 552. We perceive
no difference, so far as the construction and application of the Revenue Act is concerned, between
a gift of income in a specified amount by the creation of a trust for a year, see Hormel v. Helvering,
supra, and the assignment by the beneficiary of a trust already created of a like amount from its
income for a year.
Nor are we troubled by the logical difficulties of drawing the line between a gift of an equitable
interest in property for life effected by a gift for life of a share of the income of the trust and the
gift of the income or a part of it for the period of a year as in this case. “Drawing the line” is a
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recurrent difficulty in those fields of the law where differences in degree produce ultimate
differences in kind. See Irwin v. Gavit, 268 U.S. 161, 168. It is enough that we find in the present
case that the taxpayer, in point of substance, has parted with no substantial interest in property
other than the specified payments of income which, like other gifts of income, are taxable to the
donor. Unless in the meantime the difficulty be resolved by statute or treasury regulation, we leave
it to future judicial decisions to determine precisely where the line shall be drawn between gifts of
income-producing property and gifts of income from property of which the donor remains the
owner, for all substantial and practical purposes. Cf. Helvering v. Clifford, supra.
_______________________________________
In Helvering v. Horst, 17 cited by the Harrison v. Schaffner Court, a father owned a corporate
bearer bond with interest coupons attached. Interest coupons represent the right to receive the
associated interest payment. When the coupon is presented for payment, the corporate borrower
must pay the interest to the coupon holder. The father gave an interest coupon to his son, who
presented the coupon later in the year to the corporate borrower and received the interest payment.
The father did not include the interest in his Gross Income, arguing under Blair that he divested
himself completely of the underlying property (the interest coupon) on which the interest was paid
when he gave the coupon to his son. The Court disagreed. Here is an excerpt.
The power to dispose of income is the equivalent of ownership of it. The exercise of
that power to procure the payment of income to another is the enjoyment, and hence
the realization, of the income by him who exercises it. We have had no difficulty in
applying that proposition where the assignment preceded the rendition of the services,
Lucas v. Earl, supra; Burnet v. Leininger, supra, for it was recognized in the Leininger
case that in such a case the rendition of the service by the assignor was the means by
which the income was controlled by the donor and of making his assignment effective.
But it is the assignment by which the disposition of income is controlled when the
service precedes the assignment, and in both cases it is the exercise of the power of
disposition of the interest or compensation, with the resulting payment to the donee,
which is the enjoyment by the donor of income derived from them.
This was emphasized in Blair v. Commissioner, 300 U.S. 5, on which respondent
relies, where the distinction was taken between a gift of income derived from an
obligation to pay compensation and a gift of income-producing property. In the
circumstances of that case, the right to income from the trust property was thought to
be so identified with the equitable ownership of the property, from which alone the
beneficiary derived his right to receive the income and his power to command
disposition of it, that a gift of the income by the beneficiary became effective only as
a gift of his ownership of the property producing it. Since the gift was deemed to be a
gift of the property, the income from it was held to be the income of the owner of the
property, who was the donee, not the donor—a refinement which was unnecessary if
respondent’s contention here is right, but one clearly inapplicable to gifts of interest
or wages. Unlike income thus derived from an obligation to pay interest or
compensation, the income of the trust was regarded as no more the income of the donor
than would be the rent from a lease or a crop raised on a farm after the leasehold or
the farm had been given away. Blair v. Comm’r, supra, 12, 13 and cases cited. We
17

311 U.S. 112 (1940).

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have held without deviation that where the donor retains control of the trust property
the income is taxable to him although paid to the donee. Corliss v. Bowers, supra. Cf.
Helvering v. Clifford, supra....
Nor is it perceived that there is any adequate basis for distinguishing between the gift
of interest coupons here and a gift of salary or commissions. The owner of a negotiable
bond and of the investment which it represents, if not the lender, stands in the place of
the lender. When, by the gift of the coupons, he has separated his right to interest
payments from his investment and procured the payment of the interest to his donee,
he has enjoyed the economic benefits of the income in the same manner and to the
same extent as though the transfer were of earnings, and in both cases the import of
the statute is that the fruit is not to be attributed to a different tree from that on which
it grew. See Lucas v. Earl, supra, 115.
In both Schaffner and Horst, the attempted assignments of income failed for tax purposes, with
the result that the income had to be included by the assignors, not the assignees. In each case,
however, the assignee did receive the cash in actual fact—from the trustee in Schaffner and from
the corporate borrower in Horst. How do we account (for income tax purposes) for the cash receipt
in the hands of the assignees in an unsuccessful assignment of income? The Schaffner Court
remarked that “one who is entitled to receive, at a future date, interest or compensation for services
and who makes a gift of it by an anticipatory assignment, realizes taxable income quite as much
as if he had collected the income and paid it over to the object of his bounty.” While in form the
cash goes directly from third parties to the assignees, in unsuccessful assignments of income the
cash is deemed to have been received by the assignor first in substance (and included by him) and
then transferred to the assignee as a gift (excluded under § 102(a)). In short, we apply the Old
Colony Trust two-step (supra Chapter 5), where cash paid directly from the corporation to the IRS
was deemed to have been received, in substance, first by Mr. Wood (and included by him as
compensation) and then transferred by Mr. Wood to the IRS. While the gift deemed received from
the assignor is excludable to the extent permitted under § 102 for income tax purposes, a gift tax
under the unified gift, estate, and generation-skipping transfer taxes (briefly described in Chapter
7) could possibly be triggered in an unsuccessful assignment of income if the transfer is very large.
The § 1(g) kiddie tax
Suppose that, contrary to the facts of the case, Mr. Horst had given his son not just a single
interest coupon but also the underlying bond, with all of the coupons. Under Blair, Schaffner, and
Horst, taken together, it is clear that a complete ownership transfer of the underlying property that
produces the income succeeds in shifting that income to the assignee for tax purposes. It became
quite common, therefore, for savvy investors to transfer ownership of the family’s investment
portfolio to Junior. After all, Junior is only two years old and will not run off to Reno with the loot.
Because the assignment was successful, the investment income earned on that portfolio would be
included on Junior’s tax return and taxed at his (much lower) tax rates. In effect, they used the
lower brackets twice by shifting the investment income to Junior’s tax return.
Enter 1986. As part of the Tax Reform Act of 1986, Congress enacted § 1(g), commonly
referred to as the “kiddie tax.” Under § 1(g), “unearned income” of a child (essentially all income
except compensation for services rendered by the child) that exceeds certain thresholds, while
included in Gross Income by Junior on Junior’s tax return, is taxed at his parents’ highest marginal
tax rate, as though the income were marginal dollars received by them. In other words, even though
the assignment of income was (and remains) successful, the assignment does little good from an
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income tax perspective. I say little good because the kiddie tax applies only to unearned income
exceeding the thresholds described in § 1(g)(4)(A)(ii) (as indexed for inflation). While the
threshold could vary (depending on whether the child has significant itemized deductions of his
own), for 2022 the amount generally is $2,300, which means that the child’s unearned income in
excess of $2,300 is generally taxed at the parent’s marginal tax rate. 18
When first enacted, the kiddie tax applied to children younger than 14, but this threshold has
been increased over the years. Today, § 1(g) generally applies to those younger than 18, but it can
apply to dependents younger than age 24 (generally, those young adults for whom parents are
providing more than 50% of their support), if he or she is not filing a joint return with a spouse.
The details of § 1(g) can be somewhat complex, but my purpose here is mainly to acquaint you
with both Congress’s reaction to successful assignments of property income to children and the
general idea regarding how § 1(g) operates.
The grantor trust rules
Notice that neither taxpayer in the Blair and Schaffner cases was the “grantor” of the trusts—
the person who created the trust, transferred cash or property to it, and designated the trust
beneficiaries. Rather, the taxpayers were the lucky beneficiaries (holding life interests) of trusts
created and funded by others. In other words, the taxation of the grantor was not at issue in those
cases; the only issue was whether the trust’s designated beneficiary successfully assigned trust
income (which the beneficiary must otherwise include in Gross Income) to a third party.
Some taxpayers realized early on, however, that creating a trust and transferring one’s own
investment property to it could achieve tax savings by effectively using the lower rate brackets
more than once, while keeping the income all in the family. From the discussion in Part A., recall
that prior to 1948 there was only a single tax rate schedule applicable to all taxpayers. The married
couple in Poe v. Seaborn, who lived in a community property state, were permitted to split the
husband’s salary (as well as the couple’s investment income) on two tax returns (one for each
spouse), which effectively allowed them to use the lower rate brackets twice, lowering their
aggregate tax from what it would have been if the husband had included his wages entirely on a
single tax return. Absent rules preventing the technique, the same approach could be used to split
income between two (or more) income tax returns using trusts.
Assume, for example, that Susan is a high-income taxpayer whose marginal dollars fall in the
highest tax bracket. Susan makes large gifts to family members each year, but such gifts do not
shift income from her high-bracket tax return to low-bracket family members. (Recall the
18

Without hearings, the TCJA amended § 1(g) so that the extremely compressed § 1(e) tax rate schedule for trusts
and estates, provided later in this chapter, applied to the child’s unearned income (instead of the parents’ marginal
rate). It soon became apparent that wealthy families could pay a lower kiddie tax than before because of two features:
(1) use of the lower rate brackets in § 1(e) for the first chunks of unearned income and (2) avoidance of the 3.8%
Medicare tax that applies to net investment income exceeding $250,000, introduced as part of the Patient Protection
and Affordable Care Act, mentioned in Chapter 3. The parents’ marginal rate would include this surtax, but only a
child with unearned income exceeding $250,000 would be subject to this Medicare tax. At the same time, some lowincome families were hurt by using the trusts and estates tax rate schedule instead of their parents’ marginal rate.
Consider a college athlete from a low-income family who is awarded a substantial room-and-board scholarship, which
you will learn in Chapter 16 is not excludable from Gross Income under § 117. This includable “unearned income”
could be taxed (to the extent exceeding the student’s Standard Deduction and § 1(g) threshold amount) under the trusts
and estates compressed tax rate schedule instead of at the parents’ (lower) marginal rate. In December 2019, Congress
repealed the TCJA amendments to § 1(g) in the SECURE Act (relating primarily to retirement savings provisions).

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combination of § 262(a) for Susan and § 102(a) for her recipients.) How can she effectively move
some of those “last dollars” to one or more other tax returns, removing them from her high tax
bracket to the lower rate brackets of a second (and third, and fourth, etc.) taxpayer?
Susan creates a trust and transfers her investment portfolio to it. That is to say, unlike Messrs.
Blair and Schaffner, Susan is the trust’s grantor. If the existence of the trust is respected for tax
purposes, the investment income earned by the trust would be taxed to the trust itself if
undistributed, effectively using the lower rate brackets a second time. Alternatively, Susan could
name family members as trust beneficiaries—the very family members to whom she used to make
large gifts every year anyway—and direct that the trust distribute trust income in specified
percentages to each of these (low bracket) beneficiaries each year. In that case, the income would
be included by the beneficiaries rather than by the trust. Voila! The lower rate brackets are used
multiple times, reducing the aggregate tax liability of the family substantially. Does it work?
HELVERING v. CLIFFORD
309 U.S. 331 (1940)
MR. JUSTICE DOUGLAS delivered the opinion of the Court.
In 1934 respondent declared himself trustee of certain securities which he owned. All net
income from the trust was to be held for the “exclusive benefit” of respondent’s wife. The trust
was for a term of five years, except that it would terminate earlier on the death of either respondent
or his wife. On termination of the trust the entire corpus was to go to respondent, while all “accrued
or undistributed net income” and “any proceeds from the investment of such net income” was to
be treated as property owned absolutely by the wife. During the continuance of the trust respondent
was to pay over to his wife the whole or such part of the net income as he in his “absolute
discretion” might determine. And during that period he had full power (a) to exercise all voting
powers incident to the trusteed shares of stock; (b) to “sell, exchange, mortgage, or pledge” any of
the securities under the declaration of trust “whether as part of the corpus or principal thereof or
as investments or proceeds and any income therefrom, upon such terms and for such consideration”
as respondent in his “absolute discretion may deem fitting”; (c) to invest “any cash or money in
the trust estate or any income therefrom” by loans, secured or unsecured, by deposits in banks, or
by purchase of securities or other personal property “without restriction” because of their
“speculative character” or “rate of return” or any “laws pertaining to the investment of trust funds”;
(d) to collect all income; (e) to compromise, etc., any claims held by him as trustee; (f) to hold any
property in the trust estate in the names of “other persons or in my own name as an individual”
except as otherwise provided. Extraordinary cash dividends, stock dividends, proceeds from the
sale of unexercised subscription rights, or any enhancement, realized or not, in the value of the
securities were to be treated as principal, not income. An exculpatory clause purported to protect
him from all losses except those occasioned by his “own wilful and deliberate” breach of duties as
trustee. And finally it was provided that neither the principal nor any future or accrued income
should be liable for the debts of the wife; and that the wife could not transfer, encumber, or
anticipate any interest in the trust or any income therefrom prior to actual payment thereof to her.
It was stipulated that while the “tax effects” of this trust were considered by respondent they
were not the “sole consideration” involved in his decision to set it up, as by this and other gifts he
intended to give “security and economic independence” to his wife and children. It was also
stipulated that respondent’s wife had substantial income of her own from other sources; that there

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was no restriction on her use of the trust income, all of which income was placed in her personal
checking account, intermingled with her other funds, and expended by her on herself, her children
and relatives; that the trust was not designed to relieve respondent from liability for family or
household expenses and that after execution of the trust he paid large sums from his personal funds
for such purposes….
During the year 1934 all income from the trust was distributed to the wife who included it in
her individual return for that year. The Commissioner, however, determined a deficiency in
respondent’s return for that year on the theory that income from the trust was taxable to him. The
Board of Tax Appeals sustained that redetermination. The Circuit Court of Appeals reversed. We
granted certiorari because of the importance to the revenue of the use of such short term trusts in
the reduction of surtaxes.
Sec. 22(a) of the Revenue Act of 1934 [the predecessor to § 61] includes among “Gross Income”
all “gains, profits, and income derived … from professions, vocations, trades, businesses,
commerce, or sales, or dealings in property, whether real or personal, growing out of the ownership
or use of or interest in such property; also from interest, rent, dividends, securities, or the
transaction of any business carried on for gain or profit, or gains or profits and income derived
from any source whatever.” The broad sweep of this language indicates the purpose of Congress
to use the full measure of its taxing power within those definable categories. Hence our
construction of the statute should be consonant with that purpose. Technical considerations,
niceties of the law of trusts or conveyances, or the legal paraphernalia which inventive genius may
construct as a refuge from surtaxes should not obscure the basic issue. That issue is whether the
grantor after the trust has been established may still be treated, under this statutory scheme, as the
owner of the corpus. In absence of more precise standards or guides supplied by statute or
appropriate regulations, the answer to that question must depend on an analysis of the terms of the
trust and all the circumstances attendant on its creation and operation. And where the grantor is
the trustee and the beneficiaries are members of his family group, special scrutiny of the
arrangement is necessary lest what is in reality but one economic unit be multiplied into two or
more by devices which, though valid under state law, are not conclusive so far as § 22(a) is
concerned.
In this case we cannot conclude as a matter of law that respondent ceased to be the owner of
the corpus after the trust was created. Rather, the short duration of the trust, the fact that the wife
was the beneficiary, and the retention of control over the corpus by respondent all lead irresistibly
to the conclusion that respondent continued to be the owner for purposes of § 22(a).
So far as his dominion and control were concerned it seems clear that the trust did not effect
any substantial change. In substance his control over the corpus was in all essential respects the
same after the trust was created, as before. The wide powers which he retained included for all
practical purposes most of the control which he as an individual would have. There were, we may
assume, exceptions, such as his disability to make a gift of the corpus to others during the term of
the trust and to make loans to himself. But this dilution in his control would seem to be insignificant
and immaterial, since control over investment remained. If it be said that such control is the type
of dominion exercised by any trustee, the answer is simple. We have at best a temporary
reallocation of income within an intimate family group. Since the income remains in the family
and since the husband retains control over the investment, he has rather complete assurance that
the trust will not effect any substantial change in his economic position. It is hard to imagine that
respondent felt himself the poorer after this trust had been executed or, if he did, that it had any

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rational foundation in fact. For as a result of the terms of the trust and the intimacy of the familial
relationship respondent retained the substance of full enjoyment of all the rights which previously
he had in the property. That might not be true if only strictly legal rights were considered. But
when the benefits flowing to him indirectly through the wife are added to the legal rights he
retained, the aggregate may be said to be a fair equivalent of what he previously had. To exclude
from the aggregate those indirect benefits would be to deprive § 22(a) of considerable vitality and
to treat as immaterial what may be highly relevant considerations in the creation of such family
trusts. For where the head of the household has income in excess of normal needs, it may well
make but little difference to him (except income-tax-wise) where portions of that income are
routed—so long as it stays in the family group. In those circumstances the all-important factor
might be retention by him of control over the principal. With that control in his hands he would
keep direct command over all that he needed to remain in substantially the same financial situation
as before. Our point here is that no one fact is normally decisive but that all considerations and
circumstances of the kind we have mentioned are relevant to the question of ownership and are
appropriate foundations for findings on that issue. Thus, where, as in this case, the benefits directly
or indirectly retained blend so imperceptibly with the normal concepts of full ownership, we cannot
say that the triers of fact committed reversible error when they found that the husband was the
owner of the corpus for the purposes of § 22(a). To hold otherwise would be to treat the wife as a
complete stranger; to let mere formalism obscure the normal consequences of family solidarity;
and to force concepts of ownership to be fashioned out of legal niceties which may have little or
no significance in such household arrangements.
The bundle of rights which he retained was so substantial that respondent cannot be heard to
complain that he is the “victim of despotic power when for the purpose of taxation he is treated as
owner altogether.” See DuPont v. Comm’r, 289 U.S. 685, 689.
The judgment of the Circuit Court of Appeals is reversed and that of the Board of Tax Appeals
is affirmed.
MR. JUSTICE ROBERTS, dissenting: I think the judgment should be affirmed. The decision of the
court disregards the fundamental principle that legislation is not the function of the judiciary but
of Congress.
In every revenue act from that of 1916 to the one now in force a distinction has been made
between income of individuals and income from property held in trust. It has been the practice to
define income of individuals, and, in separate sections, under the heading “Estates and Trusts,” to
provide that the tax imposed upon individuals shall apply to the income of estates or of any kind
of property held in trust. A trust is a separate taxable entity. The trust here in question is a true
trust….
If judges were members of the legislature they might well vote to amend the act so as to tax
such income in order to frustrate avoidance of tax but, as judges, they exercise a very different
function…. Courts ought not to stop loopholes in an act at the behest of the Government, nor
relieve from what they deem a harsh provision plainly stated, at the behest of the taxpayer. Relief
in either case should be sought in another quarter.
No such dictum as that Congress has in the income tax law attempted to exercise its power to
the fullest extent will justify the extension of a plain provision to an object of taxation not embraced
within it. If the contrary were true, the courts might supply whatever they considered a deficiency
in the sweep of a taxing act. I cannot construe the court’s opinion as attempting less….

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If some short term trusts are to be treated as nonexistent for income tax purposes, it is for
Congress to specify them.
________________________________
A trust that is transparent for tax purposes—i.e., is ignored for tax purposes, as though it
did not exist—is called a “grantor trust.” The income earned by a grantor trust is included
in the Gross Income of the grantor, who created and funded the trust with cash or property—
Mr. Clifford in the above case. You learned earlier in the course that a one-owner Limited Liability
Company (LLC) is ignored for tax purposes. The sole owner of the LLC includes and deducts the
amounts attributable to the LLC on her own individual tax return, as though she did not create the
LLC but rather operated the business directly as a sole proprietor. This pattern is precisely how a
grantor trust is treated for Federal income tax purposes.
Even though Mr. Clifford lost his case, others followed in his wake and were more careful to
draft trust instruments that deprived themselves of a bit more power and that created trusts that
lasted for more than the five years in Clifford. Shortly after Clifford was decided, the Treasury
Department issued regulations that more precisely described the characteristics of a grantor trust,
which were codified in 1954 (addressing the issue highlighted in Justice Roberts’s dissent) and
modified significantly in 1969 and again in 1986. Prior to 1986, a trust’s life had to exceed 10
years to avoid grantor trust status. Such trusts, which came to be known as Clifford trusts, were
widely used to shift income. 19
In the Tax Reform Act of 1986, Congress substantially revised the grantor trust rules, now
found in §§ 671 to 677 of the Code. 20 Notice how detailed they are. To get a flavor, take a look, at
§§ 673(a), 674(a) and 676(a). Instead of a simple 10-year rule, how is the reversionary interest
necessary to avoid grantor trust status measured today? Because § 673 provides no methodology
in valuing reversionary interests, the IRS uses the same methods used to value reversionary
interests under § 2037 for estate tax purposes. 21
While you may at first assume that all trust creators seek to avoid having their trusts be
categorized as a grantor trust for income tax purposes, that assumption is false. Those of you who
go on to the Wealth Transfer Tax course will learn that taxpayers commonly transfer property to
trusts that purposefully trigger one of the rules found in §§ 671 to 677 to ensure that the trust will
be a grantor trust (ignored for tax purposes) in order to achieve certain gift or estate tax benefits.
Such trusts are often referred to as “intentionally defective grantor trusts.”
Income splitting using a non-grantor trust
Let’s suppose that Susan does not wish her trust to be treated as a grantor trust and that she has
obtained good tax advice to ensure that the trust that she creates will be respected for tax purposes
as a separate entity, rather than ignored as a grantor trust under §§ 671 to 677. Because of a second
change enacted in 1986, Susan would want to ensure that 100% of the trust’s ordinary income and
capital gains (or close to it) are distributed every year (and so taxed to the designated beneficiaries)
19

Lisa Whitcomb & Scott A. Bowman, What’s Yours Is Mine and What’s Mine Is Mine: Grantor Trust Sections 673
and 676, at www.americanbar.org/content/dam/aba/events/taxation/taxiq-11mid-022.authcheckdam.pdf.
20
Notice that §§ 671 in 677 apply only to determine whether the trust is a grantor trust (ignored for tax purposes) or
a nongrantor trust (not ignored for tax purposes). These rules are irrelevant in determining whether an assignment by
a nongrantor trust beneficiary to a third party, as in Blair and Harrison v. Schaffner, will be respected for tax purposes
under the assignment-of-income doctrine, even though the issue of “control” informs both contexts.
21
See, e.g., Rev. Rul. 76-178, 1976-1 C.B. 273.

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rather than retained and accumulated by the trust (and taxed to it). The reason for this advice is
that Congress drastically compressed the tax rate schedule for trusts and estates in § 1(e) in 1986.
Compare the schedule below to those reprinted in Chapter 1, Part B.
2022 Tax Table for Trusts & Estates
If Taxable Income is:

The tax is:

Not over $2,750…………………………...10% of taxable income
Over $2,750 but not over $9,850……….....$275 plus 24% of excess over $2,750
Over $9,850 but not over $13,450………...$1,979 plus 35% of excess over $9,850
Over $13,450……………………………...$3,239 plus 37% of excess over $13,450
In addition, undistributed net capital gain within the trust’s Taxable Income not exceeding
$2,800 (stacked last) is taxed at 0%, between $2,801 and $13,700 at 15%, and exceeding $13,700
at 20% in 2022.
Susan can shift investment income earned by her nongrantor trust to the tax returns of her lowbracket family members by ensuring distribution of 100% of the trust’s income and net capital
gain each year. 22 If Susan’s nongrantor trust does not distribute its income every year (and
therefore is analogous to her own investment portfolio), the trust’s marginal income tax rate will
quickly reach the same 37% rate (and 20% net capital gain rate) that would have applied had she
never created the trust in the first place and had included the investment income on her own return.
Final thoughts
The material in this part can be seen as an elaboration of the last part of the Glenshaw Glass
definition of residual Gross Income: accessions to wealth, clearly realized, over which the taxpayer
has complete dominion. The cumulative effect of what we have considered here is that control,
rather than enjoyment, is at the root of the analysis regarding attempted assignments of income
from both property and services. Retention of control over the thing that produces the income (your
own body and mind in the case of services and the underlying property in the case of property)
brings taxation with it. In other words, retention of control connotes tax ownership.
That analysis explains why there is much more flexibility to assign property income compared
to services income. You cannot give up ownership over your own body and mind as the income
source. As phrased by the Horst Court, “[T]he rendition of the service by the assignor was the
means by which the income was controlled by the donor and of making his assignment
effective.” 23 (Emphasis added.) The worker controls whether the services income is earned
because he can turn the spigot on or off by choosing to work or not. You can, in contrast, give up
control over property that produces income. While this reasoning may be intellectually tidy, note
that this gives propertied people—the wealthy—a much greater ability to shift their (property)
income than the larger majority whose main source of income is from labor (compensation for
services rendered).

C. Income shifting in the fractured family
22
23

But what if the beneficiaries are her 12-year-old niece and 7-year-old nephew? Do not forget about the kiddie tax.
Horst, 311 U.S. at 118.

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Because divorce, unlike transfers in the intact family, is a one-time event that is not typically
undertaken to achieve income shifting for Federal income tax purposes, Congress had historically
permitted more leeway for income shifting in this context. In the Tax Cuts and Jobs Act of 2017
(TCJA), however, Congress eliminated the ability to shift the tax burden accompanying certain
cash payments in divorce by repealing §§ 71 and 215 for years after 2018, while maintaining the
ability to shift property gain (or loss) when property is transferred in kind under § 1041.
Cash payments
The background rule regarding the tax consequences for both the payor and payee of a cash
support payment—whether in divorce, as in the case below, or in the intact family—is found in
Gould v. Gould.
GOULD v. GOULD
245 U.S. 151 (1917)
MR. JUSTICE MCREYNOLDS delivered the opinion of the court.
A decree of the Supreme Court for New York County entered in 1909 forever separated the
parties to this proceeding, then and now citizens of the United States, from bed and board; and
further ordered that plaintiff in error pay to Katherine C. Gould during her life the sum of three
thousand dollars ($3,000.00) every month for her support and maintenance [Ed. Note:
approximately $77,000 per month in current dollars]. The question presented is whether such
monthly payments during the years 1913 and 1914 constituted parts of Mrs. Gould’s income within
the intendment of the Act of Congress approved October 3, 1913, 38 Stat. 114, 166, and were
subject as such to the tax prescribed therein. The court below answered in the negative; and we
think it reached the proper conclusion.
Pertinent portions of the act follow:
… “B. That, subject only to such exemptions and deductions as are hereinafter allowed, the net
income of a taxable person shall include gains, profits, and income derived from salaries, wages,
or compensation for personal service of whatever kind and in whatever form paid, or from
professions, vocations, businesses, trade, commerce, or sales, or dealings in property, whether real
or personal, growing out of the ownership or use of or interest in real or personal property, also
from interest, rent, dividends, securities, or the transaction of any lawful business carried on for
gain or profit, or gains or profits and income derived from any source whatever, including the
income from but not the value of property acquired by gift, bequest, devise, or descent….”
In the interpretation of statutes levying taxes it is the established rule not to extend their
provisions, by implication, beyond the clear import of the language used, or to enlarge their
operations so as to embrace matters not specifically pointed out. In case of doubt they are construed
most strongly against the Government, and in favor of the citizen. U.S. v. Wigglesworth, 2 Story,
369; Am. Net & Twine Co. v. Worthington, 141 U.S. 468, 474; Benziger v. U.S., 192 U.S. 38, 55.
As appears from the above quotations, the … income upon which … an annual tax shall be
assessed, levied, collected and paid is defined in division B. The use of the word itself in the
definition of “income” causes some obscurity, but we are unable to assert that alimony paid to a
divorced wife under a decree of court falls fairly within any of the terms employed.
In Audubon v. Shufeldt, 181 U.S. 575, 577, 578, we said: “Alimony does not arise from any

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business transaction, but from the relation of marriage. It is not founded on contract, express or
implied, but on the natural and legal duty of the husband to support the wife. The general obligation
to support is made specific by the decree of the court of appropriate jurisdiction…. Permanent
alimony is regarded rather as a portion of the husband’s estate to which the wife is equitably
entitled, than as strictly a debt; alimony from time to time may be regarded as a portion of his
current income or earnings; …”
The net income of the divorced husband subject to taxation was not decreased by payment of
alimony under the court’s order; and, on the other hand, the sum received by the wife on account
thereof cannot be regarded as income arising or accruing to her within the enactment.
The judgment of the court below is Affirmed.
____________________________________
Once again, this opinion was not heavily edited. Precisely why was the alimony received by
Mrs. Gould not income within the meaning of the residual clause? If we engage in a thought
experiment and consider how Gould might have been decided if it had arisen after Glenshaw Glass
(rather than before), might it have satisfied the Glenshaw Glass construction of the residual clause,
i.e., was Mrs. Gould’s cash receipt an accession to wealth, clearly realized, over which she had
complete dominion? Of course it was. If we similarly analyze Mr. Gould’s payment through the
normative lens of measuring income accurately, the payment would be nondeductible by him as a
personal expense under § 262. In short, the cash transfers would effectively be taxed to each of
the transferor (nondeductible) and transferee (includable).
But perhaps that is not the appropriate way to conceive of this analysis. Recall that the tax
treatment of gifts explored in Chapter 7 generally ensured that the amount transferred as a gift was
taxed only once between the donor and donee, not twice (though you also learned that there is a
lot of leakage, particularly under § 1014, which allows wealth accessions to go untaxed to either
party under the income tax). Mrs. Gould’s receipt was clearly not excludable as a gift because the
payment by Mr. Gould was made out of legal compulsion, not “detached and disinterested
generosity,” in the words of Duberstein. Nevertheless, the Court stressed the fact that Mr. Gould
was denied a deduction for his payment when it said: “The net income of the divorced husband
subject to taxation was not decreased by payment of alimony under the court’s order; and, on the
other hand, the sum received by the wife on account thereof cannot be regarded as income arising
or accruing to her within the enactment.” The thought was written as a single sentence, with a
semi-colon connecting the two independent clauses. This form implies a causal link, i.e., that Mrs.
Gould need not include the receipt precisely because Mr. Gould could not deduct the payment. In
other words, the Court implied that the amount should not be taxed to both. Because the Court has
no power to create nonstatutory deductions, it exercised its power to define the contours of residual
income (where we saw in Chapter 6 that the very vagueness of the language permits consideration
of external norms) in a way that ensured that the amount was not taxed twice by holding that the
recipient need not include the payments in Gross Income. The Court would presumably have come
to the same conclusion with respect to child support, if any had been at issue.
Today, Gould stands for the proposition that, except to the extent overturned by statute, explicit
or implicit cash support payments made within the intact or broken family have no income tax
consequences for either the payor or the payee. For example, the implicit cash payments from the
working spouse to a nonworking spouse in a one-earner household residing in a common law state
result in neither deduction for the working spouse nor inclusion by the nonworking spouse under
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Gould if they should file separate returns, regardless of any possible gift analysis. Like explicit
gifts, however, the amounts are taxed only once within the payor/payee pair.
Viewed this way, the question in the broken family context is not “is it income?” but rather
“whose income is it?” The income could be taxed to the recipient by requiring the recipient to
include it and allowing the payor to deduct it. Conversely, it could be taxed to the payor by
allowing the recipient to exclude it and disallowing a deduction for the payor. The government
becomes a mere stakeholder in the matter. In other words, inclusion by the payee and deduction
by the payor (or, alternatively, exclusion by the payee and nondeduction by the payor) could be
viewed not as independent ends in themselves in trying to measure income properly for each party
as a normative matter but, rather, as merely instrumental means to implement our decision
regarding whose marginal rates should apply.
With today’s comparatively low rates, the answer may not be obvious. In 1942, however, a
practical problem arose with the Gould resolution to this question. Recall from Chapter 3 that the
top individual marginal income tax rate rose to 94% during WWII to fund the war effort (on
incomes exceeding $200,000, more than $3.2 million in today’s dollars). With the significant
increase in rates, Congress voiced concern that a payor of alimony would have little left on which
to live once he (and it was always a “he” in this era) paid his alimony and then tax on his Taxable
Income—including the alimony payment. Congress reversed the Gould rule by statute in 1942,
requiring the recipient to include alimony under new § 71 and creating a new deduction for the
alimony payor under § 215. But Congress drew the line at payments “fixed” for child support in
the divorce instrument, which remained tax-neutral payments (neither includable by the recipient
nor deductible by the payor). In this way, the statute explicitly blessed income shifting from the
payor’s (presumably higher) tax bracket to the recipient’s (presumably lower) tax bracket with
respect to alimony but not child support.
The legislative history is silent regarding why child support was carved out of the new incomeshifting rules, but we can guess at the rationale. In this more traditional era—when it was, indeed,
only husbands who paid alimony and child support—it might have been thought that shifting the
tax obligation with respect to alimony would be sufficient to alleviate the immediate and practical
problem of a husband being unable to satisfy both his alimony and income tax liability if alimony
were not deductible. A man’s financial obligation to his children—including the obligation to pay
the income tax on amounts spent to support them—might have been considered to be stronger than
that to his ex-wife.
Prior to the Tax Cuts and Jobs Act (TCJA), divorcing parties who would be in significantly
different tax brackets after the divorce when filing as single individuals could both be better off—
after tax—with payments that were includable by the payee under § 71 and deductible by the payor
under § 215 than they would be with tax-neutral payments under Gould. But they had to be very
careful in drafting their divorce agreement; traps for the unwary abounded. For example, because
amounts “fixed” as child support could not be part of the inclusion/deduction system under §
71(c)(1), parties had to draft carefully to avoid “child support” and use “family support,” instead.
The Tax Court agreed that a “family support” payment (or an unallocated payment for the support
of both the ex-spouse and children) could fully qualify for inclusion by the payee and deduction
by the payor because no amount was “fixed” specifically as child support in the agreement. 24

24

See, e.g., Crabtree v. Comm’r, T.C. Memo. 2015-163. The parties, who had two minor children, drafted their divorce
instrument themselves, which the court entered as an order. It contained 13 paragraphs, one of which required the ex-

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For example, assume that we are in 2018 and that John and Mary, who have one minor child,
age 12, are divorcing. The child will live primarily with Mary, with generous visitation to John.
Without taking into consideration the following cash transfers, John, when single, will be in the
37% bracket. While Mary earns a solid salary, she will be in the 22% bracket when she files as a
single individual after her divorce. Mary demands no alimony but demands $3,000 per month in
excludable child support until their child reaches age 21, dies, or marries, whichever occurs first.
John does not object to the figure but suggests that they call the payment a “family support
payment,” with no amount specifically designated as child support, so that he can deduct the
payment under § 215, as in effect for 2018. If Mary should die before their child is emancipated
(an actuarially unlikely event), John will gain full custody.
John’s goal is to structure the entire payment as tax alimony within the meaning of § 71, as in
effect for 2018, which would be includable by Mary and deductible by John under § 215, with no
amount treated as a tax neutral payment (neither includable by Mary nor deductible by John).
Economically, it doesn’t matter whether the payment is called “child support” or “family support”
or “alimony.” “Alimony” sounds mercenary and “child support” sounds benevolent, but otherwise
there is no difference; the recipient is under no duty to account for how the funds are used.
If Mary’s economic goal is to have at least $3,000 in after-tax cash each month from John, she
will not accept his request to label the payment as includable “family support” because she would
have only $2,340 left if she must include the payment in her Gross Income and pay $660 in tax
($3,000 x .22). John then offers to pay $4,000 each month (instead of $3,000) if Mary will agree
to label the payment as includable “family support” so that he can deduct the payment. After
Mary’s 22% tax ($880), she would have $3,120 left after tax, which is $120 more than she would
have with $3,000 of excludable child support. At the same time, John’s after-tax cost of the
payment would be reduced from $3,000 (with a $3,000 nondeductible payment) to $2,520, with a
$4,000 deductible payment that saves him $1,480 in tax ($4,000 x .37). John and Mary would
effectively save $600 net 25 and share the spoils. Will Mary accept? With better negotiations, Mary
could claim even more of the spoils, as she is better off by only $120 compared to her original
request, while John is better off by $1,480. And so the negotiations continue….
The point was that—prior to enactment of the TCJA—the structure of §§ 71 and 215 could be
used to ensure that both John and Mary could be better off—after tax—with payments that are
includable by the recipient and deductible by the payor, if they were in substantially different tax
brackets. In other words, Congress explicitly blessed income-shifting in this one context. While
this treatment appears to lose revenue for the Treasury because the parties are in different tax
brackets, remember from Part A. that the scenario of married spouses with significantly different
incomes is the very scenario in which they enjoy a “marriage bonus” while married (lost tax
revenue for the Treasury), which they lose when they divorce and must file as individuals.
Moreover, studies show that divorce is often accompanied by financial hardship (and triples the
chances of bankruptcy), aggravating the divorce penalty that occurs with the loss of their marriage

husband to pay $5,232 monthly to his ex-wife as unallocated alimony/child support “for a continued 8 year period
with the provision as long as Mrs. Girard should not remarry or cohabitate.” The Tax Court agreed that no amount
was fixed for child support (though they failed to satisfy another requirement under § 71).
25
This figure represents the difference between the $1,480 tax saved by John with his $4,000 deduction and the $880
tax that Mary will pay on including the $4,000 payment.

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bonus. 26
In the TCJA, Congress permanently amended §§ 71 and 215 to make all cash payments made
under divorce agreements finalized after 2018 (whether characterized as “alimony, “child
support,” or “family support”) tax neutral payments, excludable by the recipient and nondeductible
by the payor. In effect, we are back to Gould v. Gould. Agreements negotiated before 2019 are
grandfathered under old law in order to avoid upsetting the economic bargain reached by the
parties based on their assumptions that the payments would be includable by the recipient under §
71 and deductible by the payor under § 215.
If John’s and Mary’s divorce agreement is executed this year, Mary will exclude the cash
payment (whether $3,000, $4,000, or some other figure) and John cannot deduct the cash payment,
with no flexibility to make the payments includable by Mary and deductible by John, meaning that
both may be worse off than under prior law.
Retirement savings in divorce
The one remaining instance in which cash payments may be includable by the payee pertains
to payments made from certain retirement plans under a “qualified domestic relations order”
(QDRO) within the meaning of § 414(p). Using a QDRO, divorcing couples can negotiate the
sharing of one spouse’s retirement savings in certain eligible qualified defined benefit or qualified
defined contribution plans (such as §§ 401(k) or 457). Prior to creation of the QDRO in 1984, it
was possible to split pension assets in a divorce, but the court order was directed at the spouse with
the pension, rather than at the pension plan itself. For example, John might have been ordered by
the court to pay one-half of his monthly pension payments to Mary when he begins to receive
them—perhaps twenty years in the future. If John died before retirement, Mary received nothing.
Under § 414(p), in contrast, the pension plan administrator is the subject of the order, and Mary
receives vested rights. In other words, the administrator is ordered to treat Mary just as if she were
a plan participant.
While the primary purpose of the QDRO was to recognize these pension assignments and to
protect Mary’s interest in the plan, even if John should predecease Mary, the provisions also ensure
that Mary, as the “alternate payee” under a QDRO, includes the payments in Gross Income when
ultimately paid under the plan, just as John would have included them when paid to him absent the
QDRO. Because John will, of course, not receive these payments, he does not include the payments
made to Mary, which is the same end result as if he did include the payments but then deducted
them under (now repealed) § 215 as tax alimony. In this way, a QDRO enables just the kind of
income-shifting contemplated by prior §§ 71 and 215. The TCJA made no change to QDROs.
While QDROs cannot apply to individual retirement accounts (IRAs) § 408(d)(6) provides
similar treatment for IRA transfers in divorce.
Transfers of property in kind
Even before repeal of §§ 71 and 215 by the TCJA, transfers of property in kind could not qualify
for the inclusion/deduction system in §§ 71 and 215 because of the requirement in repealed § 71(b)
26

See Generally Deborah A. Geier, Simplifying and Rationalizing the Federal Income Tax Law Applicable to
Transfers in Divorce, 55 TAX LAW. 363 (2002), earlier version at JOINT COMMITTEE ON TAXATION, STUDY OF THE
OVERALL STATE OF THE FEDERAL TAX SYSTEM AND RECOMMENDATIONS FOR SIMPLIFICATION, JCS-3-01, VOLUME
III (ACADEMIC PAPERS), April 2001, at 19 (advocating that the parties ought to be empowered to designate all cash
payments as either includible by the payee and deductible by the payor or excludable/nondeductible, with the default
rule in the case of silence being includable/deductible).

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that such transfers be made in cash. A second question arises, however, with respect to transfers
of property in kind, illustrated by the facts in Davis v. Commissioner. 27 Mr. Davis transferred
shares of DuPont stock to his ex-wife as part of their divorce agreement. He had earlier purchased
the shares for $75,000, and they were worth $82,250 when he transferred them to Mrs. Davis. In
exchange, Mrs. Davis released Mr. Davis from all state law claims, including dower rights and any
rights that she may have had under the laws of testacy and intestacy. Mr. Davis did not include the
$7,250 built-in gain in his Gross Income in the year of transfer.
While you learned in Chapter 7 that the making of a gift is not a realization event under § 1001,
you also know that transfers in divorce cannot satisfy the Duberstein test because the transfer is
made under legal compulsion rather than detached and disinterested generosity. Moreover, the
transfer of property in settlement of a debt is a realization event. 28 If Mary borrows $4,000 from
John and repays her debt to him by transferring property with a value of $4,000 and basis of $3,000,
Mary realizes and recognizes a $1,000 § 1001 gain.
The Davis Court applied this unexceptional marketplace rule, assumed that the value of the
release of the marital rights equaled the value of the stock, concluded that Mr. Davis realized a
$7,250 § 1001 gain on the transfer, and concluded that Mrs. Davis took a $82,250 FMV cost basis
in the property under § 1012. The Court noted in a footnote the “administrative practice” of not
taxing Mrs. Davis on the release of marital rights, which presumably have a zero basis. 29
Had Mrs. Davis possessed some sort of ownership interest in the stock at the time of the divorce,
as in a community property state, the outcome would likely have been different, as a division of
jointly owned property was not usually considered to be a realization event. The Court
acknowledged, but apparently was not overly troubled by, the disparities that its decision would
create between residents of community property states and residents of common law states. (Where
have we seen this picture before? Recall the trouble caused by the different outcomes in Lucas v.
Earl and Poe v. Seaborn.)
The post-Davis era was one of confusion and uncertainty and certainly one full of traps for the
unwary. The government conceded that approximately equal divisions of community property30
or property in states where the law is “similar to community property law” 31 were not realization
events and that the transferee took a carryover basis in the property. Similarly, the IRS ruled that
approximately equal divisions of property owned as joint tenants or as tenants in common were
nontaxable divisions of property, even though ownership was not partitioned but, rather, some
assets went in their entirety to one spouse and some went in their entirety to the other. 32 Not all
transfers in community property states were tax-free events, however. An exchange of separate
(nonmarital) property for community property or an unequal division of community property

27

370 U.S. 65 (1962).
Int’l Freighting Corp. v. Comm’r, 135 F.2d 310 (2d Cir. 1943) (transfer of appreciated property to employee as
payment for services rendered is a realization event for transferor).
29
370 U.S. at 73, n.7. See also Rev. Rul. 67-221, 1967-2 C.B. 63.
30
Rev. Rul. 76-83, 1976-1 C.B. 213.
31
Rev. Rul. 74-347, 1974-2 C.B. 26.
32
Rev. Rul. 81-292, 1981-2 C.B. 158.
28

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resulted in taxation, 33 as did unequal divisions of jointly owned property in common law states. 34
This reliance on state law enabled states to enact anti-Davis legislation, exemplified by
Oregon’s statute: “Subsequent to the filing of a petition for annulment or dissolution of marriage
or separation, the rights of the parties in the marital assets shall be considered a species of coownership and a transfer of marital assets … shall be considered a partition of jointly owned
property.” 35 The “equitable distribution statutes” of other states were sometimes interpreted to vest
a property interest in the transferee in the case of a “special equity” determination. These eleventhhour vestings of property rights during the course of divorces in common law states most often
were upheld by the courts as effectively eviscerating Davis. 36
This state of affairs resulted in much confusion and costly litigation, many traps for the unwary,
and a variety of results for similarly situated taxpayers, depending on state law. It also resulted in
a fair amount of whipsaw for the Federal Treasury, with the transferor spouse claiming a tax-free
division of property and the transferee claiming a stepped-up FMV basis under Davis on later
disposition. In 1984, Congress finally enacted § 1041, which you should read now.
Section 1041(a) is the first “nonrecognition” provision that we have encountered. Had § 1041(a)
been in effect in Davis, Mr. Davis would not have “recognized” his $7,250 realized § 1001 gain,
which means that he would not include the § 1001 gain in his Gross Income under § 61(a)(3).
Notice, however, that the built-in gain would not have disappeared from the tax system; rather, it
would have been preserved for future reckoning in the hands of Mrs. Davis. Under § 1041(b)(1),
Mrs. Davis would have excluded the stock received from Mr. Davis as though it were a gift, and
she would have taken a carryover basis in the property under § 1041(b)(2), i.e., the same basis that
Mr. Davis had in the stock. The built-in gain would have been both deferred and shifted from Mr.
Davis’s return to Mrs. Davis’s return, to be realized and recognized by her when she sold the
DuPont stock to a third party. (Of course, if she had held the stock until her death, the preserved
built-in gain would then have been wiped out under § 1014.)
Notice that § 1041 is not limited to transfers incident to divorce but also applies to transfers
during marriage—whether a true gift made out of detached and disinterested generosity or a sale
for valuable consideration. For example, assume that Patti, a lawyer, sells a painting to a stranger
for $500 that she had purchased years earlier for $100. Patti’s $400 § 1001 realized gain ($500
A/R less $100 A/B) would be recognized (included in her Gross Income under § 61(a)(3)) and
would likely contribute to her preferentially taxed net capital gain. If, on the other hand, Patti sells
the same painting to her husband John, an art dealer, for $500, her $400§ 1001 realized gain would
go unrecognized under § 1041(a), and John would take Patti’s $100 basis under § 1041(b)(2).
When he sells the painting to a customer for $500, his $400 realized and recognized gain is
ordinary because the painting is an inventory item in his hands. See § 1221(a)(1). In short, Patti
33

See, e.g., Siewart v. Comm’r, 72 T.C. 326 (1979) (receipt by W of noncommunity cash and a personal note of H for
transfer of her one-half interest in community property constituted a sale, not a division of community property);
Carrieres v. Comm’r, 64 T.C. 959 (1975), aff’d, 552 F.2d 1350 (9th Cir. 1977) (per curiam) (taxable sale to W to the
extent H used his separate property to pay for W’s community property interest in stock but no taxable sale with
respect to the portion of such stock exchanged for H’s interest in other community property).
34
Rev. Rul. 74-347, 1974-2 C.B. 26.
35
ORS 107.105(1)(f) (discussed in Laird v. U.S., 16 Cl. Ct. 441 (1989)).
36
See, e.g., Collins v. Comm’r, 421 F.2d 211 (10th Cir. 1969); Imel v. U.S., 523 F.2d 853 (10th Cir. 1975); Cook v.
Comm’r, 80 T.C. 513 (1983), aff’d, 742 F.2d 1431 (2d Cir. 1984); Boucher v. Comm’r, 710 F.2d 507 (9th Cir. 1983);
Bosch v. U.S., 590 F.2d 165 (5th Cir. 1979), cert. denied, 444 U.S. 1044 (1980); McIntosh v. Comm’r, 58 T.C. 4 (1986)
(applying pre-1984 law); Laird v. U.S., 61 Cl. Ct. 441 (1989) (applying pre-1984 law).

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cannot launder out the low-tax gain by selling to her husband for valuable consideration, who
would then realize no high-tax ordinary income when he sold to his customer. Rather, he takes the
same basis that he would take in the painting if Patti had simply given the painting to him as a gift
(§ 1015) instead of selling the painting to him for $500 (§ 1012).
Even in the case of a true gift, however, the § 1041(b)(2) basis rule differs in one important
respect from the § 1015 basis rule applicable to inter vivos gifts between unmarried individuals:
the lower-of-FMV-or-basis rule in § 1015(a) does not apply to gifts between spouses. Rather, §
1041(b)(2) controls, which does not contain such a rule. See § 1015(e). Return to Patti’s painting,
which she had purchased years earlier for $100, but assume now that the painting is worth only
$70 today. If John and Patti were siblings instead of spouses, and Patti gave the painting to John
as a gift, who then sold it for $60 (because it continued to lose value), John would use the lower
$70 FMV of the property at the time of the gift (not Patti’s $100 basis) in determining his realized
loss, which would be $10 ($60 A/R less $70 A/B). Because John and Patti are spouses instead of
siblings, however, a gift of the property from Patti to John would result in a $100 basis for John
under § 1041(b)(2), which means that John realizes a $40 loss under § 1001 when he sells the
property for $60 to a customer. In short, § 1015 does not apply to spousal transfers, even in the
case of a true gift. Rather, § 1041 occupies the field.
What tax consequences arise with respect to property transfers that occur before marriage under
an ante-nuptial (or prenuptial) agreement, where § 1041 cannot apply? The taxpayer in Farid-esSultaneh v. Commissioner 37 was a 32-year-old American citizen known as Doris, who executed
an ante-nuptial agreement in 1924 with Sebastian S. Kresge, a 57-year-old store magnate 38 with
an estimated net worth of $375 million (more than $5 billion in today’s dollars). Under the
agreement, Doris received 2,500 shares of the S.S. Kresge Company from Sebastian, which were
then worth $787,500 (more than $11 million in today’s dollars). In consideration for the shares,
Doris agreed that she would release all dower and other marital rights, including any support rights
to which she would otherwise be entitled upon their marriage. Doris and Sebastian divorced in
1928, and Doris sold the shares in 1938, which raised the issue of her basis in the shares. Even
though the ante-nuptial agreement used the word “gift” with respect to the share transfer, the
Second Circuit Court of Appeals held that Doris should not take Sebastian’s carryover basis under
§ 1015 but rather should take a § 1012 cost basis of $787,500 (their FMV on her receipt) because
the shares were acquired for consideration. Under the modern-day Duberstein language that you
explored in Chapter 7, the share transfer was not made out of “detached and disinterested
generosity” but rather in expectation of the agreement’s quid pro quo—the surrender of marital
rights. Though Sebastian was not a party to the tax case, the natural consequence of this analysis
is that he should have realized and recognized a § 1001 gain equal to the excess of the shares’
$787,500 value over his (much lower) basis at the time of the 1924 transfer, just as did Mr. Davis.
To avoid this recognition today, modern parties to an ante-nuptial agreement usually delay the

37

160 F.2d 812 (2d Cir. 1947). For an interesting article that recounts and substantially expands upon the colorful
story surrounding this case, as well as explores the interesting procedural and ethical questions for lawyers in such
cases, see Linda Galler, Everything You Always Wanted to Know About Farid But Were Afraid to Ask, 13 FLA. TAX
REV. 461 (2013). Among other interesting tidbits, the article relates that Doris married a Persian prince with the title
“Farid-es-Sultaneh” in 1933. Though they divorced in 1936, Doris continued to use the name for the rest of her life
(hence the exotic name in the tax proceedings). Sebastian Kresge’s third marriage (after his divorce from Doris) lasted
more than 35 years until his death at age 99 in 1966. The Kresge Foundation continues to exist today. With more than
$3.6 billion in assets, it makes philanthropic grants exceeding $100 million each year.
38
He owned the Kresge five and dime stores and K Mart, among others.

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property transfer until after marriage in order to ensure application of § 1041.
In light of the rules embodied in § 1041, divorcing parties dividing or transferring marital
property should not focus solely on splitting up value fairly. The parties, if well advised, need to
consider the basis of each piece of property, as well—unless the property is not going to be sold
to third parties in the foreseeable future. An equal split of value can be very unequal after taxes,
once the built-in gains and built-in losses are considered, especially if the property at issue is
business or investment property, rather than personal-use property. Review, for example, § 165(c).
Problems
1. Lori and Luke are planning to divorce this year. Their jointly owned stock portfolio contains
shares of High Tech, Inc., with a basis of $70,000 and a FMV of $100,000, and shares of Realty,
Inc., with a basis of $130,000 and a FMV of $100,000. What tax consequences result if they sell
both blocks of stock to third parties while still married, split the cash, and then divorce?
2. Same as 1., except that they do not sell the stock while still married. Instead, Lori and Luke
agree that Lori will take the shares of High Tech in kind and Luke will take the shares of Realty
in kind under their divorce agreement. After the divorce, Lori sells the shares of High Tech for
$100,000 to a third party, and Luke sells the shares of Realty for $100,000 to a third party. Who is
happy, who is not, and why?
3. Instead of taking the High Tech stock, Lori demands the shares of Realty. Luke counters with
an offer to pay Lori $100,000 in cash, instead, so that he can keep the Realty shares for himself.
Any advice for Lori?
Unmarried cohabitants with no formal state-sanctioned legal relationship
Unmarried cohabitants who have no formal legal relationship and who separate households
after a long period can enter into contractual arrangements to effectuate the separation. How are
cash payments made under such a contract treated for tax purposes? The answer may depend in
part on whether state law recognizes an equitable interest in property without formal legal title
under the written or oral contract. The most famous example is the case of Marvin v. Marvin, cited
in footnote 8 in Reynolds, below, which involved the actor Lee Marvin and which brought the
colloquialism “palimony” into the lexicon, though his partner was unable to prove such a contract.
REYNOLDS v. COMMISSIONER
T.C. Memo. 1999-62
LARO, JUDGE: [Violet Reynolds and Gregg Kent met in 1957 in California, while both were
married to others, through business dealings that Mr. Kent had with Ms. Reynolds’s spouse.
Beginning in 1967, Ms. Reynolds and Mr. Kent had an affair that lasted for one year, after which
the parties left their spouses and moved in together in Washington State. Mr. Kent did not wish
for Ms. Reynolds to work outside the home, and she did not. In 1970, the parties moved back to
California, continued to cohabit, and divorced their respective spouses. Though they never
married, they continued to cohabit for 24 years, during which time Ms. Reynolds did not work
outside the home. Ms. Reynolds testified:

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Mr. Kent and I entered into an agreement whereby he was to be the provider and I
was to take care of our nest. That agreement subsequently became more involved
and included my taking care of him, the home, the interior of the boat, acting as a
hostess for all parties and entertaining he wanted to do for personal and business
reasons, doing laundry, housekeeping, ironing, cooking, shopping, supervising the
service people who occassionally [sic] worked on the home and acting as nurse for
Mr. Kent when he had health problems. In turn Mr. Kent agreed to provide for all
of my living expenses.
They looked for and purchased a home in 1980, which was solely in the name of Mr. Kent. In
1989, Mr. Kent purchased a new Mercedes automobile and told Ms. Reynolds that he was giving
to her the 1987 Lincoln Town Car that he had used previously, though the car remained in the
name of KENCOR, which was a corporation wholly owned by Mr. Kent. Mr. Kent gave Ms.
Reynolds approximately $500 to $600 each week to purchase household goods and personal items.
Over the years, Mr. Kent gave to Ms. Reynolds jewelry and other expensive items. In 1987 Mr.
Kent bought a new boat, which cost approximately $260,000, to replace a smaller one, and he
invested an additional $100,000 in upgrades to it. He referred to the boat as “our” boat, but title
was in Mr. Kent’s name. Ms. Reynolds testified that she had seen financial statements showing
that Mr. Kent’s assets were worth approximately $18 million. When they traveled, he held
themselves out as “husband and wife.”
In July 1991, Mr. Kent vacated the home in which they lived and demanded that Ms. Reynolds
vacate the home and return the Lincoln Town Car. Ms. Reynolds refused, and Mr. Kent and
KENCOR sued her “for ejectment, trespass, and conversion.” Mr. Kent asked that the court enter
a judgment confirming that Ms. Reynolds had no interest in the property purchased during their
relationship, and Ms. Reynolds responded by asserting that she had an equitable interest in such
property.
In October 1991, the parties entered into a settlement agreement, which required Mr. Kent to
pay to Ms. Reynolds (1) a lump sum of $57,500 after she returned all property items except the
Town Car and personal jewelry, which she could retain, (2) $2,000 per month for three years
commencing in November 1991, and (3) $1,000 per month for two years commencing in
November 1994 and concluding in October 1996.]
In accordance with the payment plan set forth in the settlement agreement, petitioner received
$22,000 in 1994. This amount was received from KENCOR, and KENCOR issued a Form 1099MISC, Miscellaneous Income, to petitioner reporting the amount as miscellaneous income.
Petitioner did not perform services for KENCOR during that year, nor did she sell it any property
during that year. Petitioner, allegedly relying on advice from her attorney and accountant, did not
report this amount on her 1994 Federal income tax return.
DISCUSSION
We must decide whether the $22,000 amount is includable in petitioner’s 1994 gross income.
Respondent argues it is. Petitioner argues it is not. Respondent contends that petitioner received
the disputed amount as compensation for her homemaking services. Petitioner contends that she
received the disputed amount as a gift.
We agree with petitioner that the $22,000 amount is not includable in her 1994 gross income,
but we do so for a reason slightly different than she espouses. The taxability of proceeds recovered
in settlement of a lawsuit rests upon the nature of the claim for which the proceeds were received

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and the actual basis of recovery. Sager Glove Corp. v. Comm’r, 36 T.C. 1173, 1180 (1961), affd.
311 F.2d 210 (7th Cir. 1962). Ascertaining the nature of the claim is a factual determination that
is generally made by reference to the settlement agreement in light of the facts and circumstances
surrounding it. Key to this determination is the “intent of the payor” in making the payment.
Knuckles v. Comm’r, 349 F.2d 610, 613 (10th Cir. 1965), affg. T.C. Memo. 1964-33; Agar v.
Comm’r, 290 F.2d 283, 284 (2d Cir. 1961), affg. per curiam T.C. Memo. 1960-21; Seay v. Comm’r,
58 T.C. 32, 37 (1972). We must ask ourselves: “In lieu of WHAT was the payment received?” See
Robinson v. Comm’r, 102 T.C. 116, 126-127 (1994), affd. in part, revd. in part on an issue not
relevant herein and remanded 70 F.3d 34 (5th Cir. 1995). Although the payee’s belief is relevant
to this inquiry, the payment’s ultimate character depends on the payor’s dominant reason for
making the payment. Comm’r v. Duberstein, 363 U.S. 278, 286 (1960); see Agar v. Comm’r, supra
290 F.2d at 298; Fono v. Comm’r, 79 T.C. 680 (1982), affd. without published opinion 749 F.2d
37 (9th Cir. 1984).
The settlement agreement indicates that Mr. Kent paid the disputed amount to petitioner in
surrender of her rights in most of the property purchased during their relationship. [5] Respondent
agrees with this characterization, but extrapolates therefrom that Mr. Kent paid petitioner the
disputed amount to compensate her for past services that she rendered to him. We do not agree.
Nothing in the record persuades us that petitioner ever sought in the lawsuit remuneration for
services that she may have rendered to Mr. Kent during their relationship, let alone that Mr. Kent
intended to compensate her for any such services by paying her the disputed amount. The written
judgment sought by Mr. Kent and the settlement agreement both indicate that the only reason Mr.
Kent commenced the lawsuit and paid the disputed amount to petitioner was to retain possession
of most of the assets acquired during their relationship.
Although petitioner did refer in her Declaration to an agreement under which she would provide
services to Mr. Kent in exchange for support, the facts of this case do not support an inference that
she ever sought in the lawsuit to recover remuneration for these services, or, more importantly,
that Mr. Kent paid her the disputed amount intending to compensate her for any services that she
may have rendered to him. [6] The payor’s intent controls the characterization of settlement
payments, and, as we have found, Mr. Kent intended to perfect his sole possession of most of their
joint property when he paid petitioner the disputed amount. In this regard, the cases of Green v.
Commissioner, T.C. Memo 1987-503, affd. per curiam 846 F.2d 870 (2d Cir. 1988), Cotnam v.
Commissioner, 263 F.2d 119, 122 (5th Cir. 1959), revg. in part and affg. in part 28 T.C. 947 (1957),
and Braddock v. United States, 434 F.2d 631 (9th Cir. 1970), are factually distinguishable from
the case at hand. The taxpayer in Green, unlike petitioner, sued her partner’s estate as a creditor,
seeking to recover the value of services that she rendered to him. The same is true with respect to
the taxpayer in Cotnam, where the appellate court noted that “The pleadings in the * * * [State
court] proceedings show clearly that Mrs. Cotnam’s claim was based on the theory of a contract
for services” As to Braddock, the payor there, unlike the payor here, had a legal obligation to pay
[5]

We recognize that KENCOR paid petitioner the $22,000 amount and that KENCOR issued petitioner a Form 1099MISC reporting that the amount was paid as miscellaneous income. The record, however, tends to disprove such a
characterization. The more likely explanation of the payment, and the one we find from the facts herein, is that Mr.
Kent, as principal shareholder of KENCOR, caused KENCOR to pay petitioner the $22,000 amount on his behalf.
[6]
Even if we were to assume arguendo that Mr. Kent did agree to support petitioner in consideration for her
homemaking services, it would not necessarily follow that every item of property that he gave her during their
relationship was pursuant to this agreement. In fact, if we were to believe the allegations in petitioner’s Declaration to
the effect that Mr. Kent spent approximately $32,000 to $38,400 a year on their household and her personal expenses,
it would seem most logical to conclude that many of the additional amounts that he gave her were gifts.

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the taxpayer for her services in cooking, cleaning, and helping him with his farm.
Our conclusion that Mr. Kent paid petitioner the disputed amount for her interest in the property
does not end our inquiry. Petitioner’s sale of her property interest to Mr. Kent is a taxable event
for which she must recognize gain to the extent that the selling price exceeds her basis in the
property. Sec. 1001(a). As to her basis, the record indicates that petitioner received her interest in
the property by way of numerous gifts that Mr. Kent made to her throughout their relationship.
Petitioner’s declaration depicts a setting under which Mr. Kent repeatedly “gave” her property,
and the facts of this case support the conclusion that he made these “gifts” with the “detached and
disinterested generosity, * * * affection, respect, admiration, charity, or the like” required by
Commissioner v. Duberstein, supra at 285. Given the fact that petitioner and Mr. Kent for a long
period of time lived as husband and wife in most regards, but for the obvious fact that they were
not legally married, we find it hard to believe that their relationship was actually akin to a business
arrangement. [8]
Our conclusion herein that the property received by petitioner from Mr. Kent was by way of a
gift, rather than as compensation for her services, is consistent with prior decisions of this Court.
First, in Starks v. Commissioner, T.C. Memo 1966-134, the taxpayer, a young unmarried,
nonworking woman was involved with a much older man. The man, in return for the woman’s
companionship, gave her money to buy a house and to spend on her living expenses. He also gave
her an automobile, jewelry, furniture, fur coats, and other clothing. Respondent determined that
the money and other assets were taxable to the woman as compensation for services rendered to
the man. We disagreed. We held that the woman received the money and other assets as gifts. See
also Libby v. Comm’r, T.C. Memo 1969-184 (similar holding as to cash and property given to a
young mistress by her older paramour).
Later, in Pascarelli v. Commissioner, 55 T.C. 1082, 1090-1091 (1971), affd. without published
opinion 485 F.2d 681 (3d Cir. 1973), we held to the same effect. There, the taxpayer was a woman
who lived with a man who was not her husband. The man gave money to the woman in exchange
for “wifely services.” Respondent determined that the money was taxable to the woman as
compensation that she earned for her services. We disagreed. We held that the payments were
gifts. We found that the man paid the money to the woman “motivated by sentiments of affection,
respect, and admiration.” Id. at 1091.
And later, in Reis v. Commissioner, T.C. Memo 1974-287, the taxpayer was a young female
nightclub dancer who met an older man when he bought dinner and champagne for the performers
in the show. The man paid each person at the table, other than the woman, $50 to leave the table
so that he and she would be alone. The man gave the woman $1,200 for a mink stole and another
$1,200 so that her sister could have an expensive coat too. Over the next 5 years, the woman saw
the man “every Tuesday night at the [nightclub] and Wednesday afternoons from approximately
1:00 p.m. to 3:00 p.m. * * * at various places including * * * a girlfriend’s apartment and hotels
where [he] was staying.” He paid her living expenses, plus $200 a week, and he provided her with
[8]
We are mindful that all property acquired during the relationship was placed in the name of Mr. Kent or that of a
corporation that he controlled. We do not find this fact to negate the presence of a gift under the facts herein. Federal
law answers the question of whether a gift has occurred for Federal income tax purposes, Commissioner v. Duberstein,
363 U.S. 278, 286 (1960), and we believe that Mr. Kent’s requested judgment and the settlement agreement speak
loudly to the effect that he gave petitioner interests in property under the test set forth in Duberstein. To the extent
that State law is relevant to this inquiry, applicable State (California) law does provide that a nonmarital partner may
have an equitable interest in property titled solely in the other partner’s name. See Marvin v. Marvin, 18 Cal. 3d 660,
684 n.24 (1976), and the cases cited therein at 669-670.

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money for other things, such as investing, decorating her apartment, and buying a car. We held
that none of the more than $100,000 that he gave her over the 5 years was taxable to her. We
concluded that she received the money as a gift. We reached this conclusion notwithstanding the
fact that the woman had stated that she “earned every penny” of the money.
Given our conclusion in this case that petitioner received her interest in the property as gifts
from Mr. Kent, her basis in the property equals Mr. Kent’s basis immediately before the gifts, to
the extent that his basis is attributable to the gifted property. [9] Sec. 1015(a). Although the record
does not indicate with mathematical specificity the amount of Mr. Kent’s basis that passed to
petitioner as a result of the gifts, we are satisfied from the facts at hand that her basis equaled or
exceeded the amount that she realized on the sale; i.e., $153,500. We conclude that petitioner had
no gain to recognize upon receipt of the disputed payment.
We have carefully considered all arguments by respondent for a contrary holding, and, to the
extent not discussed above, find them to be irrelevant or without merit.
_____________________________________________
Property transfers in RDPs and civil unions
You learned in Revenue Ruling 2013-17 39 earlier in this chapter that members of an RDP or
civil union are not considered married for Federal tax purposes. Until and unless this treatment
changes, § 1041 does not apply to such couples who dissolve their legal relationship using state
law procedures. Moreover, such couples are prevented from using QDROs to apportion pension
benefits. In the absence of § 1041, how are property transfers analyzed?
The pre-Davis precedents described earlier would presumably govern—even though those
precedents dealt with couples that were recognized as married for Federal income tax purposes—
because they focused on the effect of state law on the parties’ property ownership interests rather
than on their marital status. As noted in Chief Counsel Advice 201021050 (Part A.), state law
governs the property interests enjoyed by each member of an RDP for purposes of Federal income
taxation. Under Revenue Rulings 76-83 and 74-347 (described and cited earlier), approximately
equal divisions of community property or property in “equitable division” states where the
recipient is held to have an equitable interest should not result in gain or loss for the transferor,
and the transferee should take a carryover basis. The same should result under Revenue Ruling 81292 for approximately equal divisions of property held as joint tenants in common law states, even
though some property goes in its entirety to one person and some goes in its entirety to the other.
“The legal argument [in those rulings] is that there is no realization when two partners make an
equal division of their jointly owned property. The same argument can be used to support nonrealization in property divisions between … registered domestic partners.” 40 If gain is not realized
under § 1001, § 1041 is not needed to avoid recognition of that gain.
Under Revenue Ruling 74-347, however, unequal divisions of jointly owned property in
common law states could result in taxation if § 1041 does not apply. Indeed, a transfer of property
wholly owned by one party to the other in a common law state under legal compulsion of a civil

[9]

If petitioner were claiming (which she is not) that she had realized a loss on her disposition of any of the gifted
property, her basis in that property would equal the lesser of Mr. Kent’s basis at the time of the gift or the property’s
fair market value at that time. Sec. 1015(a).
39
2013-2 C.B. 201.
40
See Patricia Cain, Planning for Same-Sex Couples in 2011, 28-29, at http://ssrn.com/abstract= 1860217, at 26.

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decree dissolving the union would be a realization event for the transferor under Davis, itself.
In a community property state, the unequal division of community property in kind on
dissolution of an RDP can be resolved by one partner agreeing to pay cash (earned in the future
and so not community property at the time of the dissolution) to the other partner in order, in effect,
to equalize the unequal property split (sometimes referred to as an “equalization payment”). A
common example involves a tax-preferred retirement account, such as a § 401(k) account. Assume,
for example, that Mary and Lee are members of an RDP under California law when they decide to
dissolve their RDP. Mary has a § 401(k) account with her employer with a $100,000 balance,
which is community property under California law, at the time of dissolution. Because Mary and
Lee are not married, they cannot use a QDRO with respect to Lee’s interest. Moreover, assume
that Mary wishes to retain ownership of the full account balance and so agrees to pay to Lee
$50,000 in several installments after the dissolution in order to purchase Lee’s 50% community
interest in the account.
The proper analysis of those payments under California community property law is reflected in
the analysis in Reynolds, above, as though the couple had no formal state law relationship. Unlike
the Tax Court’s assumption in that case (that the cash payments received by Ms. Reynolds were
less than her basis in the equitable property interests that she surrendered), Lee’s basis in her share
of this community property is clearly $0 on these facts, 41 which means that 100% of each cash
receipt constitutes §1001 realized gain for Lee and would be fully includable as ordinary income. 42
Mary should, in theory, be able to increase her $0 basis in the § 401(k) account by $50,000, equal
to the $50,000 that she pays to Lee for her interest in the property.
Problem
Matthew and William have been Registered Domestic Partners under California law for 10
years, but they are now dissolving their relationship. Under California community property law,
both their primary personal residence and their vacation home are community property. As part of
their property agreement, they agree that Matthew will keep their primary residence (A/B of
$500,000 and FMV of $700,000) and that William will keep their vacation residence (A/B 600,000
and FMV of $1 million). Otherwise, they split all remaining community property equally.
Neither Matthew nor William plan to sell their properties soon. (William plans to move into
what had been their vacation home and use it as his new primary residence.) To equalize the
property split, William agrees to pay Matthew $150,000 (one-half of the $300,000 value difference
between the two homes) in three equal annual installments of $50,000 each. What tax
consequences arise on the cash payments for both Matthew and William? Specifically, can
Matthew exclude any part of the $150,000 aggregate cash payment? What will be William’s basis
in the vacation residence after the payments are complete?

41

Recall from Chapter 2 that § 401(k) accounts are funded with pre-tax dollars, as under a cash-flow consumption
tax, which means that neither Mary nor Lee would have any basis in their community interests in the account.
42
The gain is ordinary because it reflects her share of the ordinary income that she would otherwise withdraw in the
future. As you will learn in Chapter 14, a taxpayer cannot convert accrued ordinary income to capital gain by selling
the income interest to another. Moreover, in Chapter 12, you will learn that Lee can defer inclusion of her realized
gain on the sale of her property interest until receipt of the cash sale proceeds under the § 453 installment sale rules.

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Unit IV:
Everything You Ever Wanted
To Know About Debt but Were Afraid To Ask
Introduction to Chapters 9 through 11
Debt, or leverage, is an extremely important (and growing) element of the economy, as many
business and financial investments are made with borrowed money, often not because of need but
because of an attempt to increase total returns, which also increases risk if the investment does not
perform as anticipated.
For example, assume a no-tax world in which Veronica and Victor each have $100,000 in cash
to invest. Veronica purchases one rental property for $100,000 in cash (nondepreciable land rented
to tenant farmers, to keep the analysis simple), which she rents to a tenant at a monthly rent of
$1,000, or $12,000 per year. At the end of five years, the land has appreciated in value to $130,000,
and she sells the property.
Victor purchases five rental properties (nondepreciable land rented to tenant farmers) for
$100,000 each, making a $20,000 cash down payment and borrowing $80,000 at an interest rate
of 4% with respect to each property. Victor borrows $400,000 in the aggregate and pays $16,000
in annual interest ($400,000 x .04). Like Veronica, he rents each property to a tenant at a monthly
rent of $1,000, or $12,000 per year. At the end of five years, each property has appreciated in value
to $130,000, and Victor sells them and repays the borrowed $400,000.
In our no-tax world, compare the aggregate profit for each on these $100,000 cash investments.
Veronica invests $100,000

Victor invests $100,000

buys 1 land tract for $100,000 cash

buys 5 land tracts, paying $20,000 in cash and
borrowing $80,000 at 4% interest for each,
with $400,000 borrowed in the aggregate

annual rental income: $12,000

annual gross rental income: $60,000
less annual interest cost:
16,000
annual net rental income: $44,000

total rental income over 5 years: $60,000

total net rental income over 5 years: $220,000

sale: $130,000 less $100,000 cash
investment = $30,000 profit

sale: $650,000 less $100,000 cash investment
less $400,000 principal repayment = $150,000
profit

total profit: $90,000 ($60,000 plus
$30,000) = 90% ($90,000/$100,000)

total profit: $370,000 ($220,000 plus $150,000)
= 370% ($370,000/$100,000)

$190,000 cash in hand

$470,000 cash in hand

The description above is a simple example of how private equity firms use leverage (borrowed

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cash) to increase their returns on investment. Of course, if the land falls in value by 50% (to
$50,000) instead of increases in value by 30% (to $130,000), Veronica would still make an overall
profit, while Victor would suffer a loss. In other words, leverage magnifies both profit and loss.
Veronica

Victor

total rental income over 5 years: $60,000

total net rental income over 5 years: $220,000

sale: $50,000 less $100,000 cash
investment = $50,000 loss

sale: $250,000 less $100,000 cash investment
less $400,000 principal repayment = $250,000
loss

total profit: $10,000 ($60,000 less
$50,000) = 10% profit

total loss: $30,000 ($220,000 less $250,000)
= 30% loss

$110,000 cash on hand

$70,000 cash on hand

The financial sector occupied about 2.8% of GDP in 1950 but occupies more than 8% today. 1
It has doubled since 1980, making the tax system’s rules regarding debt increasingly important.
Chapter 9 examines the basic income tax rules pertaining to the borrowing and lending of
money, including the receipt and repayment of principal, the receipt and payment of interest, the
proper identification of principal and interest payments, and the proper timing of any interest
inclusion or deduction. This material also includes a discussion of how basis is recovered in
annuities (a type of financial instrument), which is subject to favorable tax rules. Because the socalled borrowing exclusion allows the receipt of cash without an income inclusion, taxpayers have
long sought to squeeze all sorts of receipts within the borrowing exclusion, so this chapter will
also examine the scope of the borrowing exclusion.
What tax consequences arise for both the lender and the borrower if events do not unfold
according to original assumptions, and the borrower fails to repay principal or fails to pay required
interest? Chapter 10 examines this issue.
Finally, Chapter 11 explores how these rules play out in the context of the purchase, ownership,
and disposition of property. Because basis, generally speaking, is the tool that allows us to keep
track of previously taxed dollars, can basis be created when property is purchased with (as-yet
untaxed) borrowed money? How is relief from indebtedness analyzed when the relief accompanies
a transfer of property ownership?

1

See Justin Lahart, Number of the Week: Finance’s Share of Economy Continues to Grow, at
http://blogs.wsj.com/economics/2011/12/10/number-of-the-week-finances-share-of-economy-continues-to-grow.
See also Paul Krugman, Three Expensive Milliseconds, at www.nytimes.com/2014/04/14/opinion/krugman-threeexpensive-milliseconds.html?ref=paulkrugman (discussing the economic consequences of the growth in the financial
sector compared to other sectors of the economy).

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Chapter 9: Borrowing and Lending
This chapter addresses the income tax treatment of the borrowing, lending, and repayment of
principal, as well as the payment and receipt of interest, which compensates the lender for the time
value of money. (You can think of interest as rent paid to use someone else’s cash, just as rent can
be paid to use someone else’s real estate.) At least, this chapter describes those tax consequences
when everything goes according to plan and all payments are made as expected.

A. The basic rules of the road
Assume that Betty Borrower borrows $100,000 from Larry Lender on January 1 of Year 1 under
a loan agreement that requires Betty to repay the $100,000 after 10 years (on December 31 of Year
10) and also requires that she pay 4% interest, compounded annually, on December 31 of Year 10
when she repays the original principal. In Year 10, she would have to pay to Larry $148,024.43. 1
What is the income tax treatment of these payments and receipts for each party?
Let’s start with Larry Lender. Does Larry’s transfer of $100,000 to Betty constitute a current
wealth decrease—an “expense”? If it is an expense, it would be deductible because Larry is
pursuing an investment return in the form of interest. Or has Larry merely changed the form in
which he is holding his wealth—a nondeductible capital expenditure—because Larry has replaced
his cash with a claim against Betty? In Chapter 4, you learned that Treas. Reg. §§ 1.263(a)4(d)(2)(i)(B) and (d)(2)(vi), Ex. (1), confirm the latter characterization. Larry cannot deduct the
$100,000 transferred to Betty in Year 1, but that nondeduction immediately creates a $100,000
basis in the loan. Of the aggregate $148,024.43 that Larry will receive in Year 10, $100,000 is taxfree basis recovery, but the remaining $48,024.43 is new wealth to Larry in the form of interest,
includable in his Gross Income under § 61(a)(4). For now, we shall gloss over the timing of Larry’s
interest inclusions, discussed in Part C., infra.
Is Betty’s Year-1 receipt of $100,000 in cash includable in her Gross Income? The usual
response is that the receipt is not a wealth accession because of the offsetting obligation to repay
the $100,000 in Year 10. For example, if we created a balance sheet for Betty, with assets listed
on the left and liabilities listed on the right, we would add $100,000 to both sides, so her net worth
(assets less liabilities) would remain unchanged.
Assets

Liabilities (face amount of principal repayment obligation)

$100,000

$100,000
No increase in her net worth (assets less liabilities)

Betty’s ability to exclude borrowed loan principal is often referred to as the “borrowing
exclusion,” but it is important to appreciate that no statutory exclusion provision exists to prevent
inclusion of her receipt. Rather, the receipt is not considered to rise to the level of Gross Income
within the meaning of § 61’s residual clause in the first place—solely because of the offsetting
obligation to repay. Were it not for Betty’s promise to repay in Year 10 the $100,000 cash received
1

If you would like to find such figures yourself, the amount can be found using an online compound interest calculator,
of which there are many, by filling in the appropriate slots with the necessary information, such as the interest rate,
the number of times compounded, and the borrowed amount.

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in Year 1, the receipt would clearly constitute an immediate wealth accession under Glenshaw
Glass’s interpretation of the § 61 residual clause.
Does Betty’s repayment of the $100,000 principal amount in Year 10 constitute a wealth
reduction that might generate a deduction for her? If we stick with this balance sheet approach, the
answer is “no.” While we remove $100,000 in assets from the left side of her balance sheet—
which might superficially look like a wealth reduction—we simultaneously remove the $100,000
liability from the right side of her balance sheet, which means that Betty’s net worth (assets less
liabilities) is not reduced.
Notice that Betty is effectively taxed on the loan proceeds, though not in the year of receipt but
rather in the year of repayment (through deduction denial). In other words, borrowed principal is
not intended to be permanently tax-free for Betty. As a sneak preview of what is coming in the
next chapter, what would happen if the borrower never repays? The exclusion of the cash receipt
in Year 1 was acceptable solely because she promised to repay it with after-tax (i.e., undeducted)
dollars. As you will learn, § 61 will generally generate Gross Income if her obligation to repay
disappears, or else Betty will have received permanently tax-free cash back in Year 1. But we are
getting ahead of ourselves!
Betty’s interest payment, on the other hand, is another matter, as it does constitute a current
wealth decrease, i.e., an expense. Section 163 provides the detailed rules under which interest
expense is, or is not, deductible. If she spends the loan principal in her business, the interest would
generally be deductible under § 163(a). If she uses the loan principal to, say, buy a personal-use
boat, the interest would not be deductible. See § 163(h)(1). Deductible “qualified residence
interest” (including a loan used to acquire a personal residence) is a tax expenditure that is carved
out of otherwise nondeductible personal interest, which we shall explore in Chapter 17. We shall
also examine the deductibility of “investment interest” under § 163(d) in Chapter 15.
As with the timing of Larry’s interest inclusion, let’s gloss over (for now) the timing of Betty’s
interest deduction, assuming that the interest is, in fact, deductible under § 163.
Notice that Larry’s tax analysis was grounded in routine SHS analysis that you learned in
Chapter 1. In contrast, the analysis described above for Betty—which looked to her balance sheet
and permitted evaluating whether a cash receipt in Year 1 is a wealth accession by looking to what
we expect to happen in a future year—is new and different. Other than § 83 (studied in Chapter 5,
pertaining to the receipt of property as compensation for services rendered if that property is
subject to a substantial risk of forfeiture), the annual accounting principle prevents the
expectation of a future repayment to negate what would otherwise be a current accession to wealth.
Rather, under the annual accounting principle introduced in Chapter 1, you learned that we usually
analyze each year in isolation. Such an approach would require the inclusion of borrowed money
in Gross Income when received and the deduction of principal repayments when made (similar to
the approach under a cash-flow consumption tax). The ability of taxpayers to invest with pre-tax
dollars under the borrowing exclusion has led to all sorts of distortions and tax shelter problems
inconsistent with income tax principles, leading to the enactment of provisions like § 7872
(described below in Part B.) and those discussed in Chapter 15 (Tax Shelters).
So where does the borrowing exclusion come from? As recounted in earlier chapters,
interpreters of the early income tax tended to borrow from other disciplines (such as trust and
financial accounting) in defining income prior to the work of Messers. Schanz, Haig, Simons (and
others), who developed a uniquely tax-specific meaning. The borrowing exclusion under the

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income tax likely arose from a reflexive borrowing (pun intended) from financial accounting,
under which borrowed principal is not included on a business’s “income” statement. Financial
accounting, however, uses transactional accounting (including the use of balance sheets), which
is different from the annual accounting principle used in income taxation. Borrowed cash was
(and is) excluded from the income statement in financial accounting because transactional
accounting expressly permits (indeed, requires) a look forward to future years (and the obligation
to repay) with respect to the front-end treatment of this transaction called borrowing.
As described more fully in Chapter 21, however, the purposes and goals of financial accounting
(under which the tension between an income tax and consumption tax is irrelevant) are very
different from those under an income tax. Nevertheless, the borrowing exclusion remains today—
even when we now know that financial accounting principles can be inconsistent with SHS income
tax principles and that the borrowing exclusion can cause mighty mischief under the income tax—
for sheer administrative ease. As described above, the plain vanilla borrowing and repayment of
principal (though not interest) can usually be ignored by both the borrower and lender for tax
purposes, which is an easy rule to administer.

B. Section 7872
Let’s return to the analysis of Betty’s receipt of that $100,000 in borrowed cash in Part A.,
which she had to repay in Year 10, together with $48,024.43 in interest. Part A. suggested that the
reason why Betty did not realize Gross Income when she received the $100,000 in cold, hard cash
is that she also incurred, at the same time, a future repayment obligation of that same $100,000
that negated any wealth accession in Year 1. Under the balance sheet approach, there is a more
sophisticated way to analyze why Betty’s receipt of the $100,000 does not constitute Gross
Income, however. Notice that the analysis in Part A. ignored the critical time value of money and
ignored her requirement to pay interest to compensate Larry for the use of his money. It focused
only on the $100,000 face amount of the principal repayment obligation, ignoring both her
obligation to pay interest and the length of time (whether one day or 10 years or 50 years) between
the receipt of that $100,000 and her future obligation to repay that $100,000 to Larry.
Instead of putting the face amount of the $100,000 of borrowed cash on the liability side of her
hypothetical balance sheet, a more accurate analysis recognizes that the reason why Betty did not
realize a wealth accession on the $100,000 cash receipt is that she incurred, at the same time, a
future obligation to pay $148,024.43 in aggregate principal and interest that had a present value
in Year 1 of $100,000, using a 4% discount rate. 2 In other words, the present value (as of the Year1 receipt) of Betty’s obligation to repay the $100,000 principal in Year 10 added to the present
value (as of the Year-1 receipt) of her obligation to pay $48,024.43 in interest in Year 10 equals
$100,000, which is precisely the amount of cash that she receives today, negating a wealth
accession for her in Year 1 on the $100,000 receipt using a transactional accounting approach.
Math alert: The material that follows will use some mathematics. Do not be intimidated by
this. These examples are here merely to illustrate the underlying economics of loans, which
helps us to better understand the tax rules that apply to them. Read them with that goal in
mind—to see how they lead to the tax rules described in this chapter. I now return you to our
2

Some lenders will necessarily charge interest rates that exceed the current “discount rate” for similar loans to other
borrowers if the particular borrower, for example, is a risky bet. But for our purposes, we shall always assume (for the
sake of simplicity) that the interest rate charged by the lender and the going “discount rate” is the same.

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regularly scheduled program.
Example 1
Due at end of Year

Amount

Present Value as of beginning of Year 1

10
10

$100,000.00
48,024.43

$67,556.42
32,443.58
$100,000.00

Assets

Liabilities (present value of future principal and interest payment)

$100,000

$100,000
No increase in her net worth (assets less liabilities)

Under this alternative view, Betty could be said to realize an immediate wealth accession on receipt
of the $100,000 if and only if the present value (as of the Year-1 receipt) of her Year-10 payment
obligation were less than $148,024.43.
For example, suppose that High Tech, Inc., makes a $100,000 loan to CEO Sam in Year 1 that
he must repay at the end of Year 10 but that, under their loan agreement, High Tech and Sam agree
that High Tech will charge no interest for the loan. If we apply the more simplistic rule described
in Part A., which looked only at the face amount of the principal repayment obligation (ignoring
both interest and the time value of money), our CEO has realized no wealth accession in Year 1:
$100,000 received offset by his Year-10 obligation to repay that $100,000. But if we look at Sam’s
situation from the perspective of our more sophisticated alternative view, the present value (as of
the Year-1 receipt) of his Year-10 $100,000 payment obligation is only $67,556.42 if we use a 4%
discount rate, compounded annually. To keep the numbers easy to read, let’s just round that figure
for purposes of discussion to $67,500. Under that view, Sam would realize an immediate Year-1
wealth accession equal to $32,500: the difference between the $100,000 that he received and the
present-value of his future repayment obligation. Another way of saying this is that, regardless of
the label attached to the $100,000 receipt, the real principal of Sam’s loan in substance (rather
than form, under the loan agreement) was only $67,500 because that is the present value (as of the
Year-1 receipt) of his aggregate future payment obligation. The remaining $32,500 paid by Sam
in Year 10 represents 4% compounded interest on the real principal amount of $67,500—
compensation to the corporation (the lender) for the time value of money.
If only $67,500 of the $100,000 that Sam receives in Year 1 is, in substance, borrowed principal,
which he can exclude under the borrowing exclusion, what is the nature of the remaining $32,500
that he receives in Year 1 from his employer? Compensation income under § 61(a)(1)! The
interest-free nature of the loan was merely a means by which High Tech paid additional
compensation to Sam in substance, though not in form, which they attempted to disguise.
And that analysis is precisely what § 7872 now requires. Section 7872, enacted in 1984, does
not describe the tax consequences to the borrower and lender of the flow of cash between the
parties in a below-market loan. Rather, the role of § 7872 is merely to correctly identify the real
principal of the loan in substance and the real interest so that the payments can then be treated
properly under other Code sections. With respect to Sam and High Tech, because only $67,500 is
the real loan principal when Sam receives the $100,000, the remaining $32,500 would be
immediately included on receipt by Sam under § 61(a)(1) as compensation, notwithstanding the
loan document’s designation of the entire $100,000 as loan principal. Similarly, while High Tech

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would be unable to deduct any part of the $100,000 transferred to Sam in Year 1 if it were treated
entirely as loan principal (a nondeductible capital expenditure), High Tech can, in fact, deduct
under § 162(a)(1) the $32,500 compensation paid to Sam in Year 1 in substance.
This example uses a 4% discount rate to determine how much of Sam’s $100,000 Year-1 receipt
is real loan principal that he must repay in Year 10 on our assumption that 4% is the going rate for
similar loans in the marketplace. Section 7872 uses the “applicable Federal rate” (often referred to
as the AFR), 3 which is the rate used by Treasury when selling Treasury bonds of varying
maturities. The AFR is a favorable rate to use for Sam, as it is a lower rate than Sam would likely
be able to negotiate in the private loan market. Moreover, compensation-related, below-market
loans that do not exceed $10,000 are free of § 7872 under a de minimis rule. 4 For both of these
reasons, the CEO Sams of the world are still better off, even with § 7872 on the books, when the
corporations that employ them make no-interest or low-interest loans to them. The IRS publishes
the AFR periodically in Revenue Rulings.
So much for the treatment (by both parties) of the $100,000 payment in Year 1. What about the
$32,500 in implicit interest? High Tech will have to include the interest under § 61(a)(4), and Sam
may or may not be able to deduct the interest under § 163, depending on how he used the borrowed
money, as mentioned earlier. The timing of the interest receipt and payment will not, however, be
respected as occurring in Year 10. Because the loan between Sam and High Tech is a “term loan”
(a loan for a term of years), Sam’s payment of the $32,500 interest (and High Tech’s receipt of the
$32,500 interest) is deemed to occur over the 10-year life of the loan under the original issue
discount rules described in Part C., infra, rather than entirely in Year 10 (when paid and received)
for reasons described in Part C. 5 But we are not there yet. Baby steps!
If, in contrast, the $100,000 loan is a demand loan rather than a term loan of 10 years, High
Tech would have the right to demand repayment of the $100,000 at any time. In that case, we
cannot compute how much of the $100,000 received by Sam in Year 1 is, in substance, disguised
compensation by using present value analysis because we do not yet know when Sam will repay
the $100,000 to High Tech. With demand loans, § 7872(a)(1) requires that the “forgone interest”
be treated as paid to Sam as additional compensation (and repaid by Sam to High Tech as interest)
on the last day of each year during which the demand loan is outstanding. Forgone interest is
defined in § 7872(e)(2) as the interest that Sam would pay each year on the $100,000 amount
received in Year 1 if the AFR had applied as the interest rate. If the AFR is 2%, for example, Sam
would include $2,000 ($100,000 x .02) under § 61(a)(1) on December 31 of each year as additional
compensation, 6 which High Tech would deduct as a business expense under § 162. Sam would
then be deemed to repay that $2,000 right back to High Tech as interest on the same date. 7 High
Tech would include the deemed interest payment, and Sam may (or may not) be able to deduct it
under § 163, again depending on how Sam uses the borrowed money.
What if Sam is not an employee of High Tech but is a major shareholder—perhaps a controlling
shareholder who could force High Tech to make a no-interest loan to him? The $32,500 that Sam
receives in Year 1 in excess of the present value of his Year-10 payment obligation (under our
original fact pattern involving the 10-year term loan and a 4% discount rate) is not disguised
3

See §§ 7872(f)(1) and (2).
See § 7872(c)(3).
5
See § 7872(b).
6
See § 7872(a)(1)(A).
7
See § 7872(a)(1)(B).
4

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compensation, includable under § 61(a)(1), but rather a disguised dividend, includable under §
61(a)(7). For High Tech, the payment of the disguised dividend would not be deductible (as would
be the payment of compensation), as no Code section provides the authority for a corporation to
deduct dividends paid to its shareholders. If Sam is both an employee and a shareholder, the loan
is generally treated as a corporation-shareholder loan (rather than a compensation-related loan). 8
Does the existence of § 7872 mean that you have to worry about a Gross Income inclusion when
you borrow money from a bank at below-market rates because of a special deal aimed at stealing
you away from another bank or because you are a very good customer whose loyalty the bank is
massaging? No. Section 7872 does not apply to all below-market loans. Rather, it applies only to
specifically listed loans where Congress had evidence that wealth transfers were occurring
between related parties that were a substitute for a clearly includable item, such as compensation
or dividends (or transfers that were aimed at avoiding the gift tax rules under the integrated wealth
transfer tax system described in Chapter 7). 9 Recall from Chapters 5 and 6 the concern when cash
payments that clearly constitute Gross Income are replaced with a substitute intended to avoid the
Gross Income inclusion that would otherwise clearly apply.
In other words, for most loans we measure whether or not there is a wealth accession by
ignoring interest as well as ignoring the time value of money and simply comparing the principal
amount received with the face amount of the principal repayment obligation (rather than the
present value of the future principal and interest payments). If they are equal (and they will
virtually always be equal in the usual case), the borrower realizes no wealth accession on the
receipt of the principal. Nevertheless, § 7872, as a loophole closer, will apply in some contexts
and use the more discerning present value approach in situations that are abusive. For our purposes,
§ 7872 is simply a helpful tool in better illuminating the real economics underlying the so-called
borrowing exclusion.

C. Identifying principal and interest (including original issue
discount) and the timing of interest inclusions and deductions
We know that interest is includable under § 61(a)(4) by lenders (unless the lender is a state or
local government issuing § 103 bonds). We also know that interest is generally deductible by the
borrower under § 163 if the loan proceeds are used in an income-producing activity by the
borrower. When should these inclusions and deductions occur, however? The answer to this
inquiry could turn on both (1) properly identifying principal and interest and (2) the borrower’s
and lender’s method of accounting.
Identifying principal and interest
Let’s return to Betty Borrower and Larry Lender, and let’s assume that Betty borrows $10,000
from Larry for three years. At the end of each of Years 1, 2, and 3, Betty must pay 4% interest to
Larry ($400 in each year), and she must also repay the $10,000 at the end of Year 3. Such a loan
arrangement is usually called an “interest-only loan with a balloon payment” because Betty pays
only interest over the loan term, with a large balloon” payment at the end of Year 3 comprising
both her final interest payment and the $10,000 loan principal. The $10,000 transferred to Betty
is, indeed, the loan’s real principal because, as of the beginning of Year 1, the present value of
8
9

See Prop. Treas. Reg. § 1.7872-4(d)(2)(i).
See § 7872(c).

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each of her $400 interest payments, as well as the present value of her obligation to repay the
$10,000 at the end of Year 3, adds up to $10,000 (using our agreed-upon 4% discount rate).
Example 2
Due at end of Year

Amount

1
2
3
3

$400
400
400
10,000

Present Value as of beginning of Year 1
$384.62
369.82
355.60
8,889.96
$10,000.00

Can Larry exclude any part of the first $400 payment received from Betty at the end of Year 1
as tax-free basis recovery in the loan—Larry’s original investment—or must he treat it entirely as
includable interest? The answer is that he must treat the entire payment as interest but not because
the loan documents call the $400 interest but rather because, if we again calculate the present value
of the remaining payments at the beginning of Year 2, we see that the present value of his future
receipts continues to add up to $10,000—the amount that he originally transferred to Betty.
Due at end of Year

Amount

2
3
3

$400
400
10,000

Present Value as of beginning of Year 2
$384.62
369.82
9,245.56
$10,000.00

Because Larry’s future aggregate receipts continue to equal $10,000, we know that Larry has
not yet recovered any of his original investment in the loan to Betty, which means that the $400
receipt must be interest, not repaid principal. The same analysis applies to his Year-2 receipt of
$400. None of it is tax-free basis recovery because the present value of his future receipts from
Betty remains $10,000.
Due at end of Year

Amount

3
3

$400
10,000

Present Value as of beginning of Year 3
$384.62
9,615.38
$10,000.00

When Larry receives $10,400 from Betty at the end of Year 3, he can finally recover his $10,000
basis tax-free, but he must include the remaining $400 as interest.
Suppose, however, that Larry and Betty agree that she will make three equal-amount annual
payments to Larry to retire the $10,000 loan at a 4% annual interest rate, compounded annually,
instead of interest-only payments coupled with a balloon payment at the end of the loan term. In
that case, Betty would make three payments of $3,603.49, 10 adding up to $10,810.47. We know
that this payment plan is correct because the present value of all three payments (as of the
beginning of Year 1) is $10,000, using the agreed-upon 4% discount rate.

10

I used an online calculator found at www.free-online-calculator-use.com/fixed-payment-loan.html to derive this
number.

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Example 3
Due at end of Year

Amount

1
2
3

$3,603.49
3,603.49
3,603.49

Present Value as of beginning of Year 1
$3,464.89
3,331.63
3,203.49
$10,000.00

We also know that Larry will include a total of $810.47 in interest and exclude $10,000 as taxfree basis (principal) recovery. But how much of each $3,603.49 represents interest and how much
represents tax-free basis recovery? Because the payments are of equal amounts, can we allocate
the $810.47 in interest equally across the three payments? No.
When Larry receives the first $3,603.49 payment, how much is tax-free basis recovery for Larry
is determined by calculating the present value of Larry’s remaining two payments.
Due at end of Year

Amount

2
3

$3,603.49
3,603.49

Present Value as of beginning of Year 2
$3,464.89
3,331.63
$6,796.52

For the first time, the present value of Larry’s future receipts is less than the $10,000 originally
loaned to Betty. Larry has suffered a loss in the underlying loan investment because of the receipt
of that first $3,603.49 payment. If, for example, Larry were to attempt to sell his debt instrument
to Bob Buyer on January 1 of Year 2 (after he received that first cash payment from Betty), he
would be in a position to demand no more than $6,796.52 for it because that is the present value
of the future payments that the holder of the loan (whether Larry or Bob) will be able to collect.
Even though Larry has not in fact sold the note to another, his loss can fairly be said to be realized
because it is permanent and irretrievable. The realized loss is $3,203.48: the $10,000 present value
of his future payments as of the beginning of Year 1 less the present value of his future payments
as of the beginning of Year 2. This $3,203.48 represents the portion of the $3,603.49 received from
Betty at the end of Year 1 that represents tax-free basis recovery of his original $10,000 investment,
i.e., that represents the return of loan principal. The remaining $400.01 received is interest.
At the end of Year 2, when Larry receives the second payment of $3,603.49, how much is taxfree basis recovery (principal) and how much is interest? Once again, we must compute the present
value of Larry’s remaining payment.
Due at end of Year

Amount

3

$3,603.49

Present Value as of beginning of Year 3
$3,464.89

The difference between the present value of his investment as of the beginning of Year 2
($6,796.52) and the present value of his remaining payment as of the beginning of Year 3
($3,464.89) is $3,331.63, which represents the portion of his $3,603.49 Year-2 receipt that
represents tax-free basis recovery, with the remaining $271.86 representing interest. As of the
beginning of Year 3, Larry has recovered $6,535.11 of his original $10,000 basis in the loan to
Betty ($3,203.48 at the end of Year 1 and $3,331.63 at the end of Year 2), leaving remaining basis
of $3,464.89 in the loan. When Larry receives the final $3,603.49 payment, $3,464.89 is tax-free
basis recovery, and $138.60 is interest. Here is a summary.

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Year 1
Year 2
Year 3
Totals

Borrowing and Lending
Payment

Principal (loss in present value)

$3,603.49
3,603.49
3,603.49

- $3,203.48 ($10,000 less 6,796.52)
- 3,331.63 ($6,796.52 less 3,464.89)
- 3,464.89 (remaining basis)
$10,000.00

Chapter 9
Interest
=
=
=

$400.01
271.86
138.60
$810.47

Notice that the portion of each payment representing interest decreases as time passes, and
the portion of each payment representing principal (basis recovery) increases as time passes.
Anyone who has made equal-amount mortgage payments on a home or car loan is familiar with
this relationship. In the early years, a large portion of each payment represents interest, but as the
years pass, the portion of each payment representing interest decreases.
Notice also that the total interest paid by Betty in Example 3 ($810.47) is significantly less than
she had to pay in Example 2 ($1,200) over the same three years. In Example 2, she paid only
interest (and made no principal repayments) during the 3-year term. By retiring a portion of the
principal with each payment in Example 3, Betty pays less aggregate interest over the 3-year
payment term on the same amount of originally borrowed principal ($10,000).
The method illustrated above to determine how much of each payment is economically interest
in a level-payment loan is referred to as the “declining balance method,” as the portion representing
interest is computed by reference to the declining balance of the loan principal over time, using
the present-value analysis of remaining future payments. It is also sometimes referred to as the
“economic accrual of interest method.”
Segue to a brief discussion of methods of accounting
The last chapter of this textbook will delve into a taxpayer’s method of accounting in greater
detail, but we need to engage in a crash course on the basic rules here, as it will affect not only the
matters considered in this chapter but also the lender’s potential bad-debt deduction (considered
in the next chapter) if a borrower fails to pay required interest.
Now that we have identified how much of each payment is economically interest and how much
is principal, we must consider whether the borrower’s and lender’s method of accounting affects
the timing of the lender’s interest inclusion or the borrower’s interest deduction. To set the stage,
I shall announce the results up front. Generally speaking, the taxpayer’s method of accounting will
not affect the timing of interest inclusions and deductions! Regardless of the method of accounting
used by Betty and Larry in Example 3, Betty would deduct and Larry would include $400.01 of
interest in Year 1, $271.86 in Year 2, and $138.60 in Year 3. Moreover, in Example 2, Betty and
Larry would deduct and include, respectively, $400 in interest in each of Years 1, 2, and 3—
regardless of their method of accounting.
More important (and perhaps most surprising to students), let’s return to the loan described way
back in Example 1, under which Betty received $100,000 in Year 1 and paid a total of $148,024.43
in Year 10 to Larry. Even here, Betty would generally have to deduct the interest as it economically
accrues over the 10-year period, and Larry would have to include the interest as it accrues over the
10-year period—regardless of their method of accounting.
Let’s explore why each of these conclusions is true.
A taxpayer’s method of accounting generally governs only the timing of (1) § 61 Gross
Income inclusions and (2) expense deductions (under Code sections authorizing deduction of

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expenses, such as §§ 163 interest, 162 business expenses, 212 investment expenses, etc.). A
taxpayer’s method of accounting has no impact on other significant timing issues, such as whether
an outlay is properly categorized as an expense or a capital expenditure in the first place or how
property basis should be depreciated or amortized.
The two major methods of accounting are the cash method of accounting and the accrual
method of accounting. See Treas. Reg. § 1.446-1(a). Under the cash receipts and disbursements
method of accounting (typically shortened to the cash method of accounting or simply the
cash method), taxpayers generally include Gross Income items in the year actually or
constructively received 11 and deduct expenses in the year actually paid.12 Virtually all
individual wage earners use the cash method of accounting. If Betty and Larry both use the cash
method in Example 3, they deduct (Betty) or include (Larry) $400.01 in Year 1, $271.86 in Year
2, and $138.60 in Year 3 because those are the years in which these interest payments were actually
paid and received.
Under the accrual method of accounting, Gross Income accrues (i.e., is included) in the
year in which (1) all the events have occurred to fix the right to receive the income and (2)
the amount can be determined with reasonable accuracy. Expenses are accrued (i.e., are
deducted) in the year in which (1) all the events have occurred to establish the fact of liability,
(2) the liability can be established with reasonable accuracy, and (3) economic performance
within the meaning of § 461(h) has occurred. 13 The first two requirements listed for both
inclusion (of Gross Income items) and deduction (of expense items) are usually referred to as the
“all-events test.” Under the all-events test, the timing of actual payment or receipt is irrelevant. 14
For an example unrelated to interest, suppose that Daniel Dentist, an accrual method taxpayer,
has performed an examination and cleaned the teeth of a patient on November 15 of Year 1. On
December 15, Daniel sends a bill for $100 to the patient, who pays the $100 on January 3 of Year
2. Because all of the events have occurred to fix Daniel’s right to receive the patient’s $100
payment when he sends the bill in December, Daniel must include the $100 in Year 1, not Year 2
(when he actually receives the payment). What tax consequences arise in Year 2 when he actually
receives it? Recall from Chapter 1 that one way to create basis (in addition to the making of a
nondeductible capital expenditure) is an income inclusion with respect to property (the property
here is called an “account receivable”). When Daniel includes $100 in his Year-1 Gross Income,
he creates a $100 basis in the account receivable represented by the amount owed by the patient.
When Daniel actually receives the $100 in Year 2, the payment is tax-free recovery of basis in the
receivable, rather than includable Gross Income.
On the deduction side, when can Daniel deduct his $150 office electricity bill for the month of
November, which he receives on December 15 of Year 1 but pays in January of Year 2? He can
deduct that $150 in Year 1 because the all-events test is satisfied by December 31 of Year 1, even
though he pays in January of Year 2. That is to say, all the events have occurred to establish his
11

Under the constructive receipt doctrine, a cash method taxpayer cannot avoid including a Gross Income item to
which he has a current right merely by delaying possession of the item. For example, a cash method taxpayer cannot
move compensation income from December 31 of Year 1 to January 1 of Year 2 (gaining a full year’s worth of the
time value of money by including the compensation on his tax return filed in Year 3 instead of his tax return filed in
Year 2) by failing to pick up his December paycheck until early January. See Treas. Reg. § 1.451-2.
12
See Treas. Reg. § 1.446-1(c)(1)(i).
13
See Treas. Reg. § 1.446-1(c)(1)(ii).
14
The timing of receipt may be relevant in some circumstances not pertaining to interest under the additional economic
performance requirement applicable to deductions, which is discussed in more detail in Chapter 21.

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liability to pay the $150 electricity bill by the end of Year 1, and the amount can be determined
with precision. 15
So when does interest accrue for an accrual method lender (inclusion under § 61(a)(4)) and for
an accrual method borrower (possible deduction under § 163)? The accrual method lender includes
interest as the right to receive it is earned simply as time passes under the “economic accrual of
interest” method and the accrual method borrower deducts interest as the liability to pay it is
established simply as time passes under the “economic accrual of interest” method because, in
each case, all the events have occurred to establish the right to receive, or the liability to pay, the
interest, which can be determined with accuracy. 16
So let’s return to Betty’s three annual payments of $3,603.49 to Larry in Example 3 but now
assume that both use the accrual method of accounting. If Betty’s interest is deductible under §
163, she can deduct it at the rate of $400.01 in Year 1, $271.86 in Year 2, and $138.60 in Year 3,
even if the loan documents recite that the aggregate $810.47 in interest should be considered as
accruing under a different formula that would allocate more than $400.01 to Year 1. 17 Similarly,
Larry accrues (includes) the interest payments in the same amount each year.
This analysis shows why the statement made at the beginning of this section was correct that
Betty and Larry would deduct and include (respectively) $400.01 in Year 1, $271.86 in Year 2,
and $138.60 in Year 3 in Example 3—regardless of their method of accounting.
Similarly, in Example 2, where Betty pays $400 in interest to Larry in each of Years 1, 2, and
3 and also repays the $10,000 principal to Larry in Year 3, both can deduct and include,
respectively, $400 in interest in each of Years 1, 2, and 3—regardless of their method of
accounting. If they each use the cash method, the interest is actually paid and received in those
years. If they each use the accrual method, the interest economically accrues at $400 in each of the
three years because the present value of Larry’s Year-3 receipt never falls below $10,000 during
the three-year loan term, which means that the interest accruals reflect the actual $400 payments.
It also does not matter if one uses the cash method and the other uses the accrual method. Each
still includes or deducts, respectively, $400 in each of Years 1, 2, and 3 of Example 2.
The sticky one is Example 1, where the borrower receives $100,000 on January 1 of Year 1 and
pays $148,024.43 to the lender on December 31 of Year 10, which brings us to the topic of original
issue discount.
Original issue discount
High Tech, Inc., uses the accrual method of accounting, and it intends to sell three-year bonds
15

Economic performance under § 461(h) would also occur as he received the electricity. See § 461(h)(2)(A).
In addition, economic performance (required for deduction of the interest payment by the accrual method borrower)
occurs with respect to interest “as the interest cost economically accrues” under Treas. Reg. § 1.461-4(e). The
reference to economic accrual in that regulation is a reference to the economic accrual of interest method.
17
In some cases, the documents may describe the rate at which interest accrues under “the Rule of 78s” or the “sum
of the digits” method. The details of the Rule of 78s are not important for our purposes except to note that this method
overstates the portion of each payment consisting of interest in the early years compared to economic accrual principles
reflected in the declining balance method (and so understates interest in the later years of the loan period). Because of
the time value of money, accrual method borrowers paying deductible interest would love to be able to identify interest
under the Rule of 78s in order to deduct the interest sooner rather than later. In Rev. Rul. 83-84, 1983-1 C.B. 97,
however, the IRS exercised its authority under § 446(b) to reject such a method of accounting for interest because it
does not clearly reflect income, and the Tax Court and 3rd Circuit agreed in Prabel v. Commissioner, 91 T.C. 1101
(1988) (reviewed), aff’d 882 F2d 820 (3rd Cir. 1989).
16

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paying the going rate of 4% interest to the public as a means of borrowing money. Candace, who
uses the cash method of accounting, is an individual interested in purchasing a three-year bond.
Assume that High Tech wishes to avoid annual interest payments so that it can invest its cash
elsewhere in the interim. Candace is informed that the face amount of the bond is $11,248.64,
which is the total amount that she will receive at the bond’s maturity on December 31 of Year 3.
How much would Candace be willing to pay on January 1 of Year 1 as the “issue price” for the
bond if she knows that the current discount rate for similar loans is 4%, compounded annually?
Using an online calculator, Candace determines that she should pay no more than $10,000 for the
bond, as that is the present value of $11,248.64 using a 4% interest rate, compounded annually. 18
The $1,248.64 difference between the bond’s $10,000 issue price and the $11,248.64 stated
principal amount at maturity is called “original issue discount” (OID), which obviously is
economic interest.
Let’s first consider High Tech’s interest accruals (deductions) for this interest in the form of
OID. How much of the aggregate $1,248.64 interest accrues economically in each of Years 1, 2,
and 3? Here is how High Tech would calculate it:
Year 1: $10,000 x .04 = $400 interest, which is unpaid. High Tech now owes $10,400.
Year 2: $10,400 x. 04 = $416 interest, which is unpaid. High Tech now owes $10,816.
Year 3: $10,816 x. 04 = $432.64 interest. Adding $10,816 and $432.64, High Tech pays to
Candace a total of $11,248.64 on December 31 of Year 3.
We can summarize this result as follows:
Example 4
Jan 1 of Year 1
End of Year 1
End of Year 2
Dec 31 of Year 3

Interest accrued at 4%

Accumulated Principal & Interest

—
$400
416
432.64

$10,000
10,400
10,816
11,248.64

If Candace is an accrual method taxpayer, she also includes $400 in Year 1, $416 in Year 2,
and $432.64 in Year 3 as interest. But we previously stipulated that Candace uses the cash method
of accounting. Does that mean that Candace can delay inclusion of her $1,248.64 in aggregate
interest until it is received in Year 3?
If Candace were permitted such a deferral, notice the mismatch that would arise between the
timing of High Tech’s deduction under the accrual method and Candace’s inclusion of the same
amounts under the cash method. Notice also that, even though High Tech deducts the interest in
each of Years 1, 2, and 3, the interest is not yet paid, which means that High Tech could effectively
invest the unpaid interest and earn a return on pre-tax (deducted) dollars, as though High Tech
were accorded more favorable consumption tax treatment (rather than income tax treatment), as
you learned in Chapter 2.
By the early 1980s, scholars such as Daniel Halperin demonstrated that, assuming that both
High Tech and Candace are in the same tax bracket, no revenue is lost to the Treasury with respect
to the implicit return on High Tech’s investment of pre-tax (deducted) dollars—so long as
18

Actually, the investment bank advising High Tech will crunch the numbers to determine this issue price.

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Candace immediately includes the interest as it accrues. If both Candace were permitted to defer
inclusion of the interest until received and High Tech were permitted to deduct the interest as it
accrues (even though not yet paid), Treasury loses the tax revenue that would otherwise be owed
on the return earned by High Tech on the accrued-but-as-yet-unpaid interest during the interim
between High Tech’s deduction and payment of the interest. In other words, because of the timing
mismatch between Candace’s inclusion and High Tech’s deduction of the unpaid interest,
investment earnings could effectively slip through the cracks between the two taxpayers and avoid
being effectively taxed at all. 19
Congress responded earlier to such timing mismatches between accrual method and cash
method taxpayers not involving interest. For example, the accrual method employer’s § 162
deduction for compensation paid to a cash method employee in the form of property paid in kind
that is subject to a substantial risk of forfeiture (considered in Chapter 5) is deferred until the year
in which the employee includes the compensation. 20 Similarly, other expense deductions of an
accrual method taxpayer for amounts paid to related cash method taxpayers (such as family
members or controlled corporations), who would not include the receipt in Gross Income until
paid, is deferred until the year in which the related party includes it. 21
In 1984—the same year that saw the enactment of § 7872, considered in Part B.—Congress
enacted §§ 1272 and 163(e), both of which essentially provide that Candace must include the OID
as it accrues daily (even though she uses the cash method and has not yet received the interest),
which effectively prevents the mismatch that would otherwise occur between High Tech’s
deduction of the three interest amounts and Candace’s inclusion of the same interest. 22 Candace
must include $400 in interest in Year 1 (and will increase her $10,000 basis in the bond to $10,400
to reflect the income inclusion), $416 in Year 2 (increasing her bond basis to $10,816), and $432.64
in Year 3 (increasing her bond basis to $11,248.64). When she receives the $11,248.64, the entire
amount is tax-free basis recovery. High Tech will send an information return to Candace so that
she knows how much to include on each year’s return.
So let’s finally return to Example 1, where Betty Borrower borrows $100,000 on January 1 of
Year 1 from Larry Lender and pays a total of $148,024.43 to him on December 31 of Year 10.
While the OID rules do not apply to loans between natural persons (i.e., human beings) so long as
the loan amount does not exceed $10,000 and the loan is not made in the course of a trade or
business of the lender, this particular loan exceeds $10,000. Even if both Larry and Betty use the
cash method of accounting, each would deduct and include, respectively, the interest as it
economically accrues over the 10-year term of the loan. 23
OID pertains to realization rather than accounting methods
In the end, OID is not really about methods of accounting at all. Instead, OID arises from the
realization doctrine. Recall that increases and decreases in the value of property are generally
ignored under the realization requirement until disposition occurs. In most cases, the many factors
that affect value are by their nature transient, which means that any changes to value may well be
temporary. Nevertheless, one strand of a property’s aggregate change in value may be permanent
and irreversible and, in this sense, realized in a real and substantial sense, even if other factors
19

See, e.g., Daniel I. Halperin, Interest in Disguise: Taxing the Time Value of Money, 95 YALE L.J.506 (1986).
See § 83(h).
21
See § 267(a)(2).
22
See §§ 1272(a)(1) and (3).
23
See § 1272(a)(2)(E).
20

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affecting a property’s overall value are not permanent, which means that value changes attributable
to those other factors are not realized.
As you will learn in Chapter 13, this reasoning justifies deductions of property basis in the form
of depreciation even before the property is disposed of. Depreciation deductions can superficially
appear to be inconsistent with the realization doctrine. Nevertheless, if and only if business
property wastes away in a predictable manner with use just as time passes, one strand of the
property’s aggregate fair market value may be fairly considered to be permanently and
irretrievably lost—just as time passes—as it gets closer and closer to the end of its useful life, even
if the property’s aggregate fair market value is constantly fluctuating because of other factors that
also affect market value, though in a way that is not permanent. Depreciation, in other words, can
be thought of as deductions of realized losses—in the sense that they are permanent and
irretrievable losses in value—that arise solely because of the passage of time with business use.
Even if the property’s aggregate fair market value is rising because of other (perhaps transient)
factors in the marketplace, one strand of the property’s value is permanently and irretrievably lost
each year as it gets one year closer to the end of its useful life. Or so the argument goes. We shall
return to this theme and explore it more fully in Chapter 13, devoted to examining depreciation
and amortization more closely.
The reasoning underlying Candace’s treatment of OID is similar (though on the flip side of the
coin) to the Lender’s treatment in Example 3 a few pages back, where Larry Lender is permitted
to use a portion of the $10,000 basis in his loan to offset a portion of each $3,603.49 payment that
he receives from Betty, even though he has not yet disposed of his loan. He is permitted (in effect)
to deduct portions of his loan basis while he still owns the loan because that portion of the loan is
permanently and irretrievably lost as he receives payments and the loan maturity gets closer and
closer. (Larry does not take an actual deduction, though. Rather, he uses that basis to prevent a
portion of each cash payment received from Betty Years 1, 2, and 3 from being includable in Gross
Income.) Even if the aggregate fair market value of his loan instrument fluctuates for other reasons
(such as changes in interest rates since he first made the loan to Betty), this one strand of value is
permanently reduced when he receives each $3,603.49 payment from Betty in Years 1 and 2.
Candace’s OID inclusions reflect the flip side of the coin. Even though she does not receive a
$400 interest payment at the end of Year 1, her debt instrument permanently and irreversibly
increases in value by $400 because $400 of interest economically accrues just with the passage of
time, as the loan instrument gets one year closer to its maturity. If Candace were to sell her High
Tech bond in the market on January 1 of Year 2, she would clearly be able to demand $10,400 for
it from Bob Buyer (not $10,000), assuming no other changes in market factors that affect other
strands of her bond’s value, such as interest rate changes. That is to say, this one strand of her
bond’s value permanently increases, which means that this one strand of increased value is realized
in Year 1, even if other market factors that affect overall value mean that she can sell the bond on
January 1 of Year 2 for, say, $10,500 (if market interest rates have dropped to less than 4% since
she bought her High Tech bond, increasing the value of Candace’s bond) 24 or, say, $10,300 (if
market interest rates have increased to more than 4%, decreasing the value of Candace’s bond). 25
24

The $100 paid in excess of the $10,400 of principal and accrued interest is called bond premium, and the buyer can
amortize (deduct) the $100 premium over the remaining term of the bond to the extent allowed under § 171.
25
The $100 discount enjoyed by the bond buyer is called “market discount,” and the buyer will not include the $100
market discount before maturity (or a prior sale to yet a new owner), though the discount will be included as ordinary
income when realized. See §§ 1276 and 1278. In contrast, the new buyer will continue to include the OID each year
as it accrues, just as Candace would have included it had she not sold the bond.

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The point is that the $400 of interest that economically accrues in Year 1 is a realized wealth
accession and so should be included. Because Candace must include $400 in interest (which is
ordinary income) for Year 1, she increases her bond basis to $10,400. If she sells for $10,500 on
January 1 of Year 2, she would realize a $100 capital gain. If she sells for $10,300 on the same
date, she would realize a $100 capital loss. In either case, though, she will have already included
$400 of ordinary income in Year 1, reflecting the Year-1 earned interest.

D. Recovery of annuity basis under § 72
The material that you just learned in Part C. can be brought to bear with respect to the timing
of basis recovery with respect to annuities, which is subject to favorable tax rules. A simple annuity
is a financial instrument under which the buyer pays a either a lump sum or stream of premium
payments to the annuity seller (often an insurance company) in order to obtain a future levelpayment stream, usually (though not necessarily) in retirement. Some annuities are funded with
pre-tax dollars through a tax-preferred employer pension plan, a § 401(k) plan, or Individual
Retirement Account. The additional refinements and modifications applicable to these types of
annuities are beyond the basic income tax course. Rather, the annuities described here are funded
with after-tax (undeducted) dollars. That is to say, the premium payments are nondeductible capital
expenditures, creating basis in the annuity contract.
You can think of the annuitant (the person purchasing the annuity) as a lender to the company
selling the annuity, who will repay the principal lent, plus interest, to the annuitant in the future.
When must the annuitant include the investment return, which represents interest?
Annuities are treated quite favorably for tax purposes. First, annuities are not subject to the OID
rules. If Candace purchases an annuity instead of the High Tech bond, she need not include the
inside buildup (the increase in the value of her contract because of the accrued but unpaid interest)
over time. Rather, she is permitted to exclude all interest until payments begin.
Annuity contracts typically pay level payments once the payment period begins. When
payments begin, the taxpayer must determine how much of each payment represents tax-free basis
recovery, with the remaining amount includable in Gross Income as interest, and this is where the
second tax preference arises. If the basis recovery schedule conforms to economic accrual of
interest principles for a level-payment loan (Example 3 in Part C.), the percentage of each payment
that represents tax-free basis recovery should start lower and increase over time, which means that
the portion of each payment attributable to includable interest should start higher and decrease
over time (as more and more of each payment constitutes tax-free basis recovery). In Example 3,
Larry Lender received three equal payments of $3,603.49 over the repayment period, and he had
to include as interest $400.01 in Year 1, $271.86 in Year 2, and $138.60 in Year 3.
Section 72 departs from these normative principles by allowing the annuitant to recover basis
ratably, which generally means in equal amounts from each payment. Start with § 72(a)(1), which
appears to provide for 100% inclusion of all annuity payments. The real operative provision,
however, is § 72(b)(1), which provides that the inclusion rule in subsection (a) shall not apply to
the extent of the “exclusion ratio,” defined as the amount of each payment received under the
contract that “bears the same ratio … as the investment in the contract (as of the annuity starting
date) bears to the expected return under the contract (as of such date).” We can reduce the language
found in § 72(b)(1) to a formula.

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Excluded portion = Payments Received in the Year x
Investment in the Contract
of each payment
Expected Return under the Contract
The “investment in the contract” is, in essence, the annuitant’s basis in the contract when
payments begin (the sum of prior nondeductible payments made to purchase the annuity), which
the taxpayer should be able to recover tax free. The “expected return under the contract” is the
aggregate gross amount expected to be received under the contract when payments begin,
computed by multiplying the annual payment to be received under the contract by the anticipated
number of annual payments.
Assume, for example, that Dora pays $1 million for an annuity contract on January 1 of Year
1, which is Dora’s 65th birthday. Under the annuity contract, Dora will receive $5,000 monthly
payments beginning on January 31 of Year 1 and ending on Dora’s death. In Year 1, Dora receives
a total of $60,000 (12 payments of $5,000 each). How much of the $60,000 is she permitted to
exclude under the § 72(b)(1) exclusion ratio as recovery of her original $1 million investment?
The numerator of Dora’s exclusion ratio is $1 million. Under § 72(c)(3)(A), the denominator
will be determined using actuarial tables issued by the Treasury Department, which can be found
at Treas. Reg. § 1.72-9. Under Table V, Dora’s life expectancy as of the annuity starting date is 20
years. Her expected gross return under the contract is $1.2 million ($60,000 annual payments x 20
years). Dora can exclude 83.4% ($1 million/$1.2 million) of each $60,000 that she receives
annually, or $50,040, as representing tax-free basis recovery. She must include $9,960 each year.
Her exclusion ratio does not change over the following 19 years. She will exclude the same $9,960
from each $60,000 annual payment. She is permitted to recover her basis faster than could Larry
Lender in Example 3. In short, § 72 permits deferral of interest compared to the economic accrual
of interest method. Why is this deferral beneficial for Dora? All together now ….
If Dora exceeds her 20-year life expectancy, she will have recovered 100% of her $1 million
basis tax-free upon reaching age 85. Any additional annuity payments that she receives will be
fully includable under § 72(b)(2), often referred to as “mortality gain.” On the other hand, Dora
may die prematurely. Some annuity contracts will, in exchange for lower annual payments, provide
a guarantee of a certain number of payment years, with any remaining payments at the time of the
annuitant’s premature death paid to a designated beneficiary or to the annuitant’s estate. Dora’s
final tax return can deduct any remaining unrecovered basis under § 72(b)(3)(A). If the deduction
exceeds her Gross Income in that final year, her executor can treat that excess as a “net operating
loss” within the meaning of § 172 26 under § 72(b)(3)(C).
In the case of a married couple, annuities are commonly measured by two lives, with payments
surviving the death of the first spouse. The life expectancy tables that determine the expected
return under the contract will differ from those applicable to an annuity measured by a single life,
and the survivor continues to apply the same exclusion ratio as before the death of the first spouse.
The price to pay for these favorable tax rules after the annuity starting date is that unfavorable
rules will apply if an annuitant receives a distribution under the contract prior to the annuity
starting date. First, the distribution is deemed to come from the untaxed inside buildup first and so
will be fully includable to the extent thereof. 27 Only after all accrued interest is distributed will
further distributions prior to the annuity starting date be considered tax-free recovery of basis.
Second, a loan under the annuity contract will usually be considered to be a distribution of inside
26
27

Section 172 is considered in Chapter 20.
See § 72(e)(2)(B).

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buildup (and so includable) rather than a true loan. 28 Third, with some hardship exceptions, an
additional 10% tax penalty will generally be imposed on withdrawals before the age of 59 and ½.29
On the face of § 72, Dora appears to be the target of these favorable tax rules, but who really
benefits from them? Annuities are notorious for providing low returns (a low interest rate). Recall
the concept of “capture” first discussed in Chapter 2 in connection with § 103 interest and further
explored in Chapter 3.
Problem
Karen pays $150,000 to an insurance company for an annuity contract that will begin making
annual $10,000 payments when she reaches age 65 on January 1 of a future year, at which time
she will have a 20-year life expectancy. When Karen begins receiving payments at age 65, how
much of each $10,000 annual payment must she include in her Gross Income? How much must
Karen include if she succeeds in beating the odds and receives a $10,000 payment in her 86th year?

E. Which receipts fall within the borrowing exclusion?
The borrowing exclusion is quite valuable because it allows the receipt of cash (in the usual
case) to be excluded from Gross Income, even though the cash does not represent basis recovery.
Not surprisingly, taxpayers have argued that all sorts of receipts fall within the borrowing
exclusion. How is a loan defined for Federal income tax purposes? What portions of the James
case, below, can be cobbled together to create a workable definition of a loan for Federal income
tax purposes? How did the Court go so wrong in Wilcox, making contorted distinctions between
embezzlers (Wilcox) and extortionists (Rutkin)? How was the language in North American Oil,
which follows James, possibly misused by the Wilcox Court in arriving at its original, misguided
decision? Note footnote 7 in James.
JAMES v. UNITED STATES
366 U.S. 213 (1961)
MR. CHIEF JUSTICE WARREN announced the judgment of the Court and an opinion in which MR.
JUSTICE BRENNAN and MR. JUSTICE STEWART concur.
The issue before us in this case is whether embezzled funds are to be included in the “Gross
Income” of the embezzler in the year in which the funds are misappropriated under § 22(a) of the
Internal Revenue Code of 1939 and § 61(a) of the Internal Revenue Code of 1954.
The facts are not in dispute. The petitioner is a union official who, with another person,
embezzled in excess of $738,000 during the years 1951 through 1954 from his employer union
and from an insurance company with which the union was doing business. Petitioner failed to
report these amounts in his Gross Income in those years and was convicted for willfully attempting
to evade the Federal income tax due for each of the years 1951 through 1954 in violation of §
145(b) of the Internal Revenue Code of 1939 and § 7201 of the Internal Revenue Code of 1954.
He was sentenced to a total of three years’ imprisonment. The Court of Appeals affirmed. Because
28
29

See §§ 72(e)(4)(A) and (p).
See §§ 72(q), (t) and (v).

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of a conflict with this Court’s decision in Commissioner v. Wilcox, 327 U.S. 404, a case whose
relevant facts are concededly the same as those in the case now before us, we granted certiorari.
In Wilcox, the Court held that embezzled money does not constitute taxable income to the
embezzler in the year of the embezzlement under § 22(a) of the Internal Revenue Code of 1939.
Six years later, this Court held, in Rutkin v. United States, 343 U.S. 130, that extorted money does
constitute taxable income to the extortionist in the year that the money is received under § 22(a)
of the Internal Revenue Code of 1939. In Rutkin, the Court did not overrule Wilcox, but stated:
“We do not reach in this case the factual situation involved in Commissioner v. Wilcox, 327 U.S.
404. We limit that case to its facts. There embezzled funds were held not to constitute taxable
income to the embezzler under § 22(a).” Id., at 138.
However, examination of the reasoning used in Rutkin leads us inescapably to the conclusion
that Wilcox was thoroughly devitalized.
The basis for the Wilcox decision was “that a taxable gain is conditioned upon (1) the presence
of a claim of right to the alleged gain and (2) the absence of a definite, unconditional obligation to
repay or return that which would otherwise constitute a gain. Without some bona fide legal or
equitable claim, even though it be contingent or contested in nature, the taxpayer cannot be said to
have received any gain or profit within the reach of § 22(a).” Since Wilcox embezzled the money,
held it “without any semblance of a bona fide claim of right,” and therefore “was at all times under
an unqualified duty and obligation to repay the money to his employer,” the Court found that the
money embezzled was not includible within “Gross Income.” But Rutkin’s legal claim was no
greater than that of Wilcox. It was specifically found “that petitioner had no basis for his claim …
and that he obtained it by extortion.” Both Wilcox and Rutkin obtained the money by means of a
criminal act; neither had a bona fide claim of right to the funds. [7] Nor was Rutkin’s obligation to
repay the extorted money to the victim any less than that of Wilcox. The victim of an extortion,
like the victim of an embezzlement, has a right to restitution. Furthermore, it is inconsequential
that an embezzler may lack title to the sums he appropriates while an extortionist may gain a
voidable title. Questions of Federal income taxation are not determined by such “attenuated
subtleties.” Lucas v. Earl, 281 U.S. 111, 114. Thus, the fact that Rutkin secured the money with
the consent of his victim is irrelevant. Likewise unimportant is the fact that the sufferer of an
extortion is less likely to seek restitution than one whose funds are embezzled. What is important
is that the right to recoupment exists in both situations.
Examination of the relevant cases in the courts of appeals lends credence to our conclusion that
the Wilcox rationale was effectively vitiated by this Court’s decision in Rutkin. Although this case
appears to be the first to arise that is “on all fours” with Wilcox, the lower Federal courts, in
deference to the undisturbed Wilcox holding, have earnestly endeavored to find distinguishing facts
in the cases before them which would enable them to include sundry unlawful gains within “Gross
Income.”
It had been a well-established principle, long before either Rutkin or Wilcox, that unlawful, as
[7]

The Government contends that the adoption in Wilcox of a claim of right test as a touchstone of taxability had no
support in the prior cases of this Court; that the claim of right test was a doctrine invoked by the Court in aid of the
concept of annual accounting, to determine when, not whether, receipts constituted income. See North American Oil
v. Burnet, 286 U.S. 417; U.S. v. Lewis, 340 U.S. 590; Healy v. Comm’r, 345 U.S. 278. In view of our reasoning set
forth below, we need not pass on this contention. The use to which we put the claim of right test here is only to
demonstrate that, whatever its validity as a test of whether certain receipts constitute income, it calls for no distinction
between Wilcox and Rutkin.

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well as lawful, gains are comprehended within the term “Gross Income.” Section II B of the
Income Tax Act of 1913 provided that “the net income of a taxable person shall include gains,
profits, and income … from … the transaction of any lawful business carried on for gain or profit,
or gains or profits and income derived from any source whatever ….” (Emphasis supplied.) When
the statute was amended in 1916, the one word “lawful” was omitted. This revealed, we think, the
obvious intent of that Congress to tax income derived from both legal and illegal sources, to
remove the incongruity of having the gains of the honest laborer taxed and the gains of the
dishonest immune. Thereafter, the Court held that gains from illicit traffic in liquor are includible
within “Gross Income.” See Johnson v. U.S., 318 U.S. 189; U.S. v. Johnson, 319 U.S. 503. And,
the Court has pointed out, with approval, that there “has been a widespread and settled
administrative and judicial recognition of the taxability of unlawful gains of many kinds,” Rutkin
v. U.S., supra, at p. 137. These include protection payments made to racketeers, ransom payments
paid to kidnappers, bribes, money derived from the sale of unlawful insurance policies, graft, black
market gains, funds obtained from the operation of lotteries, income from race track bookmaking
and illegal prize fight pictures. Ibid.
The starting point in all cases dealing with the question of the scope of what is included in
“Gross Income” begins with the basic premise that the purpose of Congress was “to use the full
measure of its taxing power.” Helvering v. Clifford, 309 U.S. 331, 334. And the Court has given a
liberal construction to the broad phraseology of the “Gross Income” definition statutes in
recognition of the intention of Congress to tax all gains except those specifically exempted.
Comm’r v. Jacobson, 336 U.S. 28, 49. The language of § 22(a) of the 1939 Code, “gains or profits
and income derived from any source whatever,” and the more simplified language of § 61(a) of
the 1954 Code, “all income from whatever source derived,” have been held to encompass all
“accessions to wealth, clearly realized, and over which the taxpayers have complete dominion.”
Comm’r v. Glenshaw Glass Co., 348 U.S. 426, 431. A gain “constitutes taxable income when its
recipient has such control over it that, as a practical matter, he derives readily realizable economic
value from it.” Rutkin v. U.S., supra, at p. 137. Under these broad principles, we believe that
petitioner’s contention, that all unlawful gains are taxable except those resulting from
embezzlement, should fail.
When a taxpayer acquires earnings, lawfully or unlawfully, without the consensual recognition,
express or implied, of an obligation to repay and without restriction as to their disposition, “he has
received income which he is required to return, even though it may still be claimed that he is not
entitled to retain the money, and even though he may still be adjudged liable to restore its
equivalent.” North American Oil v. Burnet, supra, at p. 424. In such case, the taxpayer has “actual
command over the property taxed—the actual benefit for which the tax is paid,” Corliss v. Bowers,
supra. This standard brings wrongful appropriations within the broad sweep of “Gross Income”;
it excludes loans. When a law-abiding taxpayer mistakenly receives income in one year, which
receipt is assailed and found to be invalid in a subsequent year, the taxpayer must nonetheless
report the amount as “Gross Income” in the year received. U.S. v. Lewis, supra; Healy v. Comm’r,
supra. We do not believe that Congress intended to treat a law-breaking taxpayer differently. Just
as the honest taxpayer may deduct any amount repaid in the year in which the repayment is made,
the Government points out that, “If, when, and to the extent that the victim recovers back the
misappropriated funds, there is of course a reduction in the embezzler’s income.” Brief for the
United States, p. 24.
Petitioner contends that the Wilcox rule has been in existence since 1946; that if Congress had
intended to change the rule, it would have done so; that there was a general revision of the income
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tax laws in 1954 without mention of the rule; that a bill to change it was introduced in the Eightysixth Congress but was not acted upon; that, therefore, we may not change the rule now. But the
fact that Congress has remained silent or has re-enacted a statute which we have construed, or that
congressional attempts to amend a rule announced by this Court have failed, does not necessarily
debar us from re-examining and correcting the Court’s own errors. Girouard v. U.S., 328 U.S. 61,
69-70; Helvering v. Hallock, 309 U.S. 106, 119-122. There may have been any number of reasons
why Congress acted as it did. One of the reasons could well be our subsequent decision in Rutkin
which has been thought by many to have repudiated Wilcox. Particularly might this be true in light
of the decisions of the Courts of Appeals which have been riding a narrow rail between the two
cases and further distinguishing them to the disparagement of Wilcox.
We believe that Wilcox was wrongly decided and we find nothing in congressional history since
then to persuade us that Congress intended to legislate the rule. Thus, we believe that we should
now correct the error and the confusion resulting from it, certainly if we do so in a manner that
will not prejudice those who might have relied on it. We should not continue to confound
confusion, particularly when the result would be to perpetuate the injustice of relieving embezzlers
of the duty of paying income taxes on the money they enrich themselves with through theft while
honest people pay their taxes on every conceivable type of income.
But, we are dealing here with a felony conviction under statutes which apply to any person who
“willfully” fails to account for his tax or who “willfully” attempts to evade his obligation. In Spies
v. U.S., 317 U.S. 492, 499, the Court said that § 145(b) of the 1939 Code embodied “the gravest
of offenses against the revenues,” and stated that willfulness must therefore include an evil motive
and want of justification in view of all the circumstances. Willfulness “involves a specific intent
which must be proven by independent evidence and which cannot be inferred from the mere
understatement of income.” Holland v. U.S., 348 U.S. 121, 139.
We believe that the element of willfulness could not be proven in a criminal prosecution for
failing to include embezzled funds in Gross Income in the year of misappropriation so long as the
statute contained the gloss placed upon it by Wilcox at the time the alleged crime was committed.
Therefore, we feel that petitioner’s conviction may not stand and that the indictment against him
must be dismissed.
Since MR. JUSTICE HARLAN, MR. JUSTICE FRANKFURTER, and MR. JUSTICE CLARK agree with
us concerning Wilcox, that case is overruled. MR. JUSTICE BLACK, MR. JUSTICE DOUGLAS, and MR.
JUSTICE WHITTAKER believe that petitioner’s conviction must be reversed and the case dismissed
for the reasons stated in their opinions. Accordingly, the judgment of the Court of Appeals is
reversed and the case is remanded to the District Court with directions to dismiss the indictment.
[The separate opinions of Justices Black, Clark, and Whitaker are omitted.]
_____________________________________
NORTH AMERICAN OIL CONSOLIDATED v. BURNET
286 U.S. 417 (1932)
MR. JUSTICE BRANDEIS delivered the opinion of the Court.
The question for decision is whether the sum of $171,979.22 received by the North American
Oil Consolidated in 1917, was taxable to it as income of that year.
The money was paid to the company under the following circumstances. Among many
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properties operated by it in 1916 was a section of oil land, the legal title to which stood in the name
of the United States. Prior to that year, the Government, claiming also the beneficial ownership,
had instituted a suit to oust the company from possession; and on February 2, 1916, it secured the
appointment of a receiver to operate the property, or supervise its operations, and to hold the net
income thereof. The money paid to the company in 1917 represented the net profits which had
been earned from that property in 1916 during the receivership. The money was paid to the receiver
as earned. After entry by the District Court in 1917 of the final decree dismissing the bill, the
money was paid, in that year, by the receiver to the company. U.S. v. North American Oil
Consolidated, 242 Fed. 723. The Government took an appeal (without supersedeas) to the Circuit
Court of Appeals. In 1920, that Court affirmed the decree. In 1922, a further appeal to this Court
was dismissed by stipulation.
The income earned from the property in 1916 had been entered on the books of the company
as its income. It had not been included in its original return of income for 1916; but it was included
in an amended return for that year which was filed in 1918. Upon auditing the company’s income
and profits tax returns for 1917, the Commissioner of Internal Revenue determined a deficiency
based on other items. The company appealed to the Board of Tax Appeals. There, in 1927 the
Commissioner prayed that the deficiency already claimed should be increased so as to include a
tax on the amount paid by the receiver to the company in 1917. The Board held that the profits
were taxable to the receiver as income of 1916. The Circuit Court of Appeals held that the profits
were taxable to the company as income of 1917, regardless of whether the company’s returns were
made on the cash or on the accrual basis. This Court granted a writ of certiorari.
It is conceded that the net profits earned by the property during the receivership constituted
income. The company contends that they should have been reported by the receiver for taxation in
1916; that if not returnable by him, they should have been returned by the company for 1916,
because they constitute income of the company accrued in that year; and that if not taxable as
income of the company for 1916, they were taxable to it as income for 1922, since the litigation
was not finally terminated in its favor until 1922….
The net profits were not taxable to the company as income of 1916. For the company was not
required in 1916 to report as income an amount which it might never receive. See Burnet v. Logan,
283 U.S. 404, 413. Compare Lucas v. American Code Co., 280 U.S. 445, 452; Burnet v. Sanford
& Brooks Co., 282 U.S. 359, 363. There was no constructive receipt of the profits by the company
in that year, because at no time during the year was there a right in the company to demand that
the receiver pay over the money. Throughout 1916 it was uncertain who would be declared entitled
to the profits. It was not until 1917, when the District Court entered a final decree vacating the
receivership and dismissing the bill, that the company became entitled to receive the money. Nor
is it material, for the purposes of this case, whether the company’s return was filed on the cash
receipts and disbursements basis, or on the accrual basis. In neither event was it taxable in 1916
on account of income which it had not yet received and which it might never receive.
The net profits earned by the property in 1916 were not income of the year 1922—the year in
which the litigation with the Government was finally terminated. They became income of the
company in 1917, when it first became entitled to them and when it actually received them. If a
taxpayer receives earnings under a claim of right and without restriction as to its disposition, he
has received income which he is required to return, even though it may still be claimed that he is
not entitled to retain the money, and even though he may still be adjudged liable to restore its
equivalent. See Board v. Comm’r, 51 F.2d 73, 75, 76. Compare

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Co., 274 U.S. 398, 403. If in 1922 the Government had prevailed, and the company had been
obliged to refund the profits received in 1917, it would have been entitled to a deduction from the
profits of 1922, not from those of any earlier year. Compare Lucas v. American Code Co., supra.
Affirmed.
________________________________________
In both James and North American Oil, the taxpayers had to include the cash in the year
received; they could not exclude the receipt under the borrowing exclusion. What if Mr. James or
the North American Oil company had to repay the funds in a future year? In James, the Court
observed:
When a law-abiding taxpayer mistakenly receives income in one year, which
receipt is assailed and found to be invalid in a subsequent year, the taxpayer must
nonetheless report the amount as “Gross Income” in the year received. U.S. v.
Lewis, supra; Healy v. Comm’r, supra. We do not believe that Congress intended
to treat a law-breaking taxpayer differently. Just as the honest taxpayer may deduct
any amount repaid in the year in which the repayment is made, the Government
points out that, “If, when, and to the extent that the victim recovers back the
misappropriated funds, there is of course a reduction in the embezzler’s income.”
Similarly, the North American Oil Court said in its last sentence above that the company would be
permitted to deduct a repayment in 1922 if the taxpayer had lost its appeal and disgorged the cash
previously received in 1917.
Lewis and the enactment of § 1341
In the Lewis case cited in the above quotation, 30 Mr. Lewis was lucky enough to receive a
$22,000 bonus from his employer in 1944 (nearly $319,000 in current dollars), which he dutifully
included in his Gross Income. In 1946, however, he received the bad news that his employer had
made a mathematical error in computing the amount to which he was entitled as a bonus under
their employment contract, and Mr. Lewis had to return $11,000 of the $22,000 to his employer.
While Mr. Lewis clearly would have been entitled to deduct the repayment in 1946 (as the outlay
clearly pertained to his trade or business as an employee and did not purchase personal
consumption), tax rates had been reduced somewhat at the end of WWII, and Mr. Lewis would
not have saved as much in tax with a 1946 deduction of $11,000 as he had previously paid in tax
in 1944 when that $11,000 was included in his Gross Income. Mr. Lewis sought to file an amended
return for 1944, excluding the $11,000 from his 1944 Gross Income that he returned to his
employer in 1946 (and obtaining a tax refund), rather than deducting the repayment in 1946. The
Supreme Court agreed with the government that Mr. Lewis could not file an amended return for
1944, even though the statute of limitations was still open for that year, because his 1944 return
was correct as originally filed. Mr. Lewis’s deductible wealth reduction did not occur until 1946.
His only option was to deduct $11,000 on his 1946 return.
The Lewis case is yet another example of the annual accounting principle, first introduced in
Chapter 1, under which each year is taken as it comes. If our expectations regarding what we
thought would occur in a future year (Mr. Lewis thought that he would be able to retain the extra
$11,000 for all time when he obtained it in 1944) turn out to be incorrect (he had to return $11,000
in 1946), we address those changed expectations or changed circumstances in that later year. We
30

U.S. v. Lewis, 340 U.S. 590 (1951).

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do not allow hindsight to alter what in fact happened in a prior year. 31
Congress eventually intervened by enacting § 1341, which effectively would provide a Mr.
Lewis of today with the economic result that he sought, though not by allowing him to file an
amended return for the earlier year. If § 1341 had been in place for Mr. Lewis, he would have been
effectively provided a choice to either (1) deduct the $11,000 in 1946 or (2) take a dollar-for-dollar
credit against his 1946 income tax owed (determined without a deduction for the repayment) equal
to the amount of additional tax that he paid in 1944 by reason of including the $11,000. Notice,
therefore, that a Mr. Lewis of today gets the best of both worlds! If tax rates were higher in the
earlier year than in the repayment year, as was the case for Mr. Lewis, the tax credit route would
provide the better result. If, however, the taxpayer’s marginal rate is higher in the repayment year
(either because Congress increased rates generally or the taxpayer’s income increased sufficiently
to put him in a higher tax bracket in the repayment year than applied to him in the prior inclusion
year), the deduction route would provide the better result.
Section 1341 does not apply to repayments of $3,000 or less, and it requires that, in the prior
inclusion year, “it appeared that the taxpayer had an unrestricted right to such item.” If the amount
did not exceed $3,000, or if it were known in the year of receipt that the amount might have to be
repaid, the taxpayer’s only avenue upon repayment would be deduction in the repayment year, as
in the Lewis case, itself.
A workable tax definition of loan: absolute versus contingent obligation to repay
If we combine the first sentence of the fifth paragraph in James (referring to a “definite,
unconditional obligation to repay”) with the first sentence in the eighth paragraph (referring to a
“consensual recognition, express or implied, of an obligation to repay”), we can arrive at a
workable definition of a loan for Federal income tax purposes: a consensual recognition [i.e.,
known and agreed to by both parties] of a definite, unconditional [i.e., absolute, as opposed to
contingent] obligation to repay.”
In North American Oil, in contrast, the critical language was not that referring to a “claim of
right” (though unfortunately that language is often seized upon) but that referring to the contingent
nature of the repayment obligation. The North American Oil Court effectively held that a receipt
subject to a contingent (rather than absolute) obligation to repay is includable in the year of
receipt. If the contingency ripens, and the taxpayer must return the earlier receipt, the
matter is dealt with in that later year under the annual accounting principle.
Suppose that CEO Sara receives stock from her employer corporation, subject to the condition
that she must continue to work for the corporation for the next three years, or else she must
surrender the stock back to her employer corporation. If North American Oil controlled, Sara
would have to include the FMV of the stock on receipt. If the contingency ripens, and she must
return the stock to her employer, she would be entitled to a deduction in that later year. You learned
in Chapter 5, however, that Sara can, in fact, exclude the stock receipt from her Gross Income until
the substantial risk of forfeiture lapses under § 83(a). Section 83(a), in other words, is a statutory
override of North American Oil in the particular context of employee compensation paid in kind
that is subject to a substantial risk of forfeiture. Sara can, if she wishes, effectively elect North
American Oil treatment by making an election under § 83(b) and including the FMV of the stock
in the year of receipt, but she would lose her ability to deduct her basis if the contingency ripens
31

As a sneak preview, we shall see this principle repeatedly, including in the next chapter (§ 61 debt-discharge
income), in the capital gains chapter (so-called depreciation recapture), and in Chapter 20 (the tax benefit rule).

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and she must return the stock (for unknown reasons that I shall never understand).
In sum, taking North American Oil and James together, we have different rules that turn on
whether the repayment obligation is absolute—loan and so excludable—or contingent—not a loan
and so includable (unless § 83(a) applies), subject to a deduction if and when the contingency
ripens and repayment in fact occurs. How do these rules play out in the next case?
COMMISSIONER v. INDIANAPOLIS POWER & LIGHT
493 U.S. 203 (1990)
JUSTICE BLACKMAN delivered the opinion of the Court.
Respondent Indianapolis Power & Light Company (IPL) requires certain customers to make
deposits with it to assure payment of future bills for electric service. Petitioner Commissioner of
Internal Revenue contends that these deposits are advance payments for electricity and therefore
constitute taxable income to IPL upon receipt. IPL contends otherwise.
IPL is a regulated Indiana corporation that generates and sells electricity in Indianapolis and its
environs. It keeps its books on the accrual and calendar year basis. During the years 1974 through
1977, approximately 5% of IPL’s residential and commercial customers were required to make
deposits “to insure prompt payment,” as the customers’ receipts stated, of future utility bills. These
customers were selected because their credit was suspect. Prior to March 10, 1976, the deposit
requirement was imposed on a case-by-case basis. IPL relied on a credit test but employed no fixed
formula. The amount of the required deposit ordinarily was twice the customer’s estimated
monthly bill. IPL paid [0% interest for the first 6 months and] 3% interest on a deposit held for six
months or more [which is substantially below market interest rates in the 1970s]. A customer could
obtain a refund of the deposit prior to termination of service by requesting a review and
demonstrating acceptable credit. The refund usually was made in cash or by check, but the
customer could choose to have the amount applied against future bills.
In March 1976, IPL amended its rules governing the deposit program. Under the amended rules,
the residential customers from whom deposits were required were selected on the basis of a fixed
formula. The interest rate was raised to 6% but was payable only on deposits held for 12 months
or more. [The 12 months without interest resulted in substantial below-market interest rates for the
duration of the deposit.] A deposit was refunded when the customer made timely payments for
either 9 consecutive months, or for 10 out of 12 consecutive months so long as the 2 delinquent
months were not themselves consecutive. A customer could obtain a refund prior to that time by
satisfying the credit test. As under the previous rules, the refund would be made in cash or by
check, or, at the customer’s option, applied against future bills. Any deposit unclaimed after seven
years was to escheat to the State.
IPL did not treat these deposits as income at the time of receipt. Rather, as required by state
administrative regulations, the deposits were carried on its books as current liabilities. Under its
accounting system, IPL recognized income when it mailed a monthly bill. If the deposit was used
to offset a customer’s bill, the utility made the necessary accounting adjustments. Customer
deposits were not physically segregated in any way from the company’s general funds. They were
commingled with other receipts and at all times were subject to IPL’s unfettered use and control.
…

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We begin with the common ground. IPL acknowledges that these customer deposits are taxable
as income upon receipt if they constitute advance payments for electricity to be supplied. [3] … And
it is settled that receipt of a loan is not income to the borrower. See Comm’r v. Tufts, 461 U.S. 300,
307 (1983) (“Because of [the repayment] obligation, the loan proceeds do not qualify as income
to the taxpayer”); James v. U.S., 366 U.S. 213, 219 (1961) (accepted definition of Gross Income
“excludes loans”); Comm’r v. Wilcox, 327 U.S. 404, 408 (1946). IPL, stressing its obligation to
refund the deposits with interest, asserts that the payments are similar to loans. The Commissioner,
however, contends that a deposit which serves to secure the payment of future income is properly
analogized to an advance payment for goods or services. See Rev. Rul. 72-519, 1972-2 C.B. 32,
33 (“When the purpose of the deposit is to guarantee the customer’s payment of amounts owed to
the creditor, such a deposit is treated as an advance payment, but when the purpose of the deposit
is to secure a property interest of the taxpayer the deposit is regarded as a true security deposit”).
In economic terms, to be sure, the distinction between a loan and an advance payment is one of
degree rather than of kind. A commercial loan, like an advance payment, confers an economic
benefit on the recipient: a business presumably does not borrow money unless it believes that the
income it can earn from its use of the borrowed funds will be greater than its interest obligation.
Even though receipt of the money is subject to a duty to repay, the borrower must regard itself as
better off after the loan than it was before. The economic benefit of a loan, however, consists
entirely of the opportunity to earn income on the use of the money prior to the time the loan must
be repaid. And in that context our system is content to tax these earnings as they are realized. The
recipient of an advance payment, in contrast, gains both immediate use of the money (with the
chance to realize earnings thereon) and the opportunity to make a profit by providing goods or
services at a cost lower than the amount of the payment.
The question, therefore, cannot be resolved simply by noting that respondent derives some
economic benefit from receipt of these deposits. Rather, the issue turns upon the nature of the
rights and obligations that IPL assumed when the deposits were made. In determining what sort of
economic benefits qualify as income, this Court has invoked various formulations. It has referred,
for example, to ”undeniable accessions to wealth, clearly realized, and over which the taxpayers
have complete dominion.” Comm’r v. Glenshaw Glass Co., 348 U.S. 426, 431 (1955). It also has
stated: “When a taxpayer acquires earnings, lawfully or unlawfully, without the consensual
recognition, express or implied, of an obligation to repay and without restriction as to their
disposition, ‘he has received income . . . .’” James v. U.S., 366 U.S., at 219, quoting North
American Oil Consolidated v. Burnet, 286 U.S. 417, 424 (1932). IPL hardly enjoyed “complete
dominion” over the customer deposits entrusted to it. Rather, these deposits were acquired subject
to an express “obligation to repay,” either at the time service was terminated or at the time a
customer established good credit. So long as the customer fulfills his legal obligation to make
timely payments, his deposit ultimately is to be refunded, and both the timing and method of that
refund are largely within the control of the customer.
The Commissioner stresses the fact that these deposits were not placed in escrow or segregated
from IPL’s other funds, and that IPL therefore enjoyed unrestricted use of the money. That
[3]

This Court has held that an accrual-basis taxpayer is required to treat advance payments as income in the year of
receipt. See Schlude v. Comm’r, 372 U.S. 128 (1963); American Automobile Assn. v. U.S., 367 U.S. 687 (1961);
Automobile Club of Michigan v. Comm’r, 353 U.S. 180 (1957). These cases concerned payments—nonrefundable
fees for services—that indisputably constituted income; the issue was when that income was taxable. Here, in contrast,
the issue is whether these deposits, as such, are income at all. [Ed. note: This trilogy of cases, and the treatment more
generally of advance payments received by accrual method taxpayers, is discussed in Chapter 21.]

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circumstance, however, cannot be dispositive. After all, the same might be said of a commercial
loan; yet the Commissioner does not suggest that a loan is taxable upon receipt simply because the
borrower is free to use the funds in whatever fashion he chooses until the time of repayment. In
determining whether a taxpayer enjoys “complete dominion” over a given sum, the crucial point
is not whether his use of the funds is unconstrained during some interim period. The key is whether
the taxpayer has some guarantee that he will be allowed to keep the money. IPL’s receipt of these
deposits was accompanied by no such guarantee.
Nor is it especially significant that these deposits could be expected to generate income greater
than the modest interest IPL was required to pay. Again, the same could be said of a commercial
loan, since, as has been noted, a business is unlikely to borrow unless it believes that it can realize
benefits that exceed the cost of servicing the debt. A bank could hardly operate profitably if its
earnings on deposits did not surpass its interest obligations; but the deposits themselves are not
treated as income. Any income that the utility may earn through use of the deposit money of course
is taxable, but the prospect that income will be generated provides no ground for taxing the
principal.
The Commissioner’s advance-payment analogy seems to us to rest upon a misconception of the
value of an advance payment to its recipient. An advance payment, like the deposits at issue here,
concededly protects the seller against the risk that it would be unable to collect money owed it
after it has furnished goods or services. But an advance payment does much more: it protects
against the risk that the purchaser will back out of the deal before the seller performs. From the
moment an advance payment is made, the seller is assured that, so long as it fulfills its contractual
obligation, the money is its to keep. Here, in contrast, a customer submitting a deposit made no
commitment to purchase a specified quantity of electricity, or indeed to purchase any electricity at
all. IPL’s right to keep the money depends upon the customer’s purchase of electricity, and upon
his later decision to have the deposit applied to future bills, not merely upon the utility’s adherence
to its contractual duties. Under these circumstances, IPL’s dominion over the fund is far less
complete than is ordinarily the case in an advance-payment situation.
The Commissioner emphasizes that these deposits frequently will be used to pay for electricity,
either because the customer defaults on his obligation or because the customer, having established
credit, chooses to apply the deposit to future bills rather than to accept a refund. When this occurs,
the Commissioner argues, the transaction, from a cash-flow standpoint, is equivalent to an advance
payment. In his view this economic equivalence mandates identical tax treatment.
Whether these payments constitute income when received, however, depends upon the parties’
rights and obligations at the time the payments are made. The problem with petitioner’s argument
perhaps can best be understood if we imagine a loan between parties involved in an ongoing
commercial relationship. At the time the loan falls due, the lender may decide to apply the money
owed him to the purchase of goods or services rather than to accept repayment in cash. But this
decision does not mean that the loan, when made, was an advance payment after all. The lender in
effect has taken repayment of his money (as was his contractual right) and has chosen to use the
proceeds for the purchase of goods or services from the borrower. Although, for the sake of
convenience, the parties may combine the two steps, that decision does not blind us to the fact that
in substance two transactions are involved. It is this element of choice that distinguishes an advance
payment from a loan. Whether these customer deposits are the economic equivalents of advance
payments, and therefore taxable upon receipt, must be determined by examining the relationship
between the parties at the time of the deposit. The individual who makes an advance payment

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retains no right to insist upon the return of the funds; so long as the recipient fulfills the terms of
the bargain, the money is its to keep. The customer who submits a deposit to the utility, like the
lender in the previous hypothetical, retains the right to insist upon repayment in cash; he may
choose to apply the money to the purchase of electricity, but he assumes no obligation to do so,
and the utility therefore acquires no unfettered “dominion” over the money at the time of receipt.
When the Commissioner examines privately structured transactions, the true understanding of
the parties, of course, may not be apparent. It may be that a transfer of funds, though nominally a
loan, may conceal an unstated agreement that the money is to be applied to the purchase of goods
or services. We need not, and do not, attempt to devise a test for addressing those situations where
the nature of the parties’ bargain is legitimately in dispute. This particular respondent, however,
conducts its business in a heavily regulated environment; its rights and obligations vis-a-vis its
customers are largely determined by law and regulation rather than by private negotiation. That
the utility’s customers, when they qualify for refunds of deposits, frequently choose to apply those
refunds to future bills rather than taking repayment in cash does not mean that any customer has
made an unspoken commitment to do so.
Our decision is also consistent with the Tax Court’s long-standing treatment of lease deposits—
perhaps the closest analogy to the present situation. The Tax Court traditionally has distinguished
between a sum designated as a prepayment of rent—which is taxable upon receipt—and a sum
deposited to secure the tenant’s performance of a lease agreement. See, e.g., J. & E. Enterprises,
Inc. v. Comm’r, 26 TCM 944 (1967). In fact, the customer deposits at issue here are less plausibly
regarded as income than lease deposits would be. The typical lease deposit secures the tenant’s
fulfillment of a contractual obligation to pay a specified rent throughout the term of the lease. The
utility customer, however, makes no commitment to purchase any services at all at the time he
tenders the deposit.
We recognize that IPL derives an economic benefit from these deposits. But a taxpayer does
not realize taxable income from every event that improves his economic condition. A customer
who makes this deposit reflects no commitment to purchase services, and IPL’s right to retain the
money is contingent upon events outside its control. We hold that such dominion as IPL has over
these customer deposits is insufficient for the deposits to qualify as taxable income at the time they
are made.
__________________________________
Does the previous discussion of North American Oil suggest that the government failed to make
an obvious argument in Indianapolis Power & Light, particularly in light of the phrase near the
end that “IPL’s right to retain the money is contingent upon events outside of its control”? At
another point, Justice Blackmun noted: “The key is whether the taxpayer has some guarantee that
he will be allowed to keep the money. IPL’s receipt of these deposits was accompanied by no such
guarantee.” At another, he observed: “IPL’s right to keep the money depends upon the customer’s
purchase of electricity, and upon his later decision to have the deposit applied to future bills ….”
Even if the obvious argument that you have astutely identified had been made, however, do you
think the Court would have accepted it? How does the Court avoid the conclusion that the utility’s
obligation to repay the cash was merely contingent, even though it recognized that the utility
sometimes keeps the money? Recall the following language from the opinion in particular:
The problem with petitioner’s argument perhaps can best be understood if we imagine
a loan between parties involved in an ongoing commercial relationship. At the time the
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loan falls due, the lender may decide to apply the money owed him to the purchase of
goods or services rather than to accept repayment in cash. But this decision does not
mean that the loan, when made, was an advance payment after all. The lender in effect
has taken repayment of his money (as was his contractual right) and has chosen to use
the proceeds for the purchase of goods or services from the borrower. Although, for the
sake of convenience, the parties may combine the two steps, that decision does not blind
us to the fact that in substance two transactions are involved.
In other words, in those instances when the utility in fact keeps the money, the Court applies
the substance over form doctrine (or its progeny, the step transaction doctrine) to deem a repayment
to the customer (placing the receipt in the “absolute obligation to repay” box rather than the
“contingent obligation to repay” box), followed by a deemed repayment right back to the utility by
the customer. Using this fiction, the Court concluded that the utility had an absolute obligation to
repay these deposits in every case, permitting it to exclude the deposits under the borrowing
exclusion. If the deposit is in fact repaid, the utility never includes it in Gross Income. If the utility
keeps it (i.e., applies it against the customer’s utility bill), the utility includes it in Gross Income
at that later time (because it is deemed to repay the deposit to the customer who then is deemed to
repay it right back to the utility at that time).
Was the Court’s application of the substance over form doctrine to create an absolute obligation
to repay in all cases convincing in this case? We tend to apply multi-step analysis only in those
situations in which the alternative view of the substance of what occurred (as opposed to its form)
actually could have realistically occurred. Indeed, the alternative reading is considered so likely that
we deem it to be the true substance of what in fact happened. When Mr. Wood’s employer paid his
income tax liability directly to the IRS (Chapter 5), the Court determined that, in substance, the
payment was made to Mr. Wood (includable as compensation under § 61(a)(1)), who then paid his
nondeductible income tax payment. This alternative construction not only could have realistically
occurred but is the more persuasive reading of the substance of the parties’ relationship. Are poor
people who are credit risks typically willing to act as lenders to rich corporations? Could you argue
that it is not realistic to treat these deposits as loans because they are not transferred voluntarily but
only because the utility required these transfers as a condition of doing business with the electricity
buyers? “I demand that you lend money to me or I will refuse to sell electricity to you or rent an
apartment to you.” Is that so far removed from the typical loan situation that the analogy breaks
down?
On the other hand, doesn’t the interest payments buttress the Court’s determination to find an
absolute obligation to repay in order to place the receipt in the loan box? Interest rates are so low
today that we sometimes forget, when reading older cases, that interest rates were much higher in
the 1970s and 80s. In 1976, for example, interest rates for home mortgages averaged nearly 9%. In
1976, the utility in Indianapolis Power & Light paid no interest for the first 12 months of a security
deposits and paid 6% thereafter. Especially in light of the 0% rate for the first 12 months, the interest
paid to the utility customers was clearly below market rates at the time. Does that affect how you
think about this case? Does § 7872 apply?
Problem
Joy, a landlord, demands a deposit equal to two months of rent before she will rent an apartment
to prospective tenant Joey. Under the lease agreement, the deposit will be returned to Joey at the
end of the lease term so long as he has not damaged the property or defaulted on any lease
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payments. Joy pays no interest to Joey with respect to the deposit, but she puts it in a bank account
that earns interest and includes the interest in her own Gross Income each year. Joey pays the
required deposit and rents an apartment for three years. What are the tax consequences for Joy if
she:
a. repays the deposit in full to Joey at the end of Year 3 when he leaves the apartment in good
condition and without being arrears in rent payments; or
b. retains the deposit because Joey fails to pay the last two months of rent before vacating the
premises in good condition at the end of Year 3?
c. Recall what you learned in Chapter 2 regarding the difference between an income tax and a
cash-flow consumption tax. In either a. or b., is Joy’s investment income earned on the deposit
between the time that she receives the deposit from Joey and the end of Year 3 effectively taxed
to her under income tax principles? Why or why not?

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Chapter 10: The Bad-Debt Deduction
(for Lenders) and Debt-Discharge Income (for Borrowers)
What tax consequences arise when a borrower fails to repay borrowed principal? Interest? Part
A. considers first the income tax consequences to the lender, and Part B. considers the income tax
consequences to the borrower.

A. The lender’s deduction for a bad debt (or worthless security)
You learned in Chapter 9 that the transfer of loan principal to a borrower is a nondeductible
capital expenditure (rather than a current expense) for the lender, which creates basis in the loan
instrument to keep track of those after-tax dollars. Principal repayments received by the lender
from the borrower represent tax-free recovery of basis (which reduces that basis, dollar for dollar,
as principal repayments are received) rather than Gross Income. Interest, in contrast, represents
new wealth to the lender and is includable in Gross Income under § 61(a)(4) (absent exclusion
authority under § 103).
When the borrower fails to repay principal, the lender’s basis in the loan becomes unusable.
What tax consequences arise because of the inability to recover that basis tax-free with principal
repayments because those principal repayments are not, in fact, forthcoming?
Notice that the activity of lending money to earn interest is an income-producing activity rather
than an activity in pursuit of personal consumption—either business activity (if the lender is in the
business of making loans, such as a bank or a store that sells inventory to its customers on credit)
or investment activity (if the lender is Candace, who is purchasing a High Tech bond for her
investment portfolio). Also recall from Chapter 1 that a loss—as a tax term of art—is, by definition,
a deduction of basis. For example, if Candace purchases shares of High Tech stock for $10,000, a
nondeductible capital expenditure creating a $10,000 cost basis under § 1012, and later sells those
shares for only $9,000, the $1,000 of unrecovered basis would generate a § 1001 loss that she
could deduct under § 165(c)(2) because the shares are investment property. Similarly, unrecovered
basis of a lender should produce a loss deduction if the loan is bona fide and not, say, really a
disguised gift to the supposed borrower (a nondeductible personal expense under § 262).
§ 165(g) deduction for a worthless security
A loss deduction will arise under § 165(g) if a security within the meaning of § 165(g)(2)
becomes worthless within the meaning of § 165(g)(1). Under § 165(g)(2)(A), a share of stock in a
corporation is a security. If Candace’s stock, which she purchased for $10,000, above, were to
become entirely worthless, she could deduct her $10,000 of unrecovered stock basis under §
165(g). A High Tech bond also qualifies as a security under § 165(g)(2)(C). If the High Tech bond
that Candace purchases for $10,000 becomes worthless, she can deduct her $10,000 of
unrecovered bond basis under § 165(g).
In either case, the corporate stock or corporate bond qualifies as a capital asset because such
property is not listed in § 1221(a). But recall from Chapter 1 that § 1222 requires that the
disposition of a capital asset be by “sale or exchange” for any resulting gain or loss to qualify as
capital gain or loss (as opposed to ordinary gain or loss). When a share of stock or a corporate

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bond becomes worthless, the owner is not likely to find a buyer for it. Indeed, she still owns the
stock or bond when she takes the deduction. The failure to satisfy the sale or exchange requirement
in reality is why the language in § 165(g)(1) steps in to satisfy it artificially, simply by statutory
fiat, by providing that the worthless security should “be treated as a loss from the sale or exchange”
of the stock or bond on the last day of the taxable year. (Emphasis added.) Because the stock or
bond is a capital asset, and because § 165(g)(1) artificially satisfies the § 1222 sale or exchange
requirement, the worthless security deduction will produce a capital loss (rather than an ordinary
loss) under § 1222, long-term or short-term, depending on how long Candace has held the stock
or bond.
Why does § 165(g)(1) artificially satisfy the sale or exchange requirement? Without it, consider
the disparity that would arise between Situation 1 and Situation 2, below.
Situation 1: Candace sells High Tech stock (previously purchased for $10,000) for $10
just before it loses all value, deducting $9,990 under § 165.
Situation 2: Candace retains the High Tech stock for a few more days until it becomes
entirely worthless, taking a worthless security deduction of $10,000 under § 165.
In Situation 1, Candace’s $9,990 loss is clearly a capital loss under § 1222 because she (1) sold
or exchanged (2) a capital asset. Her $9,990 capital loss, while deductible under § 165(c)(2), is
limited by § 1211(b), which we have seen allows the deduction of Candace’s otherwise deductible
capital losses in any one year only to the extent of her includable capital gains plus up to an
additional $3,000 (with a carryover under § 1212 of any remaining capital loss). If § 165(g)(1) did
not artificially satisfy the sale or exchange requirement in Situation 2, Candace’s § 165 loss
deduction would be ordinary, even though the stock is a capital asset, and Candace could
conveniently avoid that pesky § 1211 capital loss limitation rule, fully deducting the loss against
her high-tax ordinary income. Section 165(g)(1) prevents this result.
§ 166 bad-debt deduction
Suppose that Candace does not buy a bond from High Tech but rather lends $10,000 to Charles,
a friend in need. Charles and Candace execute a loan agreement under which Charles will repay
on a specified date, with 4% interest (the going market rate) in the interim. Charles pays the
required interest payments, but when the date arrives for Charles to repay the $10,000 principal,
he repays $3,000 but cannot repay the remaining $7,000. Can Candace deduct her remaining
$7,000 of unrecovered basis in the loan, even though her loan to Charles is not described in §
165(g)(2)?
Section 166 may (or may not) come to her rescue. Stop and read that Code section now.
While § 166(a) applies to business bad debts, § 166(d) applies to nonbusiness bad debts. Under
§ 166(e), neither subsection applies if the loan qualifies as a security within the meaning of §
165(g), which will control in that case.
Let’s start with business bad debts. Notice that the sale or exchange requirement is not
artificially satisfied in § 166(a). A business bad-debt deduction is necessarily an ordinary one
(rather than a capital loss), even if the loan instrument is a capital asset, because no sale or
exchange occurs. Rather, the lender simply continues to own a worthless claim against the
borrower. For example, a bank deducts as an ordinary loss the basis in a loan that becomes
uncollectible, unconstrained by § 1211. Similarly, an inventory seller who sells to customers on
credit (i.e., for future payments, with interest) can deduct as an ordinary loss any loan principal

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that becomes uncollectible. (Whether he can deduct uncollectible interest is considered shortly.)
Notice also that businesses can deduct debts that are only partially worthless under § 166(a)(2),
though the burden of proof is high for the lender to establish how much of an outstanding loan is
worthless. For example, suppose that Walter borrows $10,000 from National Bank. When the
repayment date arrives, Walter repays only $3,000, reducing National Bank’s loan basis from
$10,000 to $7,000. National Bank believes that it will be able to recover an additional $2,000 from
Walter when it brings an action against him but will be unsuccessful in collecting the remaining
$5,000. If National Bank can satisfy its burden of proving that the loan is partially worthless (to
the tune of $5,000), it can deduct that $5,000 now, reducing its basis from $7,000 to $2,000. If, in
fact, National Bank collects the remaining $2,000 from Walter, as it expects, the $2,000 would
constitute tax-free basis recovery. If National Bank is wrong, however, and is unsuccessful in
collecting anything more from Walter, National Bank could take a second bad-debt deduction
equal to its $2,000 remaining basis. Because of the time value of money, National Bank likes to
be able to take bad-debt deductions for loans that are only partially worthless, rather than waiting
to see whether the entire outstanding loan balance becomes uncollectible.
What if National Bank succeeds in taking a $5,000 partially worthless bad-debt deduction, as
described above, but Walter surprises everyone by repaying the entire $7,000 owed? Because the
prior $5,000 bad-debt deduction was a deduction of basis, reducing National Bank’s basis from
$7,000 to $2,000, only $2,000 obtained from Walter is now tax-free basis recovery. National Bank
must include the remaining $5,000 in Gross Income—simply because the bank has no more basis
in the loan to protect the additional cash receipt from constituting Gross Income.
Because § 166(d)(1)(A) provides that subsection (a) does not apply in the case of a nonbusiness
bad debts, the outstanding balance of any nonbusiness debt must be wholly worthless before any
deduction is allowed. Return to the same facts above, where Walter repays $3,000 of a $10,000
loan on the repayment date, but assume that the lender is not a bank or other professional lender.
Even if the nonbusiness lender is confident that it can prove that $5,000 of the remaining $7,000
balance is uncollectible, the nonbusiness lender cannot yet take a bad-debt deduction. Rather, the
nonbusiness lender must wait for the remaining balance ($7,000) to become wholly worthless
before taking any deduction. If Walter repays another $2,000, and it can be shown that the
remaining $5,000 balance is now wholly worthless, the nonbusiness lender can take a baddeduction for the wholly worthless $5,000 remaining debt at that time. 1
Unlike in the case of business bad debts under § 166(a), § 166(d) does artificially satisfy the
sale or exchange requirement, just as did § 165(g)(1) in the case of a deduction for a worthless
security. There is a notable difference between the language in § 165(g)(1) and § 166(d), however.
While the capital loss for a worthless security can be either long-term or short-term, depending on
how long the security owner has held the security, the nonbusiness bad-debt deduction is always
treated as short-term capital loss, even if the loan is outstanding for more than a year before it
becomes wholly worthless. There is no legislative history explaining the rationale for this rule.
Nevertheless, short-term capital losses are less harmful for the taxpayer than long-term capital
losses for reasons that will become clear when we examine capital gains and losses more deeply
in Chapter 14. The nonbusiness lender with a loan outstanding for more than a year before it
1

Once Walter repays the first $3,000 of the $10,000 owed, some students believe that the nonbusiness lender is forever
denied any bad-debt deduction. That interpretation is incorrect. The inability to deduct partially worthless debts means
only that the nonbusiness lender, unlike the business lender, must wait for any remaining balance to become wholly
worthless before taking any § 166(d) bad-debt deduction.

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becomes worthless is grateful that his loss is treated as short-term capital loss rather than longterm capital loss. Stay tuned.
Bona fide debt
Notice that the definition of “nonbusiness debt” in § 166(d)(2) appears to encompass any debt
not incurred in the course of a trade or business, which means that a nonbusiness debt can be one
made not only for investment reasons (i.e., to earn a return in the form of interest) but for personal
reasons. The nonbusiness lender who makes a loan for personal reasons, however, may have a
tough time establishing that the transfer is a “bona fide debt” within the meaning of Treas. Reg. §
1.166-1(c), which provides that “[o]nly a bona fide debt” can generate a bad-debt deduction under
§ 166. It continues: “A bona fide debt is a debt which arises from a debtor-creditor relationship
based upon a valid and enforceable obligation to pay a fixed or determinable sum of money.”
Return to our initial hypothetical in the first paragraph of this section. What if Candace and
Charles, who are friends, did not memorialize their loan in a document? What if Candace did not
charge Charles (say that three times fast) any interest on the loan? Moreover, what if Charles never
repaid any principal and Candace did not act like a real creditor and demand payment when it was
due? A loan can still be “bona fide” even if no interest is charged, as indicated by the existence of
§ 7872 (recall the no-interest loan made by High Tech to CEO Sam in the last chapter), but the
addition of each of these facts, in turn, makes it less and less likely that the purported loan (and
Candace’s desired $10,000 bad-debt deduction) will be respected. Instead of a loan, what may this
transfer be in substance? The last sentence of the regulation quoted above reminds us that “[a] gift
or contribution to capital shall not be considered a debt for purposes of section 166.” If Candace
and Charles, who are friends, did not document their purported loan, if Candace did not charge
interest, and if Candace did not act like a real creditor and take action when Charles failed to repay,
it looks like a gift, not a bona fide debt. And you know that gifts between friends are not deductible
by the donor under § 262(a).
What is a “contribution to capital,” also mentioned in that regulation? Suppose that Money Gal
is sitting at a bar when she hears Idea Guy spouting off to the bartender about this brilliant idea for
a new product. If only he could find the capital to pursue it! Money Gal listens to Idea Guy’s big
idea and introduces herself, saying that she has been looking for a new investment opportunity.
She transfers $10,000 to him to pursue his big idea (a nondeductible capital expenditure creating
basis). Alas, the idea proves to be a flop, and Money Gal never sees a dime from the venture, losing
her entire $10,000 investment. So long as Money Gal can prove that she did not transfer the
$10,000 to Idea Guy out of detached and disinterested generosity but rather out of a desire to earn
a return on her capital, Money Gal should be able to take a deduction for her $10,000 of
unrecovered basis. But under which Code section does she take her deduction?
If the $10,000 transferred to Idea Guy was a bona fide debt rather than a contribution to capital
in their joint venture, Money Gal’s bad-debt deduction is treated as a short-term capital loss under
§ 166(d)(1) because Money Gal is not in the business of lending money under § 166(d)(2). Her
resulting short-term capital loss would be subject to § 1211(b). If, on the other hand, she was a coprincipal in the venture, along with Idea Guy—with the capital coming from her and the expertise
coming from him—her investment loss deduction could be taken under § 165(c)(2) and would be
an ordinary deduction, as she did not sell or exchange a capital asset. Money Gal would prefer that
her deduction be taken under § 165(c)(2) rather than § 166(d) because the former would not be
subject to the § 1211 capital loss limitation rule.
In light of the definition of “bona fide debt” in the regulations, what facts would you need to
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explore with Money Gal to determine whether her transfer to Idea Guy was a contribution to capital
or a bona fide debt? What if their understanding provided that both Idea Guy and Money Gal
would share in all future profits from the venture in 50% shares? What if, instead, Money Gal was
entitled to receive her $10,000 plus a stipulated return once Idea Guy’s idea took off, but not more?
Worthlessness
In addition to being a bona fide debt, the debt must be wholly (nonbusiness) or partially
(business) worthless to generate a deduction under § 166. Treas. Reg. § 1.166-2 provides that legal
action is not required to establish worthlessness so long as “the surrounding circumstances indicate
that a debt is worthless and uncollectible and that legal action to enforce payment would in all
probability not result in satisfaction of execution on a judgment ….” In other words, a lender need
not incur the costs to pursue legal action to enforce the debt if a showing of worthlessness can be
made from the surrounding facts without such action.
One of the most troublesome issues in litigation has been determining the proper year in which
the debt became worthless, as the statute, by its terms, authorizes deduction only in the year in
which the debt became worthless—not in an earlier year or a later year—even if the lender would
prefer to shift the deduction to a year in which the lender is, say, in a higher tax bracket (and so
would save more in tax from a deduction in that year). Treas. Reg. § 1.166-2 provides:
In bankruptcy cases, a debt may become worthless before settlement in some
instances; and in others, only when a settlement in bankruptcy has been reached. In
either case, the mere fact that bankruptcy proceedings instituted against the debtor are
terminated in a later year, thereby confirming the conclusion that the debt is worthless,
shall not authorize the shifting of the deduction under section 166 to such later year.
Absent fraud, substantial omissions of Gross Income, or a failure to file a tax return, the normal
statute of limitations for most issues is three years. 2 Because determining the proper year of
worthlessness has proved to be so troublesome, however, Congress has extended the statute of
limitations for worthless security and bad-debt deductions to seven years. 3 A taxpayer who
believes that a debt becomes worthless in Year 6 and takes the bad-debt deduction in that year can
file an amended return if it is later determined that the debt in fact became worthless in Year 2.
The additional deduction for Year 2 on the amended return can generate a tax refund for the lender.
Deduction limited to basis
What is the proper measure of a worthless security or bad-debt deduction under §§ 165(g) or
166? Suppose that Rachel purchases High Tech stock (a security under § 165(g)(2)(A)), which is
publicly traded and so easily valued, for $10,000 in Year 1. By the end of Year 1, Rachel is happy
to find out that the stock has increased in value to $12,000 when she looks up the stock quotation
on December 31. At the end of Year 2, she is even happier to learn that the stock is now worth
$15,000. Even though Rachel gains economic wealth as the stock increases in value each year, you
know from Chapter 1 that Rachel does not include these wealth accessions in Gross Income under
the realization requirement because they are not final and irretrievable value changes.
If, in Year 3, the stock becomes worthless because of some calamity at High Tech, and you
asked a nontax observer how much Rachel lost on the bad news at High Tech, the observer would
likely respond “$15,000,” as that was what the stock was worth immediately before the plunge.
2
3

See § 6511(a).
See § 6511(d)(1).

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But also recall from Chapter 1 that, for income tax purposes, deductions must always be supported
by basis under normative income tax theory, i.e., if we are attempting to measure income
accurately, in order to ensure that the same dollars do not provide a double tax benefit to the same
taxpayer. Although Rachel lost $15,000 of wealth in the economic sense, her income tax deduction
is limited to her $10,000 basis to prevent her from both excluding (under the realization
requirement) and deducting the same dollars. If and only if the realization requirement were
repealed for publicly traded stock and Rachel had to mark to market the stock each year by
including $2,000 in Gross Income at the end of Year 1 (increasing her basis from $10,000 to
$12,000) and an additional $3,000 at the end of Year 2 (increasing her basis to $15,000) would she
then properly deduct $15,000 in Year 3 when the stock becomes worthless.
Sections 165(b) and 166(b) confirm that worthless security and bad-debt deductions are limited
to basis. In the case of a bad debt, the basis is created by the lender when she originally transfers
the loan principal to the borrower, a nondeductible capital expenditure. Merely becoming indebted
to another (under a contract or legal action, for example) without a prior transfer of funds creating
basis cannot generate a bad-debt deduction if that debt becomes uncollectible.
REVENUE RULING 93-27
1993-1 C.B. 32
ISSUE
Is a taxpayer entitled to a nonbusiness bad-debt deduction under section 166(a)(1) of the Code
for the amount of the taxpayer’s own payment in support of the taxpayer’s children caused by an
arrearage in court-ordered child support payments owed by a former spouse?
FACTS
The taxpayer, A, was divorced in 1989 from B and was granted custody of their two minor
children. Pursuant to a property settlement and support agreement that was incorporated into the
divorce decree, B agreed to pay to A $500 per month for child support. During 1991, B failed to
pay $5,000 of this obligation. Because of B’s arrearage, A had to spend $5,000 of A’s own funds
in support of A’s children.
LAW AND ANALYSIS
Section 166(a)(1) of the Code allows as a deduction any debt that becomes worthless within the
taxable year.
Section 166(b) of the Code provides that for purposes of section 166(a), the amount of the
deduction for any worthless debt is the adjusted basis provided in section 1011 for determining the
loss from the sale or other disposition of property.
Section 1011 of the Code generally provides that the adjusted basis for determining the gain or
loss from the sale or other disposition of property, whenever acquired, is the basis as determined
under section 1012.
Section 1012 of the Code provides that the basis of property is the cost of the property.
In Swenson v. Commissioner, 43 T.C. 897 (1965), the taxpayer claimed a bad-debt deduction
under section 166(a)(1) of the Code for an uncollectible arrearage in child support payments from
a former spouse. The Tax Court denied the deduction on the ground that section 166(b) precluded

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any deduction because the taxpayer had no basis in the debt created by the child support obligation.
The taxpayer had argued that her basis consisted of the expenditures for child support she was
forced to make from her own funds as a result of the father’s failure to make his required payments.
The court pointed out, however, that the father’s obligation to make the payments had been
imposed by the divorce court and was not contingent on the taxpayer’s support expenditures. It
stated that those expenditures neither created the arrearage nor constituted its cost to the taxpayer.
Swenson, at 899.
The Tax Court has followed the decision in Swenson on similar facts in Perry v. Commissioner,
92 T.C. 470 (1989); Meyer v. Commissioner, T.C. Memo 1984-487; Pierson v. Commissioner,
T.C. Memo 1984-452; and Diez-Arguelles v. Commissioner, T.C. Memo 1984-356.
In the present case, as in those above, B’s obligation to make the child support payments to A
was imposed directly by the court. A’s own child support expenditures did not create or affect B’s
obligation to A under the divorce decree. Accordingly, A did not have any basis in B’s obligation
to pay child support, and A may not claim a bad-debt deduction under section 166 (a)(1) of the
Code with regard to an arrearage in those payments.
The Service does not accept certain arguments relating to basis that were raised in Imeson v.
Commissioner, 487 F.2d 319 (9th Cir. 1973), cert. denied, 417 U.S. 917, 41 L. Ed. 2d. 222, 94 S.
Ct. 2621 (1974). The Ninth Circuit affirmed an opinion of the Tax Court, Imeson v. Commissioner,
T.C. Memo 1969-180, which held that a taxpayer was not entitled to a bad-debt deduction under
section 166 of the Code in a situation in which the taxpayer’s spouse had failed to make courtordered child support payments. However, the Ninth Circuit’s per curiam opinion was based on
the narrow ground that the taxpayer had failed to prove the amount of her expenditures to support
the children. The Ninth Circuit noted (without deciding) possible arguments to support a bad-debt
deduction for the taxpayer based on an analogy to a homeowner who pays materialmen’s liens on
a house after the builder has defaulted, or to a guarantor who pays the creditor when the principal
debtor defaults. The Tax Court, in its more recent Perry, Meyer, Pierson, and DiezArguellos
decisions, has distinguished and declined to follow the Ninth Circuit’s possible arguments in
Imeson. The Service will follow the decisions of the Tax Court on this issue.
HOLDING
A taxpayer is not entitled to a bad-debt deduction under section 166(a)(1) of the Code for the
amount of the taxpayer’s own payment in support of the taxpayer’s children caused by an arrearage
in court-ordered child support payments owed by a former spouse.
____________________________________
A taxpayer obtains no deduction for a mere failure to gain expected wealth—even if the
taxpayer has a legal right to that wealth—because the taxpayer has no basis (previously taxed
dollars) in mere expectations. To be deductible, the failed expectation must have basis in order
to prevent a double tax benefit for the same dollars to the same taxpayer.
A loan guarantor, mentioned in the ruling above, is someone who guarantees repayment by the
borrower and accepts legal responsibility to make the borrower’s loan payment if he fails to pay.
When a guarantor makes such a payment to the lender, virtually all 50 states create a right of action
for the guarantor (typically called a right of subrogation) to pursue reimbursement from the
borrower for the amount paid on his behalf. The IRS accepts that the guarantor who has made such
a payment under his guarantee obligation creates basis (after-tax dollars) that can be deducted

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under § 166 if the claim against the borrower (under his right of subrogation) becomes worthless.
Can a lender deduct uncollectible interest under § 166? Because the lender must have basis in
the unpaid interest in order to have anything to deduct under § 166(b), the answer will turn on
whether the lender has previously included the unpaid interest, either because the lender uses the
accrual method of accounting or, if the lender otherwise uses the cash method of accounting, the
interest was in the form of original issue discount under § 1272, as described in Chapter 9. In either
case, the income inclusion creates basis in the unpaid interest that can be deducted under § 166 if
the claim becomes worthless. If the interest is not in the form of original issue discount (includable
as time passes) and the lender uses the cash method of accounting, the lender would not include
the interest (creating basis) until actually received. In that case, the lender is like taxpayer A in
Revenue Ruling 93-27. That is to say, the lender's failure to collect the interest is a mere failed
expectation to gain wealth with no basis.
Problems
1. Daniel borrowed $10,000 from his sister Dora, to be repaid after one year. At the one-year
mark, Daniel does not repay the $10,000 to Dora. Can Dora deduct her $10,000 basis in the loan?
What questions would you need to explore with her? What additional facts do you need?
2. Miriam is injured by Maurice when he runs a red light and hits her with his automobile as
she crosses the road in a crosswalk. She successfully sues him in a tort action, and she wins a jury
award of $500,000. Maurice owes Miriam money! Maurice is a pauper and has no job and no
assets, and legal action to enforce payment would in all probability not result in satisfaction of
execution on a judgment. Can Miriam deduct $500,000 under § 166 with respect to her bad debt?
3. On January 1 of Year 1 Lucy lends $100,000 to Lonnie, a workaholic inventor who works in
his garage all evening after he gets home from his day job and all weekends with an idea for a new
computer chip that will revolutionize the tech world, at 4% interest. Assume that the loan is bona
fide. The $4,000 annual interest is to be paid on December 31 of each year, and the $100,000 loan
principal is to be repaid on December 31 of Year 8. Lonnie pays the $4,000 interest payments due
at the end of Years 1, 2 and 3. When Lonnie fails to pay the interest due on December 31 of Year
4, Lucy hires a lawyer to demand repayment. The lawyer has a tough time finding Lonnie, but he
finally learns in February of Year 8 that Lonnie sold all of his assets in Year 4 after his wife died,
which moved him deeply. He quit his job and moved to a fishing village in Mexico, where he plans
to live out his days simply.
a. What can Lucy deduct—and when can she deduct it—if she uses the cash method of
accounting?
b. Same as a., except that Lucy uses the accrual method of accounting.
c. What tax result in both a. and b. for Lucy if, in Year 10, Lonnie recovers from what he now
recognizes was a deep depression, returns to the U.S. and to work, and pays to Lucy the
$120,000 of aggregate principal and interest that he owes to her?

B. § 61 income from the discharge of indebtedness
You learned in Chapter 9 that, under the borrowing exclusion, Betty Borrower does not include

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the principal amount that she borrows from Larry Lender in the year of receipt because (under the
balance sheet analysis, at least) her future obligation to repay negates a wealth accession in that
year. You also learned in Chapter 9 that the borrowing exclusion is not entirely consistent with the
annual accounting principle in tax, under which we usually take each year as it comes, without
regard to our expectations about what will happen in future years. After all, the only way to squeeze
the borrower’s cash receipt (which is not basis recovery) into a no-wealth-accession box in the
year of receipt is by taking into account the future-year obligation to repay. 4
Suppose that—contrary to current law—Congress adopted a cash-flow approach to the receipt
and repayment of loan principal, under which borrowed principal is included in Gross Income by
the borrower on receipt and deducted when repaid. In that pretend world, we would need no special
rule for the borrower on the failure to repay loan principal (and we would not need Part B.). The
borrower who fails to repay would simply lose the tax deductions that would otherwise apply on
repayment. Because this pretend world does not exist, however, we must generally create an
offsetting income inclusion for the borrower on failure to repay loan principal under § 61.
Another way of understanding the role of § 61 debt-discharge income is to note that the
borrowing exclusion is a mere deferral provision, not a complete forgiveness provision. The
taxation of loan principal to the borrower effectively occurs at the time of repayment (rather
than on initial receipt), when the principal is repaid with after-tax (nondeductible) dollars. If
Betty Borrower never repays those untaxed dollars, we must create a Gross Income inclusion in
the year of nonpayment, or else Betty would enjoy permanently untaxed wealth equal to the
amount received (and excluded) in the earlier year.
We start with Kirby Lumber.
UNITED STATES v. KIRBY LUMBER
284 U.S. 1 (1931)
MR. JUSTICE HOLMES delivered the opinion of the Court.
In July, 1923, the plaintiff, the Kirby Lumber Company, issued its own bonds for $12,126,800
for which it received their par value. Later in the same year it purchased in the open market some
of the same bonds at less than par, the difference of price being $137,521.30. The question is
whether this difference is a taxable gain or income of the plaintiff for the year 1923. By the
Revenue Act of (November 23,) 1921, c. 136, § 213(a) Gross Income includes “gains or profits
and income derived from any source whatever,” and by the Treasury Regulations authorized by §
1303, that have been in force through repeated reenactments, “If the corporation purchases and
retires any of such bonds at a price less than the issuing price or face value, the excess of the
issuing price or face value over the purchase price is gain or income for the taxable year.” Article
545(1)(c) of Regulations 62, under Revenue Act of 1921. See Article 544(1)(c) of Regulations 45,
under Revenue Act of 1918; Article 545(1)(c) of Regulations 65, under Revenue Act of 1924;
Article 545(1)(c) of Regulations 69, under Revenue Act of 1926; Article 68(1)(c) of Regulations
4

In the last chapter of this textbook, you will learn that reflexive adoption of transactional accounting from financial
accounting—such as the deferral of Gross Income for cash received but not yet earned by taxpayers using the accrual
method of accounting—similarly allowed expectations of what would happen in future years to lead to tax results in
the receipt year that are inconsistent with SHS income tax values. Unlike with the borrowing exclusion, however,
some of these other results eventually led to statutory and doctrinal changes that deviate from financial (transactional)
accounting principles to better accord with income tax values.

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74, under Revenue Act of 1928. We see no reason why the Regulations should not be accepted as
a correct statement of the law.
In Bowers v. Kerbaugh-Empire Co., 271 U.S. 170, the defendant in error owned the stock of
another company that had borrowed money repayable in marks or their equivalent for an enterprise
that failed. At the time of payment the marks had fallen in value, which so far as it went was a gain
for the defendant in error, and it was contended by the plaintiff in error that the gain was taxable
income. But the transaction as a whole was a loss, and the contention was denied. Here there was
no shrinkage of assets and the taxpayer made a clear gain. As a result of its dealings it made
available $137,521.30 assets previously offset by the obligation of bonds now extinct. We see
nothing to be gained by the discussion of judicial definitions. The [Kirby Lumber Company] has
realized within the year an accession to income, if we take words in their plain popular meaning,
as they should be taken here. Burnet v. Sanford & Brooks Co., 282 U.S. 359, 364.
__________________________________
Another terse Holmes opinion! Exactly why did the Kirby Lumber Corporation realize income
when it bought back its bonds on the open market for approximately $138,000 less than it had
originally borrowed from the bond buyers? Ignore for now the reference to the Kerbaugh-Empire
case, which we shall revisit in the next chapter. The important sentence in this opinion is: “As a
result of its dealings it made available $137,521.30 assets previously offset by the obligation of
bonds now extinct.” (Emphasis added.) This language was interpreted at the time to mean that the
reason why Kirby Lumber realized income was that nearly $138,000 of its balance sheet assets,
which were previously encumbered by the corporation’s outstanding liabilities, were effectively
freed from these offsetting liabilities when it eliminated $138,000 of its outstanding debt at no
cost. This “freeing of assets” or “balance sheet improvement” that arose on the debt discharge was
thought to be the reason justifying the Gross Income inclusion.
If we construct a balance sheet for Kirby Lumber immediately after the bond sale, we would
add $12,126,800—the amount of money that it effectively borrows from the public through selling
bonds—to both sides. Because Kirby Lumber’s net worth (assets less liabilities) does not increase
by reason of the borrowing, the borrowed money does not constitute Gross Income.
Assets

Liabilities

$12,126,800

$12,126,800

No increase in Kirby Lumber’s net worth (assets less liabilities) at the time of borrowing.
After Kirby Lumber is able to repurchase some of the bonds for $138,000 less than it had
received on the bond sale, $138,000 of its assets (left side) are freed from offsetting liabilities
(right), increasing Kirby Lumber’s net worth by $138,000. Let’s assume that Kirby Lumber is able
to repurchase bonds issued for $2,000,000 for only $1,862,000. (This can occur, for example, if
interest rates rise generally in the economy, depressing the value of Kirby Lumber’s outstanding
bonds that pay a lower interest rate than potential borrowers can obtain today.) While only
$1,862,000 is spent from its $12,126,800 of assets, its liabilities are reduced by the full $2,000,000,
increasing its net worth by $138,000.
Assets

Liabilities

$10,264,800

$10,126,800

Net worth (assets less liabilities) increased by $138,000.

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Justice Holmes implied that it was this asset freeing or balance sheet improvement that creates
the Gross Income.
If that analysis is correct, what if a borrower’s net worth remains negative after a debt discharge
because the debtor continues to have more liabilities than assets? A borrower with debt exceeding
its assets is said to be insolvent. Lower court opinions issued after Kirby Lumber took its assetfreeing language literally to mean that no Gross Income is even realized unless the discharge
creates or increases a positive net worth, as no assets are freed from offsetting liabilities if a debtor
remains insolvent after the debt discharge. For example, assume that Martha has $100,000 in assets
and debts of $130,000, i.e., Martha is insolvent, when she negotiates with a creditor to forgive a
$20,000 debt. Martha remains insolvent after the discharge and so is not—at least under Kirby
Lumber’s rationale—considered to even realize income on the discharge.
Assets

Liabilities

$100,000

$130,000

Martha is insolvent, with a negative net worth (liabilities exceed assets).
Now a $20,000 debt is discharged.
Assets

Liabilities

$100,000

$110,000

Martha remains insolvent. No assets are freed of offsetting liabilities
If we stick with Kirby Lumber’s rationale, Martha would realize debt-discharge income only to
the extent that the discharge creates positive net worth, freeing some assets from debt. If, for
example, Martha’s creditor discharged a total of $50,000 in debt (instead of $20,000), Martha
would realize $20,000 of Gross Income (because, to that extent, her assets were freed from
offsetting liabilities) but would not realize $30,000 of Gross Income.
A total of $50,000 (instead of $20,000) of her $130,000 debt discharged.
Assets

Liabilities

$100,000

$80,000

Martha is solvent by $20,000 because the discharge created a $20,000 positive net worth.
Is this result normatively correct? No. If Martha does not realize $30,000 of Gross Income, the
$30,000 previously received in the borrowing year becomes permanently tax-free. The borrowing
exclusion, properly understood, is merely a deferral provision, not a complete forgiveness
provision. This error arises because of the original sin of using the balance sheet to analyze the
consequences of nonpayment rather than consulting tax values.
Today, § 61(a)(11) (or (12)) 5 confirms that “income from discharge of indebtedness” is Gross
Income. (Some refer to it as COD income, an acronym for “cancellation of debt.”) Justice
Holmes’s asset-freeing or balance sheet improvement rationale is no longer considered by most to
be the modern justification underlying the realization of debt-discharge income, though

5

Some hard copies of the Code and Regs—even those updated after the TCJA and the repeal of the § 61(a)(8) alimony
inclusion—continue to list debt-discharge income as § 61(a)(12) income, but online versions (such as Cornell’s ILL
website) now uses § 61(a)(11).

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(unfortunately) you will all too often still see such language in court opinions, as in Payne and
Zarin, below.
The modern rationale underlying § 61 debt-discharge income: the borrowing exclusion itself
The modern rationale underlying the realization of debt-discharge income is premised on the
borrowing exclusion—all by itself—and the permanently untaxed dollars that would result if those
borrowed amounts are not repaid with after-tax dollars. The modern rationale has nothing to do
with balance sheets. Remember that borrowed cash is not intended to be forever free of tax for the
borrower. If the parties’ expectations had been fulfilled, the taxation of the borrowed money was
to occur in the year of repayment because that repayment would be made with nondeductible, i.e.,
after-tax, dollars. Indeed, the Year-1 receipt would have constituted a wealth accession in that year
but for the promise to repay with after-tax dollars, regardless of the solvency or insolvency of the
borrower. If the repayment obligation disappears without repayment with after-tax dollars, Gross
Income must be created at that later time to prevent those previously received dollars from being
made permanently tax-free. Notice that balance sheets are irrelevant to this analysis.
The modern rationale can thus be stated as a three-part syllogism:
(1) The economic value received in Year 1 is not a wealth accession under Glenshaw Glass
principles solely because of the obligation to repay with after-tax dollars.
(2) The obligation to repay disappears.
(3) Because the exclusion justification is gone, the value received in Year 1 is now a
wealth accession (in the year the repayment obligation disappears) under § 61.
In a sense, you can think of the modern rationale as a version of an error-correction approach in
that we would have required the cash recipient to include the receipt in the earlier year if we had
known then that it would not, in fact, be repaid with after-tax dollars.
If a borrower’s repayment obligation disappears, can the borrower simply file an amended return
for the prior year of receipt (if the statute of limitations has not yet passed) and include the amount
in Gross Income in that year, now that we know (with the benefit of hindsight only) that it will not,
in fact, be repaid with after-tax dollars? No. The reason why the borrower must include Gross Income
in the year in which the repayment obligation disappears is that the exclusion was proper in the
borrowing year under the facts then known. Even if the statute of limitations has not expired and the
taxpayer wishes to file an amended return (e.g., perhaps the tax rate was lower in the prior year when
the proceeds were received), the taxpayer cannot file an amended return.
In this way, § 61 debt-discharge income is yet another example of the annual accounting principle,
the idea that we take each year as it comes. If our expectations turn out to be wrong about what
would happen in the future, we deal with the issue in the year in which those prior expectations prove
to be unfounded, just as Mr. Lewis in Chapter 9 could not file an amended return for 1944—even
though the statute of limitations was still open—to exclude from Gross Income the portion of his
compensation bonus that he was forced to return to his employer in 1946. The inclusion of the
compensation was proper in 1944 because everyone expected that the entire amount was his to keep.
When that expectation proved to be false in 1946 and he had to return $11,000 of the $22,000 bonus
to his employer, Mr. Lewis’s only recourse was to take a § 165 deduction in 1946—the year in which
expectations about what was going to happen in the future were upended. 6
6

As described in Chapter 9, a taxpayer in Mr. Lewis’s position today can effectively take a tax credit under § 1341 in

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Deferral of § 61 debt-discharge income under § 108
Under Justice Holmes’s outdated rationale, the insolvent borrower who escaped debt repayment
was not considered to even realize Gross Income in the first place unless (and to the extent that) he
was made solvent by the discharge. If he were not made solvent by the discharge, he was forever
free from tax pertaining to the untaxed dollars originally received and never repaid. That favorable
result is no longer true today, but a remnant of Justice Holmes’s legacy remains in § 108(a)(1)(B).
Before we get there, however, let’s first consider § 108(a)(1)(A).
Section 108(a)(1) provides the authority for the borrower to exclude § 61 debt-discharge income
from Gross Income to the extent that one of the subsections found there apply. The first (and most
important) exclusion is the bankruptcy exclusion found in § 108(a)(1)(A), which authorizes
exclusion of § 61 debt-discharge income if it “occurs in a title 11 case.” As confirmed by § 108(d)(2),
the reference to “title 11” is a reference to the entire Federal Bankruptcy Code, under which a
borrower’s debts can be reduced or eliminated by order of the bankruptcy judge. While there are
several chapters in the Bankruptcy Code (including Chapter 7 liquidations, Chapter 11
reorganizations, and Chapter 13 consumer bankruptcy actions), the § 108(a)(1)(A) reference is to all
of Title 11, so it makes no difference which type of bankruptcy proceeding results in the debt
discharge.
Viewed alone, § 108(a)(1) appears to be a complete tax forgiveness provision, but § 108(b)
quickly disabuses us of this notion to the extent that it applies. Under § 108(b)(1) and (b)(3)(A), any
amount excluded under the authority of the § 108(a)(1)(A), (B), or (C) must reduce—dollar for
dollar—the favorable tax attributes owned by the taxpayer that are listed in § 108(b)(2), such as a §
1212 capital loss carryover under § 108(b)(2)(D) or property basis under § 108(b)(2)(E). 7 The effect
of reducing these items immediately (in the year of the debt discharge) by the amount excluded
should have the effect of increasing future Gross Income as a matter of course in an equal amount,
turning what appears to be a complete forgiveness provision into a mere deferral provision.
To illustrate, return to our earlier example, where Martha has assets of $100,000 and debts of
$130,000 when a $50,000 debt is discharged. If this discharge occurs in bankruptcy court, Martha
excludes from her Gross Income the entire $50,000 of § 61 debt-discharge income under §
108(a)(1)(A), but she would reduce any items listed in § 108(b)(2)(A) through (F) by exactly
$50,000. Let’s assume that Martha does not have any of the attributes listed in § 108(b)(2)(A)
through (C), but she does have a $90,000 capital loss carryover under § 1212 that she has been
carrying on her books for future use. Under § 108(b)(2)(D), Martha must reduce her $90,000 capital
loss carryover by the $50,000 that she excludes under § 108(a)(1)(A) (to $40,000), which should
have the effect of increasing her future Gross Income by precisely $50,000 because she will have
$50,000 less to deduct in future years. If Martha does not have a capital loss carryover, but she owns
property, she must generally reduce her property basis by $50,000 under §§ 108(b)(2)(E) and 1017.
If the property is depreciable property, the basis reduction results in $50,000 of fewer depreciation
deductions in the future than she otherwise would have taken absent the basis reduction. If the
property is not depreciable, a basis reduction should increase future § 1001 gain (or reduce future
loss) when she sells the property. In either of these examples, no interest is charged by the
government for the deferral privilege, which means that Martha is still better off under § 108
the later year if a credit would be more favorable, but the matter is still addressed entirely in that later year in which
expectations changed.
7
The ordering rules, as well as some special rules, that govern basis reduction under § 108(b)(2)(E) are found in the
regulations under § 1017.

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(because of the time value of money) than she would be if she had to include the $50,000 of § 61
debt-discharge income immediately in the year of discharge.
Why does § 108(a)(1)(A) effectively defer taxation of the § 61 debt-discharge income to a future
year? The Bankruptcy Code and the Internal Revenue Code are both Federal bodies of law, which
can be in tension with each other. Under the bankruptcy provisions, the IRS is often a preferred
creditor that can jump to the head of the creditor line if the bankrupt debtor owes Federal tax. For
example, if a taxpayer owes back taxes at the time of a bankruptcy filing, the IRS’s debt may get
first priority (ahead of other unsecured creditors) when assets of the bankruptcy estate are used to
settle debts. Absent § 108(a)(1)(A), a taxpayer who owed no back taxes at the time of a bankruptcy
filing could have a new tax debt created in the bankruptcy proceeding, itself, when the judge
discharges debts owed to other creditors. Just as with back taxes owed at the time of the filing, this
brand new tax debt could jump to the head of the creditor line. Section 108(a)(1)(A) effectively
prevents this outcome, reflecting Congress’s decision to allow other creditors of the bankrupt debtor
to take first in the bankruptcy proceeding (except, of course, to the extent of Federal taxes previously
owed at the time of the filing). The Treasury should, however, get its tax when the debtor’s future
income is higher than it otherwise would be by precisely the amount of § 61 debt-discharge income
that was excluded under § 108(a)(1)(A)—all because of the § 108(b) attribute reduction.
In the legislative history underlying §108, Congress said that it anticipated that most debtors
would have at least one of the tax attributes listed in § 108(b)(2). Nevertheless, it also recognized
that some debtors may not have any § 108(b) items to reduce, in which case the § 108(a) exclusion
effectively becomes a complete forgiveness provision rather than a mere deferral provision.
Notice that our debtor Martha happens to be insolvent (with her $130,000 in liabilities exceeding
her $100,000 in assets) before the bankruptcy proceeding, that the $50,000 in debt discharged in the
bankruptcy proceeding has the effect of making her solvent by $20,000, but that these facts have
absolutely no relevance to the analysis under § 108(a)(1)(A). Indeed, debtors need not even be
insolvent to file for bankruptcy protection.
What if an insolvent debtor such as Martha negotiates a debt discharge outside bankruptcy
proceedings, where Federal bankruptcy policy is no longer in tension with Federal tax policy? In
that case, Martha realizes § 61 debt-discharge income—unlike in the Kirby Lumber era—but §§
108(a)(1)(A), (a)(3), and (d)(3) nevertheless authorizes an exclusion to the extent that the discharge
does not create a positive net worth for Martha, with § 108(b) tax attribute reduction for the
excluded income. Martha immediately includes $20,000 of her $50,000 of § 61 debt-discharge
income (to the extent that the discharge creates positive net worth), excludes the remaining
$30,000 (to the extent that it does not), and reduces the tax attributes listed in § 108(b) by the
$30,000 that she excludes. Because the insolvency exclusion is not as generous as the bankruptcy
exclusion, Martha may consider a bankruptcy filing instead of negotiating her debt discharge
outside of a bankruptcy proceeding, though of course other collateral nontax consequences are
important to consider in this regard, as well.
The fact that discharged debt of an insolvent debtor is not forgiven but merely deferred is clear
evidence that Justice Holmes’s asset-freeing rationale is a footnote in history. Under the assetfreeing test, Martha would not be considered to have even realized any debt-discharge income to
the extent of the $30,000 that failed to free any of her assets from debt on her balance sheet. In
contrast, under current law, Martha does realize the entire $50,000 of discharged debt as § 61 debtdischarge income—even to the extent that it does not make her solvent. She can only defer the
realized income (through § 108(b) attribute reduction) to a future year. Indeed, § 108(e)(1)
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confirms that the Kirby Lumber-era, common law insolvency exception to realization of debtdischarge income is defunct.
What justifies the insolvency exclusion in § 108 today? By definition, the taxpayer is not in
bankruptcy court, where Congress had to balance Federal bankruptcy policy with Federal tax
policy. Surely, insolvent workers cannot avoid including their compensation merely because the
income does not free any of their assets from debt or make them solvent. Many students, for
example, are technically insolvent (with debts exceeding their assets), but they must nevertheless
include all other types of § 61 Gross Income immediately, without deferral. It is hard to conclude
that the insolvency deferral rule for this one, particular type of § 61 Gross Income is anything more
than a remnant of the early (now outdated) doctrine first enunciated by Justice Holmes.
Other notable types of § 61 debt-discharge income that can be excluded under § 108 pertain to
discharged “qualified real property business indebtedness” under §§ 108(a)(1)(D) and (c) and
certain “purchase money debt reductions” under § 108(e)(5), both of which we shall examine in
the next chapter. Certain student loans that are discharged pursuant to the loan’s original terms
providing for such discharge upon working in certain professions for a set period of time and for
a certain set of employers and populations can be excluded under § 108(f).
Failure to grasp the modern rationale by some courts
Review the three-step syllogism that underlies the modern rationale for § 61 debt-discharge
income, described above. The measure of the income inclusion is the amount received in the prior
year that was excluded in that year solely because of the promise to repay with after-tax dollars.
If no amount is received in the earlier year, no wealth accession arises in a later year, even if a
liability is discharged. For example, the Second Circuit held in Commissioner v. Rail Joint
Company 8 that no § 61 debt-discharge income arises when a corporation repurchases corporate
bonds at a discount when the bonds were previously issued as a dividend to its shareholders. Unlike
the corporate bonds in Kirby Lumber, the corporation in Rail Joint did not sell its bonds for cash
(which would otherwise have been a wealth accession on receipt absent the promise to repay with
after-tax dollars) but rather simply distributed the bonds to its shareholders at no charge. When it
bought some of those bonds back for less than the face amount of the bonds (which it would
otherwise have had to pay at maturity), it realized no § 61 debt-discharge income—even though
its balance sheet clearly improved as a result and even though some of its assets were freed from
offsetting liability represented by the bonds. In substance, the company simply paid a lower
dividend than first appeared. Rail Joint provides a good example of the modern rationale
underlying the creation of § 61 debt-discharge income.
Similarly, no debt-discharge income is realized if a legal liability unconnected to any prior
receipt disappears. Merely avoiding an expense does not represent a wealth accession and does
not create Gross Income, even if that expense would otherwise have been legally obligated to
be made if the facts had not changed. For example, assume that, under their divorce agreement,
Michael is required to pay Maria $20,000 each year as child support until their child Manny
reaches age 18. When Manny is only 11 years old, Michael’s income is substantially reduced and
they renegotiate their legal agreement to reduce Michael’s annual child support payments from
$20,000 to $15,000. Michael does not realize § 61 debt-dischare income (or any other kind of
Gross Income) just because his legal obligation to pay money to his ex-wife (in the form of child
support) is reduced—even though his balance sheet clearly improves as a result.
8

61 F.2d 751 (2d Cir. 1932).

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Another example can be drawn from the flip side of the coin in an earlier Problem in Part A.
Miriam is injured by Maurice when he fails to stop at a red light and hits Miriam as she crosses
the road in the crosswalk. She successfully sues him in a tort action and wins a jury award of
$500,000. Maurice owes Miriam money! Unlike in the earlier problem, assume that Maurice has
current assets (or at least future earning power) that will allow him to pay the $500,000 to Miriam.
What if Miriam decides, for good business reasons, 9 to forgive the debt and tells Maurice that he
need not pay the $500,000 that he owes to her? Does Maurice realize § 61 debt-discharge income?
Even though his balance sheet has improved, Maurice does not realize § 61 debt-discharge income
under the modern rationale. He did not receive any economic value in Year 1 that would have been
a wealth accession in that year had he not promised to repay the amount with after-tax dollars.
Is Payne, below, wrongly decided? The Court’s conclusion that § 108(e)(5), which we shall
examine in the next chapter, did not apply was clearly correct. Nevertheless, should not the
taxpayers have won for reasons having nothing to do with § 108(e)(5)? What—precisely—was
discharged here? Is Payne an example of the Tax Court applying Justice Holmes’s outdated
“balance sheet improvement” rationale? The taxpayers represented themselves pro se.
PAYNE v. COMMISSIONER
T.C. Memo. 2008-66 (2008), aff’d 2010-1 U.S.T.C. (CCH) ¶ 50,132 (8th Cir.) (per curiam)
HAINES, JUDGE: Respondent determined a deficiency of $5,410 in petitioners’ Federal income
tax for 2004. The sole issue for decision is whether petitioners should have included $16,678 of
discharge of indebtedness income on their 2004 Federal income tax return. We hold that they
should have done so and therefore sustain respondent’s determination.
FINDINGS OF FACT
Some of the facts have been stipulated and are so found. The stipulation of facts, together with
the attached exhibits, is incorporated herein by this reference. At the time they filed their petition,
petitioners resided in Minnesota.
At the end of 1992 petitioner Ancil N. Payne, Jr. (Mr. Payne), opened a credit card account with
MBNA America Bank. Mr. Payne used the credit card to pay hospital bills and receive cash
advances during periods of unemployment. By April 26, 2004, Mr. Payne had accumulated
$21,407 of credit card debt. At no time did Mr. Payne challenge the accuracy of this amount.
Petitioners were not insolvent in 2004, nor did they file for bankruptcy.
By October 19, 2004, Mr. Payne and MBNA entered into an agreement whereby MBNA agreed
to accept $4,592 as a full settlement of the account balance of $21,270, payable in installments
over 4 months. Mr. Payne made the necessary payments, and MBNA issued him a Form 1099-C,
Cancellation of Debt, reporting $16,678 of discharge of indebtedness income.
On petitioners’ 2004 Form 1040, U.S. Individual Income Tax Return, filed jointly in April
2005, petitioners did not report any discharge of indebtedness income. Instead, petitioners attached
a statement to their return which disclosed that they received a Form 1099-C from MBNA that
reported discharge of indebtedness income of $16,678. The statement also explained that
petitioners believed the amount disclosed on the Form 1099-C was not subject to income tax.
9

Let’s stipulate that she has good business reasons driving her decision—rather than detached and disinterested
generosity—to avoid any possibility of exclusion for Maurice under § 102 as a gift.

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Respondent’s determination of a deficiency in petitioners’ Federal income tax for the taxable
year 2004 was attributable to petitioners’ failure to report the discharge of indebtedness income.
OPINION
Section 61 generally defines Gross Income as “all income from whatever source derived”.
Section 61(a)(12) specifically provides that Gross Income includes income from the discharge of
indebtedness. See also Gitlitz v. Comm’r, 531 U.S. 206 (2001); U.S. v. Kirby Lumber Co., 284 U.S.
1 (1931). Respondent determined that MBNA’s agreement with Mr. Payne to accept $4,592 in full
settlement of the undisputed account balance of $21,270 resulted in $16,678 of discharge of
indebtedness income to petitioners. Petitioners bear the burden of proving respondent’s
determination incorrect….
I. Reduction of Purchase Price
Petitioners contend that their settlement with MBNA did not result in the discharge of
indebtedness but was rather a retroactive reduction of the rate of interest charged by MBNA and
thus a reduction of the “purchase price” of the loans under section 108(e)(5). Although the record
does not indicate that MBNA agreed to retroactively reduce the rate of interest of its loans to
petitioners, petitioners have nevertheless painstakingly calculated the various interest rates that
applied to their outstanding balances from October 1994 through October 2004 and attempt to
show that by the time of their settlement they had paid back all of the principal they had borrowed
from MBNA.
Section 108(e)(5) provides an exception to section 61(a)(12) where the buyer of property
negotiates with the seller/creditor for a discharge of all or part of the purchase money indebtedness.
Commonly such a discharge reflects a decline in the value of the property. The resulting discharge
of indebtedness is characterized not as taxable income but in effect as a retroactive reduction of
the purchase price. Where, however, the only relationship between the parties is that of debtor and
creditor, “The rule of Kirby Lumber is clearly applicable”. OKC Corp. & Subs. v. Comm’r, 82
T.C. 638, 647 (1984).
Petitioners argue that the lending of money in a generic credit card transaction constitutes the
sale of “property” under section 108(e)(5). Petitioners are mistaken. MBNA effectively lent
petitioners money to be used for health care costs and general living expenses. [5] The only
relationship between the parties was that of debtor and creditor, and thus section 108(e)(5) does
not apply. See OKC Corp. & Subs. v. Comm’r, supra at 647.
II. Discharge of Indebtedness for Interest Payments
Petitioners also allege that no income arises from the discharge of indebtedness for interest
payments. In support of this proposition, petitioners reference Earnshaw v. Comm’r, T.C. Memo
2002-191.
Generally, when a solvent debtor’s fixed obligation is reduced or canceled, the amount of the
reduction or cancellation constitutes income. Sec. 61(a)(12); U.S. v. Kirby Lumber Co., supra. In
Earnshaw v. Comm’r, supra, we concluded that there had been a legitimate dispute between the
debtor and creditor regarding the amount of the debtor’s obligation. We held that the taxpayer
recognized discharge of indebtedness income from the settlement, but the amount was based on
[5]

Insofar as petitioners used the credit card to buy merchandise, the Commissioner treats debt forgiveness in thirdparty lender cases as a purchase price adjustment only if the forgiveness is directly related to an aspect of the sale, as
where a seller inflates the purchase price by misrepresentation. Rev. Rul. 92-99, 1992-2 C.B. 35.

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the account balance that the taxpayer admitted to rather than the higher amount the Commissioner
alleged. Earnshaw does not stand for the principle that discharge of indebtedness income does not
include the cancellation of debt attributable to interest payments.
As no exclusion applies and the amount of petitioners’ obligation was clearly fixed, petitioners
should have included $16,678 of discharge of indebtedness income in their Gross Income on their
2004 tax return.
In reaching this holding, the Court has considered all arguments made and, to the extent not
mentioned, concludes that they are moot, irrelevant, or without merit.
To reflect the foregoing,
Decision will be entered for respondent.
__________________________________
The Tax Court did not dispute the taxpayers’ contention that the $16,678 discharged by MBNA
represented entirely interest and fees that had accrued from a substantial period of nonpayment on
an originally modest principal amount of $4,592, which was entirely repaid. If the facts had been
different, and the discharged amount reflected unpaid principal, which was used to buy property
or services, § 61 debt-dischrage income would clearly have been realized. On those different facts,
the failure to repay the principal (with after-tax dollars) would reflect previously received wealth
(the value of the property or services purchased with the borrowed money in the prior year) that
was excluded solely because of the promise to repay with after-tax dollars. If the borrowers had
failed to repay unpaid principal, the taxpayers would have enjoyed a permanently tax-free wealth
accession in that prior year (equal to the value of the goods and services purchased on credit)
unless we create § 61 debt-discharge income in the discharge year. But the Paynes apparently
repaid 100% of the originally borrowed principal.
In other words, the Paynes did not receive the amount represented by the unpaid interest and
fees in a previous year, a receipt that would have represented a wealth accession in that earlier year
absent the promise to repay. Rather, they merely avoided an expense—as that word is used as a
tax term of art—i.e., an outlay that would represent a current wealth decrease when made. Do
avoided expenses create Gross Income? Recall the child support example a few pages back.
If the cancellation of the interest obligation is not § 61 debt-discharge income, is it nevertheless
residual Gross Income under Glenshaw Glass analysis? The parties effectively turned this
borrowing transaction into a no-interest loan. Does a no-interest or below-market loan create a
wealth accession in the amount of forgone interest? Return to § 7872, studied in Chapter 9. You
learned that, in general, only forgone interest that is a substitute for otherwise includable
compensation or a dividend creates a wealth accession for income tax purposes. Consistent with
that treatment, Prop. Treas. Reg. § 1.7872-11(a) provides that cancellation of interest creates
deemed § 7872 payments only if “the loan would have been subject to § 7872 had it been made
without interest ….” While only a proposed regulation, is not its logic persuasive?
Problems
Sandra makes a bona fide loan of $100,000 to Sebastian on January 1 of Year 1 at 4% annual
interest. Under the loan terms, Sebastian is required to pay $4,000 annual interest on December 31
of each year for 5 years, as well as repay the $100,000 principal on December 31 of Year 5.

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Sebastian’s finances begin to falter in Year 3, but Sebastian manages to make each annual $4,000
interest payment. When the $100,000 principal repayment becomes due at the end of Year 5,
however, Sebastian does not make the payment. What tax consequences arise for Sebastian (we
already considered Sandra’s consequences in Part A.) if:
a. Sandra and Sebastian execute an agreement under which he will repay only $70,000 of the
outstanding $100,000 loan principal over the next three years at 4% interest. Sandra cancels the
remaining $30,000 of principal owed. Before the new agreement was negotiated, Sebastian’s
balance sheet showed that he owned only one piece of property with a value of $120,000 (and
a basis of $80,000). His $100,000 debt to Sandra was his only debt. Sebastian makes the
required payments under their new agreement.
b. Same as a., except that Sebastian’s only property had value of $80,000 and basis of $50,000.
c. Same as a., except that the $30,000 debt cancellation occurs in bankruptcy court rather than
by agreement with Sandra.
d. Same as a., except that Sebastian stopped making interest payments after Year 2 when his
business began to falter. Sandra and Sebastian execute an agreement that provides that
Sebastian must repay the entire $100,000 principal owed over the next three years, but Sandra
cancels the $12,000 in interest owed. Sebastian repays the entire $100,000 in principal under
their new agreement.
____________________________________
Measuring the economic value received in the borrowing year with seller-financed purchases
When A borrows cash from B in Year 1 in order to buy property or services from C, the measure
of § 61 debt-discharge income upon the later failure to repay B with after-tax dollars is clear: the
amount of cash previously received (and excluded) in Year 1. Moreover, whether the debt is
enforceable under state law should be irrelevant to the question of whether a wealth accession is
realized if that cash is not repaid with after-tax dollars. For example, assume that Debby borrows
$10,000—cold, hard cash—from a loan shark, Dastardly Dan, promising to repay with 50%
interest. Debby excludes the $10,000 receipt under the borrowing exclusion, using the cash to take
a trip to Venice. (Lucky Debby!) Debby then learns that under her state’s usury law Dastardly Dan
would be unable to sue her for repayment in state court, so she never repays the $10,000 that she
borrowed. Does Debby realize § 61 debt-discharge income? Or can she argue that the § 61
language should be read in the literal sense to mean that she cannot be “discharged” from a debt if
she cannot be forced to repay it in any event?
Would such a literal interpretation of the word “discharge” in § 61 untether the relation of that
provision to the underlying normative principles that inform it? If Debby does not include the
$10,000 in her Gross Income in either the year received or the later year in which the repayment
obligation is due but unenforceable, she would have received permanently tax-free cash. (Whether
Debby can deduct the medical expenses that she incurs when Dastardly Dan breaks both of her
knees is considered in Chapter 17. Unlucky Debby!)
In short, the enforceability of the loan should be irrelevant to the question of whether Debby
enjoys a wealth increase when she (1) receives $10,000 in cash in Year 1 but does not include the
amount in her Gross Income solely because she promises to repay it in a future year with after-tax
dollars and (2) she learns that her state’s usury law prevents enforcement of the loan so she decides
not to repay. Under step (3) of our syllogism, Debby should have to include $10,000 of § 61 debt-

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discharge income in order to avoid permanent nontaxation of that earlier $10,000 cash receipt. The
focus, in other words, should be solely on what the taxpayer previously received and excluded
under the borrowing exclusion when analyzing § 61 debt-discharge income.
The Payne court lost sight of that focus. Perhaps the various judges in Zarin, below, also lost
sight of that key focus. Complicating matters even further in Zarin, however, is the fact that the
seller of services on credit (gambling entertainment) was also the lender (seller-financed debt
instead of three-party debt). The extent to which debt is real when the seller of the services or
property is also the lender financing the transaction is a perennial difficulty under an income tax.
Indeed, you will read more about this problem in Chapter 15, pertaining to tax shelters.
Tax Court cases are usually decided by a single judge, but the Chief Judge can designate novel
cases (or cases in which the court may decide to overrule its own prior precedent) to be heard by
the entire 15-judge court. The decision in that case is called a reviewed decision and, by its nature,
can involve a majority, dissenting, and concurring opinions. After excerpts from the Tax Court
opinions, you will read the Third Circuit decision on appeal.
Zarin has been called a “case without a right answer.” 10 I think that the case is useful, however,
because it causes us to revisit several issues that we have considered in the past, as well as causes
us to think hard (again) about underlying rationale of debt-discharge income which is so easy to
lose sight of if we think in shorthand terms that a cancelled liability equals debt-discharge income.
ZARIN v. COMMISSIONER
92 T.C. 1084 (1989) (reviewed)
COHEN, JUDGE: Respondent asserted that petitioners realized additional taxable income of
$2,935,000 in 1981 through cancellation of indebtedness. The sole issue for decision is whether
petitioners had income from discharge of gambling indebtedness during 1981.
All of the facts have been stipulated. The facts set forth in the stipulation are incorporated as
our findings by this reference. Petitioners resided in Atlantic City, New Jersey, at the time they
filed their petition in this case. They timely filed joint Federal income tax returns for 1980 and
1981 with the Internal Revenue Service Center, Holtsville, New York.
David Zarin (petitioner) was a professional engineer involved in the development, construction,
and management of multi-family housing and nursing home facilities. In 1978, 2 years after New
Jersey passed the Casino Control Act, N.J. Stat. Ann. sec. 5:12-101 et seq. (West 1988), legalizing
casino gambling in Atlantic City, petitioner began developing various housing projects in Atlantic
City, New Jersey.
Petitioner occasionally stayed at Resorts International Hotel, Inc. (Resorts), in Atlantic City in
connection with his construction activities. Prior to 1978, petitioner had gambled on credit both in
Las Vegas, Nevada, and in the Bahamas. In June 1978, petitioner applied to Resorts for a $10,000
line of credit to be used for gambling. After a credit check, which included inquiries with
petitioner’s banks and “Credit Central,” an organization that maintains records of individuals who
gamble in casinos, the requested line of credit was granted, despite derogatory information
received from Credit Central.
10

Daniel Shaviro, The Man Who Lost Too Much: Zarin v. Commissioner and the Measurement of Taxable
Consumption, 45 TAX LAW REV. 215, 250 (1990).

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The game most often played by petitioner, craps, creates the potential of losses or gains from
wagering on rolls of dice. When he played craps at Resorts, petitioner usually bet the table limit
per roll of the dice. Resorts quickly became familiar with petitioner. At petitioner’s request,
Resorts would raise the limit at the table to the house maximum. When petitioner gambled at
Resorts, crowds would be attracted to his table by the large amounts he would wager. Gamblers
would wager more than they might otherwise because of the excitement caused by the crowds and
the amounts that petitioner was wagering. Petitioner was referred to as a “valued gaming patron”
by executives at Resorts.
By November 1979, petitioner’s permanent line of credit had been increased to $200,000.
Despite this increase, at no time after the initial credit check did Resorts perform any further
analysis of petitioner’s creditworthiness. Many casinos extend complimentary services and
privileges (comps) to retain the patronage of their best customers. Beginning in the late summer
of 1978, petitioner was extended the complimentary use of a luxury three-room suite at Resorts.
Resorts progressively increased the complimentary services to include free meals, entertainment,
and 24-hour access to a limousine. By late 1979, Resorts was extending such comps to petitioner’s
guests as well. By this practice, Resorts sought to preserve not only petitioner’s patronage but also
the attractive power his gambling had on others.
Once the line of credit was established, petitioner was able to receive chips at the gambling
table. Patrons of New Jersey casinos may not gamble with currency, but must use chips provided
by the casino. Chips may not be used outside the casino where they were issued for any purpose.
Petitioner received chips in exchange for signing counter checks, commonly known as
“markers.” The markers were negotiable drafts payable to Resorts drawn on petitioner’s bank. The
markers made no reference to chips, but stated that cash had been received.
Petitioner had an understanding with Gary Grant, the credit manager at Resorts, whereby the
markers would be held for the maximum period allowable under New Jersey law, which at that
time was 90 days, whereupon petitioner would redeem them with a personal check. At all times
pertinent hereto, petitioner intended to repay any credit amount properly extended to him by
Resorts and to pay Resorts in full the amount of any personal check given by him to pay for chips
or to reduce his gambling debt. Between June 1978 and December 1979, petitioner incurred
gambling debts of approximately $ 2.5 million. Petitioner paid these debts in full.
On October 3, 1979, the New Jersey Division of Gaming Enforcement filed with the New Jersey
Casino Control Commission a complaint against Resorts and several individuals, which alleged
809 violations pertaining to Resorts’ casino gaming credit system, its internal procedures, and its
administrative and accounting controls. Of those 809 violations, 100 were specifically identified
as pertaining to petitioner and a gambling companion. Pursuant to a request for a cease and desist
order contained in the complaint, a Casino Control Commissioner issued an emergency order on
October 9, 1979. That order provided, in relevant part:
5. Effective immediately, Resorts shall not issue credit to any patron whose patron
credit reference card indicates that the credit now outstanding exceeds the properly
approved credit limit. In determining whether a credit limit has been exceeded, all yet
undeposited checks received in payment of a counter check or checks shall be included
as credits.
After the emergency order was issued, Resorts began a policy of treating petitioner’s personal
checks as “considered cleared.” Thus, when petitioner wrote a personal check it was treated as a

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cash transaction, and the amount of the check was not included in determining whether he had
reached his permanent credit limit. In addition, Resorts extended petitioner’s credit limit by giving
him temporary increases known as “this trip only” credit. Although not specifically addressed by
the New Jersey Casino Control regulations in effect during 1979 and 1980, a “this trip only” credit
increase was a temporary credit increase for a patron’s current trip to Atlantic City, and was
required to be reduced before the patron’s return. Both of these practices effectively ignored the
emergency order. Petitioner did not understand the difference between “this trip only” credit and
his permanent credit line, and he thought that he no longer had a credit limit.
By January 1980, petitioner was gambling compulsively at Resorts. Petitioner was gambling
12-16 hours per day, 7 days per week in the casino, and he was betting up to $15,000 on each roll
of the dice. Petitioner was not aware of the amount of his gambling debts.
On April 12, 1980, Resorts increased petitioner’s permanent credit line to $ 215,000, without
any additional credit investigation. During April 1980, petitioner delivered personal checks and
markers in the total amount of $3,435,000 that were returned to Resorts as having been drawn
against insufficient funds. On April 29, 1980, Resorts cut off petitioner’s credit. Shortly thereafter,
petitioner indicated to the Chief Executive Officer of Resorts that he intended to repay the
obligations.
On November 18, 1980, Resorts filed a complaint in New Jersey State Court seeking collection
of $3,435,000 from petitioner based on the unpaid personal checks and markers. On March 4,
1981, petitioner filed an answer, denying the allegations and asserting a variety of affirmative
defenses.
On September 28, 1981, petitioner settled the Resorts suit by agreeing to make a series of
payments totaling $500,000. Petitioner paid the $500,000 settlement amount to Resorts in
accordance with the terms of the agreement. The difference between petitioner’s gambling
obligations of $3,435,000 and the settlement payments of $500,000 is the amount that respondent
alleges to be income from forgiveness of indebtedness.
On July 8, 1983, Resorts was fined $130,000 for violating the Emergency Order on at least 13
different occasions, 9 of which pertained directly to credit transactions between Resorts and
petitioner.
Income From the Discharge of Indebtedness
In general, Gross Income includes all income from whatever source derived, including income
from the discharge of indebtedness. Sec. 61(a)(12). Not all discharges of indebtedness, however,
result in income. See sec. 1.61-12(a), Income Tax Regs., “The discharge of indebtedness, in whole
or in part, may result in the realization of income.” (Emphasis supplied.) The gain to the debtor
from such discharge is the resultant freeing up of his assets that he would otherwise have been
required to use to pay the debt. See U.S. v. Kirby Lumber Co., 284 U.S. 1 (1931).
Respondent contends that the difference between the $3,435,000 in personal checks and
markers that were returned by the banks as drawn against insufficient funds and the $500,000 paid
by petitioner in settlement of the Resorts suit constitutes income from the discharge of
indebtedness. Petitioner argues that the settlement agreement between Resorts and himself did not
give rise to such income because, among other reasons, the debt instruments were not enforceable
under New Jersey law and, in any event, the settlement should be treated as a purchase price
adjustment that does not give rise to income from the discharge of indebtedness.

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… The parties have primarily focused their arguments on whether the debt instruments
memorializing the credit transactions were legally enforceable and whether legal enforceability is
of significance in determining the existence of income from discharge of indebtedness. Petitioner
argues that his debt was unenforceable and thus there was no debt to be discharged and no resulting
freeing up of assets because his assets were never encumbered. Petitioner relies on N.J. Stat. Ann.
sec. 5:12-101(f) (West 1988), and Resorts International Hotel, Inc. v. Salomone, 178 N.J. Super.
598, 429 A.2d 1078 (App. Div. 1981), in arguing that the gambling debts were unenforceable.
… Respondent has not proven facts from which we can conclude that the debts were legally
enforceable. We must decide, therefore, whether legal enforceability is a prerequisite to
recognition of income in this case.
Enforceability
In United States v. Hall, supra, the taxpayer transferred appreciated property in satisfaction of
a gambling debt of an undetermined amount incurred in Las Vegas, Nevada. The Commissioner
sought to tax as gain the difference between the amount of the discharged debt and the basis of the
appreciated property. Although licensed gambling was legal in Nevada, gambling debts were
nevertheless unenforceable. The Court of Appeals concluded that, under the circumstances, the
amount of the gambling debt had no significance for tax purposes. The court reasoned that, “The
cold fact is that taxpayer suffered a substantial loss from gambling, the amount of which was
determined by the transfer.” 307 F.2d at 241. The Court of Appeals relied on the so-called
“diminution of loss theory” developed by the Supreme Court in Bowers v. Kerbaugh-Empire Co.,
271 U.S. 170 (1926). In that case, the taxpayer borrowed money that was subsequently lost in a
business transaction. The debt was satisfied for less than its face amount. The Supreme Court held
that the taxpayer was not required to recognize income from discharge of a debt because the
transaction as a whole lost money.
The Court of Appeals for the Tenth Circuit in Hall quoted at length from Bradford v.
Commissioner, 233 F.2d 935 (6th Cir. 1956), which noted that the Kerbaugh-Empire case was
decided before United States v. Kirby Lumber Co., 284 U.S. 1 (1931), and Burnet v. Sanford &
Brooks Co., 282 U.S. 359 (1931), and had been “frequently criticized and not easily understood.”
Subsequent developments further suggest that Kerbaugh-Empire has lost its vitality. See
Vukasovich, Inc. v. Comm’r, 790 F.2d 1409 (9th Cir. 1986), revg. a Memorandum Opinion of this
Court, discussed at length, infra.
In Commissioner v. Tufts, 461 U.S. 300 (1983), the Supreme Court examined the economic
realities associated with the cancellation of a nonrecourse obligation. Although a nonrecourse
mortgage does not personally obligate the borrower or create a right against the borrower’s general
assets, the Supreme Court recognized the necessity of treating nonrecourse obligations as
enforceable loans both when the obligations are made and when they are discharged. Thus, upon
sale of mortgaged property, the seller-original borrower must include the amount of the
nonrecourse mortgage assumed by the purchaser in calculating the amount realized from sale, even
when the fair market value of the property is less than the outstanding amount of the nonrecourse
obligation. Indicating a concern with symmetry, the Supreme Court observed in Tufts:
The rationale for this treatment is that the original inclusion of the amount of the
mortgage in basis rested on the assumption that the mortgagor incurred an obligation
to repay. Moreover, this treatment balances the fact that the mortgagor originally
received the proceeds on the nonrecourse loan tax-free on the same assumption. Unless

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the outstanding amount of the mortgage is deemed to be realized, the mortgagor
effectively will have received untaxed income at the time the loan was extended and
will have received an unwarranted increase in the basis of his property. 461 U.S. at
309-310.
In the instant case, symmetry from year to year is not accomplished unless we treat petitioner’s
receipt of the loan from Resorts (i.e., the markers converted to chips) and the subsequent discharge
of his obligation to repay that loan in a consistent manner. Petitioner received credit of $3,435,000
from Resorts. He treated these amounts as a loan, not reporting any income on his 1980 tax return.
Compare U.S. v. Rosenthal, 470 F.2d 837 (2d Cir. 1972), and U.S. v. Rochelle, 384 F.2d 748 (5th
Cir. 1967). The parties have stipulated that he intended to repay the amounts received. Although
Resorts extended the credit to petitioner with the expectation that he would continue to gamble,
theoretically petitioner could have redeemed the chips for cash. Certainly if he had won, rather
than lost, at gambling, the amounts borrowed would have been repaid.
Petitioner argues that he did not get anything of value when he received the chips other than the
“opportunity to gamble,” and that, by reason of his addiction to gambling, he was destined to lose
everything that he temporarily received. Thus, he is in effect arguing, based on Hall, that the
settlement merely reduced the amount of his loss and did not result in income.
In Vukasovich, Inc. v. Comm’r, supra, the taxpayer borrowed approximately $2 million to
finance a cattle feeding venture. The cattle were subsequently sold for less than the full amount of
the taxpayer’s liability, and he refused to pay the balance owed. The parties to the agreement settled
their claims for less than the full amount, and the Commissioner asserted that the taxpayer realized
income from cancellation of the debt. The Court of Appeals for the Ninth Circuit concluded that
the principles of Kerbaugh-Empire had been rejected by the Supreme Court in the
subsequent cases cited above, even though the 1926 case had not been specifically overruled. 790
F.2d at 1415-1416. Because we find the reasoning of the Court of Appeals for the Ninth Circuit
persuasive, we quote it at length as follows:
Kerbaugh-Empire depended on two premises. First, it held that the cancellation of
indebtedness was not income, because income was “gain derived from capital, from
labor, or from both combined.” Id. at 174, 46 S.Ct. at 451. Second, it held that a unitary
transactional approach to measuring income made it impermissible to look at receipts
in a given year without determining whether they were offsets of losses in another year
because while “the [loan] in question is cash gain[,] the borrowed money was lost.”
Id. at 175, 46 S.Ct. at 451. The Commissioner relies primarily on United States v.
Kirby Lumber Co., 284 U.S. 1 (1931); Burnet v. Sanford & Brooks Co., 282 U.S. 359
(1931); Commissioner v. Glenshaw Glass Co., 348 U.S. 426 (1955); [**19] and
Commissioner v. Tufts, 461 U.S. 300 (1983), to show that these premises are no longer
accepted.
Ordinarily the cancellation of indebtedness is Gross Income. Kerbaugh-Empire’s reluctance to
tax income from the cancellation of indebtedness stemmed in part from Eisner v. Macomber, 252
U.S. 189, 207 (1920) (quoting Doyle v. Mitchell Brothers Co., 247 U.S. 179 (1918)), which defined
income for the purposes of the Sixteenth Amendment as “‘the gain from capital, from labor, or
from both combined.’“ Because the cancellation of indebtedness could not be attributed to a gain
from capital or labor, the result in Kerbaugh-Empire followed from the then-existing interpretation
of the Sixteenth Amendment. See Kerbaugh-Empire, 271 U.S. at 174-75. Since then, Glenshaw
Glass has defined Gross Income in terms of “accessions to wealth, clearly realized, and over which
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the taxpayers have complete dominion.” 348 U.S. at 431.
In Kirby Lumber, a company sold its bonds and later repurchased them for less than the sale
price. The Supreme Court held that the taxpayer achieved a taxable gain through the freeing of its
assets from the obligation to repurchase the bonds at the price of issue, and therefore realized
income. Kirby Lumber shows that an increase in net worth from the discharge of indebtedness for
less than the amount loaned is income, at least to the extent that it frees up the debtor’s assets.
Thus, the taxpayer’s gain on the loan must be counted as income in the absence of something
exceptional about the underlying transaction.
In Tufts, the taxpayer sold property subject to a nonrecourse mortgage. The property was worth
less than the amount of the mortgage. Because the mortgage was nonrecourse, it could not be said,
as it had been in Kirby Lumber, that the removal of the debt freed or enhanced the taxpayer’s
assets. Nonetheless, the Supreme Court ruled that the Commissioner could treat the difference
between the initial amount of the loan and the amount repaid as income from the sale of the
property.
The Commissioner argues that Tufts supports a general rule making irrelevant whether assets
were freed because the Court focuses on the receipt of money unbalanced by an obligation to
repay, rather than on the nonrecourse nature of the obligation or on the taking of deductions. See
461 U.S. at 310 n.8. The Commissioner’s argument is supported by some authority, see Bittker &
Thompson, Jr., Income From the Discharge of Indebtedness: The Progeny of United States v.
Kirby Lumber Co., 66 CAL.L.REV. 1159, 1165-66, 1176, 1182 (1978).
However, requiring some benefit to the taxpayer from the transaction creating the indebtedness
explains such cases as Commissioner v. Rail Joint Co., 61 F.2d 751 (2d Cir. 1932), which held that
no gain was realized when a corporation issued bonds as dividends and repurchased them at less
than their face value, and B.F. Avery & Sons, Inc. v. Commissioner, 26 B.T.A. 1393 (1932),
where a claim that cancellation of indebtedness should be treated as a reduction in the purchase
price was analyzed according to whether prior tax benefits had resulted from the higher purchase
price. See generally J. SNEED, THE CONFIGURATIONS OF GROSS INCOME 322-27 (1967).
We have no doubt that an increase in wealth from the cancellation of indebtedness is taxable
where the taxpayer received something of value in exchange for the indebtedness. Unlike Tufts,
Rail Joint may not have provided an economic benefit to the taxpayer from the transaction, and
the statement in Tufts may not apply to such cases. Because Vukasovich received money in
exchange for the indebtedness, we need not determine the limits of Tufts. We decline to address
the issue. 790 F.2d at 1414-1415.
We conclude here that the taxpayer did receive value at the time he incurred the debt and that
only his promise to repay the value received prevented taxation of the value received at the time
of the credit transaction. When, in the subsequent year, a portion of the obligation to repay was
forgiven, the general rule that income results from forgiveness of indebtedness, section 61(a)(12),
should apply.
Legal enforceability of an obligation to repay is not generally determinative of whether the
receipt of money or property is taxable. James v. U.S., 366 U.S. 213, 219 (1961). Under the “all
events test,” only the fact of liability and the amount owed need be fixed as of the end of a taxable
year in order to give rise to a deduction by an accrual basis taxpayer; legal liability is not required.
Burlington Northern Railroad v. Comm’r, 82 T.C. 143, 151 (1984). Unenforceability of an
underlying gambling debt is not a bar to the recognition of income by an accrual method gambling

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casino. Flamingo Resort, Inc. v. U.S., 664 F.2d 1387 (9th Cir. 1982). Enforceability may affect the
timing of recognition of income; other factors fix the amount to be recognized.
Here the timing of recognition was set when the debt was compromised. The amount to be
recognized as income is the part of the debt that was discharged without payment. The
enforceability of petitioner’s debts under New Jersey law did not affect either the timing or the
amount and thus is not determinative for Federal income tax purposes. We are not persuaded that
gambling debts should be accorded any special treatment for the benefit of the gambler—
compulsive or not. As the Court of Appeals in United States v. Hall stated, “The elimination of a
gambling debt is … a transaction that may have tax consequences independent of the amount of
the debt and certainly cannot be used as a tool to avoid a tax incident which is shielded only by the
screen of its unenforceable origin.” 307 F.2d at 242.
Disputed Debt
Petitioner also relies on the principle that settlement of disputed debts does not give rise to
income. N. Sobel, Inc. v. Comm’r, 40 B.T.A. 1263 (1939), cited with approval in Colonial Savings
Association v. Comm’r, 85 T.C. 855, 862-863 (1985), affd. 854 F.2d 1001 (7th Cir. 1988). Prior
to the settlement, the amount of petitioner’s gambling debt to Resorts was a liquidated amount,
unlike the taxpayer’s debt in Hall. There is no dispute about the amount petitioner received. The
parties dispute only its legal enforceability, i.e., whether petitioner could be legally compelled to
pay Resorts the fixed amount he had borrowed. A genuine dispute does not exist merely because
petitioner required Resorts to sue him before making payment of any amount on the debt. The
cases cited by petitioner merely require that there be a liquidated debt, i.e., one in which the amount
has been determined. See Colonial Savings Association v. Comm’r, 85 T.C. at 863; N. Sobel, Inc.
v. Comm’r, 40 B.T.A. at 1265. In our view, petitioner’s arguments concerning his defenses to
Resorts’ claim, which apparently led to Resort’s agreement to discount the debt, are overcome by
(1) the stipulation of the parties that, at the time the debt was created, petitioner agreed to and
intended to repay the full amount, and (2) our conclusion that he received full value for what he
agreed to pay, i.e., over $3 million worth of chips and the benefits received by petitioner as a
“valued gambling patron” of Resorts.
[The discussion of § 165(d), pertaining to gambling losses, and § 108(e)(5), pertaining to
purchase-money debt reductions, is omitted.] We have considered the other arguments of the
parties and find them unnecessary to disposition of this case or unpersuasive.
TANNENWALD, J., dissenting: The foundation of the majority’s reasoning is that Mr. Zarin
realized income in an amount equal to the amount of the credit extended to him because he was
afforded the “opportunity to gamble.” Based upon that theory, the majority concludes that Mr.
Zarin is seeking to reduce the amount of his loss and that this approach runs afoul of the now
discredited (according to the majority) “diminution of loss” approach of the Supreme Court in
Bowers v. Kerbaugh-Empire Co., 271 U.S. 170 (1926).
I find it unnecessary to rely on Kerbaugh-Empire and, therefore, need not embrace or reject the
approach of that case. I am constrained to note, however, that it does not follow from the “freeing
of asset” approach adopted by the Supreme Court in Commissioner v. Glenshaw Glass Co., 348
U.S. 426 (1955), that Kerbaugh-Empire is moribund for all purposes. Nor does such moribundity
flow from United States v. Kirby Lumber Co., 284 U.S. 1 (1931), or Commissioner v. Tufts, 461
U.S. 300 (1983). See Colonial Savings Association v. Comm’r, 85 T.C. 855, 862 n. 11 (1985), affd.
854 F.2d 1001 (7th Cir. 1988).

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I think it highly significant that in all the decided cases involving the cancellation of
indebtedness, the taxpayer had, in a prior year when the indebtedness was created, received a
nontaxable benefit clearly measurable in monetary terms which would remain untaxed if the
subsequent cancellation of the indebtedness were held to be tax free. Such is simply not the case
herein. The concept that petitioner received his money’s worth from the enjoyment of using the
chips (thus equating the pleasure of gambling with increase in wealth) produces the incongruous
result that the more a gambler loses, the greater his pleasure and the larger the increase in his
wealth. Under the circumstances, I think the issue of enforceability becomes critical. In this
connection, the repeated emphasis by the majority on the stipulation that Mr. Zarin intended to
repay the full amount at the time the debt was created is beside the point. If the debt was
unenforceable under New Jersey law, that intent is irrelevant.
It is clear that respondent has not shown that the checks Mr. Zarin gave Resorts were
enforceable under New Jersey law. New Jersey law provides that checks issued to pay for gambling
are enforceable provided that a set of requirements relating to, among other things, proper payees,
dating and holding periods, is met. See N.J. Stat. Ann. sec. 5:12-101 (West 1988). “Any check
cashed, transferred, conveyed or given in violation of … [those requirements] shall be invalid and
unenforceable for the purposes of collection.” N.J. Stat. Ann. sec. 5:12-101(f) (West 1988).
Furthermore, strict compliance with those requirements is mandatory for a check to be enforceable.
GNOC, Corp. v. Endico, 692 F. Supp. 1515 (S.D.N.Y. 1988); Resorts International Hotel, Inc. v.
Salomone, 178 N.J. Super. 598, 429 A.2d 1078 (App. Div. 1981). Respondent simply has not
shown that the markers given Resorts by Mr. Zarin were drawn and handled in strict compliance
with the statute. In fact, the number of violations of the emergency order asserted against Resorts
by the New Jersey gambling commission, including some betting transactions with petitioner, casts
substantial doubt on whether the checks were in fact so handled.
... I think it significant that because the debts involved herein were unenforceable from the
moment that they were created, there was no freeing up of petitioners’ assets when they were
discharged, see U.S. v. Kirby Lumber Co., supra, and therefore there was no increase in petitioners’
wealth that could constitute income. Cf. Comm’r v. Glenshaw Glass Co., supra. This is particularly
true in light of the fact that the chips were given to Mr. Zarin with the expectation that he would
continue to gamble and, therefore, did not constitute an increase in his wealth when he received
them in the same sense that the proceeds of a non-gambling loan would. Cf. Rail Joint Co. v.
Comm’r, 22 B.T.A. 1277 (1931), affd. 61 F.2d 751 (2d Cir. 1932) (cited in Comm’r v. Tufts, 461
U.S. at 209 n. 6), where we held that there was no income from the discharge on indebtedness
when the amount paid for the discharge was in excess of the value of what had been received by
the debtor at the time the indebtedness was created even though the face amount of the
indebtedness and hence the taxpayer’s liability was reduced; Fashion Park, Inc. v. Comm’r, 21
T.C. 600 (1954) (same holding)….
I find further support for my conclusion from the application of the principle that if there is a
genuine dispute as to liability on the underlying obligation, settlement of that obligation will not
give rise to income from discharge of indebtedness. N. Sobel, Inc. v. Comm’r, 40 B.T.A. 1263
(1939), cited with approval in Colonial Savings Association v. Comm’r, 85 T.C. 855, 862-863
(1985), affd. 854 F.2d 1001 (7th Cir. 1988). Respondent simply has not met his burden of showing
that the dispute between Resorts and Mr. Zarin was not a genuine dispute as to Mr. Zarin’s liability
for the underlying obligations, and I believe that, at least as to that debt that was not entered into
as required by New Jersey law and was therefore unenforceable, the dispute was in fact genuine.
While there is language in Sobel and Colonial Savings indicating that U.S. v. Kirby Lumber Co.,
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supra, applies when there is a liquidated amount of indebtedness, I do not read that language as
requiring that Kirby Lumber must apply unless the amount is unliquidated, where there is a genuine
dispute as to the underlying liability. I would hold for petitioner.
[The separate opinions of Jacobs, J., dissenting, and Ruwe, J., dissenting, are omitted.]
ZARIN v. COMMISSIONER
916 F.2d 110 (3d Cir. 1990)
Before STAPLETON, COWEN, and WEISS, CIRCUIT JUDGES.
COWEN, CIRCUIT JUDGE: The sole issue before this Court is whether the Tax Court correctly
held that Zarin had income from discharge of indebtedness. Section 108 and section 61(a)(12) of
the Code set forth “the general rule that Gross Income includes income from the discharge of
indebtedness.” I.R.C. § 108(e)(1). The Commissioner argues, and the Tax Court agreed, that
pursuant to the Code, Zarin did indeed recognize income from discharge of gambling indebtedness.
Under the Commissioner’s logic, Resorts advanced Zarin $3,435,000 worth of chips, chips
being the functional equivalent of cash. At that time, the chips were not treated as income, since
Zarin recognized an obligation of repayment. In other words, Resorts made Zarin a tax-free loan.
However, a taxpayer does recognize income if a loan owed to another party is cancelled, in whole
or in part. I.R.C. §§ 61(a)(12), 108(e). The settlement between Zarin and Resorts, claims the
Commissioner, fits neatly into the cancellation of indebtedness provisions in the Code. Zarin owed
$3,435,000, paid $500,000, with the difference constituting income. Although initially persuasive,
the Commissioner’s position is nonetheless flawed for two reasons.
Initially, we find that sections 108 and 61(a)(12) are inapplicable to the Zarin/Resorts
transaction. Section 61 does not define indebtedness. On the other hand, section 108(d)(1), which
repeats and further elaborates on the rule in section 61(a)(12), defines the term as any indebtedness
“(A) for which the taxpayer is liable, or (B) subject to which the taxpayer holds property.” I.R.C.
§ 108(d)(1). In order to come within the sweep of the discharge of indebtedness rules, then, the
taxpayer must satisfy one of the two prongs in the section 108(d)(1) test. Zarin satisfies neither.
Because the debt Zarin owed to Resorts was unenforceable as a matter of New Jersey state law,
it is clearly not a debt “for which the taxpayer is liable.” I.R.C. § 108(d)(1)(A). Liability implies a
legally enforceable obligation to repay, and under New Jersey law, Zarin would have no such
obligation.
Moreover, Zarin did not have a debt subject to which he held property as required by section
108(d)(1)(B). Zarin’s indebtedness arose out of his acquisition of gambling chips. The Tax Court
held that gambling chips were not property, but rather, “a medium of exchange within the Resorts
casino” and a “substitute for cash.” Alternatively, the Tax Court viewed the chips as nothing more
than “the opportunity to gamble and incidental services….” Zarin, 92 T.C. at 1099. We agree with
the gist of these characterizations, and hold that gambling chips are merely an accounting
mechanism to evidence debt.
Gaming chips in New Jersey during 1980 were regarded “solely as evidence of a debt owed to
their custodian by the casino licensee and shall be considered at no time the property of anyone
other than the casino licensee issuing them.” N.J. Admin. Code tit. 19k, § 19:46-1.5(d) (1990).
Thus, under New Jersey state law, gambling chips were Resorts’ property until transferred to Zarin
in exchange for the markers, at which point the chips became “evidence” of indebtedness (and not
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the property of Zarin).
Even were there no relevant legislative pronouncement on which to rely, simple common sense
would lead to the conclusion that chips were not property in Zarin’s hands. Zarin could not do with
the chips as he pleased, nor did the chips have any independent economic value beyond the casino.
The chips themselves were of little use to Zarin, other than as a means of facilitating gambling.
They could not have been used outside the casino. They could have been used to purchase services
and privileges within the casino, including food, drink, entertainment, and lodging, but Zarin
would not have utilized them as such, since he received those services from Resorts on a
complimentary basis. In short, the chips had no economic substance.
Although the Tax Court found that theoretically, Zarin could have redeemed the chips he
received on credit for cash and walked out of the casino, Zarin, 92 T.C. at 1092, the reality of the
situation was quite different. Realistically, before cashing in his chips, Zarin would have been
required to pay his outstanding IOUs. New Jersey state law requires casinos to “request patrons to
apply any chips or plaques in their possession in reduction of personal checks or Counter Checks
exchanged for purposes of gaming prior to exchanging such chips or plaques for cash or prior to
departing from the casino area.” N.J. Admin. Code tit. 19k, § 19:45-1.24(s) (1979) (currently N.J.
Admin. Code tit. 19k, § 19:45-1.25(o) (1990) (as amended)). Since his debt at all times equalled
or exceeded the number of chips he possessed, redemption would have left Zarin with no chips,
no cash, and certainly nothing which could have been characterized as property.
Not only were the chips non-property in Zarin’s hands, but upon transfer to Zarin, the chips
also ceased to be the property of Resorts. Since the chips were in the possession of another party,
Resorts could no longer do with the chips as it pleased, and could no longer control the chips’ use.
Generally, at the time of a transfer, the party in possession of the chips can gamble with them, use
them for services, cash them in, or walk out of the casino with them as an Atlantic City souvenir.
The chips therefore become nothing more than an accounting mechanism, or evidence of a debt,
designed to facilitate gambling in casinos where the use of actual money was forbidden. Thus, the
chips which Zarin held were not property within the meaning of I.R.C. § 108(d)(1)(B).
In short, because Zarin was not liable on the debt he allegedly owed Resorts, and because Zarin
did not hold “property” subject to that debt, the cancellation of indebtedness provisions of the Code
do not apply to the settlement between Resorts and Zarin. As such, Zarin cannot have income from
the discharge of his debt.
Instead of analyzing the transaction at issue as cancelled debt, we believe the proper approach
is to view it as disputed debt or contested liability. Under the contested liability doctrine, if a
taxpayer, in good faith, disputed the amount of a debt, a subsequent settlement of the dispute would
be treated as the amount of debt cognizable for tax purposes. The excess of the original debt over
the amount determined to have been due is disregarded for both loss and debt accounting
purposes….
The Commissioner argues that Sobel and the contested liability doctrine only apply when there
is an unliquidated debt; that is, a debt for which the amount cannot be determined. See Colonial
Sav. Ass’n v. Comm’r, 85 T.C. 855, 862-863 (1985) (Sobel stands for the proposition that “there
must be a liquidated debt”), aff’d, 854 F.2d 1001 (7th Cir. 1988). See also N. Sobel, Inc. v. Comm’r,
40 B.T.A. at 1265 (there was a dispute as to “liability and the amount” of the debt). Since Zarin
contested his liability based on the unenforceability of the entire debt, and did not dispute the
amount of the debt, the Commissioner would have us adopt the reasoning of the Tax Court, which

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found that Zarin’s debt was liquidated, therefore barring the application of Sobel and the contested
liability doctrine. Zarin, 92 T.C. at 1095 (Zarin’s debt “was a liquidated amount” and “there is no
dispute about the amount [received].”).
We reject the Tax Court’s rationale. When a debt is unenforceable, it follows that the amount
of the debt, and not just the liability thereon, is in dispute. Although a debt may be unenforceable,
there still could be some value attached to its worth. This is especially so with regards to gambling
debts. In most states, gambling debts are unenforceable, and have “but slight potential….” U.S. v.
Hall, 307 F.2d 238, 241 (10th Cir. 1962). Nevertheless, they are often collected, at least in part.
For example, Resorts is not a charity; it would not have extended illegal credit to Zarin and others
if it did not have some hope of collecting debts incurred pursuant to the grant of credit.
Moreover, the debt is frequently incurred to acquire gambling chips, and not money. Although
casinos attach a dollar value to each chip, that value, unlike money’s, is not beyond dispute,
particularly given the illegality of gambling debts in the first place. This proposition is supported
by the facts of the present case. Resorts gave Zarin $3.4 million dollars of chips in exchange for
markers evidencing Zarin’s debt. If indeed the only issue was the enforceability of the entire debt,
there would have been no settlement. Zarin would have owed all or nothing. Instead, the parties
attached a value to the debt considerably lower than its face value. In other words, the parties
agreed that given the circumstances surrounding Zarin’s gambling spree, the chips he acquired
might not have been worth $3.4 million dollars, but were worth something. Such a debt cannot be
called liquidated, since its exact amount was not fixed until settlement.
To summarize, the transaction between Zarin and Resorts can best be characterized as a
disputed debt, or contested liability. Zarin owed an unenforceable debt of $3,435,000 to Resorts.
After Zarin in good faith disputed his obligation to repay the debt, the parties settled for $500,000,
which Zarin paid. That $500,000 settlement fixed the amount of loss and the amount of debt
cognizable for tax purposes. Since Zarin was deemed to have owed $500,000, and since he paid
Resorts $500,000, no adverse tax consequences attached to Zarin as a result.
In conclusion, we hold that Zarin did not have any income from cancellation of indebtedness
for two reasons. First, the Code provisions covering discharge of debt are inapplicable since the
definitional requirement in I.R.C. section 108(d)(1) was not met. Second, the settlement of Zarin’s
gambling debts was a contested liability. We reverse the decision of the Tax Court and remand
with instructions to enter judgment that Zarin realized no income by reason of his settlement with
Resorts.
STAPLETON, CIRCUIT JUDGE, dissenting: I respectfully dissent because I agree with the
Commissioner’s appraisal of the economic realities of this matter.
Resorts sells for cash the exhilaration and the potential for profit inherent in games of chance.
It does so by selling for cash chips that entitle the holder to gamble at its casino. Zarin, like
thousands of others, wished to purchase what Resorts was offering in the marketplace. He chose
to make this purchase on credit and executed notes evidencing his obligation to repay the funds
that were advanced to him by Resorts. As in most purchase money transactions, Resorts skipped
the step of giving Zarin cash that he would only return to it in order to pay for the opportunity to
gamble. Resorts provided him instead with chips that entitled him to participate in Resorts’ games
of chance on the same basis as others who had paid cash for that privilege. Whether viewed as a
one or two-step transaction, however, Zarin received either $3.4 million in cash or an entitlement
for which others would have had to pay $3.4 million.

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Despite the fact that Zarin received in 1980 cash or an entitlement worth $3.4 million, he
correctly reported in that year no income from his dealings with Resorts. He did so solely because
he recognized, as evidenced by his notes, an offsetting obligation to repay Resorts $3.4 million in
cash. See, e.g., Vukasovich, Inc. v. Comm’r, 790 F.2d 1409 (9th Cir. 1986); U.S. v. Rochelle, 384
F.2d 748 (5th Cir. 1967), cert. denied, 390 U.S. 946 (1968); Bittker and Thompson, Income From
the Discharged Indebtedness: The Progeny of United States v. Kirby Lumber Co., 66 CALIF. L.
REV. 159 (1978). In 1981, with the delivery of Zarin’s promise to pay Resorts $500,000 and the
execution of a release by Resorts, Resorts surrendered its claim to repayment of the remaining $2.9
million of the money Zarin had borrowed. As of that time, Zarin’s assets were freed of his potential
liability for that amount and he recognized Gross Income in that amount. Comm’r v. Tufts, 461
U.S. 300 (1983); U.S. v. Kirby Lumber Company, 284 U.S. 1 (1931); Vukasovich, Inc. v. Comm’r,
790 F.2d 1409 (9th Cir. 1986). But see U.S. v. Hall, 307 F.2d 238 (10th Cir. 1962).
The only alternatives I see to this conclusion are to hold either (1) that Zarin realized $3.4
million in income in 1980 at a time when both parties to the transaction thought there was an
offsetting obligation to repay or (2) that the $3.4 million benefit sought and received by Zarin is
not taxable at all. I find the latter alternative unacceptable as inconsistent with the fundamental
principle of the Code that anything of commercial value received by a taxpayer is taxable unless
expressly excluded from Gross Income. Comm’r v. Glenshaw Glass Co., 348 U.S. 426 (1955);
U.S. v. Kirby Lumber Co., supra. I find the former alternative unacceptable as impracticable. In
1980, neither party was maintaining that the debt was unenforceable and, because of the settlement,
its unenforceability was not even established in the litigation over the debt in 1981. It was not until
1989 in this litigation over the tax consequences of the transaction that the unenforceability was
first judicially declared. Rather than require such tax litigation to resolve the correct treatment of
a debt transaction, I regard it as far preferable to have the tax consequences turn on the manner in
which the debt is treated by the parties. For present purposes, it will suffice to say that where
something that would otherwise be includable in Gross Income is received on credit in a purchase
money transaction, there should be no recognition of income so long as the debtor continues to
recognize an obligation to repay the debt. On the other hand, income, if not earlier recognized,
should be recognized when the debtor no longer recognizes an obligation to repay and the creditor
has released the debt or acknowledged its unenforceability.
In this view, it makes no difference whether the extinguishment of the creditor’s claim comes
as a part of a compromise. Resorts settled for 14 cents on the dollar presumably because it viewed
such a settlement as reflective of the odds that the debt would be held to be enforceable. While
Zarin should be given credit for the fact that he had to pay 14 cents for a release, I see no reason
why he should not realize gain in the same manner as he would have if Resorts had concluded on
its own that the debt was legally unenforceable and had written it off as uncollectible.[5]
I would affirm the judgment of the Tax Court.
_________________________________
Part of the difficulty in thinking about Zarin is that there are multiple ways to characterize the
substance of the underlying facts.
[5]

A different situation exists where there is a bona fide dispute over the amount of a debt and the dispute is
compromised. Rather than require tax litigation to determine the amount of income received, the Commission treats
the compromise figure as representing the amount of the obligation. I find this sensible and consistent with the
pragmatic approach I would take.

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If we analyze the facts solely under the rubric of debt-discharge income, what did Mr. Zarin
receive in the prior year under the borrowing exclusion, which should measure any debt-discharge
income? Was the ostensible borrowing of $3.4 million mere form that did not properly reflect the
underlying substance of the facts when we remember that the seller of the gambling services was
also the lender of dollars used to gamble? There would be no doubt at all that Mr. Zarin realized
$2.9 million of § 61 debt-discharge income if he had been able to borrow the $3.4 million from a
third party (such as a bank) rather than Resorts (the seller of the gambling services to Mr. Zarin)
and then settled his bank debt for $500,000. But Mr. Zarin ostensibly borrowed the $3.4 million
from Resorts, itself—the seller of the services that he was purchasing. Does that make a difference?
Because Resorts wore two hats here—lender and seller of the services purchased with the
borrowed money—do we have reason to doubt the reality of the amount borrowed (and used to
gamble)? In other words, were the loan documents mere form that masked the underlying
substance of a case that looks more simply like the provision of $2.9 million of free consumption
(gambling) to Mr. Zarin by Resorts primarily for its own benefit because of the effect that Mr.
Zarin had on other gamblers? What case that you read in a prior chapter might such a crafting of
the facts raise?
You learned in Chapter 6 that the taxation of personal consumption under an SHS income tax
is accomplished primarily via deduction denial for outlays used to purchase personal consumption.
Thus, § 262(a) denies the deduction of personal expenses, § 167(a) denies depreciation deductions
for personal-use assets, and § 165(c)(3) denies deduction of most § 1001 losses realized with
respect to personal-use property. The taxation of personal consumption is not commonly
accomplished via a Gross Income inclusion, except in cases where the free consumption serves as
a substitute for a clearly includable item (such as compensation, a dividend, or a prize) in order to
protect the integrity of those specified inclusions, where the tax base could be significantly put at
risk if exclusion could be had merely by avoiding the cash step. Taxation of consumption received
in kind solely under the residual clause, in contrast, where there is no employment or other
relationship that makes us suspicious that the consumption is a cash substitute representing ability
to pay, is more difficult. In that context, we cannot be as sure that the free consumption can fairly
be considered the equivalent of the receipt of cash (clearly a wealth accession representing ability
to pay) followed by a nondeductible free-spending choice on personal consumption.
In other words, is Mr. Zarin more like Mr. Gotcher in Chapter 6, who was held not to have
realized Gross Income when he enjoyed free consumption (a free trip to Germany) provided by
Volkswagen Germany primarily for its own benefit, or more like the casino patrons gambling
beside him who gambled with their own (nondeductible) after-tax cash? Or perhaps Mr. Zarin
merely bought the gambling entertainment from the seller (Resorts) at an arm’s-length, bargainedfor discount and should be able to avail himself of the bargain purchase rule, under which buyers
do not realize Gross Income equal to the benefit of their bargain unless it represents disguised
compensation, a dividend, rent, a prize, etc. The Tax Court majority opinion noted that Resorts
provided to Mr. Zarin—at no charge—a luxury three-room suite, meals, entertainment, and 24hour access to a limousine. The government did not claim that the value of this consumption was
includable Gross Income under the residual clause. Why not? Was the free gambling on any
different footing for tax purposes? Is the difference merely that the latter was dressed up with loan
documents, which distracted both the government and the courts?
In holding for Mr. Zarin, the Third Circuit relied, first, on the definition of a “debt” in §
108(d)(1) and, second, on the so-called disputed debt doctrine. With respect to the former, was

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Zarin a § 108 case? Did he argue that, though he realized debt-discharge income within the
meaning of § 61, the income was excludable under one of the provisions in § 108, which covers
only a subset of the universe of all § 61 debt-discharge income? Read the first five words of §
108(d)(1), which the court completely ignored. Very sloppy statutory analysis! The disputed-debt
doctrine was created in cases in which the amount of cash originally borrowed was in dispute,
which is an important fact because the amount originally borrowed and not repaid with after-tax
dollars is the proper measure of § 61 debt-discharge income. Was there any dispute regarding the
amount ostensibly borrowed here? How did the judges use the possible lack of enforceability to
create ambiguity about the amount at issue?
Notwithstanding the language of some of the judges to the effect that the debt was clearly
unenforceable, there must have been real uncertainty about that fact, or else Mr. Zarin would never
have agreed to pay $500,000 (a good chunk of change) to settle the state court litigation. While I
think that the enforceability of the debt was a red herring for the reasons described before the
opinion, I also think—for whatever my opinion may be worth (not much?)—that Mr. Zarin did not
realize a $2.9 million wealth accession on these facts (which he spent on personal consumption),
though not for any reasons described by the judges. With Resorts serving as both lender and
services seller, we cannot trust that the entire $3.4 million loan was real (as we would with an
independent third-party lender), and the best measure of the personal consumption purchased by
Mr. Zarin was the $500,000 that he paid for it. What do you think?
Do you get the feeling that the Third Circuit and some of the dissenting Tax Court judges were
searching for any means possible (as the saying goes) to hold in favor of Mr. Zarin and thus latched
on to the supposed lack of enforceability of the debt to shoehorn the case uncomfortably into the
disputed-debt doctrine by arguing that there was in fact a dispute regarding how much was
borrowed: either zero (because the debt was unenforceable) or the entire $3.4 million?
Even if you agree that Mr. Zarin should have won—though for other reasons—the reasoning in
the cases lies there to infect future cases. The facts in Rood v. Commissioner 11 were essentially
identical to the facts in Zarin with one, big difference: there was absolutely no question that the
debt was enforceable under state law. The casino had dotted its “i”s and crossed its “t”s, and the
debt was clearly enforceable. The gambling patron settled the casino debt for less than face
amount, just as did Mr. Zarin. The Tax Court, in a memorandum opinion, stuck to its guns and
concluded that Mr. Rood realized § 61 debt-discharge income equal to the amount of the unpaid
debt. The Eleventh Circuit, in a one-page per curiam opinion, affirmed the Tax Court’s decision,
relying on the fact that the lack of enforceability in Zarin—key to the Third Circuit’s decision—
was not present in Rood. For that reason, there was no foundation on which to apply the newly
revised version of the disputed-debt doctrine. Mr. Rood did not make any of the arguments
suggested above that might perhaps be viable possibilities for a “no Gross Income” result. He
represented himself pro se and tried to fit within Zarin by arguing that some of his golfing buddies
gambled on his credit and paid back their losses but that the casino failed to credit Mr. Rood’s
account with these repayments, resulting in a dispute regarding the amount of the debt. The
taxpayer failed to support his theory with any documentation, however, so the Tax Court rejected
it, and the Eleventh Circuit deferred to the factual finding of the lower court.

11

T.C. Memo. 1996-248, aff’d, U.S.T.C. ¶ 50,619 (11th Cir. 1997) (per curiam).

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Chapter 11: Debt and Property
This chapter primarily explores the tax consequences of (1) the purchase of property with debt,
(2) the transfer of property (other than by gift) subject to debt, and (3) the reduction of debt secured
by property without a transfer of that property. Before we proceed to consider those issues,
however, let’s set the stage by considering the more straightforward tax consequences of debt
repayment with property in kind, instead of with cash.
Kent borrows $10,000 in cash from Kathy for five years at market-rate interest. When the
$10,000 principal repayment is due, Kathy agrees to accept Blackacre with a fair market value
(FMV) of $10,000 from Kent rather than $10,000 in cash. Blackacre is not encumbered by any
debt. Kent is simply using Blackacre to repay his $10,000 debt, rather than using cash to repay it.
Assume that Kent’s basis in Blackacre is $7,000. The $3,000 built-in gain in Blackacre was ignored
under the realization requirement while Kent owned the property, but now he is disposing of that
property in satisfaction of a debt.
You learned in Chapter 8 in connection with Davis v. Commissioner 1 that the transfer of
property in satisfaction of a debt is a realization event under § 1001. Therefore, when Kent transfers
Blackacre to Kathy in satisfaction of his $10,000 debt, Kent realizes a $3,000 gain under § 1001,
equal to the difference between the $10,000 FMV of the property that he transfers in satisfaction
of his debt and his $7,000 basis in that property. If Blackacre is a capital asset, this realized gain
is capital gain under § 1222.
This outcome ensues notwithstanding the language in § 1001(b), which defines “amount
realized” as the “sum of money received plus the fair market value of the property (other than
money) received.” In form, Kent does not receive “money” or “property” from Kathy in exchange
for Blackacre. Yet, in substance, the transaction is treated as though he (1) sells Blackacre for cash
equal to its $10,000 FMV—comfortably producing an “amount realized” of $10,000 under the
language in § 1001(b)—and (2) uses that $10,000 in deemed cash to repay the $10,000 that he
owes to Kathy (with no tax consequences for either party on the debt repayment). The transfer of
property in satisfaction of a debt is recast as a sale for cash for purposes of § 1001(b) because of
the “economic benefit” that Kent enjoys by having his $10,000 debt retired with Blackacre’s
$10,000 FMV (unlike a transfer by gift, which is not a realization event).
This construct also governs the analysis of Kathy’s cost basis in Blackacre under § 1012. She
is treated as having taken that $10,000 in cash deemed received from Kent in repayment of his
debt to her and using it to purchase Blackacre, which she now owns, for $10,000, producing a
$10,000 cost basis under § 1012.
Now suppose that Blackacre is worth only $8,000, which means that Kent must transfer $2,000
of cash, in addition to Blackacre, to repay his $10,000 debt. The repayment of $2,000 of his debt
with cash has no tax consequences for either party, but Kent realizes a $1,000 gain under § 1001,
equal to the difference between his $7,000 property basis and its $8,000 FMV because he repays
$8,000 of his $10,000 debt with that property. If Blackacre is a capital asset, Kent’s $1,000 realized
gain is capital gain. Kathy takes an $8,000 cost basis in Blackacre, as she is treated as having taken
1

370 U.S. 65 (1962). Davis led to the enactment of § 1041, but that provision applies only to transfers between spouses
or former spouses incident to divorce.

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$8,000 of the $10,000 in actual and deemed cash received from Kent and using it to purchase
Blackacre for its $8,000 FMV. (Kathy also has $2,000 in cash, which always has a basis equal to
face amount.)
Next iteration: Blackacre is again worth $10,000 (the full amount owed to Kathy), but Kent’s
basis in Blackacre is $14,000 instead of $7,000. Kent realizes a $4,000 loss under § 1001 on the
transfer of Blackacre to Kathy in satisfaction of his $10,000 debt to her, as though he receives
$10,000 in cash on a deemed sale and uses that cash to repay Kathy. Only if Blackacre is business
or investment property would Kent’s loss be deductible under §§ 165(c)(1) or (2). If the loss is
deductible and Blackacre is a capital asset in Kent’s hands, Kent’s loss is a capital loss, subject to
the § 1211(b) capital loss limitation rule applicable to otherwise deductible capital losses. Kathy,
as before, takes a $10,000 cost basis in Blackacre under § 1012.
Finally, suppose that Kent, in severe financial distress, transfers Blackacre, worth only $8,000
but with a $7,000 basis in Kent’s hands, to Kathy in satisfaction of his $10,000 debt, and Kathy
agrees to cancel the remaining $2,000 debt. As before, Kent is treated as selling Blackacre for
$8,000 in cash (Blackacre’s FMV) and using that $8,000 in deemed cash to fully settle his debt
with Kathy. Kent realizes a $1,000 § 1001 gain on the deemed sale for $8,000 in cash, which is
capital gain if Blackacre is a capital asset in Kent’s hands. In addition, Kent also realizes $2,000
of § 61 debt-discharge income, as you learned in Chapter 10, which is ordinary income because it
does not arise on the sale or exchange of a capital asset. Generally, Kent could exclude this § 61
debt-discharge income under § 108 only if he is either insolvent or in bankruptcy court, with a
$2,000 reduction of tax attributes under § 108(b) resulting in effective deferral only. If the debt is
bona fide and satisfies the worthlessness standard, Kathy may be able to deduct $2,000 as a bad
debt under § 166.
In the above scenarios, Kent did not purchase property with debt. Nor did he transfer property
to another subject to debt. What if he did? Part A. explores the purchase of property with borrowed
money. Part B. considers the tax consequences of transferring property subject to encumbering
debt to another. Finally, Part C. considers the tax consequences of a reduction in debt encumbering
property without a transfer of the property.

A. The purchase of property with
borrowed money: the front-end rule in Crane
Cain lists Blackacre for sale for $100,000. Connie borrows $80,000 from National Bank and,
together with $20,000 of her own previously saved (after-tax) cash, purchases Blackacre for
$100,000. What is Connie’s basis in Blackacre? We know that it should be at least $20,000, as
Connie spent $20,000 of her own cash—a nondeductible capital expenditure. The denial of a
deduction for her $20,000 outlay clearly creates basis to that extent. We also know, however, that
Connie is entitled to exclude from her Gross Income the $80,000 of borrowed cash under the
borrowing exclusion, which means that $80,000 of the purchase price represents pre-tax dollars,
instead of after-tax dollars. Should that $80,000 create basis?
In Chapter 1, you learned that basis generally is a running record of previously or concurrently
taxed dollars. In Chapter 7, you learned of the first major exception to that rule when you studied
§ 1014, which permits the basis of property received on death to be stepped up to FMV without

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the recognition of gain by the decedent. The first rule pronounced in Crane v. Commissioner, 2
together with its progeny, is the second major exception to the rule that basis generally represents
previously taxed dollars. Under Crane, debt used to purchase property is included in the basis of
that property, even though the borrowed money represents pre-tax dollars. Connie’s Blackacre
basis is $100,000 right from the moment of purchase, notwithstanding the fact that only $20,000
of her purchase price represents after-tax dollars.
Moreover, Connie achieves the same result if she effectively borrows $80,000 from Cain,
instead of from National Bank, through purchasing the property from him for $20,000 in cash
coupled with her note requiring her to pay $80,000 in the future (with interest) to Cain. Her Year1 basis reflects the entire $100,000, equal to the $20,000 that she transfers to Cain and the $80,000
that she will pay to him in the future.
Finally, Connie achieves the same $100,000 basis if she pays $20,000 to Cain and takes the
property “subject to” an $80,000 previously existing debt to National Bank, which Cain had
incurred when he bought Blackacre. Connie steps into Cain’s shoes with respect to that previously
existing debt and continues to make the payments that Cain would have made had he not sold the
property to her subject to the debt.
The ability to include borrowed money (pre-tax dollars) in basis in Year 1 is an extraordinary
privilege when combined with the ability to depreciate the basis of certain business and investment
property and to deduct business and investment interest on the loan. First, recall from Chapter 2
that two requirements must be met for business or investment income to be taxed under income
tax principles instead of more favorable consumption tax principles (as under a cash-flow
consumption tax or wage tax). First, the investment must be made with after-tax dollars. Second,
the investment return must be fully included in the tax base. If either of those two requirements is
missing, the investment is being taxed under more favorable consumption tax principles (rather
than income tax principles). If the investment is made with pre-tax dollars, the investment is being
taxed according to cash-flow consumption tax principles. If the investment is made with after-tax
dollars but the return is explicitly excluded from the tax base, the investment is being taxed under
wage tax principles, under which only labor income (not capital income) is taxed.
Moreover, you also learned in Chapter 2 that the economic outcome under a cash-flow
consumption tax and wage tax can be the same and that both are better than the outcome under an
income tax. Even though the investment return is nominally included in the cash-flow consumption
tax base, the bottom-line, after-tax consequences can be the same as under a wage tax (at least with
respect to the normal return expected when the asset is purchased), where the investment is made
with after-tax dollars but the return is explicitly excluded from the tax base.
Finally, you learned that interest should not be deductible under either a cash-flow consumption
tax or wage tax.
Because Crane basis consists of pre-tax dollars, the return on that investment can be perceived
as effectively free from tax (even though nominally included on the tax return) between the time
that the property purchased with debt begins to generate includable income and the time that the
debt is repaid with after-tax dollars. Moreover, the business or investment interest paid on the loan
is nevertheless deductible under § 163, and Crane basis may be depreciated (deducted) beginning
immediately, so long as the property satisfies the requirements in § 167(a), explored in Chapter
13. See § 167(c)(1) (providing that depreciation is calculated by using the property’s basis). If
2

331 U.S. 1 (1947).

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Crane basis is depreciated before the loan principal is repaid with after-tax dollars, the taxpayer is
enjoying a double tax benefit for the same dollars (exclusion of the loan proceeds and deduction
of the Crane basis generated by those excluded collars) during that period. We have previously
seen that, under normative income tax theory, deductions must be supported by basis (in the usual
sense of after-tax dollars) in order to ensure that the same dollars do not provide a double tax
benefit (both exclusion and deduction) to the same taxpayer. Indeed, the failure to have basis to
deduct is what prevented the taxpayer in Revenue Ruling 93-27 from taking a § 166 bad-debt
deduction in the last chapter! Because Crane violates these principles—allowing deductions to be
created with pre-tax dollars—much business or investment property is purchased with debt, even
if the taxpayer has sufficient cash to avoid debt. The tax treatment is just too favorable to pass up!
Even though the ability to create basis with untaxed dollars is an extraordinary privilege under
Crane, we lack a practical alternative. Absent Crane, Connie’s basis would be limited to the
$20,000 that she paid with after-tax dollars in our hypothetical above. Only if and to the extent
that she made principal payments to National Bank (or to Cain, if Cain acted as the lender) would
her basis increase, as each principal payment is made, representing additional after-tax dollars that
she has effectively invested in the property. Would the property’s depreciation deductions (if the
property is depreciable) be calculated by reference to the entire $100,000 value of the property, or
would they be calculated by reference only to her initial $20,000 basis? If the latter, how would
we calculate depreciation as she increased her basis with principal repayments, year by year?
Moreover, consider what would happen if Connie were to sell the property to Connor for
$100,000 in cold, hard cash before its value changed, using $80,000 of the $100,000 in cash
received from Connor to repay her loan to National Bank. While the debt repayment has no tax
consequences for Connie (as you learned in Chapter 9), if we did not permit her to include the
borrowed funds in her basis, her § 1001 gain would be $80,000, equal to the difference between
the $100,000 in cold, hard cash that she obtained from Connor on the sale and her $20,000 basis.
Such a result would be absurd, however, as the property did not increase in value at all between
her purchase from Cain and her sale to Connor.
For these reasons, allowing her to include the entire sum of borrowed money in basis from the
beginning—even though those dollars are pre-tax—is the only practical alternative. Therefore, the
corollary is that her basis does not increase as and when she makes principal payments to National
Bank because she was entitled to include the full amount of the borrowed principal in her basis
from the beginning in Year 1. In effect, Crane permits her to accelerate the creation of basis.
Borrowed money is included in the property’s basis under Crane so long as the borrower can
prove that the loan proceeds were used to purchase the property. This burden of proof is easy when
the loan proceeds go directly from the lender to the property seller (Cain, above), as is often the
case, but Crane applies even if the loan amount does not go directly from the lender to Cain so
long as Connie can show that the cash that she borrowed was, in fact, used to buy Blackacre.
Moreover, Crane applies to purchase debt regardless of whether the loan is secured by the
property and, if it is secured by the property, regardless of whether the debt is “recourse”
or “nonrecourse.”
A recourse loan is one for which the borrower is personally liable for repayment, beyond
any property securing the loan. If, for example, the $80,000 that Connie borrows from National
Bank to purchase Blackacre from Cain is also secured by Blackacre, and the loan is a recourse
loan, Connie would be personally liable for any shortfall if she fails to repay any part of the $80,000
loan principal and the bank seizes Blackacre at a time when its value has fallen to, say, $70,000.
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Depending state law, National Bank might be able to attach a lien against other property owned
by Connie, even though she did not provide a security interest in such other property to the lender,
or perhaps even garnish Connie’s wages, in order to obtain the final $10,000 that she owes.
A nonrecourse loan is one for which the borrower is not personally liable for repayment.
The lender’s only remedy on nonpayment is to seize the property security. If the securing
property is worth less than the outstanding balance, the lender is out of luck. For example, if the
$80,000 loan described above is nonrecourse instead of recourse and Connie fails to repay it,
National Bank has no further remedy beyond seizing Blackacre in a foreclosure action, even if it
is worth only $70,000 at the time of the foreclosure. In other words, the only difference between a
recourse loan and a nonrecourse loan is the extent of the lender’s remedies under state law on
nonpayment. By definition, all nonrecourse debt is secured by property, but recourse debt also may
(or may not) be secured by property.
If borrowed money is not used to purchase property, it cannot be included in the
property’s basis, even if the property is used to secure the loan (whether recourse or
nonrecourse). For example, assume that Ronnie purchases Redacre with $100,000 in cash drawn
from his savings. Ronnie’s Redacre basis is $100,000 under § 1012, equal to the cash that he uses
to purchase it. After several years, Redacre appreciates in value to $120,000, and Ronnie borrows
$90,000 from National Bank, using Redacre as property security for the recourse loan. Redacre’s
basis does not increase by the $90,000 in new debt because that debt was not used to purchase
Redacre. Because that $90,000 is not used to purchase Redacre, that $90,000 is accounted for
elsewhere in the tax system and so should not also create Redacre basis. If, for example, Ronnie
uses that $90,000 to pay salary to his employees, he deducts the $90,000 under § 162. If he uses
that $90,000 to pay his child’s summer camp costs, the outlay is a nondeductible personal expense
under § 262. The point is that, because he does not use the cash to buy Redacre, it should not be
included in Redacre’s basis or else Ronnie would be doubly counting it, perhaps providing a double
tax benefit (§ 162 deductions and Redacre basis) or providing a tax benefit where none should
exist (creating Redacre basis when the funds were used in what should be nondeductible personal
consumption). In short, no Crane basis is created for after-acquired debt.

B. The transfer of property subject to debt:
the back-end rule in Crane, Tufts, and Rev. Rul. 90-16
In determining the tax consequences of debt relief on the transfer of property subject to debt,
we need to distinguish among several different contexts.
Relief from recourse debt not in excess of property FMV
Let’s add some additional facts to Connie’s purchase of Blackacre from Cain, above. Let’s
assume that the $80,000 that she borrows from National Bank is secured by Blackacre and that the
loan is a recourse loan. Let’s also assume that Blackacre is land, which is not depreciable under
§§ 167 and 168, so that her original $100,000 Crane basis is not reduced during her ownership
period for any depreciation deductions under § 1016(a)(2). After Blackacre appreciates to
$120,000, Connie sells Blackacre to Richard for $40,000 in cash, with Richard “assuming” the
$80,000 recourse debt or taking it “subject to” the debt, which means that Richard essentially steps
into Connie’s shoes with respect to future debt repayments. With a recourse debt, National Bank
may have to approve the sale (because Connie was personally liable for the loan) and Richard will
likely have to formally “assume” the recourse loan. We know that Connie’s Blackacre basis is
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$100,000 under Crane, but what is her “amount realized” within the meaning of § 1001(b) for
purposes of computing her § 1001(a) realized gain or loss on the sale to Richard?
With recourse loans less than the FMV of the property securing the debt, Connie’s amount
realized has always been assumed to be the full $120,000, equal to the $40,000 in cash paid by
Richard plus the $80,000 recourse debt that he assumes, even though § 1001(b) provides that
“amount realized” is equal to “the money received plus the fair market value of the property (other
than money) received.” Just as in the hypotheticals discussed at the beginning of this chapter
pertaining to Kent and Kathy, where a debtor transferred unencumbered property in kind (rather
than cash) to repay a loan, the transaction is treated as though Connie sells the property entirely
for $120,000 in cold, hard cash (comfortably fitting within the § 1001(b) language) and then repays
her $80,000 loan. The deemed sale for $120,000 in cash produces a $20,000 gain ($120,000 A/R
less $100,000 A/B), while the deemed loan repayment has no tax consequences for Connie. In
short, she is treated as receiving an additional $80,000 in cash (equal to her debt relief) for purposes
of determining her amount realized under § 1001(b) because of the “economic benefit” that Connie
enjoys by having the debt, for which she was personally liable, assumed by Richard.
Relief from recourse debt on the transfer of property to another is treated as “amount
realized” under § 1001(b) (in addition to any cash consideration) to the extent that the
assumed recourse debt is less than or equal to the property’s FMV.
This rule applies even if the debt was not earlier included in the basis of the property secured
by the recourse debt because it was not used to acquire the property. Return, for example, to
Ronnie’s purchase of Redacre entirely with $100,000 in cash, creating a $100,000 cost basis. When
that property appreciates in value to $120,000, he borrows $90,000 from National Bank in a
recourse loan, using Redacre as property security. We earlier concluded that Ronnie does not
increase his Redacre basis by the after-acquired debt because that debt is not used to acquire
Redacre. Redacre’s basis remains $100,000. Perhaps Ronnie uses that $90,000 loan to pay $90,000
in wages to his employees. Before Ronnie repays any of the $90,000 loan principal, Ronnie sells
Redacre to Ryan for $30,000 in cash, with Ryan assuming the $90,000 recourse loan.
Even though the $90,000 debt encumbering Redacre was not earlier included in Redacre’s
basis, Ronnie’s relief from that debt on the sale adds $90,000 of amount realized to the $30,000
cash, producing a total amount realized of $120,000 and a $20,000 realized gain ($120,000 A/R
less $100,000 A/B). If Ronnie were not required to include the debt relief in amount realized, he
would never be made to account for the $90,000 of tax-free borrowed money. Regardless of
whether Ronnie deducted the $90,000 as salary or did not deduct the amount because spent on
personal consumption, the important point is that he excluded that $90,000 on initial receipt under
the borrowing exclusion. If he were not made to account for the debt relief by adding the $90,000
to his amount realized in computing his § 1001 gain, he would enjoy a double tax benefit for the
same dollars (exclusion from Gross Income and no addition to § 1001(b) amount realized, reducing
his gain or creating or increasing a loss). Notice that the need to account for the $90,000 recourse
loan encumbering Redacre on the sale of the property is not dependent on the inclusion of the debt
in the property’s basis. Rather, the need to account for the $90,000 on the transfer of property
subject to the debt is the prior receipt of tax-free dollars, which were permitted to be received taxfree solely on Ronnie’s promise that he would repay with after-tax dollars (which we now know
he will not, in fact, do). While this rationale sounds very much like the rationale underlying § 61
debt-discharge income, we cannot, on these facts, create § 61 debt-discharge income for Ronnie
because the value of the property exceeds the outstanding debt encumbering it. The only way to

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account for the debt relief, therefore, is to include it in § 1001(b) amount realized.
Relief from nonrecourse debt—whether or not in excess of property FMV
Should the same rule (including the debt relief in amount realized when calculating § 1001 gain
or loss) apply if the debt is nonrecourse rather than recourse?
The debt at issue in Crane was, in fact, nonrecourse. In addition to holding that debt is included
in the basis of property purchased with the debt, whether recourse or nonrecourse (the front-end
rule in Crane), Crane also held (the back-end rule in Crane) that the same rule described just above
for recourse debt (not in excess of the property’s FMV) applies on the transfer of property to
another “subject to” nonrecourse debt. Return to Connie’s Blackacre purchase with $20,000 in
cash and $80,000 of debt, but let’s change the nature of the debt from recourse to nonrecourse.
Connie’s initial basis in Blackacre is $100,000 under the front-end rule in Crane. She sells
Blackacre to Richard when it is worth $120,000 for $40,000 in cash, subject to the $80,000
nonrecourse debt. Because Connie is not personally liable for the debt, National Bank may not be
involved when Connie transfers the property subject to the nonrecourse debt to Richard, who may
not have to formally assume the debt. But Richard knows that he owns it subject to the debt. If he
stops making payments, National Bank could foreclose and take possession of Blackacre.
The Crane Court reasoned that, even though the debt is nonrecourse, Connie will treat it as
though she were personally liable for it (i.e., as though it were recourse) in the case in which the
outstanding debt is less than the property’s FMV (our facts) in order to protect her equity
investment in it. That is to say, Connie will repay the $80,000 nonrecourse loan when due, even
though she is not personally liable for it, because the property is worth $120,000; if she fails to
repay the loan, she could risk losing her $40,000 equity investment (the excess of the property’s
$120,000 FMV over the $80,000 nonrecourse debt encumbering it). The Crane Court concluded
that Connie enjoys an $80,000 “economic benefit” when she transfers the property subject to the
nonrecourse debt, even though she is not personally liable for it.
All the talk about “economic benefit” aside, an easier way to think about why Connie’s debt
relief must create § 1001(b) amount realized on these facts is to think about her tax consequences
if she sold Blackacre to Richard entirely for $120,000 in cash (the property’s FMV) and then uses
$80,000 of the cash obtained to repay her nonrecourse debt to National Bank. She clearly realizes
a $40,000 gain under § 1001, as the $120,000 in cash clearly constitutes “amount realized” under
the language in § 1001(b), and she has no tax consequences on the debt repayment. We must
include the $80,000 nonrecourse debt relief in her amount realized in the economically equivalent
transaction in which sells the property to Richard for $40,000 in cash, subject to the $80,000 debt.
Considering those two economically equivalent ways for Connie to structure the sale also
illustrates that the only way for Connie to account for her $80,000 debt relief in this situation (in
which the nonrecourse debt is less than the FMV of the securing property) is to include it in §
1001(b) amount realized. The debt relief could not create § 61 debt-discharge income, instead,
because a sale entirely for cash coupled with repayment of the debt would not create § 61 debtdischarge income on these facts. The two economically equivalent ways to structure this sale
should produce the same tax consequences under both the neutrality norm and horizontal equity,
both studied in Chapter 3.
The Crane Court took its “economic benefit” language seriously, however, when it dropped
footnote 37, the most famous footnote in tax (until Tufts was decided). In footnote 37, the Court
said:

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Obviously, if the value of the property is less than the amount of the mortgage, a
mortgagor who is not personally liable cannot realize a benefit equal to the mortgage.
Consequently, a different problem might be encountered where a mortgagor
abandoned the property or transferred it subject to the mortgage without receiving
boot. 3 That is not this case.
COMMISSIONER v. TUFTS
461 U.S. 300 (1983)
JUSTICE BLACKMUN delivered the opinion of the Court.
Over 35 years ago, in Crane v. Commissioner, 331 U.S. 1 (1947), this Court ruled that a
taxpayer, who sold property encumbered by a nonrecourse mortgage (the amount of the mortgage
being less than the property’s value), must include the unpaid balance of the mortgage in the
computation of the amount the taxpayer realized on the sale. The case now before us presents the
question whether the same rule applies when the unpaid amount of the nonrecourse mortgage
exceeds the fair market value of the property sold.
I
On August 1, 1970, [Tufts] borrowed $1,850,000 to build a 120-unit apartment complex in
Duncanville, Texas, a Dallas suburb. [Editor’s note: The case actually involved a partnership, of
which Mr. Tufts was one partner. The analysis in the case does not, however, turn on this
distinction, and I have edited the opinion to indicate that Mr. Tufts operated as an individual.] He
obtained the loan on a nonrecourse basis. Tufts invested no money in the complex beyond the
borrowed nonrecourse loan proceeds. The construction of the complex was completed in August
1971. During 1971, Tufts claimed depreciation deductions equal to $400,000. Due to these
deductions, the adjusted basis in the property in August 1972 was $1,450,000.
In 1971 and 1972, major employers in the Duncanville area laid off significant numbers of
workers. As a result, the complex’s rental income was less than expected, and Tufts was unable to
pay the interest due on the mortgage. On August 28, 1972, Tufts sold the complex to an unrelated
third party, Fred Bayles. As consideration, Bayles assumed the nonrecourse mortgage.
On the date of transfer, the fair market value of the property did not exceed $1,400,000. Mr.
Tufts reported the sale on his Federal income tax return as realizing a loss of $50,000. The loss
was the difference between the adjusted basis, $1,450,000, and the fair market value of the
property, $1,400,000. The Commissioner of Internal Revenue, on audit, determined that the sale
resulted in a capital gain of $400,000. His theory was that Mr. Tufts realized the full amount of
the nonrecourse obligation. The Commissioner determined the gain on the sale by subtracting the
adjusted basis, $1,450,000, from the liability assumed by Bayles, $1,850,000.
Relying on Millar v. Commissioner, 577 F.2d 212, 215 (CA3), cert. denied, 439 U.S. 1046
(1978), the United States Tax Court, in an unreviewed decision, upheld the asserted deficiencies.
3

The reference to “boot,” above, refers back to one of the hypotheticals described at the beginning of this chapter,
under which Kent, who owned Blackacre with a FMV of $8,000 and who owed $10,000 to Kathy had to throw $2,000
of cash in to boot, in addition to Blackacre, to settle his debt with Kathy. The extra cash that is required to even up the
consideration on both sides (to $10,000 on our facts) is often referred to as “boot”—a nomenclature even more
common in connection with § 1031 like kind exchanges, examined in the next chapter.

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The United States Court of Appeals for the Fifth Circuit reversed. That court expressly disagreed
with the Millar analysis, and, in limiting Crane v. Commissioner, supra, to its facts, questioned
the theoretical underpinnings of the Crane decision. We granted certiorari to resolve the conflict.
II
In Crane v. Commissioner, supra, this Court took the first and controlling step toward the
resolution of this issue. [In holding that the relief from nonrecourse debt on the sale of property
should be included in the amount realized under § 1001(b)], the Court concluded that Crane
obtained an economic benefit from the purchaser’s assumption of the mortgage identical to the
benefit conferred by the cancellation of personal debt. Because the value of the property in that
case exceeded the amount of the mortgage, it was in Crane’s economic interest to treat the
mortgage as a personal obligation; only by so doing could she realize upon sale the appreciation
in her equity represented by the $2,500 boot [equal to the excess of the property’s FMV over the
nonrecourse debt encumbering it, and which the buyer had to pay to Mrs. Crane, in addition to
taking the property subject to the nonrecourse debt]. The purchaser’s assumption of the liability
thus resulted in a taxable economic benefit to her, just as if she had been given, in addition to the
boot, a sum of cash sufficient to satisfy the mortgage.
In a footnote, pertinent to the present case, the Court observed [here the Court quoted footnote
37, reprinted above].
This case presents that unresolved issue. We are disinclined to overrule Crane, and we conclude
that the same rule applies when the unpaid amount of the nonrecourse mortgage exceeds the value
of the property transferred. Crane ultimately does not rest on its limited theory of economic
benefit; instead, we read Crane to have approved the Commissioner’s decision to treat a
nonrecourse mortgage in this context as a true loan. This approval underlies Crane’s holdings that
the amount of the nonrecourse liability is to be included in calculating both the basis and the
amount realized on disposition. That the amount of the loan exceeds the fair market value of the
property thus becomes irrelevant.
When a taxpayer receives a loan, he incurs an obligation to repay that loan at some future date.
Because of this obligation, the loan proceeds do not qualify as income to the taxpayer. When he
fulfills the obligation, the repayment of the loan likewise has no effect on his tax liability.
Another consequence to the taxpayer from this obligation occurs when the taxpayer applies the
loan proceeds to the purchase price of property used to secure the loan. Because of the obligation
to repay, the taxpayer is entitled to include the amount of the loan in computing his basis in the
property; the loan, under § 1012, is part of the taxpayer’s cost of the property. Although a different
approach might have been taken with respect to a nonrecourse mortgage loan, the Commissioner
has chosen to accord it the same treatment he gives to a recourse mortgage loan. [5] The Court
[5]

The Commissioner might have adopted the theory, implicit in Crane's contentions, that a nonrecourse mortgage is
not true debt, but, instead, is a form of joint investment by the mortgagor and the mortgagee. On this approach,
nonrecourse debt would be considered a contingent liability, under which the mortgagor's payments on the debt
gradually increase his interest in the property while decreasing that of the mortgagee. Note, Federal Income Tax
Treatment of Nonrecourse Debt, 82 COLUM. L. REV. 1498, 1514 (1982); Lurie, Mortgagor's Gain on Mortgaging
Property for More than Cost Without Personal Liability, 6 TAX L. REV. 319, 323 (1951). Because the taxpayer's
investment in the property would not include the nonrecourse debt, the taxpayer would not be permitted to include
that debt in basis. Note, 82 COLUM. L. REV., at 1515.
We express no view as to whether such an approach would be consistent with the statutory structure and, if so, and
Crane were not on the books, whether that approach would be preferred over Crane's analysis. We note only that the

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approved that choice in Crane, and the respondents do not challenge it here. The choice and its
resultant benefits to the taxpayer are predicated on the assumption that the mortgage will be repaid
in full.
When encumbered property is sold or otherwise disposed of and the purchaser assumes the
mortgage, the associated extinguishment of the mortgagor’s obligation to repay is accounted for
in the computation of the amount realized. See U.S. v. Hendler, 303 U.S. 564, 566-567 (1938).
Because no difference between recourse and nonrecourse obligations is recognized in calculating
basis, [7] Crane teaches that the Commissioner may ignore the nonrecourse nature of the obligation
in determining the amount realized upon disposition of the encumbered property. He thus may
include in the amount realized the amount of the nonrecourse mortgage assumed by the purchaser.
The rationale for this treatment is that the original inclusion of the amount of the mortgage in basis
rested on the assumption that the mortgagor incurred an obligation to repay. Moreover, this
treatment balances the fact that the mortgagor originally received the proceeds of the nonrecourse
loan tax-free on the same assumption. Unless the outstanding amount of the mortgage is deemed
to be realized, the mortgagor effectively will have received untaxed income at the time the loan
was extended and will have received an unwarranted increase in the basis of his property. [8] The
Commissioner’s interpretation of § 1001(b) in this fashion cannot be said to be unreasonable.
The Commissioner in fact has applied this rule even when the fair market value of the property
falls below the amount of the nonrecourse obligation. Treas. Reg. § 1.1001-2(b) [Ed. note: this
regulation was issued during the pendency of the Tufts litigation]; Rev. Rul. 76-111, 1976-1 C.B.
214. Because the theory on which the rule is based applies equally in this situation, see Millar v.
Commissioner, 67 T.C. 656, 660 (1977), aff’d on this issue, 577 F.2d 212, 215-216 (CA3), cert.
denied, 439 U.S. 1046 (1978); Mendham Corp. v. Commissioner, 9 T.C. 320, 323-324 (1947);
Lutz & Schramm Co. v. Commissioner, 1 T.C. 682, 688-689 (1943), we have no reason, after
Crane, to question this treatment. [11]
Crane Court's resolution of the basis issue presumed that when property is purchased with proceeds from a
nonrecourse mortgage, the purchaser becomes the sole owner of the property. Under the Crane approach, the
mortgagee is entitled to no portion of the basis. The nonrecourse mortgage is part of the mortgagor's investment in the
property, and does not constitute a coinvestment by the mortgagee. But see Note, 82 COLUM. L. REV., at 1513 (treating
nonrecourse mortgage as coinvestment by mortgagee and critically concluding that Crane departed from traditional
analysis that basis is taxpayer's investment in property).
[7]

The Commissioner's choice in Crane ‘laid the foundation stone of most tax shelters,’ Bittker, Tax Shelters,
Nonrecourse Debt, and the Crane Case, 33 TAX L. REV. 277, 283 (1978), by permitting taxpayers who bear no risk to
take deductions on depreciable property. Congress recently has acted to curb this avoidance device by forbidding a
taxpayer to take depreciation deductions in excess of amounts he has at risk in the investment. 26 U.S.C. § 465(a).
Real estate investments, however, are exempt from this prohibition. § 465(c)(3)(D). Although this congressional action
may foreshadow a day when nonrecourse and recourse debts will be treated differently, neither Congress nor the
Commissioner has sought to alter Crane’s rule of including nonrecourse liability in both basis and the amount realized.
[8]

Our analysis applies even in the situation in which no deductions are taken. It focuses on the obligation to repay
and its subsequent extinguishment, not on the taking and recovery of deductions.

[11]

Professor Wayne G. Barnett, as amicus in the present case, argues that the liability and property portions of the
transaction should be accounted for separately. Under his view, there was a transfer of the property for $1.4 million,
and there was a cancellation of the $1.85 million obligation for a payment of $1.4 million. The former resulted in a
capital loss of $50,000, and the latter in the realization of $450,000 of ordinary income. Taxation of the ordinary
income might be deferred under § 108 by a reduction of respondent’s basis in [property].
Although this indeed could be a justifiable mode of analysis, it has not been adopted by the Commissioner. Nor is
there anything to indicate that the Code requires the Commissioner to adopt it. We note that Professor Barnett's

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Tufts received a mortgage loan with the concomitant obligation to repay by the year 2012. The
only difference between that mortgage and one on which the borrower is personally liable is that
the mortgagee’s remedy is limited to foreclosing on the securing property. This difference does
not alter the nature of the obligation; its only effect is to shift from the borrower to the lender any
potential loss caused by devaluation of the property. If the fair market value of the property falls
below the amount of the outstanding obligation, the mortgagee’s ability to protect its interests is
impaired, for the mortgagor is free to abandon the property to the mortgagee and be relieved of his
obligation.
This, however, does not erase the fact that the mortgagor received the loan proceeds tax-free
and included them in his basis on the understanding that he had an obligation to repay the full
amount. See Woodsam Associates, Inc. v. Comm’r, 198 F.2d 357, 359 (CA2 1952); Bittker, supra
n. 7, at 284. When the obligation is canceled, the mortgagor is relieved of his responsibility to
repay the sum he originally received and thus realizes value to that extent within the meaning of §
1001(b). From the mortgagor’s point of view, when his obligation is assumed by a third party who
purchases the encumbered property, it is as if the mortgagor first had been paid with cash borrowed
by the third party from the mortgagee on a nonrecourse basis, and then had used the cash to satisfy
his obligation to the mortgagee.
…
In the specific circumstances of Crane, the economic benefit theory did support the
Commissioner’s treatment of the nonrecourse mortgage as a personal obligation. The footnote in
Crane acknowledged the limitations of that theory when applied to a different set of facts. Crane
also stands for the broader proposition, however, that a nonrecourse loan should be treated as a
true loan. We therefore hold that a taxpayer must account for the proceeds of obligations he has
received tax-free and included in basis. Nothing in either § 1001(b) or in the Court’s prior decisions
requires the Commissioner to permit a taxpayer to treat a sale of encumbered property
asymmetrically, by including the proceeds of the nonrecourse obligation in basis but not
accounting for the proceeds upon transfer of the encumbered property. See Estate of Levine v.
Comm’r, 634 F.2d 12, 15 (CA2 1980).
[Parts III and IV omitted]
The judgment of the Court of Appeals is therefore reversed.
JUSTICE O’CONNOR, concurring.
I concur in the opinion of the Court, accepting the view of the Commissioner. I do not, however,
endorse the Commissioner’s view. Indeed, were we writing on a slate clean except for the decision
in Crane v. Commissioner, 331 U.S. 1 (1947), I would take quite a different approach—that urged

approach does assume that recourse and nonrecourse debt may be treated identically.
The Commissioner also has chosen not to characterize the transaction as cancellation of indebtedness. We are not
presented with and do not decide the contours of the cancellation-of-indebtedness doctrine. We note only that our
approach does not fall within certain prior interpretations of that doctrine….
In the context of a sale or disposition of property under § 1001, the extinguishment of the obligation to repay is not
ordinary income; instead, the amount of the canceled debt is included in the amount realized, and enters into the
computation of gain or loss on the disposition of property. According to Crane, this treatment is no different when the
obligation is nonrecourse: the basis is not reduced as in the cancellation-of-indebtedness context, and the full value of
the outstanding liability is included in the amount realized….

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upon us by Professor Barnett as amicus [Ed. note: see footnote 7 of the majority opinion.]
Crane established that a taxpayer could treat property as entirely his own, in spite of the
“coinvestment” provided by his mortgagee in the form of a nonrecourse loan. That is, the full basis
of the property, with all its tax consequences, belongs to the mortgagor. That rule alone, though,
does not in any way tie nonrecourse debt to the cost of property or to the proceeds upon disposition.
I see no reason to treat the purchase, ownership, and eventual disposition of property differently
because the taxpayer also takes out a mortgage, an independent transaction. In this case, the
taxpayer purchased property, using nonrecourse financing, and sold it after it declined in value to
a buyer who assumed the mortgage. There is no economic difference between the events in this
case and a case in which the taxpayer buys property with cash; later obtains a nonrecourse loan by
pledging the property as security; still later, using cash on hand, buys off the mortgage for the
market value of the devalued property; and finally sells the property to a third party for its market
value.
The logical way to treat both this case and the hypothesized case is to separate the two aspects
of these events and to consider, first, the ownership and sale of the property, and, second, the
arrangement and retirement of the loan. Under Crane, the fair market value of the property on the
date of acquisition—the purchase price—represents the taxpayer’s basis in the property, and the
fair market value on the date of disposition represents the proceeds on sale. The benefit received
by the taxpayer in return for the property is the cancellation of a mortgage that is worth no more
than the fair market value of the property, for that is all the mortgagee can expect to collect on the
mortgage. His gain or loss on the disposition of the property equals the difference between the
proceeds and the cost of acquisition. Thus, the taxation of the transaction in property reflects the
economic fate of the property. If the property has declined in value, as was the case here, the
taxpayer recognizes a loss on the disposition of the property. The new purchaser then takes as his
basis the fair market value as of the date of the sale. See, e.g., U.S. v. Davis, 370 U.S. 65, 72 (1962);
Gibson Products Co. v. U.S., 637 F.2d 1041, 1045, n. 8 (CA5 1981) (dictum); see generally Treas.
Reg. § 1.1001-2(a)(3), 26 CFR § 1.1001-2(a)(3) (1982); 2 B. Bittker, Federal Taxation of Income,
Estates and Gifts para. 41.2.2., pp. 41-10 -- 41-11 (1981).
In the separate borrowing transaction, the taxpayer acquires cash from the mortgagee. He need
not recognize income at that time, of course, because he also incurs an obligation to repay the
money. Later, though, when he is able to satisfy the debt by surrendering property that is worth
less than the face amount of the debt, we have a classic situation of cancellation of indebtedness,
requiring the taxpayer to recognize income in the amount of the difference between the proceeds
of the loan and the amount for which he is able to satisfy his creditor. 26 U.S.C. § 61(a)(12). The
taxation of the financing transaction then reflects the economic fate of the loan.
The reason that separation of the two aspects of the events in this case is important is, of course,
that the Code treats different sorts of income differently. A gain on the sale of the property may
qualify for capital gains treatment, §§ 1202, 1221, while the cancellation of indebtedness is
ordinary income, but income that the taxpayer may be able to defer. §§ 108, 1017. Not only does
Professor Barnett’s theory permit us to accord appropriate treatment to each of the two types of
income or loss present in these sorts of transactions, it also restores continuity to the system by
making the taxpayer-seller’s proceeds on the disposition of property equal to the purchaser’s basis
in the property. Further, and most important, it allows us to tax the events in this case in the same
way that we tax the economically identical hypothesized transaction.
Persuaded though I am by the logical coherence and internal consistency of this approach, I
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agree with the Court’s decision not to adopt it judicially. We do not write on a slate marked only
by Crane. The Commissioner’s longstanding position, Rev. Rul. 76-111, 1976-1 C.B. 214, is now
reflected in the regulations. Treas. Reg. § 1.1001-2. In the light of the numerous cases in the lower
courts including the amount of the unrepaid proceeds of the mortgage in the proceeds on sale or
disposition, see, e.g., Estate of Levine v. Commissioner, 634 F.2d 12, 15 (CA2 1980); Millar v.
Commissioner, 577 F.2d 212 (CA3), cert. denied, 439 U.S. 1046 (1978); Estate of Delman v.
Commissioner, 73 T.C. 15, 28-30 (1979); Peninsula Properties Co., Ltd. v. Commissioner, 47
B.T.A. 84, 92 (1942), it is difficult to conclude that the Commissioner’s interpretation of the statute
exceeds the bounds of his discretion. As the Court’s opinion demonstrates, his interpretation is
defensible. One can reasonably read § 1001(b)’s reference to “the amount realized from the sale
or other disposition of property” (emphasis added) to permit the Commissioner to collapse the two
aspects of the transaction. As long as his view is a reasonable reading of § 1001(b), we should
defer to the regulations promulgated by the agency charged with interpretation of the statute.
National Muffler Dealers Assn. v. U.S., 440 U.S. 472, 488-489 (1979. Accordingly, I concur.
____________________________________
We can restate the Tufts holding as follows.
Relief from nonrecourse debt on the transfer of property to another is treated as “amount
realized” under § 1001(b)—regardless of whether the nonrecourse debt is less than, equal to,
or in excess of the property’s FMV.
Before we get to whether the majority or the concurrence contained the better analysis, let’s
make sure that you understand why the result that Mr. Tufts requested—a $50,000 loss deduction
under §§ 1001 and 165 and no other tax consequences—was clearly wrong. Did Mr. Tufts suffer
any economic loss? Review the facts. He borrowed $1.85 million, which he never included in
Gross Income under the borrowing exclusion, he deducted $400,000 in depreciation while he
owned the property, which reduced his tax liability (and remember that those depreciation
deductions were created by basis that was itself never taxed to him because it was created entirely
by the untaxed debt under Crane), and then he walked away from a $1.85 million debt by
transferring property worth only $1.4 million to Mr. Bayles. He was smelling like roses! He
suffered no loss in either the economic or tax sense! So his requested result was clearly wrong.
But was the government’s requested result, which the Court adopted, clearly right?
Notice that the third sentence from the end of Justice O’Connor’s concurrence describes the
majority’s approach as one that allows Mr. Tufts to “collapse” the tax consequences from his
property disposition under § 1001 with his effective debt relief (because he transferred property
with an FMV of only $1.4 million and escaped a $1.85 million debt). We can call this the
“collapsed” approach. Under the majority’s collapsed approach, only § 1001 is triggered for Mr.
Tufts. The majority concluded that he realized a $400,000 § 1001 gain when he transferred
property subject to a $1.85 million nonrecourse debt to Mr. Bayles (with no additional cash
consideration) because his A/B in the property was $1.45 million ($1.85 million debt relief A/R
less $1.45 million A/B). Under the majority’s collapsed approach, he realized no § 61 debtdischarge income.
In contrast, Justice O’Connor would have preferred that the majority adopt what we can call
the “bifurcated approach” recommended by Professor Barnett, a tax law professor from Stanford,
Justice O’Connor’s alma mater. Under the bifurcated approach, two transactions are deemed to
occur when the property subject to debt in excess of its FMV is transferred: (1) a sale of the

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property for its FMV (creating either gain or loss under § 1001, depending on the property’s basis)
and (2) settlement of the debt with the cash deemed obtained in step 1. If we use the numbers in
Tufts, Mr. Tufts would be deemed to have (1) sold the property for its $1.4 million FMV, producing
a $50,000 loss in light of its $1.45 million basis ($1.4 million A/R less $1.45 million A/B) and (2)
used the $1.4 million sales proceeds deemed obtained in step 1 to settle his $1.85 million debt,
producing $450,000 of § 61 debt-discharge income.
What difference does it make, you might ask, between realizing a $400,000 gain under § 1001
(the majority’s collapsed approach) or realizing a $50,000 loss under § 1001 coupled with
$450,000 of § 61 debt-discharge income (the bifurcated approach)? After all, do not the two
approaches both ultimately produce the same amount of $400,000 of net income? By now, you
can appreciate why the collapsed approach and the bifurcated approach may not result in the same
bottom-line tax consequences.
• Property gain or loss can be capital whereas debt-discharge income is ordinary.
• Section 1001 gain cannot be deferred under § 108, whereas § 61 debt-discharge income may
be deferred by certain taxpayers.
• In Tufts, the choice was between a $50,000 deductible loss (because it was incurred with
respect to investment property) coupled with $450,000 of includable income (under the
bifurcated approach)—or—$400,000 of includable gain (under the majority’s collapsed
approach). Under the bifurcated approach, the deduction of the loss may be deferred if it is
a capital loss under § 1211, but the loss is nevertheless allowable under § 165(c)(2). The
loss, however, may not always be allowable.
Suppose, for example, that the property in Tufts was an expensive yacht used for personal
purposes rather than investment property. Tufts would no longer have been able to take
depreciation deductions, so his basis would have remained at $1.85 million. Under the majority’s
collapsed approach, Tufts would realize neither gain nor loss under § 1001 when he transfers the
boat subject to its $1.85 million debt, as his $1.85 million debt relief A/R under §1001(b) would
exactly equal his $1.85 A/B. Under the bifurcated approach, in contrast, Tufts would have been
deemed to (1) sell the boat for its $1.4 million FMV and (2) settle the $1.85 million debt with the
deemed sales proceeds from step 1. Step 1 would produce a $450,000 loss under § 1001 ($1.4
million A/R less $1.85 million A/B), but this loss would be a nondeductible personal consumption
loss under § 165(c)(3), as the value loss reflects personal consumption. Step 2, however, would
produce $450,000 of § 61 debt-discharge income, as he would settle a $1.85 million debt with only
$1.4 million in deemed cash received in step 1. In other words, the Tufts majority approach
inappropriately allows our yacht owner, in effect, to deduct his personal consumption loss through
the back door.
Moreover, the collapsed approach is not consistent with the theory underlying § 1001 and the
realization requirement. Section 1001 is intended primarily to capture the increases and decreases
in the value of property that went unrecognized during the ownership period because of the
realization requirement. In Tufts, the Court concluded that the taxpayer realized a $400,000 “gain”
when the property had actually lost value since Tufts acquired it. The accession to wealth that Tufts
realized was not “gain” but rather was due to being relieved of debt that he never included in Gross
Income in Year 1 when he received (and excluded) the $1.85 million loan proceeds solely on his
promise to repay it with after-tax dollars—the rationale underlying debt-discharge income, not §
1001 “gain.”

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The collapsed approach in Tufts is reminiscent of a very early (1926) Supreme Court decision
in Bowers v. Kerbaugh-Empire, 4 which the Kirby Lumber Court in the last chapter cited but
distinguished. The taxpayer in that case borrowed German Deutschmarks before WWI, converted
them into U.S. dollars, lost them in a business transaction, and finally repaid the post-war devalued
Deutschmarks with U.S. dollars that cost about $685,000 less than the borrowed marks were worth
when received and originally converted into dollars. In other words, the taxpayer profited from the
drop in value of the German Deutschmark. In effect, the taxpayer borrowed more than it repaid
(measured in U.S. dollars), even though the transaction as a whole—considering the use to which
the borrowed funds were put—resulted in a loss for the taxpayer. The Kerbaugh-Empire Court
held that the difference between the FMV of the Deutschmarks when received and when repaid
did not create Gross Income because “the whole transaction was a loss” and “the mere diminution
of loss is not gain, profit, or income.” 5
In effect, the Kerbaugh-Empire Court applied the collapsed approach in considering the net
effect of the borrowing transaction coupled with the transaction in which the proceeds were spent.
The better approach would have been to analyze the tax consequences of the borrowing and
repayment of the Deutschmarks independently of the business or investment success (or failure)
to which those Deutschmarks were put because foreign currency gains or losses are (generally
speaking) capital gains or losses, whereas the business income or loss would be ordinary.
Collapsing the two transactions together can distort the proper treatment of each leg. Today, the
income tax consequences of dealings in foreign currency are governed by §§ 985 to 989, studied
in the course entitled The Federal Income Tax Consequences of International Transactions. They
generally adopt the bifurcated approach that is at odds with the approach evident in KerbaughEmpire.
From the beginning, Kerbaugh-Empire was heavily criticized. Taken literally, it would require
the tracing of all loan proceeds to evaluate whether a debt discharge produces § 61 debt-discharge
income, as no such income would be deemed realized if the borrowed amounts were used in an
unprofitable transaction. While the facts in Tufts were easy in that sense because only a single
piece of property was purchased with the borrowed money, “[i]t is usually impossible to make this
latter determination … since the borrowed funds are ordinarily absorbed into the business so
completely that tracing the travels of interchangeable dollars lacks even the surface plausibility
that it could claim in Kerbaugh-Empire.” 6 In addition to that practical consideration, there is a
fundamental conceptual criticism to the Kerbaugh-Empire Court’s approach. The business
transaction in which the proceeds were lost may also produce deductions (e.g., under §§ 162, 167,
165, etc.), producing the effect of a double deduction if the related § 61 debt-discharge income is
not taken into account.
Unfortunately, the Kirby Lumber Court did not expressly overrule Kerbaugh-Empire, but it did
distinguish it, and Tufts did not cite it, even though the majority’s collapsed approach could be
characterized as coming uncomfortably close to it. Some lower courts have argued that KerbaughEmpire has been implicitly abandoned. For example, the Tax Court majority opinion in Zarin
(considered in the last chapter) rejected Kerbaugh-Empire as implicitly overruled by later Supreme
Court opinions, quoting at length a Ninth Circuit opinion concluding the same. 7 Even though, as
4

271 U.S. 170 (1926).
Id. at 175.
6
Boris I. Bittker & Barton H. Thompson, Jr., Income from the Discharge of Indebtedness: The Progeny of United
States v. Kirby Lumber, 66 CAL. L. REV. 1159, 1162 (1978).
7
92 T.C. 1084, 1093-94 (1989) (quoting Vukasovich, Inc. v. Comm’r, 790 F.2d 1409, 1414-15 (9th Cir. 1986)).
5

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you learned, the Third Circuit overruled the Tax Court decision in Zarin, it expressly stated, “We
do not pass on the question whether or not Bowers [v. Kerbaugh-Empire] is good law.” 8 The IRS
itself has stated in a Revenue Ruling that Kerbaugh-Empire is no longer good law when it
concluded that “[s]ubsequent Supreme Court decisions and other court cases, when viewed
together, have discredited Kerbaugh-Empire.” 9
Relief from recourse debt in excess of property FMV
What would have been the result in Tufts if the debt had been recourse instead of nonrecourse
and Tufts transferred the property to the creditor in full settlement of the debt? Now the authorities
really begin to make no sense!
REVENUE RULING 90-16
1990-1 C.B. 12
ISSUE
A taxpayer transfers to a creditor a residential subdivision that has a fair market value in excess
of the taxpayer's basis in satisfaction of a debt for which the taxpayer was personally liable. Is the
transfer a sale or disposition resulting in the realization and recognition of gain by the taxpayer
under sections 1001(c) and 61(a)(3) of the Internal Revenue Code?
FACTS
X was the owner and developer of a residential subdivision. To finance the development of the
subdivision, X obtained a loan from an unrelated bank. X was unconditionally liable for repayment
of the debt [i.e., the debt was recourse]. The debt was secured by a mortgage on the subdivision.
X became insolvent (within the meaning of section 108(d)(3) of the Code and defaulted on the
debt. X negotiated an agreement with the bank whereby the subdivision was transferred to the bank
and the bank released X from all liability for the amounts due on the debt. When the subdivision
was transferred pursuant to the agreement, its fair market value was 10,000x dollars, X's adjusted
basis in the subdivision was 8,000x dollars, and the amount due on the debt was 12,000x dollars,
which did not represent any accrued but unpaid interest. After the transaction X was still insolvent.
LAW AND ANALYSIS
Sections 61(a)(3) and 61(a)(12) of the Code provide that, except as otherwise provided, Gross
Income means all income from whatever source derived, including (but not limited to) gains from
dealings in property and income from discharge of indebtedness.
Section 108(a)(1)(B) of the Code provides that Gross Income does not include any amount that
would otherwise be includible in Gross Income by reason of discharge (in whole or in part) of
indebtedness of the taxpayer if the discharge occurs when the taxpayer is insolvent. Section
108(a)(3) provides that, in the case of a discharge to which section 108(a)(1)(B) applies, the
amount excluded under section 108(a)(1)(B) shall not exceed the amount by which the taxpayer is
insolvent (as defined in section 108(d)(3)).
Section 1.61-6(a) of the Income Tax Regulations provides that the specific rules for computing
the amount of gain or loss from dealings in property under section 61(a)(3) are contained in section
8
9

916 F.2d at 116 n.11.
Rev. Rul. 92-99, 1992-2 C.B. 35.

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1001 and the regulations thereunder.
Section 1001(a) of the Code provides that gain from the sale or other disposition of property
shall be the excess of the amount realized therefrom over the adjusted basis provided in section
1011 for determining gain.
Section 1001(b) of the Code provides that the amount realized from the sale or other disposition
of property shall be the sum of any money received plus the fair market value of the property (other
than money) received.
Section 1001(c) of the Code provides that, except as otherwise provided in subtitle A, the entire
amount of the gain or loss, determined under section 1001, on the sale or exchange of property
shall be recognized.
Section 1.1001-2(a)(1) of the regulations provides that, except as provided in section 1.10012(a)(2) and (3), the amount realized from a sale or other disposition of property includes the
amount of liabilities from which the transferor is discharged as a result of the sale or disposition.
Section 1.1001-2(a)(2) provides that the amount realized on a sale or other disposition of property
that secures a recourse liability does not include amounts that are (or would be if realized and
recognized) income from the discharge of indebtedness under section 61(a)(12).
Example (8) under section 1.1001-2(c) illustrates these rules as follows:
Example (8). In 1980, F transfers to a creditor an asset with a fair market value of
$6,000 and the creditor discharges $7,500 of indebtedness for which F is personally
liable. The amount realized on the disposition of the asset is its fair market value
($6,000). In addition, F has income from the discharge of indebtedness of $1,500
($7,500 − $6,000).
In the present situation, X transferred the subdivision to the bank in satisfaction of the 12,000x
dollar debt. To the extent of the fair market value of the property transferred to the creditor, the
transfer of the subdivision is treated as a sale or disposition upon which gain is recognized under
section 1001(c) of the Code. To the extent the fair market value of the subdivision, 10,000x dollars,
exceeds its adjusted basis, 8,000x dollars, X realizes and recognizes gain on the transfer. X thus
recognizes 2,000x dollars of gain.
To the extent the amount of debt, 12,000x dollars, exceeds the fair market value of the
subdivision, 10,000x dollars, X realizes income from the discharge of indebtedness. However,
under section 108(a)(1)(B) of the Code, the full amount of X's discharge of indebtedness income
is excluded from Gross Income because that amount does not exceed the amount by which X was
insolvent.
If the subdivision had been transferred to the bank as a result of a foreclosure proceeding in
which the outstanding balance of the debt was discharged (rather than having been transferred
pursuant to the settlement agreement), the result would be the same. A mortgage foreclosure, like
a voluntary sale, is a “disposition” within the scope of the gain or loss provisions of section 1001
of the Code. See Helvering v. Hammel, 311 U.S. 504, 85 L. Ed. 303, 61 S. Ct. 368, 1941-1 C.B.
375, 1941-1 C.B. 375 (1941), 1941-1 C.B. 375; Electro-Chemical Engraving Co. v. Comm’r, 311
U.S. 513, 85 L. Ed. 308, 61 S. Ct. 372, 1941-1 C.B. 380 (1941), 1941-1 C.B. 380; and Danenberg
v. Comm’r, 73 T.C. 370 (1979), acq., 1980-2 C.B. 1.
HOLDING

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The transfer of the subdivision by X to the bank in satisfaction of a debt on which X was
personally liable is a sale or disposition upon which gain is realized and recognized by X under
sections 1001(c) and 61(a)(3) of the Code to the extent the fair market value of the subdivision
transferred exceeds X's adjusted basis. Subject to the application of section 108 of the Code, to the
extent the amount of debt exceeds the fair market value of the subdivision, X would also realize
income from the discharge of indebtedness.
______________________________________
In other words, Treas. Reg. § 1.1001-2(a)(2) adopts Justice O’Connor’s and Professor Barnett’s
bifurcated approach, but it limits the bifurcated approach to recourse debt in excess of the FMV
of the transferred property. The taxpayer in Rev. Rul. 90-16 is considered to (1) sell the property
for its $10,000 FMV (producing a $2,000 § 1001 gain because the property’s basis is $8,000) and
(2) use the $10,000 of cash deemed obtained on the transfer to settle the $12,000 debt (producing
$2,000 of § 61 debt-discharge income, which the taxpayer, who is insolvent, can defer under §
108). In contrast, if the facts in the ruling were precisely the same except that the debt had been
nonrecourse instead of recourse, Tufts would have controlled, and the taxpayer would have realized
only a $4,000 § 1001 gain ($12,000 debt relief A/R under Tufts less $8,000 A/B) and no § 61 debtdischarge income. Because § 1001 gain is not § 61 debt-discharge income, § 108 and the taxpayer’s
insolvency would have been irrelevant.
What if the facts were the same as in Rev. Rul. 90-16 except that the creditor seizes the property
in foreclosure and does not cancel the remaining $2,000 owed but rather pursues repayment by,
say, garnishing wages, filing a lien against other property owned by A, etc., depending on the rights
provided to the creditor under state law? The Tax Court held on similar facts in Aizawa v.
Commissioner 10 that only the first part of the bifurcated approach would apply at the time of the
property transfer. A would realize only the $2,000 § 1001 gain (equal to the difference between
the $10,000 FMV of the transferred property and the $8,000 basis) at the time of the foreclosure.
If the creditor’s pursuit of the remaining $2,000 debt is successful and A pays it, she would avoid
§ 61 debt-discharge income. At some point (when the statute of limitations runs?), A could be
charged with $2,000 of § 61 debt-discharge income if she fails to pay the remaining $2,000. In
other words, Aizawa takes a “wait and see” approach with respect to excess recourse debt that is
not cancelled by the creditor.
If property subject to recourse debt in excess of the property’s FMV is transferred in full
settlement of the debt, two transactions are deemed to occur: (1) a sale of the property for its
FMV (creating either gain or loss under § 1001, depending on the property’s basis) and (2)
settlement of the debt with the cash deemed obtained in step 1, creating § 61 debt-discharge
income. If the excess debt is not cancelled, step 2 is avoided at the time of transfer, but § 61
debt-discharge income may be realized later.
The Tufts Court did not appear to understand that it was cementing different approaches on the
facts before it, depending on whether the excess debt is recourse or nonrecourse. Indeed, at many
points it noted that there is no essential difference for tax purposes between recourse and
nonrecourse debt. Examples include: (1) “Because no difference between recourse and
nonrecourse obligations is recognized in calculating basis, Crane teaches that the Commissioner
may ignore the nonrecourse nature of the obligation in determining the amount realized upon
disposition of the encumbered property;” (2) “According to Crane, this treatment [including debt
10

99 T.C. 197 (1992).

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relief in amount realized] is no different when the obligation is nonrecourse;” and (3) “The only
difference between [a nonrecourse mortgage] and one on which the borrower is personally liable
is that the mortgagee’s remedy is limited to foreclosing on the securing property.”
The government’s briefs did not alert the Court to the fact that adopting the collapsed approach
for nonrecourse debt in excess of the property’s FMV differed from the approach to the
cancellation of recourse debt in excess of the property’s FMV. At the time, there existed in § 108
a broad exclusion for most discharged business debt of even solvent debtors (since repealed) that
would have allowed Mr. Tufts to exclude the $450,000 of § 61 debt-discharge income (with a
concomitant reduction in tax attributes under § 108(b)) if the Court had adopted the bifurcated
approach recommended by Justice O’Connor. The government’s interest in maximizing current
revenue likely caused it to argue for § 1001(b) amount realized in full, rather than the bifurcated
approach, because § 1001 gain is not subject to § 108 deferral. In fact, the government’s briefs
repeatedly said that if the debt relief were not included in amount realized, it would escape taxation
altogether, 11 which the Court appeared to accept in the last paragraph of Section II of the opinion
when it said: “Nothing in either § 1001(b) or in the Court’s prior decisions requires the
Commissioner to permit a taxpayer to treat a sale of encumbered property asymmetrically, by
including the proceeds of the nonrecourse obligation in basis but not accounting for the proceeds
upon transfer of the encumbered property.”
The brief’s implication was wrong, of course, because the proceeds would be accounted for
under the bifurcated approach, though not by creating additional § 1001(b) amount realized but
rather by creating § 61 debt-discharge income to the extent that the debt exceeded the FMV of the
property. Moreover, remember that whether or not the debt is included in basis is unimportant, as
revealed in the earlier Ronnie example, where after-acquired debt was not included in basis but
was accounted for in amount realized on the later transfer of the property subject to that debt
(where the nonrecourse debt did not exceed the property’s FMV). Finally, even the Court appeared
to understand this when it stated in footnote 8 that its holding was not premised on the taking of
depreciation deductions (of basis) but rather on the fact that the original receipt of the $1.85 million
was excluded from Gross Income as a “true loan.”
Is the collapsed approach dictated by Crane, as the Court suggests in the first line in Part II of
the opinion? No. There is no tension in the Crane situation (where the nonrecourse debt is less
than the FMV of the securing property) between § 61 debt-discharge income and § 1001(b) amount
realized because the two economically equivalent ways of structuring the sale produce the same
tax results. Recall Connie’s sale of Blackacre, subject to $80,000 of nonrecourse debt, with an A/B
in her hands of $100,000 and an FMV of $120,000. Regardless of whether she (1) sells the property
entirely for $120,000 in cash and then repays the $80,000 of nonrecourse debt to National Bank
or (2) sells the property for $40,000 in cash, subject to the $80,000 nonrecourse debt, Connie’s §
1001(b) amount realized would necessarily be $120,000. Either way, Connie could not realize any
§ 61 debt-discharge income. That is not true in the Tufts situation, where the two ways of
structuring the transaction produce very different results: a $400,000 § 1001 realized gain, on the
one hand, versus a $50,000 § 1001 realized loss coupled with $450,000 § 61 debt-discharge
income, on the other. The tension between § 1001(b) amount realized and § 61 debt-discharge
income arises only in the Tufts situation—when the debt exceeds the FMV of the securing property.
Whether the excess debt should be considered additional amount realized or should be considered
11

See generally Deborah A. Geier, Tufts and the Evolution of Debt-Discharge Theory, 1 FLA. TAX REV. 115 (1992)
(describing briefs).

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§ 61 debt-discharge income was a new issue presented in Tufts that was not present in Crane, and
the Tufts majority’s decision to adopt the former was not dictated by Crane.
Finally, return to the very first set of hypotheticals in this chapter, where the transfer of property
satisfies a debt, but the property itself is not purchased with debt or secured by any after-acquired
debt, whether recourse or nonrecourse. Rather, Kent had simply earlier borrowed $10,000 in cash
from Kathy and was now repaying his loan with Blackacre (A/B of $7,000 in Kent’s hands), rather
than with cash. In the case in which Blackacre was worth only $8,000, and Kathy accepted
Blackacre in full settlement of the debt, cancelling the remaining $2,000 owed, we correctly
concluded that Kent would realize a $1,000 § 1001 gain ($8,000 A/R less $7,000 A/B) coupled
with $2,000 of § 61 debt-discharge income (the $8,000 obtained on the deemed sale for cash that
was then deemed used to settle his $10,000 debt to Kathy). Why should the tax consequences on
the transfer be different if (1) Blackacre is originally purchased with $10,000 borrowed from Kathy
in nonrecourse debt, secured by Blackacre, creating a $10,000 basis under the front-end rule in
Crane, (2) Blackacre’s basis is reduced to $7,000 because Blackacre is depreciable and Kent
properly deducted $3,000 in depreciation deductions, and (3) Kent transfers Blackacre to Kathy in
foreclosure at a time when Blackacre’s value had fallen to $8,000? Under the Tufts collapsed
approach, which clearly controls the analysis in this fact pattern, Kent realizes a $3,000 § 1001
gain ($10,000 debt relief A/R less $7,000 A/B), instead of a $1,000 gain coupled with $2,000 of §
61 debt-discharge income. Why should these two fact patterns be treated so differently?
One response may be that nonrecourse debt, unlike recourse debt, is so closely intertwined with
the property securing the debt (because the taxpayer is not personally liable, with the lender’s
remedy limited to taking the property security) that the nonrecourse debt relief should be analyzed
under the Code’s property rules rather than analyzed separately under the bifurcated approach. If
you find that argument convincing, what result if nonrecourse debt is cancelled without a transfer
of the securing property? If the property is not transferred, we cannot analyze the debt relief as
amount realized under § 1001(b) as there is no § 1001 property transfer, but we could still analyze
the debt relief under the Code’s property rules by reducing the property’s basis. Can a taxpayer
do that, citing the underlying analytical approach evidenced in Tufts? Or must she realize § 61
debt-discharge income by analyzing the nonrecourse debt relief separately from the underlying
property ownership? Through the looking glass we go, as we consider that question in Part C.

C. Reduction of property debt without a property transfer
We begin with Revenue Ruling 91-31.
REVENUE RULING 91-31
1991-1 C.B. 19
ISSUE
If the principal amount of an undersecured nonrecourse debt is reduced by the holder of the
debt who was not the seller of the property securing the debt, does this debt reduction result in the
realization of discharge of indebtedness income for the year of the reduction under, section
61(a)(12) of the Internal Revenue Code or in the reduction of the basis in the property securing the
debt?

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FACTS
In 1988, individual A borrowed $1,000,000 from C and signed a note payable to C for
$1,000,000 that bore interest at a fixed market rate payable annually. A had no personal liability
with respect to the note, which was secured by an office building valued at $1,000,000 that A
acquired from B with the proceeds of the nonrecourse financing. In 1989, when the value of the
office building was $800,000 and the outstanding principal on the note was $1,000,000, C agreed
to modify the terms of the note by reducing the note’s principal amount to $800,000.
The facts here do not involve the bankruptcy, insolvency, or qualified farm indebtedness of the
taxpayer. Thus, the specific exclusions provided by section 108(a) do not apply.
LAW AND ANALYSIS
Section 61(a)(12) of the Code provides that Gross Income includes income from the discharge
of indebtedness. Section 1.61-12 (a) of the Income Tax Regulations provides that the discharge of
indebtedness, in whole or in part, may result in the realization of income.
In Rev. Rul. 82-202, 1982-2 C.B. 35, a taxpayer prepaid the mortgage held by a third party
lender on the taxpayer’s residence for less than the principal balance of the mortgage. At the time
of the prepayment, the fair market value of the residence was greater than the principal balance of
the mortgage. The revenue ruling holds that the taxpayer realizes discharge of indebtedness income
under section 61(a)(12) of the Code, whether the mortgage is recourse or nonrecourse and whether
it is partially or fully prepaid. Rev. Rul. 82-202 relies on United States v. Kirby Lumber Co., 284
U.S. 1 (1931), in which the United States Supreme Court held that a taxpayer realized ordinary
income upon the purchase of its own bonds in an arm’s length transaction at less than their face
amount.
In Commissioner v. Tufts, 461 U.S. 300 (1983), the Supreme Court held that when a taxpayer
sold property encumbered by a nonrecourse obligation that exceeded the fair market value of the
property sold, the amount realized included the amount of the obligation discharged. The Court
reasoned that because a nonrecourse note is treated as a true debt upon inception (so that the loan
proceeds are not taken into income at that time), a taxpayer is bound to treat the nonrecourse note
as a true debt when the taxpayer is discharged from the liability upon disposition of the collateral,
notwithstanding the lesser fair market value of the collateral. See section 1.1001-2(c), Example 7,
of the Income Tax Regulations.
In Gershkowitz v. Commissioner, 88 T.C. 984 (1987), the Tax Court, in a reviewed opinion,
concluded, in part, that the settlement of a nonrecourse debt of $250,000 for a $40,000 cash
payment (rather than surrender of the $2,500 collateral) resulted in $210,000 of discharge of
indebtedness income. The court, following the Tuft’s holding that income results when a taxpayer
is discharged from liability for an undersecured nonrecourse obligation upon the disposition of the
collateral, held that the discharge from a portion of the liability for an undersecured nonrecourse
obligation through a cash settlement must also result in income.
The Service will follow the holding in Gershkowitz where a taxpayer is discharged from all or
a portion of a nonrecourse liability when there is no disposition of the collateral. Thus, in the
present case, A realizes $200,000 of discharge of indebtedness income in 1989 as a result of the
modification of A's note payable to C.
In an earlier Board of Tax Appeals decision, Fulton Gold Corp, v. Commissioner, 31 B.T.A.
519 (1934), a taxpayer purchased property without assuming an outstanding mortgage and

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subsequently satisfied the mortgage for less than its face amount. In a decision based on unclear
facts, the Board of Tax Appeals, for purposes of determining the taxpayer’s gain or loss upon the
sale of the property in a later year, held that the taxpayer’s basis in the property should have been
reduced by the amount of the mortgage debt forgiven in the earlier year.
The Tufts and Gershkowitz decisions implicitly reject any interpretation of Fulton Gold that a
reduction in the amount of a nonrecourse liability by the holder of the debt who was not the seller
of the property securing the liability results in a reduction of the basis in that property, rather than
discharge of indebtedness income for the year of the reduction. Fulton Gold, interpreted in this
manner, is inconsistent with Tufts and Gershkowitz. Therefore, that interpretation is rejected and
will not be followed.
HOLDING
The reduction of the principal amount of an undersecured nonrecourse debt by the holder of a
debt who was not the seller of the property securing the debt results in the realization of discharge
of indebtedness income under section 61(a)(12) of the Code.
______________________________
So much for the theory that the collapsed approach for excess nonrecourse debt in Tufts could
be defended (as opposed to the bifurcated approach that applies to excess recourse debt) by arguing
that nonrecourse debt is so closely intertwined with the securing property that such debt relief
should be analyzed entirely under the Code’s property rules. By rejecting basis reduction for
cancelled nonrecourse debt when property is retained instead of transferred (which some had
argued occurred in the early and extremely vague Fulton Gold opinion cited in the ruling) and
requiring, instead, that the cancelled nonrecourse debt be analyzed separately from the property
ownership (creating § 61 debt-discharge income), the ruling effectively rejects the collapsed
approach in Tufts. But wait, you say! The ruling cites the Tufts decision as supporting its approach!
“’Curiouser and curiouser!’ cried Alice (she was so much surprised, that for the moment she quite
forgot how to speak good English).” 12
A debt discharge without the transfer of property creates § 61 debt-discharge income—
even if the debt is nonrecourse—unless §§ 108(a)(1)(D) or (e)(5) applies.
§§ 108(a)(1)(D) and (e)(5)
In 1991, § 108 did not contain §§ 108(a)(1)(D) and (c), which could apply today to facts
identical to those Revenue Ruling 91-31, thanks to the quick action of the real estate lobby after
that ruling was issued.
Under §§ 108(a)(1)(D) and (c), a taxpayer with cancelled “qualified real property business
indebtedness” (whether recourse or nonrecourse) can elect to reduce basis instead of
including the cancelled debt immediately under § 61. This privilege is limited, however, to
an amount equal to the excess of the entire debt over the fair market value of the securing
property. If these rules were applied to the facts in Revenue Ruling 91-31, for example, the entire
$200,000 of the cancelled debt could be excluded, and the property’s basis would be reduced by
$200,000. If, contrary to the facts in the ruling, the bank had cancelled $250,000 of debt (instead
of $200,000), only the first $200,000 could be excluded (with a basis reduction); the remaining
$50,000 would be included in Gross Income under § 61(a)(12).
12

LEWIS CARROLL, ALICE’S ADVENTURES IN WONDERLAND (1865).

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Owners of personal property (such as machines) instead of real property cannot take advantage
of § 108(a)(1)(D). They may nevertheless be able to reduce basis (instead of immediately including
the cancelled debt under § 61) if the more stringent requirements of § 108(e)(5) are met, which
can apply regardless of the nature of the property.
Under § 108(e)(5), a reduction of seller-financed debt (whether recourse or nonrecourse)
is “treated” like a purchase price adjustment (reducing basis) if (1) the lender and the seller
of the property to the taxpayer are the same party (2-party debt) and (2) the debt reduction
occurs outside bankruptcy court and while the debtor is solvent.
Section 108(e)(5) can potentially apply only in the narrow situation in which the lender is also
the seller of the property to the borrower/buyer, unlike the third-party debt at issue in Revenue
Ruling 91-31. Section 108(e)(5) was enacted in 1980 in reaction to a very practical problem.
Suppose that Jane buys a widget machine from George for $100,000, paying George $20,000 at
the time of purchase and giving him her note for the remaining $80,000, to be paid in annual
installments (along with market-rate interest) for the next five years. In Year 2, Jane discovers a
significant malfunction with the machine, and she suspects that George knew about the problem
when he sold the property to her. Jane threatens to sue George for breach of warranty, and George
agrees to cancel $10,000 of the $80,000 aggregate debt that Jane owes to him under her original
note. Jane agrees, and they redraft the note to reflect the lower $70,000 amount, which lowers her
remaining annual installment payments, accordingly.
Alternatively, suppose that no malfunction is found with the machine but that Jane suffers
significant cash-flow problems in Year 4. George agrees to cancel $10,000 of the debt in order to
stave off default on the entire remaining debt, and they, as before, redraft the note to reflect the
lower $70,000 amount.
If we look at the real facts, Jane and George merely renegotiate their purchase price in the first
instance (and the new note is issued to reflect the lower price), while Jane appears to have realized
real § 61 debt-discharge income in the second. The courts were clogged with such cases, where
the trier of fact had to determine whether George had his seller’s hat on or his lender’s hat on when
he cancelled the $10,000 debt. In reaction to this practical problem, Congress enacted § 108(e)(5)
“to eliminate disagreements between the Internal Revenue Service and the debtor as to whether,
in a particular case to which the provision applies, the debt reductions should be treated as
discharge income or a true price adjustment.” 13 Section 108(e)(5) avoids the necessity of
examining the underlying facts. In both cases above, the parties are able to “treat” the cancelled
debt as a purchase price adjustment. The cancelled debt results in a reduction in basis (reflecting
the new purchase price) rather than includable § 61 debt-discharge income.
While § 108(e)(5) reflects the collapsed approach in the sense that the debt relief is permitted
to be accounted for under the Code’s property rules (basis reduction) rather than separately as §
61 debt-discharge income, § 108(e)(5) is not premised on grand theory but, rather, was enacted in
reaction to a practical proof problem and the resulting case backlog in the unique context of sellerfinanced property sales. Tufts, in contrast, is ostensibly based in theory.
One of the arguments made by Mr. Zarin, our gambler from the last chapter, was that his
cancelled debt was excludable under § 108(e)(5) because he bought casino chips (property) from
Resorts for $3.4 million with money borrowed from Resorts, the seller of the chips, and that he
and Resorts agreed to reduce the debt used to purchase the chips to $2.9 million. The Third Circuit
13

S. REP. NO. 96-1035 (1980), 1980-2 C.B. 620, 628.

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did not address the argument, but the Tax Court rejected it by saying:
Obviously the chips in this case were a medium of exchange within the Resorts casino,
and in that sense they were a substitute for cash, just as Federal Reserve Notes, checks,
or other convenient means of representing credit balances constitute or substitute for
cash. Recognition that foreign currency has, for some purposes, been held to be
“property” that qualifies as a capital asset is not in point here. Foreign currency
fluctuates in United States dollar value, whereas the chips in question do not. We
conclude that petitioner’s settlement with Resorts cannot be construed as a “purchasemoney debt reduction” arising from the purchase of property within the meaning of
section 108(e)(5).
Did Mr. Zarin really spend $3.4 million to purchase little pieces of plastic? Of course not. He
purchased the opportunity to gamble, with chips serving merely as an accounting tool to keep track
of his gambling wins and losses. More important, § 108(e)(5) should not apply where the debt
extinguishment also extinguishes the property itself. Mr. Zarin did not continue to own the chips
(with a lower basis), which he could sell to another. In other words, the property must survive the
debt cancellation in order for § 108(e)(5) to be able to operate properly through basis reduction.
Final thoughts
Do these rules, taken collectively, make sense? Consider the case of Gershkowitz v.
Commissioner, 14 mentioned in Revenue Ruling 91-31. The simplified facts involved the purchase
of computer software for $250,000 with nonrecourse debt borrowed from a third party (not the
software seller), establishing a $250,000 Crane basis. The software was depreciated so that its
basis was reduced to $50,000 when a new generation of software was issued, resulting in a
plummeting of the FMV of the taxpayer’s software to $2,500. The taxpayer was insolvent when
the lender threatened foreclosure on nonpayment of the $250,000 nonrecourse debt.
If a foreclosure transfer occurred, the Tufts collapsed approach would apply, resulting in a
$200,000 § 1001gain ($250,000 debt relief A/R less $50,000 A/B). The $200,000 gain would not
be excludable under § 108, notwithstanding the taxpayer’s insolvency, because § 1001 gain is §
61(a)(3) Gross Income, not § 61 debt-discharge income, and § 108 can potentially apply only to
the latter. Obtaining good tax advice, the taxpayer negotiated with the lender to accept a $40,000
cash payment to cancel the $250,000 debt in lieu of foreclosure. (What lender would refuse such
an offer on similar facts?) The taxpayer realized $210,000 of § 61 debt-discharge income, which
the taxpayer could exclude under § 108(a)(1)(B), with a concomitant $210,000 reduction in tax
attributes under § 108(b) (to the extent that the taxpayer had any § 108(b) items to reduce).
If Tufts had adopted the bifurcated approach, such traps for the unwary—or planning
opportunities, depending on your point of view—would not arise. Instead of realizing a $200,000
gain on a foreclosure transfer, Mr. Gershkowitz would have been treated, under the bifurcated
approach, as (1) selling the property for its $2,500 FMV and (2) using the $2,500 deemed sales
proceeds to settle the $250,000 debt. Step (1) would produce a $47,500 § 1001 loss ($2,500 A/R
less $50,000 A/B), which would have been deductible under § 165(c)(1) as a business loss. Step
(2) would produce $247,500 of § 61 debt-discharge income, excludable under § 108(a)(1)(B)
because of his insolvency but reducing his tax attributes under § 108(b).
Alas, however, Tufts is here to stay. Some academics may think that these rules are internally
14

88 T.C. 984 (1987).

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incoherent, but there is no constituency for change, as many in the business world like the
“planning opportunities” presented by them. For this reason, you need to understand how they
operate in order to be in a position to advise your clients well (or buy good malpractice insurance).
Problems
Describe the tax consequences for Brian in each of the following problems.
1. Brian borrows $20,000 in cash from Barbara in Year 1, unsecured by any property. The debt
terms require Brian to pay market-rate interest each year and to repay the $20,000 principal amount
in Year 5. In Year 5, Barbara agrees to repayment in kind rather than in cash, with Brian
transferring Greenacre, FMV $20,000, to her, which Brian bought for $25,000 years earlier and
has held for investment.
2. Same as 1., except that Greenacre’s FMV is only $18,000, but Barbara nevertheless accepts
Greenacre in full settlement of their debt.
3. Brian buys a widget machine for use in his business for $25,000, using $5,000 cash and
borrowing $20,000 from National Bank in nonrecourse debt, secured by the machine. During his
ownership, Brian pays market-rate interest on the loan but makes no principal payments. After
properly deducting $10,000 in depreciation under §§ 167 and 168—do not forget § 1016(a)(2)—
Brian sells the property to Barbara for $2,000 in cash, subject to the $20,000 nonrecourse debt.
4. Same as 3., except that Brian did not use debt to purchase the widget machine. Rather, he
paid $25,000 in cash. The following year, he used the machine as security to borrow $20,000 in
nonrecourse debt, which he used to pay employee salary. The remaining facts are the same.
5. Same as 3., except that, because Brian made no principal payments, National Bank
forecloses, taking the property at a time when the property’s FMV is $10,000. Brian is insolvent.
6. Same as 5., except that the debt is recourse instead of nonrecourse, and National Bank cancels
the remaining unpaid debt at the time of foreclosure. Brian is insolvent.
7. Same as 3., except that, at a time when Brian’s basis is $15,000 and the widget machine’s
FMV is $18,000, National Bank cancels $5,000 of the $20,000 nonrecourse debt. Brian is not
insolvent.
8. Same as 7., except that the property is real estate instead of a widget machine.
9. Same as 7., except that Brian originally borrowed the $20,000 not from National Bank but
from the widget machine seller.
10. Same as 3., except that, at a time when Brian’s basis is $5,000 (and the outstanding
nonrecourse debt principal is still $20,000), the property’s value plummets to $3,000. National
Bank is threatening foreclosure because Brian has made no principal payments. Brian is insolvent.
Do you have any advice for Brian?

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Unit V:
The Ownership and Disposition of Property
Introduction to Chapters 12 through 15
By this point in the course, you already know quite a lot about the acquisition, ownership, and
disposition of property. Chapter 1 introduced you to the basic principles, and you have learned in
the last unit how debt affects § 1012 cost basis and § 1001(b) amount realized. Nevertheless, there
are still a few more topics to be explored under this broad heading.
Chapter 12 will first consider the proper accounting for § 1001 gain or loss, including a
discussion of accounting for inventory sales and installment sales. The bulk of the chapter,
however, will be spent exploring several nonrecognition or deferral provisions.
Chapter 13 will review the rate of basis recovery in the case of debt instruments and compare
it to the rate of basis recovery under the depreciation and related provisions. It will also explore
the new limits on the business interest deduction imposed under the TCJA.
You became acquainted in Chapter 1 with the fact that “net capital gain” is subject to a lower
tax rate than “ordinary” gain or income and that “capital” losses that are otherwise deductible
under § 165 are subject to deduction restrictions in §§ 1211 and 1212 that are not applicable to
ordinary losses. It was important to introduce you to these important concepts early because they
have affected so many of the topics that we have already explored. Now is the time, however, to
take a closer look at these rules and to introduce you to some additional ones, such as depreciation
recapture and § 1231 gains and losses. Welcome to Chapter 14!
Finally, Chapter 15 will consider the topic of tax shelters. While the subject may not appear to
fit precisely within the topic of property ownership and disposition, I think that all of the
knowledge that you have learned up to this point in the course comes together to make this a good
point in time to examine the problem. Thus, I shoehorn it in right here.

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Chapter 12: Properly Accounting for, and the
Nonrecognition of, § 1001 Realized Gain or Loss
There is a logical order in the steps to take when analyzing the tax consequences of a realization
event, i.e., when property is sold (for cash), exchanged (for other property), destroyed, stolen, etc.
On the disposition of property
Step 1: What is the § 1001 realized gain or loss (asset by asset)? This step must always come
first in the analysis, as this amount is what may possibly be included in § 61(a)(3) Gross Income
(if a gain) or deducted under § 165 (if a loss). Moreover, do not lose sight of the fact that basis
must always be recovered tax free under § 1001, regardless of the manner of disposition, if we are
to avoid doubly taxing the same dollars to the same taxpayer. If property is subject to debt, your
determination of § 1001 realized gain and loss will necessarily take into account the material that
you just learned in Chapter 11.
Step 2: If a gain, is it includable? See, e.g., §§ 61(a)(3), 1041(a), 1033, 1031, 121. If a loss,
is it deductible? See, e.g., §§ 165(c), 1041(a), 1031, 267(a)(1), 1091. Section 61(a)(3) provides
that “gain derived from dealings in property” is an item of Gross Income, and § 1001(a) defines
“gain” as the excess of § 1001(b) amount realized over adjusted basis. The introductory clause to
§ 61 (“except as otherwise provided in this subtitle”) reminds us, however, that other Code sections
may provide authority for a realized gain to go unrecognized, which means not taken into account
now. You encountered your first nonrecognition provision in Chapter 8 when you studied § 1041,
which applies to transfers between spouses or, if incident to divorce, between former spouses.
Although the gain or loss may be realized within the meaning of § 1001 under Davis v.
Commissioner, 1 it goes unrecognized under the authority of § 1041(a). In this chapter, you will
study §§ 1033 and 1031, which also permit realized gain to go unrecognized.
Realized losses within the meaning of § 1001—the excess of adjusted basis over amount
realized—may go unrecognized not only under § 1041 but also under §§ 1031, 267(a)(1), and
1091, each of which we shall examine in this chapter. Do not forget, however, that even if a
realized loss under § 1001 is recognized (because no nonrecognition provision applies), the loss
may nevertheless not be deductible. Recall from Chapter 1 that, for a wealth reduction to be
deductible, a taxpayer must find a Code section saying “there shall be allowed as a deduction” and
satisfy its terms. For a “loss,” the Code section providing that authority is § 165. With respect to
individuals, the loss must be described in § 165(c), which generally provides for deduction of
business and investment losses only. If the realized loss pertains to personal-use property, the loss
is generally not deductible, except for a limited category of personal casualty and theft loss. 2
Step 3: If (and only if) the answer to (2), above, is “yes,” what is the character of the gain
or loss (ordinary, capital, or § 1231), and why does that character matter? See, e.g., §§ 1221,
1222, 1211, 1212, 1245, 1250, 1231, 1(h). Only if a realized gain is includable or a realized loss
1

370 U.S. 65 (1962).
Section 1001(c), which provides that, “[e]xcept as otherwise provided in this subtitle,” realized gains and losses
“shall be recognized,” is mere surplusage. Section 61(a)(3) requires inclusion of realized gains in any event, “[e]xcept
as otherwise provided by this subtitle.” And no realized loss can be deducted unless § 165 is satisfied. Thus, § 1001(c)
has no independent force.
2

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is deductible does it matter whether it is capital, ordinary, or § 1231 gain or loss. If the realized
gain is not includable or realized loss is not deductible, its character is irrelevant. We shall explore
characterization issues in Chapter 14.
Step 4: If new property is obtained, what is the basis of the new property? See, e.g., §§
1012, 1041(b)(2), 1033(b)(2), 1031(d). Determining the basis of new property (if any) obtained is
the very last step in the analysis. This step must come last because the determination of basis
sometimes requires knowing the outcome of the analysis in Step 2.
You learned in Chapter 8 that unrecognized § 1041 gain or loss is not laundered out of the tax
system, as it is under § 1014 on the transfer of property at death (studied in Chapter 7). Rather, the
unrecognized gain is preserved for future reckoning because the transferee spouse takes the same
basis that the transferor spouse had in the property under § 1041(b)(2). Similarly, you also learned
in Chapter 7 that gifts are not realization events and that the donee generally takes the same basis
that the donor had in the property under § 1015(a). Such a basis was historically referred to as a
carryover basis—and, as an old dog, I still refer to it as a carryover basis—though now it is
technically called a transferred basis. See § 7701(a)(43).
Another kind of basis that preserves unrecognized gain for future reckoning is a substituted
basis (or exchanged basis), a concept that you will shortly learn when we examine § 1031. See §
7701(a)(42) and (44). In general, a substituted basis in property received in an exchange (property
2) is determined by reference to the basis of the property exchanged (property 1) if some or all of
the realized gain or loss with respect to property 1 is unrecognized. In either case, carryover and
substituted bases are instrumental tools that are used to transform what may look like a complete
forgiveness provision at first glance into a mere deferral provision. 3
Part A. explores both (1) how to properly measure § 1001 realized and recognized gain or loss
in Step 1 and (2) the proper timing of inclusions and deductions of such gain or loss. Part B. then
considers several nonrecognition provisions: involuntary conversions (§ 1033), like kind
exchanges (§ 1031), sales of built-in loss property between related parties (§ 267), and so-called
wash sales of securities with built-in loss.

A. Properly accounting for realized and recognized gain and loss
Section 1001 must generally be applied separately to each piece of property sold or exchanged,
even if the dispositions occur in a single transaction, in order to ensure that the tax consequences
of each are not distorted.
Assume, for example, that Barbara owns (1) a diamond ring that she purchased many years ago
for $5,000, which she wears for personal adornment, and (2) a personal-use car that she purchased
for $20,000 a few years ago. Barbara, who needs to raise cash, decides to sell both properties, and
she finds Bob Buyer, who is interested in purchasing both for $30,000. Barbara cannot simply add
the $5,000 basis in her ring to the $20,000 basis in the car and subtract this aggregate $25,000
basis from the $30,000 paid by Bob Buyer, resulting in a § 1001 gain of $5,000. Rather, she must
allocate the $30,000 sales proceeds to each property according to their relative fair market values
(FMVs) and calculate her § 1001 realized gain (or loss) separately for each property. If the
personal-use car is today worth $10,000, $10,000 of the $30,000 sales proceeds is allocated to the
3

In contrast, § 121, a nonrecognition provision that we shall examine in Chapter 17, allows certain gain realized on
the sale of a principal residence to be completely forgiven.

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car sale, and the remaining $20,000 of the sales proceeds is allocated to the ring sale. The car sale
produces a $10,000 realized loss under § 1001 ($10,000 A/R less $20,000 A/B), which is a
nondeductible personal loss under § 165(c)(3). Because the loss is nondeductible, the character of
the loss as ordinary or capital is irrelevant. The ring sale produces a $15,000 realized gain under §
1001 ($20,000 A/R less $5,000 A/B), which is includable under § 61(a)(3) and is a capital gain
because the ring is not listed in § 1221(a). Collapsing the sales of the two properties into a single
§ 1001 analysis would effectively allow Barbara to deduct her $10,000 personal consumption loss
through the backdoor (by realizing less gain). 4
Similarly, Bob Buyer must allocate the $30,000 purchase price between the two properties
according to their relative FMVs for purposes of determining his § 1012 cost basis in each.
Therefore, Bob Buyer allocates $10,000 of his purchase price to the car, taking a $10,000 cost
basis under § 1012, and allocates the remaining $20,000 to the ring as its cost basis.
When an entire business is sold, the allocation of the purchase price among the assets for
purposes of calculating both the seller’s realized gains and losses under § 1001 and the buyer’s §
1012 cost basis in each asset is done under rules provided in § 1060, the details of which are beyond
this course. This allocation can make a big difference to the buyer if only some of the acquired
assets are depreciable while others are not. The allocation also matters to the seller if some assets
produce ordinary gain and loss while others produce capital (or § 1231) gain and loss.
While Barbara’s sale (and Bob’s purchase) of two, distinct assets (a ring and a car) is obvious,
sometimes the fact that two distinct assets are in play is not so obvious. A simple example of this
idea can be illustrated with Marty’s $500,000 purchase of Blackacre, which consists of both (1)
land and (2) a building. At the time of purchase, Marty must allocate his $500,000 aggregate basis
between the land and the building based on their relative FMVs because the land is not depreciable
under § 167(a) while the building is depreciable if Marty uses it in a business or investment
activity. Suppose that Marty properly allocates $100,000 of the $500,000 aggregate basis to the
land and the remaining $400,000 to the building and that he properly deducts $100,000 in
depreciation with respect to the building before selling the land and building for $600,000. While
Marty’s basis in the land remains $100,000, his original $400,000 building basis will be reduced
by $100,000 (equal to the depreciation deductions) under § 1016(a)(2) to $300,000.
Once again, on the sale for $600,000 Marty cannot simply add his land basis to his building
basis (equal to the sum of $400,000) and subtract this aggregate basis from the $600,000 aggregate
amount realized on the sale to reach a $200,000 gain. Rather, just as Barbara did, he must allocate
the $600,000 aggregate amount realized between the land and the building based on their relative
FMVs at the time of sale. For example, assume that the value of the land had decreased to $75,000
by the time that Marty sold it. In that case, $75,000 of the aggregate $600,000 amount realized is
allocated to the land sale, producing a § 1001 loss of $25,000 ($75,000 A/R less $100,000 A/B).
Marty also realizes a § 1001 gain of $225,000 ($525,000 A/R less $300,000 A/B) with respect to
the building sale. (Chapter 14 will explore the character of these gains and losses under Step 3.)
Inventory sales
Inventory accounting is a major exception to the rule that § 1001 must be applied separately to
each sale of property. Can you imagine if the owner of a hardware store had to calculate his § 1001
gain or loss separately with respect to each individual nail that he sold? Taxpayers who sell
4

Astute students may realize that collapsing these two sales into a single tax analysis creates just the kind of distortion
that the collapsed analysis in Tufts can create, as described in the last chapter.

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inventory include Gross Income under § 61(a)(2) (“Gross Income derived from business”) and
calculate that Gross Income by subtracting the Cost of Goods Sold from Gross Receipts. 5 The
resulting amount, of course, is merely Gross Income. The business would then deduct any
allowable business expenses under § 162, interest under § 163, depreciation in any business
equipment or building that it owns under §§ 167 and 168, etc., in reaching Taxable Income.
Gross Receipts
less Cost of Goods Sold
Gross Income derived from business under § 61(a)(2)
less allowable deductions
Taxable Income
You can think of the Cost of Goods Sold as an aggregate basis concept. The taxpayer
determines the Cost of Goods Sold for the year as follows:
Opening Inventory
plus Purchased Inventory (new inventory purchased during the year)
less Closing Inventory (inventory on hand at the close of the year)
Cost of Goods Sold
Closing Inventory becomes Opening Inventory for the next year’s calculation of Cost of Goods
Sold. Closing Inventory is determined by doing a physical count of inventory items left on the
shelves at the end of the year and then determining the cost basis of that remaining inventory using
conventions, often referred to as FIFO (first in, first out) or LIFO (last in, first out).
Here is an example. Suppose that John opens a new store that sells toy trains in Year 1,
purchasing 50 trains for $50 each (a total of $2,500) but selling none of them in Year 1. In Year 2,
John’s Opening Inventory for his trains would be $2,500. In Year 2, John purchases 10 additional
trains for $70 each (a total of $700) and sells 8 trains for $100 each (a total of $800).
At the end of the year, John’s physical count shows that he has 52 trains left on his shelves. If
John uses the FIFO convention (which is the default convention), the 8 trains that he sold this year
would be assumed to come from the trains purchased in Year 1 for $50 each (a total of $400),
leaving $2,100 left of the $2,500 that he spent in Year 1 on inventory and the entire $700 that he
spent in Year 2. In contrast, if John is eligible to elect use of the LIFO convention, the 8 trains that
he sold this year would be assumed to come from the trains that he purchased in Year 2 for $70
each (a total of $560), leaving only $140 left of the $700 that he spent in Year 2 on inventory and
the entire $2,500 that he spent in Year 1. Notice that John’s Cost of Goods Sold would be higher
under the LIFO method than under the FIFO method.
Cost of Goods Sold (FIFO)
Opening Inventory:
plus Purchased Inventory:
less Closing Inventory:

Cost of Goods Sold (LIFO)

$2,500
700
2,800

Opening Inventory:
plus Purchased Inventory:
less Closing Inventory:

$400

$2,500
700
2,640
$560

John’s § 61(a)(2) Gross Income derived from business would be lower under the LIFO method
5

See Treas. Reg. § 1.61-3.

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than under the FIFO method.
§ 61(a)(2) Gross Income using FIFO
less

Gross Receipts:
Cost of Goods Sold:

$800
400

§ 61(a)(2) Gross Income using LIFO
Gross Receipts:
less Cost of Goods Sold:

$400

$800
560
$240

For those of you who are in a panic about now, my main reasons for describing inventory
accounting are to illustrate both that (1) inventory accounting departs from the usual rule that §
1001 gain or loss must be computed by using an asset-by-asset approach and that (2) the LIFO
method has been an important tool in reducing the tax burden of businesses that are eligible to use
it. The ability to elect LIFO treatment had been front and center in tax reform proposals a few
years ago because a lot of revenue is at stake. Moreover, International Financial Reporting
Standards do not permit use of the LIFO method. President Obama advocated repeal of the method
in his Budget proposals in each year of his presidency since 2010. In 2014, former Republican
Chair of the House Ways & Means Committee Dave Camp proposed repealing LIFO in his
revenue-neutral tax reform proposal, which went nowhere. The elimination of LIFO was estimated
to generate about $80 billion in revenue over the 10-year window between 2014 and 2023. 6 But
businesses selling inventory have lobbied hard to retain the use of LIFO, and repeal was in neither
the House nor Senate version of the Tax Cuts and Jobs Act of 2017 (TCJA).
Timing of § 1001 realized and recognized gain inclusion
When is realized and recognized § 1001 gain (i.e., gain that is not protected from inclusion
under a nonrecognition provision, such as §§ 1033 or 1031) included on the tax return? As you
learned in Chapter 9, the timing of § 61 Gross Income inclusions (including § 61(a)(3) and (a)(2)
Gross Income) usually depends on the taxpayer’s method of accounting: either the cash method or
the accrual method. Some students interpret the word “cash” in the term “cash method of
accounting” to imply that Gross Income is not included until cash is received. That assumption is
not correct. While use of the word “cash” may be unfortunate, you learned in Chapter 9 that cash
method taxpayers include Gross Income when the Gross Income item is actually or constructively
received—even if that item is not in the form of cash. 7 Thus, for example, you learned in Chapter
5 that an employee using the cash method of accounting must include the $100,000 FMV of
Blackacre received as compensation for services rendered from her employer under § 61(a)(1) in
the year in which Blackacre is received (unless subject to a substantial risk of forfeiture within the
meaning of § 83). Similarly, a cash method taxpayer must include the $100 FMV of free home
cleaning services received in kind (paid for by the employer) as compensation in kind under §
61(a)(1) in the year in which those cleaning services are received. Note that neither of these
receipts is in the form of cash. Similarly, absent application of § 453 (discussed below), § 1001
gain must be included in the year in which the § 1001(b) amount realized is received, even if the
seller uses the cash method of accounting and the amount realized is not in the form of cash.
For example, assume that Nora, who uses the cash method of accounting, owns undeveloped
land with an A/B of $10,000 and a FMV of $100,000, which she exchanges for a boat owned by
Nick with a FMV of $100,000. (Any classic film “Thin Man” fans out there? We’ll bring Asta into
the picture shortly.) While we ignored the $90,000 wealth accession in the form of the increase in
6
7

See www.treasury.gov/resource-center/tax-policy/Documents/General-Explanations-FY2014.pdf.
See Treas. Reg. § 1.446-1(c)(1)(i).

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land value during her ownership period, the property exchange is a realization event under § 1001,
and Nora realizes and recognizes a $90,000 gain ($100,000 A/R less $10,000 A/B) because no
nonrecognition provision applies on these facts. Moreover, because Nora uses the cash method of
accounting, she must include that $90,000 realized and recognized gain immediately in the year in
which she obtains the boat. (She may have to mortgage the boat to pay the tax due on the exchange.
Or she may have cash from, say, a salary or her past savings with which to pay the tax.)
Nora would include her $90,000 realized gain in the sale year on the facts described above if
she uses the accrual method of accounting, as well, because (1) all the events have occurred to fix
her right to receive the income and (2) the amount can be determined with reasonable accuracy. 8
Installment sale reporting
Suppose that Nora sells her land (A/B $10,000) to Nick for $100,000 of cash consideration on
July 1 of Year 1 (rather than exchanges her land for Nick’s boat) but that Nick pays to Nora only
$20,000 at the time of sale. He also transfers to her a note for the remaining $80,000, to be paid in
four annual installments of $20,000 each on June 30 of each of Years 2, 3, 4, and 5, plus marketrate interest. Just as the boat is § 1001(b) amount realized in the form of property, so is the note.
Absent application of § 453, Nora must include her $90,000 realized and recognized § 1001 gain
entirely in Year 1, just as she would if she exchange her land for Nick’s boat. 9
Nora may, however, be able to take advantage of § 453 installment sale reporting in the case of
the note, which would permit her to defer including her realized and recognized gain until
payments are received on the note. Under § 453(b)(1), an installment sale is any sale in which at
least one payment will be received after the close of the taxable year in which the sale occurs. We
can reduce the language found in § 453(c) to a formula. The amount of total realized and
recognized gain to be included in any year is equal to:
Payments Received in the Year x

Gross Profit
Total Contract Price

The Gross Profit is the entire § 1001 realized and recognized gain: $90,000 on our facts. The Total
Contract Price is the entire § 1001(b) amount realized: $100,000. Of each annual $20,000 Payment
that Nora receives (including the Year-1 Payment), 90% (or $18,000) represents includable § 1001
gain, while 10% (or $2,000) represents tax-free recovery of her $10,000 basis.
$20,000 x

$90,000
$100,000

In addition, of course, Nora must include in her Gross Income the interest that she receives from
Nick under § 61(a)(4).
Section 453 contains several important exceptions. Under § 453(i), any depreciation recapture
under §§ 1245 and 1250 (discussed in Chapter 14) must be recognized in the year of sale. Only
the remaining gain, if any, would be eligible for installment sale reporting. Because land is not
depreciable, there could be no depreciation recapture on our facts. Dispositions of inventory and
dispositions of real estate by dealers are big exceptions under §§ 453(b)(2) and (l), but let’s assume
that Nora is not a real estate dealer. Because of the inventory and real estate dealer exceptions, §
8

See Treas. Reg. § 1.446-1(c)(1)(ii).
See Treas. Reg. § 1.1001-1(g). If the note does not pay market-rate interest, the amount realized would actually be
less than the $80,000 because part of that $80,000 would really be disguised interest. The rules that achieve this result
are found in §§ 1274 and 483, both of which are beyond the scope of this course.
9

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453 is primarily used on the sale of a closely held business to a new owner with the new owner
paying the seller under a note funded with the business’s future profits. Installment reporting is
unavailable if the note that Nick transfers to Nora is a demand note (entitling Nora to require
Nick’s payment on her demand) or is readily tradable on an established securities market, as such
a note is a cash equivalent. 10 Finally, taxpayers otherwise eligible to use the installment method
can elect out of installment reporting under § 453(d).
Installment sale reporting is valuable because of the time value of money; no interest is usually
charged by the government for this deferral privilege. 11 Why, therefore, would anyone who is
otherwise eligible to use installment sale reporting elect out under § 453(d) and include the entire
sale gain immediately? Perhaps Nora’s realized gain is capital gain and Nora has a large capital
loss carryover under § 1212(b) that would make immediate recognition painless. Or perhaps Nora
does not want to leave the future tax obligation to her heirs but would rather allow them to receive
payments on the note after her death entirely free of tax. For example, if Nora reports her sale
under the installment method (under which she would include in Gross Income $18,000 of every
$20,000 payment to be received) but dies before receiving the final two note payments, her heirs
step into her shoes and include $18,000 of each of the two remaining $20,000 payments that they
receive. If, in contrast, Nora elects out of installment sale reporting, she will include her entire
$90,000 realized gain in Year 1. Thus, when her heirs receive the final two payments of $20,000,
they exclude the entire amount.
Open transaction reporting
Finally, suppose that Nora owns land with an A/B of $80,000 and an uncertain FMV because
she knows that iron ore resides beneath the land but does not know the extent of the deposit. With
this uncertainty, Nora is unwilling to sell the land to Nick for a sum certain. Rather, she sells the
land to Nick for, say, $50,000 at closing in Year 1 plus 10% of the value of each ton of iron ore
that he mines from the land over the next 5 years. Thereafter, Nora receives $40,000 in Year 2,
$50,000 in Year 3, $10,000 in Year 4, and $40,000 in Year 5.
Because at least one payment is made after the sale year, the transaction is an installment sale
under § 453(b), but neither the Gross Profit nor the Total Contract Price is known. In this case,
Nora may use “open transaction reporting,” a method first described in Burnet v. Logan 12 and now
found in Treas. Reg. § 15A.453-1(d)(2)(iii). Under open transaction reporting, Nora would be
permitted to treat 100% of each payment as tax-free recovery of basis until her basis is fully
recovered. Nora would fully exclude 100% of the Year-1 $50,000 payment, as well as $30,000 of
the $40,000 Year-2 payment (including the remaining $10,000). She would fully include the
remaining payments. Because of the time value of money, open transaction reporting is the most
favorable reporting method because the gain is maximally deferred. For this reason, Treas. Reg. §
15A.453-1(d)(2)(ii) permits open transaction reporting only if both (1) the FMV of the sold
property and (2) the total consideration to be received are not ascertainable.

B. The nonrecognition of § 1001 realized gain or loss
This section explores several important nonrecognition provisions in the Code. Those of you
10

See §§ 453(f)(4) and (5).
But see § 453A (imposing an interest charge under certain circumstances).
12
283 U.S. 404 (1931).
11

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who go on to other income tax courses will learn that the basic paradigm in §§ 1033 and 1031 are
used in many other contexts, such as with the transfer of property to controlled corporations or to
partnerships and LLCs in exchange for ownership interests, the transfer of property and stock in
tax-free corporate mergers and other combinations, the tax-free division of a single corporation
into two or more corporations, etc. In each case, the gain or loss that is realized but goes
unrecognized is merely deferred (rather than forgiven) by manipulating the basis rules in such a
way as to perfectly preserve the unrecognized gain or loss for possible future reckoning. Wealthy
taxpayers often take advantage of many of these rules again and again to diversify their property
and financial holdings during life without gain recognition. Then, at death, the final property
transfers to heirs is not a realization event, even though the heirs take a fresh FMV basis under §
1014, forever eliminating the deferred gain from the income tax system; the gain disappears into
the ether, never taxed to anyone.
§ 1033 involuntary conversions of built-in gain property
Suppose that Mark purchases a boat for $100,000 for use in his fishing business. After properly
deducting $60,000 of depreciation under §§ 167 and 168, his basis is reduced under § 1016(a)(2)
to $40,000, though its FMV is $90,000 when a storm destroys the boat on March 2 of Year 1.
Luckily, the boat is fully insured, and Mark receives insurance proceeds of $90,000 on July 1 of
Year 1. Because Mark has been thinking about downsizing his business on the way to retirement,
he decides to replace his boat with a smaller one that costs only $70,000, which he purchases on
September 30 of Year 3, and he pockets the remaining $20,000 in insurance proceeds.
Mark obviously did not wish to engage in a realization event, but a realization event it was
when he received $90,000 in cash for his destroyed boat. Thus, Mark realizes a $50,000 gain under
§ 1001 in Year 1 ($90,000 A/R less $40,000 A/B), which he must include in his Gross Income
under § 61(a)(3)—unless he is eligible to make (and does make) an election under § 1033 to defer
recognition of all or a portion of his realized gain.
Read §§ 1033(a)(2)(A) and (B) and (b)(2). If Mark makes the election referred to in §
1033(a)(2)(A) in Year 1 (by submitting the proper form with his Year-1 tax return) and purchases
property “similar or related in service or use” to his destroyed property by the end of Year 3, he
can avoid recognizing a portion of his $50,000 realized gain. How much can he avoid recognizing?
Under § 1033(a)(2)(A), he must recognize his $50,000 realized gain “only to the extent that the
amount realized upon such conversion … exceeds the cost of [the replacement] property.” Because
Mark’s “amount realized” was $90,000 (equal to the insurance proceeds), and the cost of his new
boat was $70,000, Mark must recognize only $20,000 of his $50,000 realized gain in Year 1 if he
properly makes a § 1033 election.
The $30,000 of unrecognized gain is not forgiven, however, as § 1033(b)(2) requires Mark to
reduce his $70,000 § 1012 cost basis in his new boat by the $30,000 portion of his realized gain
that is not recognized in Year 1. Thus, his new boat’s basis of $40,000 ($70,000 cost basis less
$30,000 of unrecognized gain) perfectly preserves the unrecognized gain. If he sold his new boat
for exactly $70,000 (what he paid for it), he would realize and recognize the $30,000 of realized
gain that was not recognized in Year 1.
Section 1033 is a “rollover” provision that permits Mark to avoid recognizing his realized gain
so long as he “rolls over” 100% of the insurance proceeds that he receives on the involuntary
conversion into the replacement property. To the extent that Mark does not roll over 100% of the
insurance proceeds, he must recognize his realized gain—but no more than his realized gain. If

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Mark’s new boat costs at least $90,000 (equal to 100% of the insurance proceeds that he receives),
Mark recognizes none of his $50,000 realized gain in Year 1, though the cost basis of the new boat
is reduced by the entire $50,000 in that case.
Section 1033, in effect, mimics cash-flow consumption tax treatment. Recall from Chapter 2
that, under a cash-flow consumption tax, the entire “amount realized” on the sale of property is
includable in the tax base (as potential consumption) but that business or investment outlays are
immediately deductible in full, even if the property has a long life and would be a nondeductible
capital expenditure under income tax principles. The end result is that only amounts that are
withdrawn from investment and spent on consumption are taxed. In our hypothetical, only the
$20,000 that Mark does not roll over into the replacement property but rather withdraws from
investment is included in his Gross Income.
One difference between § 1033 and a real cash-flow consumption tax is that § 1033 is not
limited to business or investment property. Realized gain can be deferred even if the property that
is involuntarily converted is personal-use property. For example, return to Barbara’s diamond ring
from earlier in the chapter, which she purchases for $5,000 but which is worth $20,000 when she
sells it, except let’s change the facts so that the ring is stolen, instead, and she obtains $20,000
from her insurance company. If Barbara uses the entire $20,000 insurance proceeds to buy a
replacement diamond ring, she can defer recognizing her $15,000 realized gain, so long as she
properly files a § 1033 election. If she uses only $13,000 of the $20,000 insurance proceeds to buy
a diamond ring, she must recognize $7,000 of her $15,000 realized gain. In either case, she must
reduce her § 1012 cost basis in the new ring by any unrecognized gain on the involuntary
conversion under § 1033(b)(2).
Do not fall into the trap of thinking that any cash that is not rolled over into the replacement
property is includable in Gross Income, however. The taxpayer must always be permitted to
recover his basis tax-free to avoid doubly taxing the same dollars to the same taxpayer. Let’s return
to Mark’s example. Suppose that Mark’s A/B in the boat is $80,000 (instead of $40,000) but that
all of the other facts are the same. As before, Mark receives $90,000 in insurance proceeds when
his boat is destroyed but rolls over only $70,000 in the new boat, pocketing the remaining $20,000.
Mark does not include $20,000 in Gross Income on these changed facts (as he did in our original
example), as his realized gain under § 1001 under these changed facts (Step 1 in the analysis) is
only $10,000 ($90,000 A/R less $80,000 A/B). Revisit the language in § 1033(a)(2)(A), which
provides that “the gain shall be recognized only to the extent that the amount realized upon such
conversion … exceeds the cost of [the replacement] property.” (Emphasis added.) The words “the
gain” refers to Mark’s § 1001 realized gain of $10,000. This analysis reminds us why Step 1 in
any property disposition is to calculate the § 1001 realized gain (or loss). Mark’s $10,000 realized
gain is the most that he can be forced to include in Gross Income. Of the $20,000 of cash that he
does not roll over into replacement property, $10,000 is tax-free basis recovery. In effect, § 1033
provides no benefit for Mark if he retains insurance proceeds in excess of his realized gain.
What is “property similar or related in service or use”? With one exception noted below, the
standard is rigorous. The Tax Court has said that the test is a “functional” one because of the
reference to “service or use.” In Collins v. Commissioner, 13 for example, the Tax Court held that
rental real estate and a retail establishment were not functionally related to chicken houses because
they are used in quite different ways. In Revenue Ruling 76-319, 14 the IRS ruled that a billiards
13
14

29 T.C. 670 (1958).
1976-2 C.B. 242.

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hall is not similar or related in service or use to a bowling alley destroyed by fire. In a PLR the
IRS concluded that art in other media, such as oil paintings, water colors, sculptures, and graphic
art, is not similar or related in service or use to destroyed lithographs. 15
Under § 1033(g) real estate used in business or held for investment has a much easier standard
to meet if (and only if) the involuntary conversion event results from “its seizure, requisition, or
condemnation or threat or imminence thereof.” In that case, § 1033 can be satisfied if the
conversion proceeds are rolled over into “like kind” property—a much easier standard to meet, as
you will learn below—even if the property is not “similar or related in service or use” under the
functional relation test. If the involuntary conversion event is, say, a fire (as in the case of the
bowling alley, above), however, the less rigorous standard in § 1033(g) for real estate does not
apply. Rather, the more rigorous “similar or related in service or use” standard controls.
§ 1031 like kind exchanges
While § 1033 is a rollover provision, allowing the taxpayer who receives cash on an involuntary
disposition to avoid gain recognition to the extent that the cash is used to purchase qualified
replacement property, § 1031 nominally applies only on the exchange of property in kind (and
only if the properties exchanged are of “like kind”). Moreover, while § 1033 avoids the recognition
of only realized gain, § 1031 prevents recognition of both realized gain and loss. Finally, unlike §
1033, § 1031 is not explicitly elective. A taxpayer who realizes a loss and wishes to avoid
nonrecognition must intentionally fail at least one requirement in § 1031—typically the
“exchange” requirement. Like § 1033, however, § 1031 manipulates the basis of the new property
obtained by the taxpayer in the exchange (under § 1031(d)) to preserve any unrecognized gain (or
loss) for future reckoning.
Let’s work our way through § 1031 in a series of fact patterns that start with the simple and
progress through the more complex. After you have a better understanding of the mechanics of §
1031, we shall consider whether it makes sense as a normative or policy matter. Take your time in
working through these examples. Stop and read the statutory language at issue as you progress.
Nora owns ranchland in Montana, which she purchased for $40,000 but which is now worth
$100,000. In each case, we are interested only in Nora’s tax consequences when she exchanges
her property for property owned by Nick. Assume that she holds the ranchland as business property
and will hold the property obtained from Nick as business or investment property.
Example 1
Nora

exchanges with

Ranchland in Montana:
FMV $100,000
A/B $40,000

Nick
Boat:
FMV $100,000

Nora must recognize her $60,000 § 1001 realized gain immediately because § 1031 applies
only to real property exchanges. Even though she exchanged her real property (rather than sold it
for cash), a boat is not real property Because she must recognize her realized gain, she takes a §
1012 cost basis in the boat equal to its $100,000 FMV. 16
15

PLR 8127089 (Apr. 10, 1981).
The rule that the § 1012 cost basis of property received in a taxable exchange is the FMV of the property received
is found in Philadelphia Park Amusement Co. v. U.S., 126 F. Supp. 184 (Ct. Cl 1954), where the Court said:
16

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Example 2
Nora

exchanges with

Ranchland in Montana:
FMV $100,000
A/B $40,000

Nick
Land & office building in Manhattan:
FMV $100,000

Now Nora exchanges her real property for other real property. But is Montana ranchland of
“like kind” with land and an office building in Manhattan? Yes! Treas. Reg. § 1.1031(a)-1(b)
provides that “the words ‘like kind’ have reference to the nature or character of the property and
not to its grade or quality…. The fact that any real estate involved is improved or unimproved is
not material, for that fact relates only to the grade or quality of the property and not to its kind or
class.” Treas. Reg. § 1.1031(a)-1(c) goes on to describe each of the following exchanges as
satisfying the like kind requirement: “a taxpayer who is not a dealer in real estate exchanges city
real estate for a ranch or farm, or exchanges a leasehold of a fee with 30 years or more to run for
real estate, or exchanges improved real estate for unimproved real estate.” Congress has
periodically considered replacing this very generous standard with the one found in § 1033 that
the property received be “similar or related in service or use” to that of the property exchanged,
under which ranchland in Montana could not be exchanged for land and office building without
gain recognition because those properties are used quite differently. The real estate lobby has
worked hard, however, to preserve the § 1031 “like kind” standard for real estate as broad as it is.
Virtually all real estate is of like kind with all other real estate, so long as land is part of both sides
of the exchange.
Prior to the TCJA, like kind non-real estate could be the subject of a§ 1031 exchange, but the
standard for “like kind” was much more rigorous. Treas. Reg. § 1.1031(a)-1(c) provided that an
exchange “of a truck for a new truck or a passenger automobile for a new passenger automobile to
be used for a like purpose” satisfied the like kind requirement, thereby implying that an exchange
of a truck for an automobile would fail the like kind requirement. Revenue Ruling 79-143 17 ruled
that numismatic coins, which are valued on the basis of their age, number minted, history, art and
aesthetics, condition, and metal content, are not of like kind with bullion-type coins, which are

The succinct statement in section [1012] that “the basis of property shall be the cost of such property,”
although clear in principle, is frequently difficult in application…. The view that “cost” is the fair market
value of the property given is predicated on the theory that the cost to the taxpayer is the economic value
relinquished. The view that “cost” is the fair market value of the property received is based upon the theory
that the term “cost” is a tax concept and must be considered in the light of the designed interrelationship of
[§§ 1001 and 1012] and the prime role that the basis of property plays in determining tax liability. We
believe that when the question is considered in the latter context that the cost basis of the property received
in a taxable exchange is the fair market value of the property received in the exchange.
… To maintain harmony with the fundamental purpose of [§§ 1001 and 1012], it is necessary to consider
the fair market value of the property received as the cost basis to the taxpayer. The failure to do so would
result in allowing the taxpayer a stepped-up basis, without paying a tax therefor, if the fair market value of
the property received is less than the fair market value of the property given, and the taxpayer would be
subjected to a double tax if the fair market value of the property received is more than the fair market value
of the property given. By holding that the fair market value of the property received in a taxable exchange
is the cost basis, the above discrepancy is avoided and the basis of the property received will equal the
adjusted basis of the property given plus any gain recognized, or that should have been recognized, or minus
any loss recognized, or that should have been recognized.
17
1979-1 C.B. 264.

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valued on the basis of their metal content alone. Moreover, the statute provided that livestock of
different sexes were not of like kind. For this reason, the vast majority of like kind exchanges have
always involved real estate, for which the like kind standard is so lax. Dave Camp, former
Republican Chair of the House Ways & Means Committee, bravely recommended repeal of § 1031
in his revenue-neutral 2014 tax reform bill, which went nowhere. The TCJA, in contrast, retained
§ 1031 but limited it to exchanges of real estate (only), so long as the real estate is not held
primarily for sale.
Because Nora’s exchange in Example 2 satisfies each of § 1031(a)’s requirements, her $60,000
realized gain (Step 1) will go unrecognized (Step 2). Because she recognizes no gain, we can skip
Step 3 (characterizing that gain). Step 4 requires that she determine her new basis in the Manhattan
property. Under the first sentence in § 1031(d), she will substitute her $40,000 basis in the property
exchanged (the ranchland) for the basis of the Manhattan property received in the exchange
(referred to as a “substituted basis” or “exchanged basis”), allocating the $40,000 between the land
and the building according to their relative FMVs. If the land represents 10% of the total value of
the land and building, she will allocate 10% of her $40,000 basis ($4,000) to the land and the
remaining 90% (36,000) to the building. The substituted basis provided in § 1031(d) ensures that
the $60,000 of realized but unrecognized gain is preserved for possible future reckoning in the
real property that Nora now owns.
Because her basis in the new property is determined by reference to the basis in the property
that she exchanges, § 1223(1) allows Nora to tack on to her holding period in the new property the
period for which she held the ranchland (often referred to as a “tacked holding period”) if the
property that she exchanges is either a capital asset or § 1231 property (examined in Chapter 14),
which should almost always be the case. If, for example, she held the ranchland for 5 years before
the exchange, her holding period on the first day that she owns the Manhattan property is 5 years. 18
Example 3
Nora

exchanges with

Ranchland in Montana:
FMV $100,000
A/B $40,000

Nick
Land & office building in Manhattan:
FMV $80,000
$20,000 cash

Because Nick’s land and office building are worth only $80,000, Nora is not willing to engage
in a straight-up exchange. Rather, she demands that Nick transfer $20,000 in cash to boot, which
is why non-like kind property or cash is typically referred to as “boot” in tax jargon. This exchange
fails the § 1031(a) requirement that Nora receive solely like kind property in exchange for her
ranchland because she received not only like kind property (the land and building) but also boot.
Congress could have provided, on these facts, that Nora effectively (1) sold 20% of the value
of the ranchland for cash and (2) exchanged the remaining 80% of the value of her ranchland for
the Manhattan property. Under (1), she would allocate 20% of her $40,000 basis ($8,000) to the
sale transaction, realizing and recognizing a $12,000 gain. Under (2), she would take a substituted
18

While § 1223(1) applies to substituted (or “exchanged”) basis property, § 1223(2) applies to carryover (or
“transferred”) basis property. Thus, property received by inter vivos gift takes a tacked holding period in the hands of
the donee that includes the period for which the donor held the property because the donee’s basis is determined by
reference to the donor’s basis under § 1015, regardless of the property’s status as capital, ordinary, or § 1231 property.
Property received at death, the basis of which is stepped up (or down) to its FMV under § 1014, is assumed to be held
for more than one year under § 1223(9), regardless of how long the decedent held the property before death.

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basis of $32,000 in the Manhattan property, equal to 80% of her ranchland basis.
But Congress chose another route. Instead, § 1031(b) provides that, if every requirement in §
1031(a) is satisfied except the requirement that she receive “solely” like kind property, Nora must
recognize her realized gain ($60,000) but only to the extent of the boot received ($20,000). To be
specific, it provides that, if the property received by Nora “consists not only of property permitted
… to be received without the recognition of gain [the like kind property], but also of other property
or money [non-like kind property or money, i.e., boot], then the gain [$60,000] … shall be
recognized, but in an amount not in excess of the sum of such money and the fair market value of
such other property [i.e., not in excess of the boot].” In short, Nora recognizes her $60,000 realized
gain only to the extent of the $20,000 boot that she receives. Notice that this approach is not as
favorable to Nora as the alternative approach described in the last paragraph, as she must recognize
$20,000 (instead of only $12,000) of her $60,000 realized gain.. In effect, § 1031(b) requires that
boot obtained in exchange for like kind property is allocated entirely to any built-in gain in
the like kind property first (before being allocated to tax-free basis recovery).
Just as in Example 2, Nora’s $40,000 unrecognized gain is not forgiven but merely deferred
under the § 1031(d) basis rule. Under § 1031(d), the aggregate basis of property (other than
money) received in a like kind exchange is “the same as that of the property exchanged
[$40,000], decreased by any money received by the taxpayer [less $20,000] and increased in
the amount of gain or decreased in the amount of loss to the taxpayer that was recognized
on such exchange [plus $20,000],” or $40,000. The reason why Nora must reduce her basis in the
Manhattan property by any money received is because cash automatically has a basis equal to its
face amount. If, for example, Nora uses that $20,000 in cash to purchase Blackacre, she would
take a $20,000 cost basis under § 1012 in Blackacre. We cannot allow her to also include that same
$20,000 in the basis of the Manhattan property received from Nick, or Nora would be getting a
double tax benefit (double basis) for the same dollars. Alternatively, if Nora uses that $20,000 to
take a vacation to Paris, the $20,000 outlay is a nondeductible personal expense under § 262(a),
and Nora should not obtain a tax benefit indirectly by allowing that same $20,000 to create basis
in the Manhattan property. The reason why Nora must increase her basis by any gain that is
recognized on the exchange is to ensure that she is not taxed a second time on that same $20,000
gain when she sells the Manhattan property or else she would be doubly taxed on the same dollars.
Under § 1031(d), Nora’s basis in the new property will be $40,000 ($40,000 less $20,000 plus
$20,000). Because the Manhattan property has an FMV of $80,000, Nora’s $40,000 unrecognized
gain is perfectly preserved in the basis of her new property. In contrast, if Nora’s exchange fails §
1031 (because, say, she plans to use the new property as her personal residence rather than as
business or investment property), then Nora would recognize her entire $60,000 realized gain on
the exchange, and she would take an $80,000 FMV basis in the new property under § 1012 instead
of a substituted basis under § 1031(d).
Example 4
Nora

exchanges with

Ranchland in Montana:
FMV $100,000
A/B $40,000

Nick
Land & office building in Manhattan:
FMV $30,000
$70,000 cash

Because Nick’s property is worth only $30,000, Nora demands that he transfer $70,000 in cash
to boot. Do not translate § 1031(b) to mean “include the boot.” That is not what § 1031(b) says.

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Indeed, if Nora were forced to include the entire $70,000 in cash received, she would include
$10,000 of what should be tax-free basis recovery! After all, if Nora sold her ranchland entirely
for $100,000 in cash, she would realize and recognize only a $60,000 gain under § 1001. This
result is not changed simply because she receives only $70,000 in cash and property worth
$30,000. Nora realizes no wealth accession in the tax sense to the extent of basis recovery.
Because the boot that Nora receives exceeds her realized gain, § 1031 provides no benefit.
Under § 1031(b), Nora must recognize her $60,000 realized gain but not in excess of (i.e., no more
than) the $70,000 boot received. She must recognize 100% of her $60,000 realized gain. The final
$10,000 of boot that Nora receives is tax-free basis recovery. Under § 1031(d), she takes a basis
in Manhattan property equal to her $40,000 ranchland basis less the $70,000 money received plus
the $60,000 recognized gain, or $30,000 (the property’s FMV). Because Nora has recognized
100% of her realized gain, this result is not surprising; there is no unrecognized gain to preserve.
Example 5
Nora

exchanges with

Ranchland in Montana:
FMV $100,000
A/B $120,000

Nick
Land & office building in Manhattan:
FMV $80,000
$20,000 cash

Notice that Nora’s property has a built-in loss rather than a built-in gain. Under Step 1, she
realizes a $20,000 § 1001 loss on this exchange. Can she recognize this loss, which would allow
her to deduct it now under § 165 in Step 2? She would prefer that result because of the time value
of money. While § 1031(a) prevents the recognition of both gain and loss, this exchange fails the
“solely” requirement in § 1031(a). In the case of gain, you learned that § 1031(b) forces gain
recognition on the receipt of boot. Can she recognize loss just because she receives boot?
Alas, even though § 1031(a), which would deny her loss recognition, does not apply because
she fails the “solely for” requirement, § 1031(c) nevertheless steps in to deny her loss recognition
on the receipt of boot. Nora’s loss is not forever lost, however, as it is preserved in the basis of the
Manhattan property, which will take a basis under § 1031(d) equal to her $120,000 ranchland basis
less the $20,000 in “money” received, or $100,000. Because the new property is worth only
$80,000, her $20,000 realized but unrecognized loss is preserved. Because of the time value of
money, however, this result is cold comfort to Nora. What should Nora have done? She should
have sold her property for $100,000 in cash (to Nick or to someone else), thus ensuring that she
would fail the “exchange” requirement in § 1031(a). If she really wants the Manhattan property,
she can purchase it with the cash obtained on the sale.
Example 6
Nora

exchanges with

Ranchland in Montana:
FMV $100,000
A/B $40,000

Nick
Land & office building in Manhattan:
FMV $80,000
Boat: FMV $20,000

These facts are the same as Example 3, except that Nora’s boot receipt is in the form of property
in kind with an FMV of $20,000 (the boat) rather than $20,000 in cash. The boat is, indeed, boot
for Nora because it is not real property. Thus, Nora must recognize $20,000 of her $60,000 realized
gain under § 1031(b), just as she does in Example 3.

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She has an additional question in Example 6 that she did not have when her boot was in the
form of cash. What is her basis in the boat under § 1031(d)? Under the first sentence in § 1031(d),
her aggregate new basis in all the property that she receives (other than money) is the same as that
of the ranchland that she exchanges ($40,000) less “money” received ($0), plus recognized gain
($20,000), or $60,000. How does she allocate this $60,000 basis between the two properties that
she now owns: the like kind Manhattan property and the boot property (the boat)? Read the second
sentence in § 1031(d). The boot property (the boat) takes an FMV basis of $20,000, with the
remaining amount ($40,000) allocated to the like kind Manhattan property. If she sells the
Manhattan property for $80,000 in cash, she realizes and recognizes the $40,000 gain that went
unrecognized on the initial exchange. If Nora sells the boat, instead, for $20,000 in cash, she
realizes no gain or loss, as her amount realized is equal to her basis. In short, the second sentence
in § 1031(d) ensures that the entire $40,000 unrecognized gain is reflected in the like kind property
(not the boot property), as the like kind property permits this $40,000 gain to go unrecognized in
the first place.
Example 7
Nora

exchanges with

Ranchland in Montana:
FMV $100,000
A/B $40,000
Boat
FMV $30,000
A/B $40,000

Nick
Land & office building in Manhattan:
FMV $130,000

Because Nick’s property is worth $130,000 while Nora’s Montana ranchland is worth only
$100,000, Nick is now the one who demands that Nora throw in additional cash or property to
boot. Thus, Nora disposes of two pieces of property in exchange for Nick’s property. Recall from
Part A. that Nora cannot simply add the basis of the two pieces of property together and determine
a single § 1001 realized gain or loss in Step 1. Rather, she must separately apply § 1001 to each
piece of property. Nora realizes (1) a $60,000 gain on the exchange of the ranchland for $100,000
worth of the Manhattan property and (2) a $10,000 loss on the exchange of the boat for $30,000
worth of the Manhattan property. The ranchland/Manhattan property exchange satisfies each
requirement in § 1031(a), so none of the $60,000 realized gain on the exchange of the ranchland
for the Manhattan property is recognized.
Because a boat is not real property, however, the ranchland/boat exchange fails § 1031(a),
which means that Nora’s $10,000 realized loss on the boat disposition is immediately recognized.
If she uses this boat in her business, this recognized loss would be deductible under § 165(c)(1).
In contrast, if she uses this boat for recreation, this recognized loss would be nondeductible under
§ 165(c)(3). It’s important to note that the loss is “recognized” in either case, however, because
the recognized loss will factor into her basis of the Manhattan real property under § 1031(d).
What would be Nora’s basis in the Manhattan property? Walk through that first sentence in §
1031(d) very carefully. Her substituted basis includes the basis in both of the properties that she
transfers to Nick (not merely the real property)—a total of $80,000—less “money” received ($0)
less recognized loss ($10,000), or $70,000. Because the Manhattan property has an FMV of
$130,000, Nora’s $70,000 basis perfectly preserves her $60,000 realized gain that is not recognized
on the exchange.

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Some students want to cite § 1031(b) in Example 7 when analyzing Nora’s tax consequences,
but § 1031(b) is irrelevant to Nora because she did not receive boot in addition to the Manhattan
property. Section 1031(b) would be relevant only to Nick’s tax consequences if he, too, were
applying § 1031 because the boat receipt would be boot to him, forcing him to recognize some or
all of any realized gain on the exchange of the Manhattan property (but not, under § 1031(c),
allowing him to recognize any realized loss). Because we do not know Nick’s bases in the
Manhattan property, however, we do not have sufficient information to determine how the boat
receipt would affect his tax consequences.
Finally, how does § 1031 operate if property is encumbered with debt? Does debt relief
constitute boot? And how does Crane apply in the context of § 1031 exchanges? The applicable
rules have to be deduced from working through the examples found at Treas. Reg. § 1.1031(d)-2.
In effect, they provide three important rules.
• For purposes of possible gain recognition under § 1031(b), net liability relief is treated as
boot received. If the taxpayer enjoying net liability relief also transfers cash boot, however,
the cash transferred will reduce the boot deemed received.
• Gross liability relief is treated as “money received” for purposes of computing basis in the
property received under § 1031(d).
• Gross liability assumption is added to the basis of the property received under § 1031(d) to
implement Crane’s front-end rule that acquisition debt is included in property basis.
These rules are illustrated in Example 8.
Example 8
Nora

exchanges with

Ranchland in Montana:
FMV $100,000
A/B $40,000
subject to $30,000 debt

Nick
Land & office building in Manhattan:
FMV $80,000
subject to $20,000 debt
$10,000 cash

These facts are a variation on Example 2, except that both properties are encumbered by debt.
In determining how much boot Nora would demand in exchange for her encumbered ranchland,
she would determine the net value that she is transferring to Nick and demand the same net value
in the package received from him. Because Nora’s ranchland has an FMV of $100,000 but is
subject to a $30,000 debt, the net value that she is transferring to Nick is $70,000. Because Nick’s
Manhattan property has an FMV of $80,000 but is subject to a $20,000 debt ($60,000 of net value),
Nora would demand $10,000 of cash boot to even up the deal, and Nick agrees.
In Step 1, Nora’s realized gain remains $60,000 (as in Example 2). The easy way to determine
this is simply to compare the ranchland’s A/B and FMV. 19 In Step 2, she is deemed to receive
$20,000 in boot for purposes of § 1031(b), which is equal to the $10,000 in cash plus the $10,000
of net liability relief that she enjoys (the amount by which the $30,000 debt encumbering her
ranchland exceeds the $20,000 debt encumbering the Manhattan property received from Nick).
Thus, Nora must recognize $20,000 of her $60,000 realized gain under § 1031(b).
19

The more convoluted way to determine this is to compute her § 1001(b) “amount realized” as equal to the $10,000
cash received plus the $60,000 net value in the Manhattan property received plus the $30,000 liability relief under
Crane’s back-end rule. The excess of this $100,000 A/R over her $40,000 A/B produces a $60,000 realized gain.

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Under § 1031(d), her basis in the like kind property received is equal to the $40,000 basis in
the ranchland that she transfers less $40,000 in “money” deemed received ($10,000 in actual cash
and $30,000 in gross liability relief) plus $20,000 recognized gain plus $20,000 Crane basis (equal
to the gross debt assumed), or $40,000. Because the FMV of the like kind property received is
$80,000, this basis perfectly preserves her $40,000 realized but unrecognized gain. Whew!
You may have noticed as we moved along that there is a handy dandy shortcut for determining
Nora’s basis in the like kind property obtained in the exchange. Simply determine its FMV and
reduce it to reflect any unrecognized gain (or increase it to reflect any unrecognized loss). Any
boot property received in kind takes a FMV basis. We expressly took this approach when we
applied § 1033(b)(2) in the case of an involuntary conversion followed by a rollover into property
similar or related in service or use. Better yet, do it both ways (under § 1031(d)’s very precise
formula and under the shortcut) to double check yourself. Either way, if you applied § 1031
correctly, the basis in the like kind property obtained in the exchange should perfectly preserve the
unrecognized gain or loss on the exchange.
Three-corner exchanges
In the real world, it is rare to find two property owners who happen to each want what the other
one owns. More often, only one (tax conscious) party wishes to engage in an exchange rather than a
sale. Suppose, for example, that Nora wishes to dispose of her property in a § 1031 exchange that
will allow some of her $60,000 built-in gain to go unrecognized. She likes Nick’s Manhattan
property, but Nick is not interested in engaging in a like kind exchange. Rather, he has listed his
property for sale because he wants cash. Suppose further that Asta (I told you that we would bring
Asta into the picture) has $100,000 in cash, that she is interested in acquiring Nora’s property, but
that Nora has refused to sell to Asta because, as just noted, she wants at least some of her realized
gain to go unrecognized under § 1031. What can the parties do?
One possibility is that they could engage in two transactions. In the first, Asta could buy Nick’s
Manhattan property for $80,000. In the second, Asta could exchange the land and building just
purchased from Nick, along with $20,000 in cash, for Nora’s ranchland. That would work, but it
could trigger four real estate transfer taxes (instead of two) because Nick’s property is located in
Manhattan. Both New York City and New York State impose real estate transfer taxes. Moreover,
suppose that Asta does not wish to take title to the Manhattan property, even for a nanosecond,
because she is concerned about, say, toxic sludge that may lie beneath the building, for which she
could become liable under environmental law as an owner in the chain of title. If they wish to
avoid two transactions, is there another viable option?
They could engage in a deferred, three-corner exchange, but they would need to ensure that
they avoid the problem illustrated in Crandall.
CRANDALL v. COMMISSIONER
T.C. Summary Opinion 2011-14
PANUTHOS, CHIEF SPECIAL TRIAL JUDGE: This case was heard pursuant to the provisions of
section 7463 of the Internal Revenue Code in effect when the petition was filed. Pursuant to section
7463(b), the decision to be entered is not reviewable by any other court, and this opinion shall not
be treated as precedent for any other case.
Respondent determined a deficiency of $14,475 in petitioners’ 2005 Federal income tax and an

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accuracy-related penalty of $2,895. After concessions, the sole issue for decision is whether
petitioners are entitled to nonrecognition of gain under section 1031 for a 2005 real estate
transaction.
Background
Petitioners resided in California at the time the petition was filed. Petitioners owned an
undeveloped parcel of property in Lake Havasu City, Arizona (Arizona property). Petitioners held
the Arizona property for investment. Petitioners desired to own investment property closer to their
California residence. After receiving some limited advice concerning a tax-free exchange of
properties, petitioners took steps to sell the Arizona property and purchase new property with the
intention of executing a tax-free exchange. On March 4, 2005, petitioners sold the Arizona
property for $76,000. The buyers of the property paid petitioners $10,000, and the remaining
$66,000 was placed in an escrow account with Capital Title Agency, Inc. (Capital Title). At
petitioners’ direction $61,743.25 was held in the escrow account. Capital Title initially released
$4,256.75 to petitioners. Petitioners’ basis in the Arizona property was $8,500. This payment was
transferred from the Capital Title escrow account to the Chicago Title escrow account as
petitioners directed.
The Capital Title and Chicago Title escrow agreements did not reference a like kind exchange
under section 1031, nor did they expressly limit petitioners’ right to receive, pledge, borrow, or
otherwise obtain the benefits of the funds.
Discussion
The general rule regarding recognition of gain or loss on the sale or exchange of property is that
the entire amount of the gain or loss is recognized. Sec. 1001(c). An exception to the general rule
is found in section 1031.
Section 1031 provides that no gain or loss is recognized when business or investment property
is exchanged solely for other business or investment property of like kind. The regulations define
“like kind” as a reference to the nature or character of the property and not the property’s grade or
quality. Sec. 1.1031(a)-1(b), Income Tax Regs. In order to take advantage of the nonrecognition
provisions of section 1031 through a deferred exchange, a taxpayer must satisfy a number of
technical requirements. Sec. 1031(a)(3); sec. 1.1031(k)-1, Income Tax Regs.
A deferred exchange is defined as “an exchange in which, pursuant to an agreement, the
taxpayer transfers property held for * * * investment * * * and subsequently receives property to
be held * * * for investment”. Sec. 1.1031(k)-1(a), Income Tax Regs. To qualify as a deferred
exchange the transaction must be an exchange of property, not a transfer of property for money.
Id. The reinvestment of the proceeds from a cash sale of one property into a second property of
like kind will not qualify as a section 1031 exchange. Greene v. Comm’r, T.C. Memo. 1991-403
(citing Carlton v. U.S., 385 F.2d 238, 242 (5th Cir. 1967), Coastal Terminals, Inc. v. U.S., 320
F.2d 333, 337 (4th Cir. 1963), and Estate of Bowers v. Comm’r, 94 T.C. 582, 589 (1990)); Lee v.
Comm’r, T.C. Memo. 1986-294; Gibson v. Comm’r, T.C. Memo. 1982-342; sec. 1.1031(k)-1(a),
Income Tax Regs. Gain or loss may be recognized if the taxpayer actually or constructively
receives money that does not meet the qualifications of section 1031(a) before the taxpayer actually
receives like kind property. Sec. 1.1031(k)-1(a), Income Tax Regs.
“The taxpayer is in constructive receipt of money or property at the time the money or property
is credited to the taxpayer’s account, set apart for the taxpayer, or otherwise made available so that
the taxpayer may draw upon it at any time.” Sec. 1.1031(k)-1(f)(2), Income Tax Regs. If the
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taxpayer’s control of receipt of the money or property is subject to substantial limitations or
restrictions, then there is no constructive receipt. Id. To avoid being in constructive receipt of
money or property, a taxpayer may use a qualified escrow account. Section 1.1031(k)-1(g)(3),
Income Tax Regs., defines a qualified escrow account as the following:
(ii) A qualified escrow account is an escrow account wherein—
(A) The escrow holder is not the taxpayer or a disqualified person * * *, and
(B) The escrow agreement expressly limits the taxpayer’s right to receive, pledge, borrow, or
otherwise obtain the benefits of the cash or cash equivalent held in the escrow account * * *.
The taxpayer’s own limitation of use of the funds does not convert the escrow account into a
qualified escrow account. Klein v. Comm’r, T.C. Memo. 1993-491.
The Arizona property and the California property are like kind properties. At issue is whether
there was an exchange within the meaning of the statute and the regulations. We have no doubt
that petitioners intended the transaction to qualify under the provisions of section 1031. However,
it is well established that a taxpayer’s intention to take advantage of tax laws does not determine
the tax consequences of his transactions. Bezdjian v. Comm’r, 845 F.2d 217 (9th Cir. 1988), affg.
T.C. Memo. 1987-140; Carlton v. U.S., supra at 243 (citing Comm’r v. Duberstein, 363 U.S. 278,
286 (1960)). To support their argument, petitioners testified that the funds in the Capital Title
escrow account were held solely for the purchase of the California property and that they received
no proceeds from the sale of the Arizona property.
Respondent argues that petitioners’ transactions were a sale and reinvestment of the proceeds
because the Capital Title escrow agreement did not expressly restrict petitioners’ access to and use
of the funds held in the escrow account. Respondent asserts that petitioners were in constructive
receipt of the proceeds from the sale of the Arizona property and that the gain on the sale must be
recognized in 2005.
The underlying purpose of section 1031 is to permit a taxpayer to defer gain with respect to “an
ongoing investment, rather than ridding himself of one investment to obtain another.” Teruya
Bros., Ltd. v. Comm’r, 580 F.3d 1038, 1042 (9th Cir. 2009) (citing Starker v. U.S., 602 F.2d 1341,
1352 (9th Cir. 1979) (“The legislative history [of sec. 1031] reveals that the provision was designed
to avoid the imposition of a tax on those who do not ‘cash in’ on their investments in trade or
business property.”)), affg. 124 T.C. 45 (2005).
Neither escrow agreement expressly limited petitioners’ right to receive, pledge, borrow, or
otherwise obtain the benefit of the funds nor made any mention of a like kind exchange. Because
of the lack of limitations, neither escrow account was a qualified escrow account. See Hillyer v.
Comm’r, T.C. Memo. 1996-214; Lee v. Comm’r, supra. Although petitioners used the funds in the
Capital Title escrow account to purchase the California property, the lack of express limitations in
the escrow agreement results in petitioners’ being treated as having constructively received the
proceeds.
We conclude that the disposition of the Arizona property was a sale and the funds deposited in
the Capital Title escrow account represent the receipt of the proceeds. See sec. 1001(c).
Consequently, this transaction does not qualify for section 1031 nonrecognition, and petitioners
must recognize gain for 2005. See sec. 1001(c). The Court notes that the tax consequences are not
what petitioners intended and the result may seem somewhat harsh. However, Congress enacted
strict provisions under section 1031 with which taxpayers must comply.

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____________________________________
In Crandall, the taxpayer retained power over the escrow agent to have all of the proceeds from
the sale of his property transferred to himself. Crandall (and many cases like it) illustrates an
important lesson. If the intermediary obtaining the cash is under the control of the taxpayer, the
intermediary is considered to be the taxpayer’s agent. Receipt of cash by the taxpayer’s agent is
considered receipt by the taxpayer (remember Poe v. Seaborn in Chapter 8?), and the “exchange”
requirement in § 1031(a) is failed. Because the escrow agreement did not limit Mr. Crandall’s right
to obtain the cash from the escrow account, the Tax Court concluded that Mr. Crandall was in
constructive receipt of the cash paid to the escrow agent by the purchasers of his Arizona property.
In short, he was considered to have simply sold his Arizona property for cash and then reinvested
most of the cash in the California property. Only property exchanges qualify for § 1031 treatment.
Nora could sell her property for cash and still obtain the benefits of § 1031 so long as she (1)
arranges (prior to the sale) for the cash to be received by a third party that avoids the Crandall
failure (a qualified intermediary) and (2) buys the replacement property (with funds held by the
qualified intermediary) within the time limitations found in § 1031(a)(3) for so-called deferred
exchanges. A § 1031 firm that specializes in helping people like Nora can set up the qualified
intermediary arrangement properly and, just as important, can help her to find suitable replacement
real property within the time limits prescribed in § 1031(a)(3).
Treas. Reg. § 1.1031(k)-1(g) provides several “safe harbors the use of which will result in a
determination that the taxpayer is not in actual or constructive receipt of money or other property.”
As cited in Crandall, a “qualified escrow account” requires that “[t]he escrow agreement expressly
limits the taxpayer’s rights to receive, pledge, borrow or otherwise obtain the benefits of the cash
or cash equivalent in the escrow account.”
In effect, Nick and Nora could transfer their titles to the Montana ranchland and the Manhattan
property, respectively, and Asta could transfer the $100,000 in cash—all to the qualified
intermediary. The intermediary would then transfer $80,000 in cash to Nick, the Montana ranchland
to Asta, and the Manhattan property plus the remaining $20,000 cash to Nora. Nick would recognize
any realized gain (or loss). If the transaction is structured correctly, however, Nora’s exchange would
be governed by § 1031(b), and she would have the tax consequences described in Example 3, above.
(Asta simply takes a cost basis under § 1012 in the Montana ranchland.)
The outcome in Crandall may bother some students. After all, he had every intention of using §
1031 and tried in good faith to come within the provision by setting up the escrow account. What
are judges to do, however, when Congress deliberately writes an “exchange” requirement into
§ 1031—particularly when Congress has shown that it knows well how to draft a rollover provision
when it wants one? Indeed, numerous bills have been introduced over the years to transform § 1031
from an “exchange” provision to a “rollover” provision, but the (lucrative) § 1031 industry works
very hard to keep § 1031 as it is, under which professional help is usually needed to avoid just the
kind of traps for the unwary that tripped up Mr. Crandall. Under these circumstances, a court has no
choice but to give effect to the exchange requirement if it is to act like a court and not a legislature.
What is the difference between a “sale,” on the one hand, and an “exchange,” on the other? The
fundamental difference is the receipt of unfettered cash in the former.
Should Congress amend the statute to make it a rollover provision? Well, that might depend on
whether you think § 1031 is a good idea in the first place and what rationale you think underlies
§ 1031 ... which provides a nice segue to a discussion of the policy ramifications of § 1031.
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Does § 1031 reflect sound policy?
Supporters of § 1031 typically cite several rationales to justify it. First, some argue that it allows
the parties to avoid having to establish a value for the properties (in order to calculate § 1001
realized gain) because the taxpayers simply substitute their old basis for the basis in the property
received in the exchange. Convincing? In the real world, every property exchanged under § 1031
is formally appraised in order for each party to determine whether he or she should demand boot
to even up the deal. Indeed, a § 1031 deal without boot is a very rare species!
Second, some argue that the lack of liquidity (cash) justifies deferral. Convincing? The lack of
liquidity is self-imposed because § 1031 continues to exist. Few in a modern economy would ever
exchange real estate if § 1031 were repealed. Moreover, in other contexts, the receipt of an asset in
kind provides no deferral. For example, when an employer transfers Blackacre to an employee as
compensation for services rendered, you know well by now that the employee must include the FMV
of the property in his Gross Income under § 61(a)(1). The employee may have to sell Blackacre or
mortgage it to pay the resulting tax due. Why should § 61(a)(3) gain be on any different footing?
Moreover, unlike in the § 1033 context, the realization event here is not involuntary.
Those shortcomings leave us with two alternative ways to view § 1031. Because the taxpayer has
continued his investment in the same kind of property under the “like kind” requirement, some argue
that he should not be considered as having “realized” the built-in gain or loss in the exchanged
property, even though of course it is technically “realized” when he disposes of the property. This
view was encapsulated in § 1031’s legislative history when it was originally enacted way back in
1921. (Apparently, it was common at the time for ranchers to swap acreage.) But if that is the
rationale, the “like kind” standard is woefully inadequate. Rural farmland and a skyscraper on an
urban lot are quite different investments with very different risks and returns, and yet they are
considered to be of like kind. In short, under this rationale, § 1031 is too broad as drafted.
The alternative view is that § 1031 implements a consumption tax value. Because the investment
remains tied up, rather than spent on consumption, the built-in gain should be deferred until it is no
longer rolled over into another investment. Under this view, the “like kind” requirement is far too
narrow; an exchange of any sort of investment property for investment property should qualify,
whether or not the properties are real estate. Recall, for exaample, Nora’s exchange of her farmland
for a boat, which fails to qualify for nonrecogntion under § 1031, as does exchanges of other types
of investment property, such as stocks and bonds. And rollovers, rather than merely exchanges,
should qualify, as well, if that is § 1031’s rationale.
In other words, current § 1031 appears to be incoherent; it is either too broad or too narrow,
depending on which view you take regarding the rationale underlying § 1031.
Another serious concern is that § 1031 violates the neutrality economic norm discussed in Chapter
3 and thus exacts efficiency costs. That is to say, taxpayers may funnel resources into less profitable
before-tax properties rather than into more economically profitable investments that would reflect a
more efficient allocation of capital across the economy because the latter would result in immediate
gain recognition that is avoided under the former.
Finally, when combined with the § 1014 step up in basis at death, nonrecognition provisions like
§ 1031 (and those studied in other income tax courses) contribute meaningfully to the avoidance of
income tax on property gain, while the types of wealth accessions more commonly realized by
middle-class taxpayers (wages) are taxed. In short, these provisions contribute meaningfully to
wealth inequality over time.

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Public finance economist Martin A. Sullivan summarizes the economic case against § 1031. 20
In 2013 then-Senate Finance Committee Chair Max Baucus [Democrat] suggested
repealing § 1031. And in 2014 then-House Ways and Means Committee Chair Dave
Camp [Republican] proposed a sweeping tax reform plan that included repeal of §
1031…. The Joint Committee on Taxation estimated that Camp’s proposed
elimination of like-kind exchanges would raise $41 billion over 10 years.
There is a massive lobbying effort to preserve § 1031. Supporters of retaining
current law include the National Association of Realtors, the National Association of
Real Estate Investment Trusts, and the Federation of Exchange Accommodators.
Despite this loud clamor for keeping current law, the economic case for repealing §
1031 is straightforward. Like-kind exchanges distort investment within the real estate
industry …; they distort investment across industries; and qualifying for § 1031
benefits requires engaging in transactions and complying with rules that are costly to
the taxpayer and unproductive for the economy….
Section 1031 distorts the allocation of investments across industries. In general, in
order to promote maximum economic growth, the tax system should tax all industries
equally. Otherwise, there will [be] too much investment in tax-favored sectors and too
little in others.
An exception to the level-playing-field rule arises when industries generate positive
externalities. Businesses that conduct significant amounts of research and
development generate positive spillover benefits for the economy for which they are
not fully compensated. Therefore, there is an economic justification for a tax subsidy
directed to research-intensive industries…. There are no readily apparent positive
externalities associated with [real estate exchanges]. So there appears to be no
economic justification for the beneficial treatment made available to them by §
1031….
Commentators often remark on the generous breadth of [the like kind standard for
real estate], but from an economics perspective it is not broad enough. It does not help
the economy for tax rules to encourage an investor to remain in real estate if other
investments offer a higher pre-tax rate of return….
[R]evenue raised from the repeal of § 1031 could be used to lower income tax rates
as part of a 1986-style tax reform…. Or revenues from repeal could be used to enlarge
economically justified tax subsidies, such as the research credit.
As intimated above, however, § 1031 has created an exchange industry. 21 Notwithstanding its
conceptual weaknesses, the real estate lobby works very hard to keep § 1031 in place and to keep
the “like kind” standard as lax as it is.
§§ 1400Z-1 and -2 Qualified Opportunity Zones and Funds
The TCJA enacted new §§ 1400Z-1 and 1400Z-2, which creates significant new tax preferences
for investors who roll over capital gains into Qualified Opportunity Zones (QOZ) through the
20

Martin A. Sullivan, The Simple Economics of Like-Kind Exchanges, 148 TAX NOTES 491 (2015).
For example, § 1031 firms have placed half-page advertisements in the New York Times with “1031 Exchanges—
Preserving Wealth Using the Tax Code” in large type. See, e.g., N.Y. TIMES, Oct. 8, 2008, at B15.
21

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purchase of an interest in a Qualified Opportunity Zone Fund (QOF), which is a corporation or
partnership with at least 90% of its assets consisting of QOZ property.
A Qualified Opportunity Zone is a low-income population census tract (or a census tract that is
contiguous with a low-income tract that is also designated as a QOZ) that is nominated by each
state’s Governor (and the D.C. mayor) and certified by the Secretary of the Treasury as satisfying
certain criteria. As of December 2019, more than 8,700 census tracts (12% of all census tracts)
were certified as Qualified Opportunity Zones. A QOZ designation remains in effect for 10 years.
An investor who realizes any sort of gain (such as on the sale of stock or real estate) and who
invests that gain within 180 days in a QOF defers recognition of that gain until the earlier of
December 31, 2026, or sale of the QOF interest. Any investment in a QOF made with deferred
gain takes a $0 basis. In addition to deferral until 2026, the investor may enjoy three additional tax
benefits, although the investment must have been made before December 31, 2019, to take full
advantage of the first two. First, if the investor holds the QOF interest for at least 5 years before
December 31, 2026, he increases his basis by 10% of the deferred gain. Second, if the investor
holds the QOF interest for an additional 2 years (7 years total) before December 31, 2026, he
increases his basis by another 5% of the deferred gain (for a total basis increase of 15%). Finally,
if the investor holds the QOF interest for at least 10 years, he excludes 100% of any realized gain.
This gain will not reflect any of the originally deferred gain, which the investor must include on
December 31, 2026, reduced (if eligible) by the 10% or 15% basis increase mentioned above.
Example. On August 1, 2019, Ann sells stock for $12 million, which she had purchased
years ago for $2 million. On December 20, 2019, she invests her $10 million realized
gain in a QOF. On December 27, 2029, Ann sells her QOF interest for $18 million.
Ann does not include the $10 million realized gain on her 2019 tax return, saving $2
million in tax (20% capital gains rate), and she takes a $0 basis in her QOF interest. On
December 20, 2024, Ann increases her QOF basis from $0 to $1 million (10% of her
deferred gain). On December 20, 2026, she increases her basis by another $500,000 (5%
of her deferred gain) to $1.5 million. On December 31, 2026, Ann includes $8.5 million
of capital gain, which is her $10 million deferred gain reduced by her $1.5 million basis,
paying $1.7 million in capital gains tax. In this way, Ann both deferred her $10 million
gain from 2019 to 2026 (enjoying the time value of money) and reduced that gain from
$10 million to $8.5 million, to boot! Ann increases her QOF basis by her $8.5 million
recognized gain to $10 million. When Ann sells in 2029, she realizes an $8 million gain
($18 million A/R less $10 million A/B), but she entirely excludes this gain (saving $1.6
million in tax) because she held her QOF interest for at least 10 years.
In total, Ann realizes $18 million of capital gains ($10 million in 2019 and $8 million in
2029) but pays only $1.7 million in capital gains tax (in 2026)—a 9.4% capital gains rate
(coupled with the time value of the deferral).
The QOZ legislation has been criticized on several grounds. First, it rewards investments that
would have been made anyway, creating inefficient windfall losses in tax revenue. An Urban
Institute Report 22 found that many of the developers they interviewed said that they would have
proceeded even without a tax incentive. Second, the legislation directly benefits only the wealthy
22

THE URBAN INSTITUTE, An Early Assessment of Opportunity Zones for Equitable Development Projects, at
https://www.urban.org/research/publication/early-assessment-opportunity-zones-equitable-developmentprojects/view/full_report.

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investors, not those who live and work in QOZs. The Urban Institute study reports that most of the
investment is going to real estate, particularly high-return luxury real estate development, rather
than lower-margin projects that could bring jobs and services to black communities. The reporting
requirements of the program require only identification of the investors and a description of the
QOZ property, so it will be very difficult to determine whether it has a positive economic impact
or whether it merely enriches investors who would have invested anyway.
§ 267(a)(1) sales of loss property to a related party
Mom owns Blackacre as investment property, which she purchased years before her marriage
to Dad for $150,000, but which is now worth only $140,000. It has a juicy $10,000 built-in loss,
just waiting to be realized, recognized, and deducted under § 165(c)(2). While the loss would be
capital, subject to the § 1211(b) capital loss limitation rule, Mom can generate sufficient capital
gain to allow immediate deduction of the loss.
Under the mark-to-market approach to changes in property value explored in Chapter 1, Part
A., Mom would be able to deduct those losses in Blackacre value as they occur each year, but the
realization requirement prevents this result. Mom could, of course, sell Blackacre to a stranger and
obtain her desired deduction, but Mom really does not wish to do that, as she likes the location and
thinks that future development will be profitable. What to do?
If she sells to Dad, you learned in Chapter 8 that § 1041(a)(1) would prevent recognition of her
her realized loss. What if she sells to Junior, their son, for $140,000? Read §§ 267(a)(1), (b)(1),
and (c)(4). Mom’s $10,000 realized loss is disallowed but possibly preserved for future use, though
in an unusual manner. Junior does not take Mom’s $150,000 basis but rather takes a $140,000 cost
basis under § 1012, as usual. If Junior later sells the property for, say, $180,000, however, his
$40,000 § 1001 realized gain ($180,000 A/R less $140,000 A/B) is recognized only to extent of
$30,000. See § 267(d). What if Junior is later able to sell Blackacre for only $120,000 (instead of
$180,000)? In that case, his realized loss is only $20,000 ($120,000 A/R less $140,000 A/B); no
provision in § 267 allows him to augment his $20,000 realized loss by the $10,000 loss deduction
that was denied to Mom on her earlier sale to him.
§ 1091 wash sales of loss securities
Mom owns stock in High Tech Corp, which she purchased years before for $150,000 but which
is now worth only $140,000. It has a juicy $10,000 built-in loss, just waiting to be realized,
recognized, and deducted under § 165(c)(2). While the loss would be capital, subject to the §
1211(b) capital loss limitation rule, Mom can generate sufficient capital gain to allow immediate
deduction of the $10,000 loss. Mom could, of course, sell her High Tech stock and obtain her
desired deduction, but Mom really does not wish to do that, as she likes High Tech’s potential for
future profitability. What to do?
What if she sells the High Tech stock for $140,000 over the New York Stock Exchange (thus
realizing the $10,000 loss) but then buys it back, say, 20 days later, at a price of $142,000? Read
§§ 1091(a) and (d). Mom’s $10,000 loss deduction is denied, but she increases her $142,000 cost
basis in the new High Tech shares by the $10,000 denied loss deduction to $152,000.
Problems
As indicated at the beginning of the chapter, the first step to take in analyzing a property
disposition is always to calculate the § 1001 realized gain or loss, as that is what may be included

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(if a gain) or deducted (if a loss). In each problem below, describe the tax consequences for each
taxpayer, skipping Step 3, as we have not yet fully considered characterization issues.
1. Jacob owns High Tech stock with an FMV of $60,000 and A/B of $30,000 and a personaluse car with an FMV of $10,000 and A/B of $20,000, both of which he sells to Becky for $70,000
in the aggregate.
2. Hallie owns a diner with an FMV of $200,000 and A/B of $70,000 when it burns to the
ground on June 15 of Year 1. Luckily, Hallie’s business is fully insured, and she obtains $200,000
in insurance proceeds on October 30 of Year 1. She decides to rebuild the diner, spending not only
the $200,000 in insurance proceeds but an additional $30,000, as well, re-opening for business on
March 1 of Year 3. (I know that you just learned in this chapter that Hallie must compute her §
1001 realized gains and losses with respect to her diner using an asset-by-asset approach, but for
the sake of simplicity, you may calculate a single § 1001 gain for her.)
3. Same as 2., except that she decides to rebuild on a smaller scale, spending only $150,000 of
the insurance proceeds and putting the remaining $50,000 in the bank.
4. Lori owns High Tech stock with an FMV of $10,000 and A/B of $2,000, which she exchanges
for Info Tech stock owned by Becky that has an FMV of $10,000 and A/B of $13,000.
5. Lori owns Blackacre, which she holds for investment, with an FMV of $100,000 and A/B of
$30,000. She exchanges it with Jacob for Whiteacre, which she will also hold for investment and
which has an FMV of $90,000, and $10,000 cash. Jacob’s A/B in Whiteacre is $60,000. Jacob also
holds Whiteacre for investment and will hold Blackacre for investment.
6. Same as 5., except that Jacob transfers to Lori a diamond ring with an FMV of $10,000 and
A/B in his hands of $4,000, instead of the $10,000 cash.
7. Same as 5., except that Whiteacre’s FMV is only $20,000, so Jacob must transfer $80,000
cash (instead of $10,000) to boot. If the parties are well advised, will they engage in this exchange?
If Jacob really wants Blackacre and Lori really wants Whiteacre, how should the parties structure
their transaction? Remember that § 1031, unlike § 1033, is not explicitly elective.
8. Same as 5., except that Jacob wants simply to sell Whiteacre for cash, so he won’t engage in
an exchange with Lori. Hallie has $100,000 in cash and wants to buy Blackacre, but Lori wants to
take advantage of § 1031 and wants Whiteacre, so she refuses to sell to Hallie. What can the parties
do to accommodate all of their wishes in a tax-efficient manner?
9. Lori owns High Tech stock with an FMV of $12,000 and A/B of $15,000, which she sells to
her brother Jim for $12,000 in Year 1. In Year 3, Jim sells the High Tech stock for $20,000.

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Chapter 13: Depreciation in a Realization
Income Tax and the Business Interest Deduction
In the early days of the income tax, before Messrs. Schanz, Haig, and Simons developed a taxspecific meaning of the term “income,” you have learned that both Congress and the courts often
borrowed from other disciplines, such as financial accounting or trust accounting, in providing
content to the term. Indeed, an allowance for depreciation was likely imported into the income tax
reflexively from financial accounting, where depreciation is required to further the goal underlying
the so-called matching principle.
In financial accounting (not tax accounting), the matching principle is a very important one,
and sometimes those steeped in a financial accounting background have trouble letting go of it
when they cross over the great divide into the tax realm. 1 Indeed, even Tax Court Judge Laro in
the Simon case (Part C., below) fell into this trap when he wrote: “The primary purpose of
allocating depreciation to more than 1 year is to provide a more meaningful matching of the cost
of an income-producing asset with the income resulting therefrom; this meaningful match, in turn,
bolsters the accounting integrity for tax purposes of the taxpayer’s periodic income statements.” 2
Notice his reference to “income statements,” which is a financial accounting document, as opposed
to tax returns. This quotation (with the exception of the reference to “tax purposes”) is consistent
with the following description of the role of depreciation in furthering the matching principle for
financial accounting purposes found at “Accounting-Simplified.com (the easy way to learn
accounting online, for free!).”
Depreciation results in a systematic charge of the cost of a fixed asset to the income
statement over several accounting periods spanning the asset's useful life during which
it is expected to generate economic benefits for the entity. Depreciation ensures that
the cost of fixed assets is not charged to the profit & loss at once but is “matched”
against economic benefits (revenue or cost savings) earned from the asset’s use over
several accounting periods.
[The] matching principle therefore results in the presentation of a more balanced and
consistent view of the financial performance of an organization than would result from
the use of cash basis of accounting. 3
That last sentence illustrates the role of the matching principle in financial accounting: to
provide a more informative view of the economic health of a business over time to those interested
in its performance, such as shareholders of a corporation housing the business or a bank
contemplating making a loan to the business. That is to say, the role of the financial accountant is
only to provide helpful information to interested parties; no payment obligations (such as a tax)
depend on the computation of “income” for an “income statement.” Indeed, because of this goal,
a range of reasonable ways to account for costs—usually referred to as “generally accepted
accounting principles” or GAAP—can be used by the accountant, depending on the individual
1

See generally Deborah A. Geier, The Myth of the Matching Principle as a Tax Value, 15 AM. J. TAX POL’Y 17 (1998)
(exploring how reflexively borrowing the matching principle from financial accounting for purposes of measuring
income for income tax purposes can undermine income tax values).
2
Simon v. Comm’r, 103 T.C. 247, 253 (1994).
3
http://accounting-simplified.com/financial/concepts-and-principles/matching.html.

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circumstances of the business. A “one size fits all” approach would be inappropriate if using
different rules for different businesses can actually boost the usefulness and reliability of the
resulting information for the consumer or creditor. But depreciation of some sort is common for
all businesses under GAAP.
Assume, for example, that Widget Company purchases in Year 5 a new factory building for
$10 million to replace its outdated one. In Year 7, Widget Company replaces an expensive widgetmaking machine for $500,000. Widget Company has a steady stream of contracts and consistently
earns gross revenue from sales of its widgets of $300,000 each year. If Widget Company, in
preparing its annual “income statement” for shareholders and lenders, shows “income” of
$300,000 in each of Years 3 and 4, a “loss” of $9.7 million in Year 5, “income” of $300,000 in
Year 6, and a $200,000 “loss” in Year 8, consumers of that information might assume that Widget
Company’s business is risky, suffering from roller coaster profits and losses, when in fact the
business has nice, steady sales. “Matching” the cost of the factory and equipment to the future
revenue expected to be earned by using the assets (which can vary from industry to industry or
even company to company under GAAP) provides a more accurate impression of the company’s
economic health over time to those who might rely on this information to make important
economic decisions, such as whether to invest in the company’s stock or to make a loan to it.
In the income tax world, some might argue that depreciation is inconsistent with the realization
principle, as it allows a deduction for an asset’s cost before its disposition. Nevertheless, a
principled argument can be made that a realization-based income tax demands an allowance for
depreciation before disposition but only with respect to certain types of assets, described below in
Part A. But “matching” has nothing to do with this principled argument. Indeed, importing
financial accounting’s “matching principle” into the tax realm can do fundamental damage to
income tax values, inadvertently providing consumption tax treatment through the backdoor—an
irrelevant concern in financial accounting, where no payment obligation arises with respect to the
“income statement.” 4

A. Economic depreciation in a realization-based income tax
Recall from Chapter 2 that the capitalization principle defines the difference between an income
tax and a cash-flow consumption tax.
Under a cash-flow consumption tax, the cost of business or investment property would be fully
expensed (deducted) in the year of purchase, regardless of the expected useful life of the property.
Under an income tax, in contrast, the purchase of property with a useful life extending substantially
beyond the end of the taxable year is not a current expense (a current wealth decrease) but rather
a nondeductible capital expenditure because the taxpayer has not yet lost wealth but rather has
merely changed the form in which his wealth is held. The nondeduction of the outlay, however,
immediately creates basis, which can reduce the tax base in the future as that wealth is lost if such
loss occurs in an income-producing activity.
If our income tax abandoned the realization requirement in favor of a mark-to-market system,
briefly explored in Chapter 1, changes in property value would be taken into account as they
occurred. The amount by which property increased in value would be included in Gross Income
4

See infra Chapter 21, Part B., for a more extended discussion of GAAP and the different goals and purposes of
financial accounting and tax accounting.

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year by year, with a concomitant increase in basis to avoid taxing the same dollars twice to the
same taxpayer in the future. Similarly, the loss in value of business or investment property would
be deductible year by year, with a concomitant reduction in basis to avoid providing a double tax
benefit for the same dollars to the same taxpayer in the future. But we do have a realization
requirement, so changes in value are generally ignored during the ownership period.
Nevertheless, a normative income tax with a realization requirement does allow deductions of
property basis in the form of “depreciation” (the term used for tangible property) or “amortization”
(the term used for intangible property) during the ownership period—before disposition of the
asset—but only if certain requirements are met. Why?
Economic depreciation or amortization is consistent with a realization-based income tax
to the extent that they are limited to deduction of final, irretrievable losses in value. Because
these losses in value are final and irretrievable, they are realized in a nontrivial sense, even
though the taxpayer continues to own the property. Losses that are not final and irretrievable
should not be deducted in a realization-based income tax as a normative matter, which means
that some assets that are depreciable for financial accounting (information) purposes should
not be depreciable for income tax (wealth accessions and reductions) purposes.
Several ingredients combine to establish changes in the aggregate fair market value (FMV) of
an asset over time, such as changes in supply or demand for the asset or changes in interest rates
(if the asset is, for example, a debt instrument). Only one strand of value, however, can produce
final and irretrievable losses in an asset’s aggregate FMV, and that strand is the passage of time if
and only if that asset wastes away predictably over time from use in an income-producing activity.
Take, for example, a machine used in the manufacturing of widgets. As the widget-making
machine gets each year closer to the end of its income-producing life, one strand of its value is
permanently and irretrievably lost and cannot be restored, even with normal maintenance or with
a shift from one income-producing use to another income-producing use. In contrast, land used by
a farmer is not depreciable, even though it is used in an income-producing activity, because it does
not waste away in a predictable manner simply with the passage of time. If the land becomes
unsuitable for farming, it can be used for, say, real estate development. A building rented to tenants
or a factory building is depreciable, however, even if the building’s aggregate FMV is temporarily
rising, because buildings do—eventually—fall down, even with good maintenance. Just as time
passes with business use, and the building gets one year closer to the end of its useful life, that one
strand of value is permanently reduced, even if the building’s popular location means that its
overall FMV is temporarily rising, i.e., even if other strands contributing to the building’s overall
FMV are temporarily masking the permanent loss in this one strand of value.
As a normative matter, the analysis just described should inform the determination of both (1)
which assets are properly depreciable or amortizable and (2) the scheduling of those depreciation
and amortization deductions over time.
Let’s assume that (1) Tom purchases a widget-making machine for $10,000, (2) he expects to
earn a return from using this machine in his business sufficient to recover his original $10,000
investment plus a 4% profit, and (3) this machine has a useful life of 3 years in producing widgets
before it becomes worthless. Under such assumptions, Tom expects to earn about $3,609.49 in
gross receipts each year from use of the machine in his business.
Because this widget-making machine wastes away predictably from Tom’s business use, it is
properly depreciable during his ownership period, even under a realization-based income tax. Tom

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will deduct $10,000 (the machine’s basis) over the machine’s 3-year useful life (even if its overall
FMV temporarily rises in Year 2 because of, say, a shortage of widget-making machines). But at
what rate should Tom’s basis be recovered as deductions, effectively offsetting (in reaching
Taxable Income) a portion of each year’s $3,603.49 in anticipated gross receipts?
We know the answer by reviewing the proper rate of basis recovery with respect to a 3-year
debt instrument with a principal amount of $10,000 and an interest rate of 4%, under which the
borrower makes three annual payments of $3,603.49, an amount sufficient for the lender to recover
both his original $10,000 investment plus the 4% profit. We explored that analysis in Chapter 9,
Part C., Example 3, where Larry Lender loaned $10,000 to Betty Borrower, creating a $10,000
basis. Betty repaid the principal plus 4% interest by making three annual payments of $3,603.49
to Larry. How much of each payment was basis recovery and how much was interest? Let’s review
our analysis from that Chapter.
We determined those answers by determining the present value of Larry’s remaining payments
in each year. The loss in present value as each payment is received represents the amount of each
payment that is tax-free basis recovery, with the remainder of each payment representing interest.
Year 1
Year 2
Year 3
Totals

Payment

Principal (loss in present value)

$3,603.49
3,603.49
3,603.49

- $3,203.48 ($10,000 less 6,796.52)
- 3,331.63 ($6,796.52 less 3,464.89)
- 3,464.89 (remaining basis)
$10,000.00

Interest
=
=
=

$400.01
271.86
138.60
$810.47

Notice that the portion of each payment representing interest decreases as time passes, and
the portion of each payment representing principal (basis recovery) increases as time passes.
Anyone who has made equal-amount mortgage payments on a home or car loan is familiar with
this relationship. In the early years, a large portion of each payment represents interest, but as the
years pass, the portion of each payment representing interest decreases.
With respect to Larry’s debt instrument, notice that basis is recovered at the § 61 Gross
Income stage. That is to say, because of the basis offset, only a portion of each year’s $3,603.49
payment is includable in Larry’s § 61 Gross Income in the first place each year; no deduction is
actually taken by Larry. With respect to Tom’s widget machine, in contrast, every dollar of the
$3,603.49 gross receipts produced by the machine must be included in Tom’s § 61 Gross
Income. We must create a deduction from Gross Income (in reaching Taxable Income) for Tom.
This mechanical difference in how basis is used to reduce profit in each case should not mask the
fact, however, that the schedule of Tom’s basis deductions should precisely mirror the schedule
of Larry’s tax-free basis recovery if we want to avoid premature deduction of that basis, as under
a cash-flow consumption tax.
Tom should deduct his basis each year in an amount equal to the loss in present value of the
remaining expected gross return from use of the widget-making machine. In other words, Tom
should deduct $3,203.48 in Year 1, $3,331.63 in Year 2, and $3,464.89 in Year 3. This schedule
is called “economic depreciation” and reflects the final, irretrievable passage-of-time losses as the
machine gets closer each year to the end of its useful life. Notice the slope of the deduction curve.
If we graphed Tom’s deductions, with the amount of the deduction on the vertical access and time
along the horizontal access, the line would slope gently upward from left to right, with lower
deductions in the early years and higher deductions in the later years.

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While this schedule of capital recovery, which reflects the declining-balance method of
identifying principal and interest in a loan, is normatively correct, Congress permits much faster
basis recovery in the case of depreciation and amortization of tangible and intangible assets,
respectively, under §§ 179, 167, 168, and 197. These deviations from economic depreciation are
tax expenditures—departures from normative principles because of nontax policy or because of
the raw lobbying power of affected industries.
The ability to deduct basis prematurely is a subtle but important cash-flow consumption tax
feature of the current Code. Because of the premature deduction of basis before the economic loss
is realized, a portion of the investment’s return is effectively earned on pre-tax (rather than aftertax) dollars, garnering the investor preferable treatment compared to a normative income tax. But
at least some of this favorable effect is “captured” by the sellers of these assets through the price
mechanism. That is to say, the sellers of these assets can charge a higher price than they would be
able to charge for these same assets if they were subject to normative economic depreciation. As
with other instances of capture, the asset buyer may not fully appreciate that the asset seller is the
one indirectly benefiting from a tax expenditure that appears to be directed, on the face of the
statute, at the buyer.
More important, purchases of quickly depreciable business assets with borrowed money (very
common in the real world) can result in better than consumption tax treatment if the business
interest can be fully deducted under § 163(a), while interest would be nondeductible under a cashflow consumption tax—a significant tax arbitrage problem discussed in Part F.

B. “Wear and tear” within the meaning of § 167(a)
The primary authority to deduct depreciation with respect to property, whether tangible or
intangible, is found in § 167(a), which contains the magic words “there shall be allowed as a
depreciation deduction.” To be depreciable, the property must be (1) subject to “wear and tear”
and (2) used in a trade or business or held for investment. Under the second requirement, inventory
is not depreciable, as it is not used in the trade or business. 5 A personal residence, as personal-use
property, is generally not depreciable, though a taxpayer can depreciate the portion of the home’s
basis used exclusively and regularly for business to the extent that the taxpayer satisfies the
stringent requirements of § 280A(c), explored in Chapter 19.
The wear-and-tear language had always been interpreted—prior to Simon v. Commissioner,
below—to mean that the property wasted away on a predictable basis, even with proper
maintenance, i.e., that it had an ascertainable useful life that could be determined in the year that
it was placed into service in the business or investment activity. This interpretation is consistent
with the rationale underling depreciation described in Part A. In addition to the land example noted
earlier, 6 shares of corporate stock, though held for investment, do not waste away due solely to the

5

See Treas. Reg. § 1.167(a)-2.
Although land is not depreciable, a different issue arises when a buyer purchases land along with rights to extract
oil, gas, or minerals underneath the land. For example, assume that Joseph purchases Blackacre and the right to extract
oil from Blackacre for $1 million. Joseph would first allocate his $1 million purchase price between the land and the
oil. Let’s say that the land would be worth only $200,000 without the oil rights, so $200,000 of the $1 million purchase
price is allocable to the land, and the remaining $800,000 is allocable to the oil. As Joseph extracts and sells the oil,
he should be (and is) permitted to recover his $800,000 cost basis in that oil as a series of annual deductions in the
years in which he sells oil. The rate at which he can schedule his deductions is determined under either § 611 (cost

6

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passage of time and thus are not depreciable. Artwork hanging on the walls of a corporate
headquarters building is not depreciable, even though the artwork is being used in an incomeproducing activity, as it does not waste away in a predictable fashion due solely to the passage of
time. Finally, collectibles, though held for investment (hoped-for gain on later sale), are not
depreciable because they have a potentially infinite life in the collector market. We cannot know
when tastes in the collector market will change, affecting the item’s useful life as a collectible, so
no realized loss can arise due solely to the passage of time.
While the authority to take depreciation is found in § 167(a), the manner in which tangible (but
not intangible) property is depreciated is now found in § 168, first enacted in 1981. While its title
remains the Accelerated Cost Recovery System (ACRS), its provisions were amended in the Tax
Reform Act of 1986 so that cases and other sources sometimes refer to it as MACRS for “Modified
Accelerated Cost Recovery System.” Professional musicians are clearly permitted to depreciate
the typical types of musical instruments used in their professions to earn income under §§ 167(a)
and 168, including violin bows, that have no value in the collector market. The violin bows at issue
in Simon, however, had potentially infinite lives in the collector market—even after they were
“played out,” i.e., even after they were no longer useful in making music—because of their unique
provenance. You can think of the relationship of François Xavier Tourte to bows as that of
Stradivarius to violins. Even a Stradivarius violin that can no longer be played has a potentially
infinite life in the collector market.
SIMON v. COMMISSIONER
103 T.C. 247 (1994) (reviewed), aff’d, 68 F.3d 41 (2d Cir. 1995)
LARO, JUDGE: Richard Simon and Fiona Simon petitioned the Court for a redetermination of
respondent’s determinations in a notice of deficiency issued to them on December 11, 1991. [T]he
sole issue for decision is whether petitioners are entitled to deduct depreciation claimed under the
accelerated cost recovery system (ACRS) for the year in issue. Petitioners claimed depreciation on
two 19th-century violin bows that they used in their trade or business as full-time professional
violinists. As discussed below, we hold that petitioners may depreciate their violin bows during
the year in issue.
FINDINGS OF FACT
Petitioners’ Backgrounds
Richard Simon started playing and studying the violin in 1943, at the age of 7. In 1945, he was
awarded a full scholarship to the Manhattan School of Music. He studied the violin there through
college and received a bachelor of music degree in 1956. Following his graduation, Richard Simon
pursued a master’s degree in music by taking additional courses at the Manhattan School of Music
and Columbia University. Throughout his education, Richard Simon studied the violin under many
renowned musicians.
In 1965, Richard Simon joined the New York Philharmonic Orchestra (orchestra) and began
playing in its first violin section. In 1981, he joined and began playing with the New York
Philharmonic Ensembles (ensembles) (hereinafter, the orchestra and the ensembles are collectively
referred to as the Philharmonic). Since 1965, Richard Simon has maintained two careers, one as a
depletion) or § 613 (percentage depletion). The details of each are beyond the scope of this course.

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player with the orchestra (and later with the Philharmonic) and the second as a soloist, chamber
music player, and teacher.
Fiona Simon began playing and studying the violin at the age of 4. Her musical studies included
courses at Purcell School in London from 1963-71 and at the Guildhall School of Music from
1971-73. Throughout her career, Fiona Simon studied the violin with renowned musicians.
In 1985, Fiona Simon joined the Philharmonic and began playing in its first violin section. Since
1985, Fiona Simon has maintained two careers, one as a full-time player with the Philharmonic
and a second as a soloist, chamber music player, teacher, and free-lance performer.
During the year in issue, petitioners were both full-time performers with the Philharmonic,
playing locally, nationally, and internationally in the finest concert halls in the world. In 1989,
petitioners performed four concerts per week with the Philharmonic, playing over 200 different
works, and attended many rehearsals with the Philharmonic that were more demanding and more
time-consuming than the concerts. Petitioners also carried out the busy schedules connected with
their second careers.
Construction of a Violin Bow
A violin bow consists of a flexible wooden stick, horsehair, a frog, and a ferrule (screw). The
stick, which varies in thickness, weight, and balance, is the working part of the bow and is an
integral part in the production of sound through vibration. It is designed so that horsehair can be
stretched between its ends.
The horsehair is a group of single strands of hair that come from the tails of Siberian horses. A
hatchet-shaped head holds one end of the horsehair, and the other end is attached to a frog. The
frog, which is inserted into the stick, is a movable hollow piece by which the bow is held. The frog
has an eyepiece on the end that catches the screw. The screw is the small knob at the end of the
bow that is adjusted to tighten or loosen the horsehair in order to change the tension on the
horsehair. The horsehair is the part of the bow that touches the violin strings. Rosin is applied to
the horsehair to supply the frictional element that is necessary to make the violin strings vibrate.
Old violins played with old bows produce exceptional sounds that are superior to sounds
produced by newer violins played with newer bows. The two violin bows in issue were made in
the 19th century by François Xavier Tourte (1747-1835). François Tourte is considered the premier
violin bow maker. In particular, he is renowned for improving the bow’s design. (Hereinafter, the
two bows in issue are separately referred to as bow 1 and bow 2, and are collectively referred to
as the Tourte bows.)
Purchase of the Tourte Bows
On November 13, 1985, petitioners purchased bow 1 for $30,000; the bow was purchased from
Moes & Moes, Ltd., a dealer and restorer of violins and violin bows. On December 3, 1985,
petitioners purchased bow 2 from this dealer for $21,500. The sticks, frogs, and screws were
originals of François Tourte at the time of each purchase. No cracks or other defects were apparent
in the sticks at the time of each purchase. The frogs and screws, however, were not in playable
condition. Therefore, petitioners replaced them.
Petitioners acquired the Tourte bows for regular use in their full-time professional employment
as violinists. Petitioners purchased the Tourte bows for their tonal quality, not for their monetary
value. In the year of acquisition, petitioners began using the Tourte bows with the original sticks
in their trade or business as full-time professional violinists. Petitioners continued to use the Tourte
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bows with the original sticks during the year in issue.
Depreciation Deductions Claimed for the Tourte Bows
On their 1989 Form 1040, petitioners claimed a depreciation deduction of $6,300 with respect
to bow 1 and $4,515 with respect to bow 2; these amounts were in accordance with the appropriate
ACRS provisions that applied to 5-year property. Respondent disallowed petitioners’ depreciation
deduction in full and reflected her disallowance in the notice of deficiency at issue here.
Conditions Affecting the Wear and Tear of Violin Bows
Playing with a bow adversely affects the bow’s condition; when a musician plays with a bow,
the bow vibrates up, down, sideways, and at different angles. In addition, perspiration from a
player’s hands enters the wood of a bow and ultimately destroys the bow’s utility for playing.
Cracks and heavy-handed bearing down while playing certain pieces of music also create wear
and tear to a bow. A player who has a heavy hand may cause the stick to press against the horsehair;
in turn, this may cause the bow to curve and warp. The appendix illustrates the wear and tear that
was suffered by a violin bow that was used for 20 to 25 years. [4] Petitioners’ use of the Tourte
bows during the year in issue subjected the bows to substantial wear and tear.
Frequent use of a violin bow will cause it to be “played out,” meaning that the wood loses its
ability to vibrate and produce quality sound from the instrument. From the point of view of a
professional musician, a “played out” bow is inferior and of limited use. The Tourte bows were
purchased by petitioners, and were playable by them during the year in issue, only because the
Tourte bows were relatively unused prior to petitioners’ purchase of them; the Tourte bows had
been preserved in pristine condition in collections. At the time of trial, the condition of the Tourte
bows had deteriorated since the dates of their purchase. Among other things, the sticks on the
Tourte bows were worn down.
Value of the Tourte Bows
On November 21, 1985, bow 1 was appraised for insurance purposes as having a fair market
value of $ 35,000. On December 3, 1985, bow 2 was appraised for insurance purposes as having a
fair market value of $25,000. Petitioners obtained both appraisals from Moes & Moes, Ltd.
In 1994, at the time of trial, the Tourte bows were insured with the Philharmonic for $45,000
and $35,000, respectively. These amounts are based on an appraisal dated May 14, 1990, from
Yung Chin Bowmaker, a restorer and dealer of fine bows. The record does not indicate whether
these appraised amounts were the fair market values of the Tourte bows or were their replacement
values.
An independent market exists for the Tourte bows and other antique bows. Numerous antique
bows (including bows made by François Tourte) are regularly bought and sold in this market. The
Tourte bows are unadorned; they are not as lavish or decorative as some other bows (including
other bows made by François Tourte) that are sold in the independent market. Adornments on
other bows include engravings, gold, silver, ivory, and mother-of-pearl.

[4]

The appendix (petitioners' Exhibit 15) is not one of the Tourte bows. The appendix is provided to show the nature
of the types of wear and tear that a bow can suffer. The large indentation at the bottom of the stick immediately before
the frog was caused by perspiration and pressure from the player's thumb. See 1 infra the appendix. Further down the
stick towards the right is a second indentation that was caused by perspiration and pressure from the player's hand.
See 2 infra the appendix.

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One factor that adds value to the Tourte bows is the fact that Pernambuco wood, the wood that
was used to make the sticks, is now very scarce. The wood that is currently used to make the sticks
of violin bows is inferior to Pernambuco wood.
OPINION
Taxpayers have long been allowed asset depreciation deductions in order to allow them to
allocate their expense of using an income-producing asset to the periods that are benefited by that
asset. The primary purpose of allocating depreciation to more than 1 year is to provide a more
meaningful matching of the cost of an income-producing asset with the income resulting
therefrom; this meaningful match, in turn, bolsters the accounting integrity for tax purposes of the
taxpayer’s periodic income statements. Hertz Corp. v. U.S., 364 U.S. 122, 126 (1960); Massey
Motors, Inc. v. U.S., 364 U.S. 92, 104 (1960)…. In this sense, an allocation of depreciation to a
given year represents that year’s reduction of the underlying asset through wear and tear.
Depreciation allocations also represent a return to the taxpayer of his or her investment in the
income-producing property over the years in which depreciation is allowed. Virginian Hotel Corp.
v. Helvering, 319 U.S. 523, 528 (1943); Detroit Edison Co. v. Comm’r, 319 U.S. 98, 101 (1943).
Section 167(a) provide[s]:
SEC. 167(a). General Rule. -- There shall be allowed as a depreciation deduction a
reasonable allowance for the exhaustion, wear and tear (including a reasonable
allowance for obsolescence) –
(1) of property used in the trade or business, or
(2) of property held for the production of income.
The regulations under this section expanded on the text of section 167 by providing that
personal property was only depreciable before [enactment of § 168] if the taxpayer established the
useful life of the property. See sec. 1.167(a)-1(a) and (b), Income Tax Regs.
The “useful life” of property under pre-[§ 168] law was the period over which the asset could
reasonably be expected to be useful to the taxpayer in his or her trade or business, or in the
production of his or her income. Fribourg Navigation Co. v. Comm’r, 383 U.S. 272, 277 (1966);
Massey Motors, Inc. v. U.S., supra; sec. 1.167(a)-1(b), Income Tax Regs. This useful life period
was not always the physical life or maximum useful life inherent in the asset. Massey Motors, Inc.
v. U.S., supra; sec. 1.167(a)-1(b), Income Tax Reg. A primary factor to consider in determining
an asset’s useful life was any “wear and tear and decay or decline from natural causes” that was
inflicted upon the asset. Sec. 1.167(a)-1(b), Income Tax Regs.
Before [§ 168], the primary method that was utilized to ascertain the useful life for personal
property was the asset depreciation range (ADR) system. Under the ADR system, which was
generally effective for assets placed in service after 1970 and before 1981, property was grouped
into broad classes of industry assets, and each class was assigned a guideline life. See, e.g., sec.
1.167(a)-11, Income Tax Regs.; Rev. Proc. 83-35, 1983-1 C.B. 745, superseded by Rev. Proc. 8756, 1987-2 C.B. 674. A range of years, i.e., the ADR, was then provided for each class of personal
property; the ADR extended from 20 percent below to 20 percent above the guideline class life.
For each asset account in the class, the taxpayer selected either a class life or an ADR that was
utilized as the useful life for computing depreciation. If an asset was not eligible for ADR
treatment, or if the taxpayer did not elect to use the ADR system, the useful life of that asset was
generally determined based on either the particular facts and circumstances that applied thereto, or

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by agreement between the taxpayer and the Commissioner. Massey Motors, Inc. v. U.S., supra;
sec. 1.167(a)-1(b), Income Tax Regs. See generally Staff of Joint Comm. on Taxation, General
Explanation of the Economic Recovery Tax Act of 1981, at 67 (J. Comm. Print 1981) (hereinafter
referred to as the 1981 Bluebook).
In enacting [§ 168], the Congress found that the pre-[§ 168] rules for determining depreciation
allowances were unnecessarily complicated and did not generate the investment incentive that was
critical for economic expansion. The Congress believed that the high inflation rates prevailing at
that time undervalued the true worth of depreciation deductions and, hence, discouraged
investment and economic competition. The Congress also believed that the determination of useful
lives was “complex” and “inherently uncertain”, and “frequently [resulted] in unproductive
disagreements between taxpayers and the Internal Revenue Service.” S. Rept. 97-144, at 47 (1981),
1981-2 C.B. 412, 425. See generally 1981 Bluebook, at 75. Accordingly, the Congress decided
that a new capital cost recovery system would have to be structured which, among other things,
lessened the importance of the concept of useful life for depreciation purposes. S. Rept. 97-144,
supra at 47, 1981-2 C.B. at 425. See generally 1981 Bluebook, at 75. This new system is ACRS.
ACRS is mandatory and applies to most tangible depreciable assets placed in service after 1980….
Thus, through [§ 168], the Congress minimized the importance of useful life by: (1) Reducing
the number of periods of years over which a taxpayer could depreciate his or her property from
the multitudinous far-reaching periods of time listed for the ADR system to the … short periods
of time listed in [§ 168] … and (2) basing depreciation on an arbitrary statutory period of years
that was unrelated to, and shorter than, an asset’s estimated useful life. This minimization of the
useful life concept through a deemed useful life was in spirit with the two main issues that [§ 168]
was designed to address, namely: (1) Alleviating the income tax problems that resulted mainly
from complex depreciation computations and useful life litigation, and (2) responding to economic
policy concerns that the pre-[§ 168] depreciation systems spread the depreciation deductions over
such a long period of time that investment in income-producing assets was discouraged through
the income tax system. S. Rept. 97-144, supra at 47, 1981-2 C.B. at 425. See generally 1981
Bluebook, at 75.
Rev. Rul. 68-232, 1968-1 C.B. 79 states:
A valuable and treasured art piece does not have a determinable useful life. While the
actual physical condition of the property may influence the value placed on the object,
it will not ordinarily limit or determine the useful life. Accordingly, depreciation of
works of art generally is not allowable. [Emphasis added.]
In the instant case, respondent determined that petitioners were not entitled to deduct
depreciation for the Tourte bows. On brief, respondent supports her disallowance with two primary
arguments. First, respondent argues that the useful lives of the Tourte bows are indeterminable
because the bows are treasured works of art for which it is impossible to determine useful lives.
According to respondent, the Tourte bows are works of art because the Tourte bows have existed
for more than 100 years and have increased in value over that time; the presence of an independent
market for the Tourte bows also gives them a value independent of their capacity to be used to
play music, and serves to extend their useful lives indefinitely.
As an alternative to this first argument, respondent argues that the Tourte bows are depreciable
under section 168 only if petitioners first prove that each bow has a determinable useful life within
the meaning of section 167. In this regard, respondent contends that petitioners must prove a

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specific or reasonable estimate of the number of years that the Tourte bows will be useful in order
to depreciate them under ACRS. Given that the Tourte bows have existed for more than 100 years,
respondent concludes, petitioners may not depreciate the Tourte bows because petitioners cannot
determine the number of remaining years during which the Tourte bows will continue to be useful.
Petitioners’ argument is more straightforward. According to petitioners, they may claim
depreciation on the Tourte bows because the Tourte bows: (1) Were necessary to their profession
as full-time professional violinists, and (2) suffered wear and tear attributable to their use in that
profession. In this regard, petitioners contend, the Tourte bows can be used to produce beautiful
sounds superior to those produced by any newer bow, and the Tourte bows harmonize this beautiful
music with the reputation of the Philharmonic as one of the most prestigious orchestras in the
world.
We agree with petitioners that they may depreciate the Tourte bows under [§ 168]. [Section
168] was enacted partially to address and eliminate the issue that we are faced with today, namely,
a disagreement between taxpayers and the Commissioner over the useful lives of assets that were
used in taxpayers’ trades or businesses….
[P]etitioners regularly used the Tourte bows in their trade or business as professional violinists
during the year in issue. We are convinced that petitioners’ frequent use of the Tourte bows
subjected them to substantial wear and tear during the year in issue. Petitioners actively played
their violins using the Tourte bows, and this active use resulted in substantial wear and tear to the
bows. [11] Indeed, respondent’s expert witness even acknowledged at trial that the Tourte bows
suffered wear and tear stemming from petitioners’ business; the witness testified that the Tourte
bows had eroded since he had examined them 3 years before, and that wood had come off them.
Thus, we conclude that petitioners have satisfied the final prerequisite for depreciating personal
property under section 168, and, accordingly, hold that petitioners may depreciate the Tourte bows
during the year in issue.
With respect to respondent’s arguments in support of a contrary holding, we believe that
respondent places too much reliance on the fact that the Tourte bows are old and have appreciated
in value since petitioners acquired them. We disagree; section 168 does not support her proposition
that a taxpayer may not depreciate a business asset due to its age, or due to the fact that the asset
may have appreciated in value over time. Noyce v. Comm’r, supra at 675, 691 (taxpayer allowed
to deduct depreciation under section 168 on an airplane that had appreciated in economic value).
We also reject respondent’s contention that the Tourte bows are nondepreciable because they
have value as collectibles independent of their use in playing musical instruments, and that this
value prolongs the Tourte bows’ useful life forever. First, it is firmly established that the term
“useful life” under pre-[§ 168] law refers to the period of time in which a particular asset is useful
to the taxpayer in his or her trade or business. Fribourg Navigation Co. v. Comm’r, supra at 277;
Massey Motors, Inc. v. U.S., 364 U.S. 92 (1960); sec. 1.167(a)-1(b), Income Tax Regs. Thus, the
[11]
In this regard, we do not believe that the Tourte bows are so-called works of art. We define a “work of art” as a
passive object, such as a painting, sculpture, or carving, that is displayed for admiration of its aesthetic qualities. See
Webster’s New World Dictionary 1539 (3d coll. ed. 1988). The Tourte bows, by contrast, functioned actively,
regularly, and routinely to produce income in petitioners' trade or business. Although a computer utilized by a child
to play games is not a depreciable asset, the same computer becomes a depreciable asset if it is used actively, regularly,
and routinely by a data processor in his or her trade or business. By the same token, the Tourte bows could have been
collector’s items except for the fact that petitioners used them actively, regularly, and routinely in their full-time
business.

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fact that an asset such as the Tourte bows may outlive a taxpayer is not dispositive of the issue of
whether that asset has a useful life for depreciation purposes under pre-[§ 168] law. Second, the
same argument concerning a separate, nonbusiness value can be made of many other assets. Such
types of assets could include, for example, automobiles, patented property, highly sophisticated
machinery, and real property. For the Court to delve into the determination of whether a particular
asset has a separate, nonbusiness value would make the concept of depreciation a subjective issue
and would be contrary to the Congress’ intent to simplify the concept and computation of
depreciation.
With respect to respondent’s contention that petitioners must prove a definite useful life of the
Tourte bows, we acknowledge that the concept of useful life was critical under pre-[§ 168] law.
Indeed, the concept of useful life was necessary and indispensable to the computation of
depreciation because taxpayers were required to recover their investments in personal property
over the estimated useful life of the property. However, the Congress enacted [§ 168] in part, to
avoid constant disagreements over the useful lives of assets, to shorten the writeoff periods for
assets, and to encourage investment by providing for accelerated cost recovery through the tax
law. S. Rept. 97-144, at 47 (1981), 1981-2 C.B. 412, 425. See generally 1981 Bluebook, at 75….
Respondent’s argument that a taxpayer must first prove the useful life of personal property before
he or she may depreciate it … would bring the Court back to pre-[§ 168] law and reintroduce the
disagreements that the Congress intended to eliminate by its enactment of [§ 168]. This the Court
will not do.
Respondent mainly relies on … Browning v. Commissioner, T.C. Memo. 1988-293, affd. 890
F.2d 1084 (9th Cir. 1989), to support a holding contrary to the one that we reach today. [14]
Browning v. Commissioner, T.C. Memo. 1988-293, affd. 890 F.2d 1084 (9th Cir. 1989), is …
distinguishable. In Browning, the taxpayer was a musician who performed in nightclubs and bars
and for private engagements. Prior to and during 1980 and 1981, the taxable years in issue there,
the taxpayer purchased several expensive antique violins, including a Ruggeri, a Stradivarius, and
a Gabrielli. The Ruggeri and the Stradivarius violins were purchased in 1978 and 1979,
respectively, and were subject to the pre-[§ 168] rules for depreciation. The Gabrielli violin was
purchased in 1981, and was subject to ACRS. During 1980 and 1981, the taxpayer claimed
depreciation deductions with respect to the Ruggeri and Stradivarius violins; the taxpayer amended
his petition in this Court to claim that section 168 … allowed him to deduct depreciation on the
Gabrielli violin for his 1981 taxable year.
The Court in Browning sustained respondent’s determination that the taxpayer was not entitled
to any depreciation deductions on the violins. In so doing, the Court first stressed that the taxpayer
had presented no credible evidence to support a contrary holding with respect to the Stradivarius
violin. Indeed, neither the taxpayer nor his wife testified at trial; we also found unpersuasive the
evidence that the taxpayer did present at trial, an expert’s report and that expert’s testimony. With
respect to the other two violins (including the one subject to ACRS), we held for respondent

[14]
Respondent also relies on sec. 1.168-3(a), Proposed Income Tax Regs., 49 Fed. Reg. 5957 (Feb. 16, 1984), and
Rev. Rul. 68-232, 1968-1 C.B. 79. We find this reliance misplaced; neither proposed regulations nor revenue rulings
are entitled to judicial deference. See, e.g., Tandy Corp. v. Comm’r, 92 T.C. 1165, 1170 (1989); Natomas North
America, Inc. v. Comm’r, 90 T.C. 710, 718 n.11 (1988); North Ridge Country Club v. Comm’r, 89 T.C. 563, 579-580
(1987), revd. on other grounds 877 F.2d 750 (9th Cir. 1989). Moreover, we conclude that the Tourte bows are not
“works of art” because, inter alia, the bows were used by petitioners in their trade or business as professional violinists.
See supra note 11.

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because the taxpayer failed to present any evidence with respect to those violins.
The record in the instant case, by contrast to the record in Browning, is replete with evidence
showing clearly that the Tourte bows suffered substantial wear and tear while petitioners used
them in their trade or business. To state the obvious, violin bows are subject to wear and tear when
in use by a professional violinist. Indeed, as stated by Publilius Syrus circa 42 B.C.: “The bow too
tensely strung is easily broken.” Bartlett, Familiar Quotations 1103 (12th ed. 1951).
We have considered all other arguments made by respondent and find them to be without merit.
PARKER, SWIFT, WRIGHT, PARR, WELLS, RUWE, and COLVIN, JJ., agree with this majority
opinion.
[The separate concurring opinions of Judges Ruwe and Beghe are omitted.]
HAMBLEN, C.J., dissenting: I must disagree with the majority opinion. I respectfully submit that
the basis for the majority’s allowance of a depreciation deduction in this instance is sophistical and
wrong…. The statutory interpretation of sections 167 and 168 is wrong in this context. Pertinent
legislative history regarding determinable useful life is ignored. The antique violin bows are
treasured “works of art” that for 71 years the Internal Revenue Service has treated, with
congressional acquiescence, as nondepreciable property because as instruments and collectibles
they have an indeterminable useful life. The majority’s holding is contrary to legal precedent. See
Browning v. Comm’r, T.C. Memo. 1988-293, affd. 890 F.2d 1084 (9th Cir. 1989); see also Clinger
v. Comm’r, T.C. Memo. 1990-459.
I. Legal Analysis
A. Statutory Construction
The majority opinion concludes, as a matter of law, that if a taxpayer uses in his trade or
business tangible personal property which suffers some wear and tear, irrespective of whether the
wear and tear can be restored by ordinary maintenance, irrespective of whether it has a
determinable useful life, and irrespective of whether it declines in value, the taxpayer is entitled to
depreciate the property under ACRS (section 168). I cannot agree. That conclusion contradicts the
basic underpinnings of the depreciation allowance and the holdings of this Court and other courts.
It is true that section 168 represents a restructuring of the concept of depreciation deductions
and that Congress has deemphasized the concept of useful life and abandoned the concept of
salvage value. But Congress did not release the concept of depreciation from the moorings of
useful life. In Newark Morning Ledger Co. v. United States, 113 S. Ct. 1670, 1680 (1993), the
Supreme Court noted that “The entire justification for refusing to permit the depreciation * * *
evaporates, however, when the taxpayer demonstrates that the asset in question wastes over an
ascertainable period of time.” The corollary is that, if property suffers no waste and lacks a
determinable useful life, it is not depreciable. Tunnell v. U.S., 512 F.2d 1192 (3d Cir. 1975); S.S.
Ballin Agency, Inc. v. Comm’r, 446 F.2d 554 (3d Cir. 1971), affg. T.C. Memo. 1969-203;
Westinghouse Broadcasting Co. v. Comm’r, 309 F.2d 279 (3d Cir. 1962), affg. 36 T.C. 912 (1961);
Citizens & Southern Corp. v. Comm’r, 91 T.C. 463, 479 (1988), affd. 919 F.2d 1492 (11th Cir.
1990); Judge v. Comm’r, T.C. Memo. 1976-283.
Although section 168 effects significant changes in the calculation of the depreciation
allowance, useful life remains a hallmark of the basic concept of depreciation in both sections 167
and 168. Property depreciable under section 167 must be subject to waste and have a determinable
useful life. See Browning v. Comm’r, supra. While the majority opinion apparently acknowledges
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that this is correct as far as section 167 is concerned, it ignores this requirement in discussing
section 168. As we stated in Clinger v. Commissioner, supra, “the concept of useful life was not
eliminated by the enactment of ACRS; hence * * * petitioner must establish that an asset used in
a trade or business has a determinable useful life”. Accord Arkla, Inc. v. U.S., 27 Fed. Cl. 226
(1992).
The premise underlying the depreciation allowance is that wear and tear or obsolescence causes
a corresponding reduction in the value of an asset and diminishes its useful life. The end product
of the depreciation allowance is the taxpayer’s recovery of capital expenditures (costs) made in
acquiring a wasting asset used in a trade or business or held for the production of income. See
Noyce v. Comm’r, 97 T.C. 670, 688 (1991). Depreciation is therefore keyed to wear and tear or
obsolescence because they generally cause corresponding reductions in the useful life and value
of property.
Consequently, sections 167 and 168 are connected or linked so that an asset, such as a Tourte
bow, that has an indeterminable useful life is not depreciable. It seems to me that the majority
opinion has twisted these depreciation provisions beyond the contours of their clear and
unambiguous language so as to defeat the plain purpose of Congress.
B. Legislative History, Proposed Regulations, and Rulings
The legislative history of section 168, as revealed in the “Overview” section of the Senate
Finance Committee (S. Rept. 97-144 (1981), 1981-2 C.B. 412) and the House Ways and Means
Committee (H. Rept. 97-201 (1981), 1981-2 C.B. 352) reports states:
In general, property is depreciable if it is (1) used in a trade or business or for the
production of income, and (2) subject to wear and tear, decay or decline from natural
causes, exhaustion, or obsolescence. Land, goodwill, stock, and other assets that do
not have a determinable useful life and that do not decline in value predictably are not
depreciable. * * * [S. Rept. 97-144, supra, 1981-2 C.B. at 421; emphasis supplied.]
Substantially similar language is used in the conference committee report, H. Conf. Rept. 97215 (1981), 1981-2 C.B. 481, 487, under the heading “Eligible Property”, which states that “ACRS
does not apply to (1) property not depreciated in terms of years.” Moreover, the Joint Committee
on Taxation summary (the so-called Blue Book) states that ACRS “does not change the
determination under prior law as to whether property is depreciable or nondepreciable”. Staff of
Joint Comm. on Taxation, General Explanation of the Economic Recovery Tax Act of 1981, at 77
(J. Comm. Print 1981). The majority opinion essentially ignores these statements. The Joint
Committee on Taxation summary likewise reiterates the statements made in the committee reports
that assets that do not decline in value on a predictable basis or that do not have a determinable
useful life are not depreciable.
Section 1.168-3(a)(1)(ii), Proposed Income Tax Regs., 49 Fed. Reg. 5957 (Feb. 16, 1984),
tracks and is entirely consistent with the legislative history. It provides in part: “Property is
considered recovery property only if such property would have been depreciable under section
167. ACRS does not apply to * * * works of art”. I think Congress was aware of the longstanding
rulings of the Internal Revenue Service that “works of art” are not depreciable….
C. Legal Precedent
The majority opinion has dubiously attempted to distinguish Browning v. Commissioner, T.C.
Memo. 1988-293, affd. 890 F.2d 1084 (9th Cir. 1989), and Clinger v. Commissioner, T.C. Memo.

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1990-459. Candor requires that we not try to discard or overrule them sub silentio. In Browning,
we held that the Stradivarius, Ruggeri, and Gabrielli violins were nondepreciable because the
taxpayer, a professional musician, could not prove they had a determinable useful life. In affirming
our decision, the Court of Appeals stated:
As the Tax Court noted, antique violins such as a Stradivarius are considered
collectible items and not all purchasers need necessarily be professional musicians.
Therefore, the violins have a value independent of their tonal qualities and that value
may extend their useful lives which makes the violins more like pieces of art. * * *
[890 F.2d at 1086-1087.]
The majority opinion relies principally on one case, Noyce v. Commissioner, 97 T.C. 670
(1991), which stands in sharp contrast to and is distinguishable from Browning. In Noyce we
concluded that the taxpayer’s use of his private airplane and payment of related expenses in the
course of his employment were part of his trade or business of being a corporate official. Thus, it
was held that he may deduct depreciation and expenses related to such travel to the extent such
amounts exceed amounts reimbursable under his employer’s policy. Noyce is distinguishable from
this case. At issue in Noyce was the second section 168 requirement—whether the taxpayer used
the airplane in his trade or business. It was undisputed that, if properly used, the airplane suffered
wear and tear and could be depreciated. The Commissioner did not argue that the airplane was not
depreciable property under section 167, but only that the [plane was not used in the taxpayer’s
business]. We rejected that argument. By contrast, the key issue in the present case is the first
requirement—whether the Tourte bows are the type of property subject to depreciation. Petitioners
have not shown that they are.
…
D. Work of Art Vel Non
The majority opinion characterizes the Tourte bows as not being “works of art” because they
are actively and regularly used in petitioners’ trade or business as professional musicians. I would
not characterize a “work of art” so narrowly. I think the term should be given a broad, expansive
meaning. One definition of a “work of art” contained in Webster’s New 20th Century Dictionary
(unabridged 1983) is “anything beautifully made, played, sung or acted.” That definition would
certainly include an antique musical instrument or bow, a Shakespearean play, a Verdi opera, or a
Navajo rug. And “art” is defined in the same dictionary as “products of creative work.” In the final
analysis the answer probably lies in the eyes of the beholder or owner. In any event, this Court has
rejected the notion that “works of art and commercial equipment necessarily are mutually
exclusive concepts.” London Displays Co. v. Comm’r, 46 T.C. 511, 514 (1966). Even if used in a
trade or business, a “work of art” retains its character as a work of art because it does not have a
determinable useful life and generally does not decline in value over a predictable period. See
Clinger v. Comm’r, supra; Associated Obstetricians & Gynecologists, P.C. v. Comm’r, T.C.
Memo. 1983-380, affd. per curiam 762 F.2d 38 (6th Cir. 1985). To say the least, I expect the
Smithsonian curator of musical instruments would be shocked to learn that a Stradivarius violin
or a Tourte bow is not regarded as a treasured “work of art.” Consequently, in my view, the Tourte
bows in this case should be considered as a type of property which is not subject to depreciation.
In cases of this kind it seems that our role should begin and end with assuring that the
Commissioner’s authority to implement the congressional mandate has been exercised in a
reasonable manner. See U.S. v. Correll, 389 U.S. 299 (1967). I respectfully submit that the majority
has not done so.
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…
D. Determinable Useful Life
The record in this case clearly shows that the Tourte bows have no determinable useful life.
Nobody knows how long they will last as either usable works of art in petitioners’ hands or
ultimately as collectibles.
…
Finally, Wiley Grant, respondent’s expert, stated in his report that the bows were treasured
works of art that had no determinable useful life. Who can say with any degree of certainty how
long these bows will last if given reasonable care?
CHABOT, JACOBS, WHALEN, and HALPERN, JJ., agree with this dissent.
[The separate dissenting opinions of Judges Gerber and Halpern are omitted.]
____________________________________
The fact that the Tourte bows increased in value after purchase should be irrelevant to the issue
of whether they are properly depreciable under §§ 167 and 168. As described in Part A., a
property’s aggregate FMV has several strands, and the one strand of value that is permanently and
irretrievably lost as time passes may be transiently overcome by other strands of value that
temporarily mask the permanent loss in that one strand of value. Rental real estate buildings that
were appreciating spectacularly during the real estate bubble in the mid-2000s were nevertheless
properly depreciable during that time period because buildings will eventually fall down, even
with adequate maintenance, in a predictable way.
As noted earlier, the majority’s reference to the “matching principle” from financial accounting
is unfortunate. Capitalization and depreciation under a realization-based income tax has nothing
to do with matching, i.e., smoothing out the hills and valleys of the business’s revenue stream in
order to provide more accurate information regarding the business’s overall economic health to
someone that is considering, say, making a loan to the business.
Rather, capitalization and depreciation in a realization-based income tax serves to ensure
effective taxation of the property’s capital return. In other words, allowing premature deduction
of the cost of an asset with a potentially infinite life means that the return on that investment is not
fully taxed, as though the asset were being conferred preferable cash-flow consumption tax
treatment. Recall from Chapter 2 that, under a cash-flow consumption tax, the cost of even longlived assets is deducted in the year of purchase. Even though the investment’s return is included
in the tax base, the normal (expected) return is not effectively taxed—as though the property’s
basis were not prematurely deducted but the asset’s return was explicitly excluded from the tax
base (as under a wage tax). Also recall from Chapter 2 that, for an investment to be taxed under
income tax principles, two requirements must be satisfied: (1) the investment must be made with
after-tax dollars, which means that the investment should not be prematurely deducted, and (2)
the investment’s return must be fully included in the tax base.
A case decided in the same year and similar to Simon was Liddle v. Commissioner, 7 pertaining
to a 17th century bass viol created by “Francesco Ruggeri (c. 1620-1695), a luthier active in
Cremona, Italy. He studied stringed instrument construction under Nicolo Amati, who also
instructed Antonio Stradivari. His other contemporaries include the craftsmen Guadanini and
7

103 T.C. 285 (1994), aff’d, 65 F.3d 329 (1995).

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Guarneri. These artisans are members of the so-called Cremonese School of instrument makers.” 8
The IRS issued an AOD announcing “nonacquiescence” to both Simon and Liddle, which means
that the IRS will continue to litigate the issue on similar facts. 9 Nevertheless, I was not surprised
to see some tax advisors advocating that their clients begin to depreciate all sorts of assets that
were not previously thought to satisfy the “wear and tear” language in § 167(a). 10
Section 168 contains both normative elements (the allowance of depreciation deductions in
wasting assets in order to measure income properly in a realization-based income tax) and tax
expenditure elements (faster deduction than would be allowed under economic depreciation). Let’s
finally turn to the mechanics of § 168 to see why these statements are true.

C. Depreciation of tangible assets
While the authority to take a depreciation deduction is found in § 167(a), the rules under which
the deductions are taken over time are found in § 168 if the property is tangible. Moreover, small
businesses are permitted to expense (currently deduct) certain capital expenditures of tangible nonreal estate under § 179. In the case of intangible property, amortization deductions, if allowable,
are taken under the rules found in either §§ 167 or 197, discussed in Part E.
The TCJA supercharged the ability to immediately deduct the cost of non-real estate assets
through 2022 by permitting 100% of the cost of tangible assets with useful lives of 20 years or less
to be deducted in the year of purchase under § 168(k), commonly referred to as “bonus
depreciation,” if they were placed in service after September 27, 2017. For that reason, § 179
expensing and § 168(a) regular depreciation (as opposed to § 168(k) bonus depreciation) are
effectively irrelevant for such property until 2023. Because real estate is not eligible for either §
179 expensing or § 168(k) bonus depreciation, however, depreciable real estate remains subject to
the regular depreciation rules.
Even though § 168(k) occupies the field for a large swath of non-real estate assets through 2022,
I nevertheless run through the logical order of steps to take, including consideration of § 179 and
regular depreciation, so that you understand the analysis for years after § 168(k) begins to phase
down, as well as the analysis for real estate under current law.
(1) Can all or a portion of the purchase price be treated as an “expense” that is deducted
immediately under § 179 (as opposed to a capital expenditure, which is not deductible but
which creates basis that can be depreciated)?
(2) After taking any § 179 expense deduction that is allowable, what is the initial basis that
can be depreciated under § 168(a)? Under § 168(b)(4), salvage value can be ignored.
(3) What is the property’s classification under § 168(e)? You need this information in
order to determine …
(4) What is the property’s recovery period under § 168(c)? If 20 years or less, is “bonus”
depreciation available under § 168(k) or has § 168(k) expired?
(5) If not all of the property’s cost can be immediately deducted under §§ 179 and 168(k),
§ 168(a) regular deprecation must be calculated, as well. What is the property’s applicable
8

103 T.C. at 287.
See 1996-2 C.B. 2.
10
Deborah A. Geier, Loose Application of Depreciation Doctrine, 120 TAX NOTES 989 (2008).
9

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depreciation method for this purpose under § 168(b)?
(6) What is the property’s applicable convention under § 168(d) regarding when it is
deemed to be placed in service in the first year (or taken out of service if disposed of before
the property’s basis has been fully deducted)?
The material below first explores non-real estate tangible assets (such as business equipment)
and then considers real estate (buildings).
Non-real estate
Let’s use the following fact pattern below to explore each of these steps in the analysis.
Sally purchases a widget-making machine for $1.3 million on April 3, 2022, for
use in her profitable business, and she places the equipment into service on
May 18, 2022. The IRS has assigned a “class life” of 7 years to this equipment
in a Revenue Procedure. This is the only depreciable business property that
Sally purchases for her business this year.
Section 179 expensing
Sally’s entire $1.3 million outlay would be a nondeductible capital expenditure under the
standards explored in Chapter 4 rather than its opposite, an expense (a current wealth decrease),
because the widget-making machine will last beyond the end of the current year. Because a widgetmaking machine satisfies the “wear and tear” language (i.e., has an ascertainable useful life or,
under Simon, demonstrates physical manifestations of use under a literal approach to “wear and
tear”), Sally’s equipment satisfies § 167(a), and she would depreciate her $1.3 million basis under
the rules found in § 168.
To the extent that Sally is eligible to make (and does make) an election under § 179, however,
Sally can treat all or a portion of the outlay as a current expense rather than a nondeductible capital
expenditure, which permits her to deduct the cost immediately. Read §§ 179(a), (d)(1), and (b)(1)
& (2). The reference to “section 1245 property” in the definition of “section 179 property” means
that the property generally must not be real property, such as a building. 11 (You will learn about §
1245 in the next chapter.) Because a widget-making machine is not real property, it is § 1245
property that is eligible for immediate deduction to the extent not exceeding the limits found in §§
179(b)(1) and (2).
Section 179(b) is the means by which Congress effectively limits § 179 to small businesses.
Indeed, when § 179 was first enacted in 1981 (the same year in which § 168 was enacted), it was
originally entitled “Additional First-Year Depreciation Allowance For Small Business.” For most
of its life, the § 179(b)(1) deduction was capped at $25,000, and the phase-out threshold in §
179(b)(2) was $200,000. Since 2001, however, these amounts have sporadically increased
substantially—albeit only temporarily (usually for one year only in reaction to economic
recessions). In late 2015, however, Congress permanently amended § 179 in the Protecting
Americans from Tax Hikes Act of 2015 (PATH Act) to provide for a $500,000 expense cap under
§ 179(b)(1) and a § 179(b)(2) phase-out threshold of $2 million. The TCJA doubled the expense
cap to $1 million and the phase-out threshold to $2.5 million, with both indexed for inflation for
11

Narrow exceptions to the rule that § 179 cannot apply to real property are found in § 179(d)(1)(B)(ii) and (e),
pertaining to “qualified improvement property,” as defined in § 168(e)(6), and roofs, heating and air conditioning
units, fire protection, alarm, and security systems installed in nonresidential real estate after the property was first
placed in service by the taxpayer.

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years after 2018. The historic $25,000 and $200,000 figures truly cabined § 179 to small
businesses, but with the substantially increased figures now found in § 179, many larger businesses
can now use § 179.
In 2022, the § 179 cap is $1,080,000, and the phase-out threshold is $2.7 million. Because we
are primarily illustrating concepts here (rather than engaging in math exercises), let’s keep the
math easy by using the statutory figures without inflation adjustments. Doing that, no more than
$1 million of Sally’s purchase price could be treated as a current expense, and this $1 million
deduction is phased out, dollar for dollar, as the aggregate amount of § 179 property that Sally
places into service in the year exceeds $2.5 million.
Because Sally does not place into service more than $2.5 million of § 179 property this year,
her $1 million deduction is not phased out to any extent under § 179(b)(2). If we changed the facts
so that she purchases a second piece of § 179 property for, say, $700,000, her $1 million § 179
deduction would be reduced by $500,000: $3 million (the aggregate of § 179 property) less $2.5
million. In that case, she could treat only $500,000 of her aggregate $3 million cost of § 179
property as a current expense ($1 million less $500,000). If Sally purchases, in the aggregate, $3.5
million of § 179 property, she would fully phase out of § 179. Returning to our original
hypothetical, however, Sally can take full advantage of the $1 million maximum § 179 deduction.
Section 168 depreciation
For purposes of § 168 analysis under Step (2), Sally’s basis in the equipment is only $300,000
(instead of $1.3 million) because only capital expenditures (not expenses) create basis. Indeed, if
Sally were permitted to treat $1 million of her $1.3 million purchase price both as an immediately
deductible expense under § 179 and as a capital expenditure creating basis (to be deducted under
§ 168), she would inappropriately enjoy a double tax benefit for the same dollars. Sally can ignore
any potential salvage value of the machine under § 168(b)(4). (Ignoring salvage value was one of
the simplification measures enacted in § 168, as only the basis in excess of the property’s
anticipated scrap or salvage value at the end of its useful life could be depreciated prior to 1981.)
Next, Sally must determine her property’s classification in Step (3) because she needs this
information in order to determine the property’s recovery period in Step (4). With respect to real
property, Congress has described the requirements to be classified as either “residential rental
property” or “nonresidential real property” in § 168(e)(2). In addition, Congress has determined
the classification of many types of property in § 168(e)(3), such as certain race horses (classified
as 3-year property), automobiles and light purpose trucks (5-year property), railroad track (7-year
property), municipal wastewater treatment plant (15-year property), and so on. For property that
is not explicitly classified in § 168(e), the IRS has published lengthy Revenue Procedures that
assign class lives to virtually any type of property that you can imagine. Notice that our fact pattern
provides that Sally’s widget-making machine has been assigned a 7-year class life by the IRS.
Using the table found in § 168(e)(1), Sally determines that property with a class life of 7 years
(right side of the table) is classified as 5-year property (left side of the table).
Armed with this information, Sally can now proceed to Step (4) and determine the property’s
recovery period under § 168(c). Under § 168(c)(1), 5-year property (left side of the table) is
assigned (not surprisingly) a 5-year recovery period (right side of the table). Notice that property
with a class life of 7 years does not have a recovery period of 7 years but rather 5 years.
For many of the years since 2001, though not all, Congress inserted an extra step in the analysis
at this point under § 168(k), a provision typically referred to as “bonus depreciation.” Bonus

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deprecation permits basis to be deducted in the acquisition year before computing regular
depreciation if, in general, the property is tangible and has a recovery period of 20 years or less, is
computer software (which is intangible property), or certain other items listed in § 168(k)(2). Basis
is then reduced under § 168(k)(1)(B) by the amount of bonus deprecation for purposes of then
computing regular depreciation for the first and later years. The PATH Act extended bonus
depreciation under § 168(k) at 50% for 2016 and 2017 but then phased it out in steps, with § 168(k)
scheduled to expire in 2021. The TCJA changed all that! Not only was § 168(k) revived, but the
percentage amount of bonus depreciation was increased to 100% through 2022, 80% for 2023,
60% for 2024, 40% for 2025, 20% for 2026, and 0% in 2027 and thereafter. See § 168(k)(6).
Notice that § 168(k), unlike § 179, is not limited to small and mid-size businesses. There is
no cap to the amount that can be deducted under § 168(k), and there is no phase-out
threshold. Because Sally purchased this equipment in 2022, Sally is able to deduct 100% of
the remaining $300,000 purchase cost for her equipment. Indeed, because § 168(k) could
equally apply to the first $1 million, as well, § 179 is effectively irrelevant to Sally through 2022.
She can go directly to § 168(k) and deduct 100% of the cost of all non-real estate with
recovery periods of 20 years or less. Sally has no § 168(a) regular depreciation to take in
Year 1 or the years following her purchase because she has already deducted the entire
purchase price in Year 1. Her adjusted basis in the property is now $0 under § 1016(a)(2).
In short, she enjoys cash-flow consumption tax treatment for this investment!
Just for purposes of illustration, however, let’s change the facts so that Sally’s purchase occurs
in 2023 (when § 168(k) bonus depreciation is reduced from 100% to 80%) so that we can see how
her regular depreciation would also be calculated. As before, for the sake of simplicity, let’s ignore
the § 179 inflation adjustments both to the expense cap and the phase-out thresholds, which means
that Sally would deduct the first $1 million of the widget-making machine’s $1.3 million cost
under § 179. In that case, she would then be permitted to deduct 80% of the remaining $300,000
cost, or $240,000, under § 168(k)(1)(A) in 2023, reducing her basis under § 168(k)(1)(B) for
purposes of calculating her 2023 § 168(a) regular depreciation to $60,000.
In Step (5), Sally learns that her remaining $60,000 basis will be depreciated under § 168(b)(1)
using the 200% declining balance method, switching to straight-line depreciation in the first year
in which that method would provide a larger deduction. You need not know how the 200%
declining balance method works, as the depreciation tables (described below) will do the work for
you. For the geeks among you, though, the declining balance method means that a constant
percentage (determined by the number of years in the recovery period) is multiplied by the
declining adjusted basis of the property each year.
To illustrate, assume that Andrew will depreciate property with an initial basis of $100,000 over
5 years. The constant percentage that would apply against the property’s adjusted basis would be
20%, as 20% reflects one-fifth of the recovery period. (If the property’s recovery period were 10
years instead of 5 years, the constant percentage would be 10%.) Because Andrew’s recovery
period is 5 years, Andrew would deduct 20% of $100,000 (or $20,000) in Year 1 if he is entitled
to a full year of depreciation in Year 1, reducing his basis to $80,000, 20% of $80,000 (or $16,000)
in Year 2, reducing his basis to $64,000, 20% of $64,000 (or $12,800) in Year 3, and so on. Notice,
therefore, that the declining balance method, under which deductions start higher and move lower
over time, is much faster than economic depreciation, where the deductions start lower and move
higher over time, as described in Part A.
The 200% declining balance method is even better though, as it doubles the percentage (the
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200% reference) that would otherwise be multiplied against the property’s declining adjusted basis
each year. Instead of deducting 20% of $100,000 ($20,000) in Year 1, Andrew deducts 40% of
$100,000 ($40,000) in Year 1 if he is entitled to a full year of deprecation in that year, reducing
his basis to $60,000, 40% of $60,000 ($24,000) in Year 2, reducing his basis to $36,000, and 40%
of $36,000 ($14,400) in Year 3, reducing his basis to $21,600. If we continued to apply the 200%
declining balance method to Year 4, he would deduct 40% of $21,600, or $8,640. Under §
168(b)(1), however, he would abandon the 200% declining balance method and switch to straight
line (ratable deduction of remaining basis over the remaining years) in the first year in which that
method would provide a higher deduction. If the $21,600 basis remaining at the end of Year 3
were deducted in equal amounts in Years 4 and 5, his Year-4 deduction would be $10,800, which
is higher than $8,640. Andrew would switch to the straight-line method for Years 4 and 5.
But we cannot yet jump to applying the 200% declining balance method to Sally’s facts without
considering the half-year convention in Step (6). Under § 168(d)(1), Sally is assumed to place her
equipment into service precisely in the middle of 2023 (rather than on May 18) so that the IRS can
issue depreciation tables for easy taxpayer use (avoiding the need for taxpayers to calculate
depreciation by hand). Absent this simplifying convention, Sally would have to determine her
allowable depreciation for Year 1 by multiplying the depreciation deduction that would be
allowable for the full year by a fraction, the numerator of which would be 228 (the number of days
from May 18 to December 31, inclusive) and the denominator of which would be 365. The halfyear convention in § 168(d)(1) avoids this tedium. Sally would deduct her remaining $60,000 basis
(after applying §§ 179 and 168(k)) over 5 years, with a half year of depreciation in Year 1 (because
she is deemed to place the property into service precisely in the middle of Year 1) and a half year
of deprecation in Year 6 (completing the 5-year recovery period).
Armed with this information, Sally finds the correct table in Revenue Procedure 87-57, 12 which
you can find online. Rev. Proc. 87-57 provides:
Taxpayers use the appropriate table for any property based on the depreciation system,
the applicable depreciation method, the applicable recovery period, and the applicable
convention. The tables list the percentage depreciation rates to be applied to the
unadjusted basis of property in each taxable year.
(Emphasis added.) In other words, taxpayers do not actually have to keep track of the property’s
declining adjusted basis over time, as Andrew did, above, in order to multiply it against the proper
constant percentage under the declining balance method. Rather, to make life simple, the IRS has
figured out the declining percentage amount that, when multiplied by the property’s unadjusted
basis, will arrive at the correct depreciation deduction for each year of the recovery period.
Table 1, below, incorporates the 200% declining balance method switching to straight line, as
well as the half-year convention, for properties with recovery periods of 3, 5, 7, and 10 years.

12

Recovery
Year
1
2
3
4

3-Year

Recovery Period:
5-Year
7-Year

10-Year

33.33
44.45
14.81
7.41

20.00
32.00
19.20
11.52

10.00
18.00
14.40
11.52

1987-2 C.B. 687.

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14.29
24.49
17.49
12.49

Chapter 13

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5
6
7
8
9
10
11

11.52
5.76

8.93
8.92
8.93
4.46

Chapter 13
9.22
7.37
6.55
6.55
6.56
6.55
3.28

The column under 5-Year Recovery Period provides the percentages of Sally’s unadjusted
basis (after applying §§ 179 and 168(k)) that she can deduct in each year of the recovery period.
The percentage for Year 1 to multiply against Sally’s $60,000 unadjusted basis is 20% (.20).
Under the 200% declining balance method and a 5-year recovery period, Sally would be entitled
to deduct 40% in Year 1 if she were entitled to a full year of deprecation in Year 1, but Table 1
properly incorporates the half-year convention, reducing the 40% figure to 20% for Year 1 only.
Sally’s regular deprecation deduction for Year 1 (2023) would be $12,000 ($60,000 x .20). If we
had to determine her Year-2 (2024) deduction without the table, we would have to reduce her
$60,000 basis by the $12,000 deducted in Year 1 to reach $48,000 and then multiply that amount
by 40% to reach $19,200. Table 1, however, allows us to avoid having to figure Sally’s adjusted
basis at this point. Rather, Sally simply would multiply her original $60,000 unadjusted basis
(after applying §§ 179 and 168(k)) by 32%, the figure supplied for Year 2, and we reach the
same $19,200 amount ($60,000 x .32). Similarly, Sally would deduct $11,520 in Year 3 ($60,000
x .1920). Notice the switch to straight-line depreciation in Year 4 of the table, as well as the half
year of depreciation allowable in Year 6, completing the 5-year recovery period.
Continuing with these facts, what if Sally sells the machine on February 3 of Year 3 for, say,
$900,000 because it has lost $400,000 of value since her original purchase for $1.3 million? Sally
must remember to take her Year-3 depreciation deduction before computing her § 1001 gain or
loss. Even though Sally sells on February 3, under the half-year convention she is deemed to sell
precisely in the middle of Year 3, meaning that she deducts one-half of the $11,520 depreciation
deduction that she would otherwise have taken had she not sold, or $5,760. While the half-year
convention is incorporated into the Table for Year 1, the IRS cannot know when Sally may sell, so
she must remember to apply the half-year convention herself in the sale year.
Her A/B for purposes of § 1001 is equal to her original $1.3 million outlay reduced under §
1016(a)(2) by all of the deductions taken under §§ 179 and 168 ($1 million under § 179, $240,000
under § 168(k), and $12,000 under § 168(a) in Year 1, $19,200 in Year 2, and $5,760 in Year 3).
That is to say, Sally’s A/B at the time of sale would be $23,040 ($1.3 million less $1,276,960).
Yes, even after § 168(k) begins to phase out, Sally would be able to deduct in the 20 months (plus
a few days) that she owned this property, more than 98% of its original purchase price—almost
cash-flow consumption tax treatment! Her § 1001 realized gain would be $876,960 ($900,000 A/R
less $23,040 A/B). Even though her depreciation deductions were excessively generous in that
they allowed her to deduct much more than the property’s actual loss in FMV, the § 1016(a)(2)
basis reductions ensure that gain (equal to the excess deprecation) will be realized if Sally sells the
property rather than using it up in her business. Nevertheless, Sally is still better off because of the
time value of money. With respect to the character of this gain (ordinary, capital, or § 1231 gain),
stay tuned, as we shall turn to that issue in the very next chapter.
While § 179 is explicitly elective, regular depreciation under § 168 is not elective. Unlike
regular depreciation, § 168(k) bonus depreciation is elective, but the taxpayer is presumed

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to make the election to take bonus depreciation unless she expressly opts out. See § 168(k)(7).
To police the mandatory nature of § 168(a) depreciation (and § 168(k) bonus depreciation if
the taxpayer fails to elect out), § 1016(a)(2) provides that Sally’s basis will be reduced by
depreciation deductions “allowed as deductions in computing taxable income … but not less
than the amount allowable….” (Emphasis added.) The amount “allowed” refers to the amounts
that Sally actually deducted under §§ 179 and 168. If Sally had taken only the § 179 deduction ($1
million) but had failed to deduct any § 168 depreciation (whether § 168(k) bonus depreciation or
§ 168(a) regular depreciation), her basis would nevertheless have been reduced as though she had
taken her § 168 deductions (the amount allowable). In this manner, Congress does not permit Sally
to delay deductions if, say, she anticipates being in a much higher marginal rate bracket in the
future than in the current year so that she would save more in tax by deducting under the future
higher marginal rates than she would lose because of the time value of money. In short, § 168(a)
depreciation is mandatory.
Real estate
In contrast to Sally’s business equipment, the depreciation of buildings is much more
straightforward. Because a building is not § 1245 property, it is also not § 179 property within the
meaning of § 179(d)(1), so no § 179 expensing is permitted. Moreover, because real property has
recovery periods exceeding 20 years, it is not eligible for § 168(k) bonus depreciation. In short,
only regular § 168(a) depreciation is allowable.
Sally purchases land and an apartment building that is rented to tenants for $1.1
million on May 18, 2022, $100,000 of which $100,000 is allocable to the land.
Because it is already rented to tenants, the building is placed into service
simultaneously with her purchase date.
In Step (2), Sally can depreciate the entire $1 million basis allocable to the building (and none
of the $100,000 allocable to the land). In Step (3), Sally determines that the property is classified
as “residential rental property” within the meaning of § 168(e)(2)(A), rather than “nonresidential
real property” within the meaning of § 168(e)(2)(B). In Step (4), Sally determines that the recovery
period is 27.5 years under § 168(c), as opposed to the 39-year recovery period applicable to
nonresidential real property. In Step (5), Sally must use the straight-line method of depreciation
under § 168(b)(3), which means that her $1 million basis will be deducted in relatively equal
amounts over the 27.5-year recovery period, with the exception of the first and last years. In Step
(6), the mid-month convention applies to real property, rather than the mid-year convention that
applies to Sally’s business equipment. Sally will be deemed to place her apartment building into
service precisely in the middle of May (rather than on May 18).
Armed with this information, Sally finds the depreciation table in Rev. Proc. 87-57 that
incorporates a 27.5-year recovery period, straight-line depreciation, and a mid-month convention,
reproduced below.
27.5-Year Recovery Period and Straigh-Line Depreciation
Month Placed In Service
1
Year 1
Years 2-9
Years 10,
12, 14, 16,

2

3

4

5

6

7

8

9

10

11

12

3.485 3.182 2.879 2.576 2.273 1.970 1.667 1.364 1.061 0.758 0.455 0.152
3.636 3.636 3.636 3.636 3.636 3.636 3.636 3.636 3.636 3.636 3.636 3.636

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18, 20, 22,
24, 26
3.637 3.637 3.637 3.637 3.637 3.637 3.636 3.636 3.636 3.636 3.636 3.636
Years 11,
13, 15, 17,
19, 21, 23,
25, 27
3.636 3.636 3.636 3.636 3.636 3.636 3.637 3.637 3.637 3.637 3.637 3.637
Year 28
1.97 2.273 2.576 2.879 3.182 3.485 3.636 3.636 3.636 3.636 3.636 3.636
Just as with her business equipment, the tables instruct Sally to multiply her $1 million
unadjusted basis by the percentages listed under column 5 (May) for each year of her recovery
period. Sally multiplies her $1 million basis by 2.273% (.02273) and deducts $22,730 in Year 1
because that is the percentage listed under “5” for the 5th month of the year (May). Sally deducts
$36,360 or $36,370 (because of rounding) in each of Years 2 through 27. In Year 28, she deducts
$31,820 ($1 million x .03182). The amounts in Years 1 and 28 differ from the other years because
of both the mid-month convention for Year 1 (which means that Sally deducts 7.5 months of
depreciation in Year 1) and, in Year 28, the remaining half year in the 27.5-year recovery period
plus the 4.5 months of depreciation not deducted in Year 1 under the mid-month convention.
What if Sally spends $150,000 on a new addition, expanding the size of the building, which is
placed into service on August 4 of Year 5? The new addition is a nondeductible capital
expenditure, creating $150,000 of new basis that Sally can depreciate. Under § 168(i)(6), Sally
does not add the $150,000 to her previous basis and depreciate it over the remaining 22 years or
so of her recovery period for the original building. Rather, Sally starts depreciating the $150,000
of new basis over 27.5 years, using the mid-month convention and the straight-line method. Sally
deducts $2,046 ($150,000 x .01364) in Year 1, as that is the Year-1 percentage in column 8 (for
the 8th month), $5,454 ($150,000 x .03636) in Year 2, the same amount in Year 3, and so on.
What if the property had been a factory (nonresidential real property), instead of an apartment
building (residential rental property)? While Sally would still use straight-line depreciation and
the mid-month convention, § 168(c) now requires Sally to depreciate the factory over 39 years
instead of over 27.5 years.
39-Year Recovery Period and Straight-Line Depreciation
Month Placed In Service
1
Year 1
Years 2-39
Year 40

2

3

4

5

6

7

8

9

10

11

12

2.461 2.247 2.033 1.819 1.605 1.391 1.177 0.963 0.749 0.535 0.321 0.107
2.564 2.564 2.564 2.564 2.564 2.564 2.564 2.564 2.564 2.564 2.564 2.564
0.107 0.321 0.535 0.749 0.963 1.177 1.391 1.605 1.819 2.033 2.247 2.461

Prior to 1986, even real estate was depreciable using the declining balance method. One of the
revenue-raising measures adopted in 1986 (to pay for the significant marginal rate reductions that
you read about in Chapter 3) was to require the use of straight-line depreciation for real estate.
Recall, however, that deductions would start lower and increase over time under economic
depreciation, so even straight-line depreciation is accelerated by comparison. Moreover, the
recovery periods of 27.5 years and 39 years are shorter than the probable useful lives of many
buildings.
§ 280F limitations
As noted earlier, both §§ 179 and 168 were first enacted in 1981, and together they operated to

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allow much higher deductions in the early years for non-real estate than had been previously
allowed. After it became apparent both that many were using these provisions to purchase luxury
cars instead of business equipment on the taxpayers’ dime and that deficits were increasing,
Congress enacted § 280F in The Deficit Reduction Act of 1984 to limit the use of §§ 179 and 168
in the case of luxury automobiles. Here is an excerpt from the legislative history.
Congress believed that the investment incentives afforded by … accelerated cost
recovery should be directed to encourage capital formation, rather than to subsidize
the element of personal consumption associated with the use of very expensive
automobiles. The transportation necessary for conducting a business can be obtained
from a luxury car or another car. To the extent an automobile is required for this
necessary transportation, the generally allowable tax benefits should be available.
Beyond that point, however, the extra expense of a luxury automobile provides, in
effect, a tax-free personal emolument which Congress believed should not qualify for
… acceleration of depreciation deductions because such expenditures do not add
significantly to the productivity which these incentives were designed to encourage. 13
Although § 280F uses the words “luxury automobiles” in its title, note that the operative
statutory language in § 280F(a) refers only to “passenger automobiles.” After the TCJA, §§ 179
and 168 deductions are limited under § 280F to $10,100 in Year 1 (for 2020) 14 if § 168(k) bonus
is not taken (increased by $8,000 to $18,100 if bonus depreciation is claimed), 15 $16,100 in Year
2, $9,700 in Year 3, and $5,760 in each subsequent year until basis is fully deducted. In addition,
personal use of a car results in a proportionate reduction of the amount allowable each year. If a
taxpayer uses a car for business purposes 60% of the time (keeping very good contemporaneous
records establishing this business use) and for personal purposes 40% of the time, she can deduct
only $6,000 in 2018 ($10,000x .60). 16 If her business use falls below 50%, she is subject to
additional restrictions. 17
One of the more interesting stories about § 280F pertains to what is now commonly called the
“SUV loophole.” In 1984, Congress wanted to ensure that the new § 280F limits did not apply to
heavier vehicles typically used for farming, construction, and other hauling work (such as in timber
operations). It defined “passenger automobile” to exclude vehicles rated at more than “6,000
pounds unloaded gross vehicle weight.” 18 In 1984, so-called sport utility vehicles (SUVs) were
rare, and those that existed were not yet commonly used by members of the general public for
everyday transportation. Today, of course, SUVs are ubiquitous. The end result is that
environmentally conscious individuals who purchase fuel efficient cars for business use are subject
to the § 280F limits, whereas individuals who purchase an SUV weighing at least 6,000 pounds
for business use are free from § 280F and are thus subsidized with taxpayer dollars. The industry
heavily advertises this loophole, maintaining lists of SUVs that exceed the 6,000 pound
threshold. 19 While bills have been introduced to overturn the SUV loophole in § 280F, none have
13

JOINT COMMITTEE ON TAXATION, GENERAL EXPLANATION OF THE REVENUE PROVISIONS OF THE DEFICIT
REDUCTION ACT OF 1984, JCS-41-84 (Dec. 31, 1984) at 559-60,
at www.jct.gov/publications.html?func=startdown&id=3343.
14
Rev. Proc. 2020-37, 2020-31 I.R.B. 1. These figures are indexed for inflation for years after 2018.
15
See § 168(k)(2)(F)(i).
16
See § 280F(a)(2).
17
See § 280F(b).
18
See § 280F(d)(5).
19
See, e.g., http://fhf-cpa.com/heavy-vehicle-purchases-offer-significant-business-tax-breaksfor-now/.

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been enacted, though § 179(b)(5) was enacted in 2004 to limit the § 179 deduction to $25,000 for
SUVs that escape § 280F (because exceeding 6,000 pounds gross weight) but weigh less than
14,000 pounds. The § 179(b)(5) limit does not apply to trucks and other vehicles weighing more
than 14,000. For the first time, the TCJA indexed the $25,000 figure for inflation for years after
2018. For 2022, it’s $27,000.
In short, vehicles weighing less than 6,000 pounds are subject to § 280F, those weighing
between 6,000 and 14,000 pounds are not subject to § 280F but have a reduced $27,000 § 179
expensing limit in 2022, and those weighing more than 14,000 pounds are not limited by either §
280F or the reduced § 179 expensing limit.

D. Amortization of intangible assets
While § 168 applies only to tangible property, the legislative history described the § 167(a)
standard for depreciable property generally. Recall the following passage from the legislative
history when § 168 was enacted, which was quoted in Judge Hamblen’s Simon dissent.
Assets used in a trade or business or for the production of income are depreciable if
they are subject to wear and tear, decay or decline from natural causes or obsolescence.
Assets that do not decline in value on a predictable basis or do not have a determinable
useful life, such as land, goodwill, and stock, are not depreciable.
(Emphasis added.)
The word “goodwill” in that passage generally refers to the value of a going business beyond
the identifiable tangible and intangible assets (such as patents or licenses) of the business. If Frank
is willing to pay, say, $20,000 to purchase a hot dog stand from Fannie, the excess of $20,000 over
the value of the cart, umbrella, apron, transferable city licenses, hot dogs, buns, mustard, etc., is
the value of the goodwill purchased by Frank. It reflects the customer base already in place that
frequents the hot dog stand, the stand’s reputation for selling good hot dogs, the value of having
trained employees in place (previously hired and trained by Fannie but retained by Frank) who
know how to operate the stand when Frank is not present, and the like. Fannie, who built the
business from scratch, would likely have no basis in this goodwill because the outlays that she
made to build that goodwill would typically have been deducted as ordinary and necessary
business expenses under § 162. But purchasers of going concerns, such as Frank, can have a basis
in goodwill equal to the portion of the $20,000 purchase price for the business as a whole that is
properly allocable to the goodwill (under the rules of § 1060).
Until the enactment of § 197, described below, goodwill was one of those assets always used
as an example of property that clearly was not depreciable or amortizable because it does not waste
away on any predictable basis. Other types of intangible property have long been amortizable
under § 167(a), so long as they had an ascertainable useful life, such as purchased patents, which
have a life that will expire at a time certain under patent law. But purchased goodwill was not
amortizable under § 167(a).
Taxpayers who purchased businesses in the 1980s and 1990s began to argue that certain strands
of goodwill could be carved out and amortized because those particular strands had an
ascertainable useful life. Bank purchasers, for example, attempted to amortize the basis attributable

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to the “core deposits” of the bank on the theory that depositors left their cash in bank accounts for
predicable periods of time. 20 The taxpayer in Newark Morning Ledger Co. v. United States21
bought a newspaper business in Newark, New Jersey, for approximately $328 million and argued
that the one strand of goodwill represented by the current customer subscription base had an
ascertainable useful life (even though the rest of the purchased goodwill did not) because it could
be shown through statistical sampling how long the average current subscriber would remain a
subscriber. The taxpayer argued that the $67.8 million portion of the purchase price properly
allocable to the current customer subscription base should be amortizable under § 167(a),
notwithstanding the general rule that goodwill is not amortizable. The government chose not to
challenge the quality of the taxpayer’s statistical evidence regarding the duration of the paid
subscribers but rather stressed that (1) the paid subscribers list was part of goodwill, (2) goodwill
has no ascertainable useful life and thus is not amortizable, and (3) even if the paid subscriber list
could be carved out from goodwill, it is a self-replenishing asset because new subscribers generally
replace customers who drop their subscription. Over four dissents, however, the Supreme Court
agreed with the taxpayer.
Only very wealthy taxpayers had the resources to fund the kind of exacting statistical data that
are described in these cases when trying to show that one strand of overall goodwill had an
ascertainable useful life. When these cases went to litigation, they consumed vast resources on the
part of both the government and the taxpayer in their battle of the experts. Congress enacted § 197
in 1993 as a measure intended to level the playing field between wealthy taxpayers and small
business taxpayers (like Frank) and to save litigation costs all around. Under § 197, purchased
goodwill is now amortizable using the straight-line method over 15 years—regardless of whether
it has an ascertainable useful life. The entire basis attributable to the purchased goodwill in Newark
Morning Ledger (not limited to the $67.8 million allocable to the paid subscribers list) would have
been amortizable under § 197 had it been in effect then. 22 In short, Congress chose simplicity over
theoretical purity.
The definition of a “§ 197 intangible” is broad, including not only goodwill in general but also
most of its constituent parts, such as going concern value, workforce in place, customer-based
intangibles, licenses, permits, franchise, trademarks, covenants not to compete, and even the “core
deposits” sought to be amortized by the bank buyer noted earlier. 23 Notable exceptions are listed
in § 197(e), including items purchased separately and not part of a going business. 24 For example,
if Janice purchases a patent (and nothing else) with a remaining life of 10 years, the patent is not
amortizable under § 197, but she can amortize that patent under § 167(a) using the straight-line
method over its remaining 10-year life. If, however, Janice purchases an entire business, one asset
of which is a patent with a remaining life of 10 years, she must amortize that basis (along with the
basis of the purchased goodwill generally) over 15 years because it is a § 197 intangible. 25 Whether
amortizable under § 167(a) or § 197(a), intangible property is amortized using the straight-line
method, starting on the first day of the month in which the intangible is placed in service. 26

20

See, e.g., Citizens & Southern Corp. v. Comm’r, 91 T.C. 463 (1988), aff'd, 919 F.2d 1492 (11th Cir. 1990).
507 U.S. 546 (1993).
22
See §§ 197(a) and (d)(1)(A).
23
See § 197(d)(2)(B).
24
See § 197(e)(4).
25
See § 197(b) (providing that § 197 is the exclusive provision governing amortization of any § 197 intangible).
26
See Treas. Reg. §§ 1.167(a)-3(b)(3); 1.197-2(f)(1).
21

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E. Amortization of start-up costs
One of the § 162 requirements for deduction of business expenses is that they must be incurred
in “carrying on” a trade or business. The carrying-on requirement generally means that even
outlays that otherwise qualify as expenses (current wealth decreases) are not currently deductible
if incurred before the business begins operation. Rather, these outlays must be capitalized in the
basis of the new business as a whole. Absent § 195, this basis would usually be recovered only as
an offset against amount realized under § 1001 when the business is eventually sold. Section 195,
however, allows such start-up costs to be deducted sooner. 27
How much sooner depends on how substantial they are. See § 195(b)(1). In the year the business
opens, an electing taxpayer may deduct an amount equal to the lesser of (1) the aggregate start-up
costs or (ii) $5,000 reduced (but not below zero) by the amount by which the start-up costs exceed
$50,000. The remainder (if any) of the start-up costs is deductible ratably (i.e., straight-line
amortization) over the 180 months (15 years) beginning with the month in which the business
begins. The amortization of the remainder (if any), in other words, is patterned after § 197.
Assume, for example, that Annie opens her new business on November 1 of Year 1. How much
can she deduct in Years 1 and 2 if her aggregate start-up costs total $4,000? $54,500? $540,000?
If Annie’s start-up costs total $4,000, she can deduct the entire $4,000 in Year 1, leaving no
remainder to deduct in later years. If Annie’s start-up costs total $54,500, she can deduct in Year
1 $500 ($5,000 less [$54,500 less $50,000]) plus 2 months of amortization of the remaining
$54,000, calculated at $300 per month ($54,000/180). She can deduct $1,100 in Year 1 and $3,600
in Year 2 ($300 x 12 months).
If Annie’s start-up costs total $540,000, she can deduct 2 months of amortization of the
$540,000, calculated at $3,000 per month ($540,000/12). She can deduct $6,000 in Year 1 and
$36,000 in Year 2 ($3,000 x 12).
While the language in § 195 refers to a taxpayer election, the regulations deem the election to
have been made unless the taxpayer affirmatively elects to capitalize the costs. 28 A taxpayer who
is amortizing start-up costs under § 195 but disposes of the business before the 15-year
amortization period expires can deduct the remaining basis as a loss under § 165. 29

F. Tax arbitrage: the business interest deduction for
debt-financed purchases of expensed (or nearly expensed) assets
As described above, depreciation is normative in a realization-based income tax (i.e., necessary
to measure the tax base properly) to the extent that it is allowed (1) only with respect to assets that
predictably waste away over time and (2) at a rate no faster than economic depreciation. The
portion of allowable depreciation (and § 179 deductions) in the Internal Revenue Code that
exceeds these constraints is a tax expenditure—a provision that exists for nontax reasons, such as
to encourage larger investments in business equipment than would otherwise occur.
27

Subchapters C (pertaining to corporations) and K (pertaining to partnerships) have similar rules for start-up costs
incurred by businesses operated by those entities rather than by an individual. See §§ 248 and 709.
28
See Treas. Reg. § 1.195-1(b).
29
See § 195(b)(2).

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Alternatively, the provisions permitting either expensing or depreciation faster than economic
depreciation can be viewed as deliberately moving the income tax closer to a cash-flow
consumption tax. But the tax arbitrage that can result when interest is fully deducted (under the
income tax rules for debt) with respect to debt used to purchase assets accorded consumption-taxlike treatment provides better than consumption tax treatment—or negative tax (a subsidy). In
other words, this combination can supercharge inefficient rent-seeking behavior, which you read
about in Chapter 3—resulting in a mere transfer of wealth from taxpayers in general to the debtfinanced equipment purchaser, rather than an increase in aggregate societal wealth.
Recall from Chapter 2 that, under an income tax, borrowed principal is excluded from the tax
base, repaid principal is not deducted, but business interest is deducted. Under a cash-flow
consumption tax, in contrast, borrowed principal is included in the tax base (as potential
consumption), and both repaid principal and interest are deductible (as non-consumption outlays).
To avoid the messiness of including borrowed principal and deducting principal repayments, the
rules applicable to debt under a wage tax could be used, instead, as these two tax systems are (with
caveats) economically equivalent. Under a wage tax, borrowed principal is not included and repaid
principal is not deducted (as under an income tax) but business interest is not deducted (unlike
under an income tax). To the extent that the Internal Revenue Code allows premature deduction
of basis (as under a cash-flow consumption tax), it should disallow the interest deduction on debt
used to purchase the property.
In this context, tax arbitrage, a concept also introduced in Chapter 2, is the mixing of the rules
of one tax regime with the rules of another tax regime to achieve a result that is inconsistent with
(and better than) either of them. The combination of allowing both (1) cash-flow consumption
taxation of an investment and (2) an interest deduction accompanying the purchase of that taxpreferred investment with debt can result in better-than-consumption-tax treatment. This tax
arbitrage “profit” is not the result of entrepreneurial daring but the effective equivalent of a simple
transfer payment from the Treasury (other taxpayers).
Prior to the TCJA, this kind of tax arbitrage was limited chiefly to small businesses who could
take advantage of § 179 expensing of assets purchased with debt. Their § 179 assets could be
immediately expensed, and yet their § 163(a) business interest deduction was not limited to any
extent. More subtle tax arbitrage arose when debt-financed assets could be depreciated faster than
would be permitted using economic depreciation, under which depreciation deductions would start
lower and increase as the asset gets closer to the end of its useful life. Recall the 200% declining
balance method for most non-real estate and even the straight-line method for real estate, both of
which are faster than economic depreciation. Yet, business interest was generally fully deductible
prior to the TCJA.
As you learned in Part C., the TCJA extended the life of § 168(k) bonus depreciation (which
had previously been scheduled to expire) and then supercharged it by permitting 100% expensing
for property with a recovery period not exceeding 20 years through 2022. If we are to honor tax
values, all interest attributable to debt used to purchase long-lived property that is immediately
expensed (instead of depreciated over time) should be nondeductible.
Yet, these taxpayers are permitted to deduct their business interest, though the TCJA reduces it
for some taxpayers. Amended § 163(j) generally provides that business interest expense in excess
of business interest income (i.e., net business interest expense) is deductible in any year only to

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the extent of 30% of “adjusted taxable income” (defined below). 30 Any nondeductible interest
under this formula can be carried forward indefinitely for possible deduction in future years when
“adjusted taxable income” is high enough to allow deduction of both that year’s net business
interest expense and the business interest deduction carryover.
Where did the 30% figure come from? There is no legislative history explaining it. Perhaps it’s
simply patterned after German law, which adopts a similar rule to discourage heavily leveraged
acquisitions while not troubling most businesses. 31
Because § 163(j) continues to allow a business interest deduction, it creates tax arbitrage profits
for heavily debt-financed, capital-intensive businesses that can expense much of their capital
spending immediately and yet continue to offset up to 30% of their “adjusted taxable income” with
business interest deductions
Until 2022, § 163(j)(8) defined “adjusted taxable income” generally as business gross income
less business expenses (not depreciation or amortization) except for the business interest itself, §
172 NOL deductions (if any), and the § 199A pass-through deduction (if any). Beginning in 2022,
depreciation and amortization also reduce “adjusted taxable income,” which effectively means that
less interest will be deductible.
Businesses with average annual gross receipts of less than $25 million (indexed for inflation
for years after 2017) are free from the § 163(j) limit. 32 The 2022 indexed amount is $27 million.
Recall that real estate is not eligible for § 168(k) bonus depreciation because the recovery period
for real estate is either 27.5 years or 39 years, which exceeds 20 years. Presumably for that
reason—though again there is no legislative history explaining it—those conducting certain real
estate businesses (as defined by § 469(c)(7)(C)) can elect to avoid the § 163(j) interest deduction
limit so long as they agree to lengthen the recovery period for their real estate to 30 years for
residential real estate (instead of 27.5 years) and 40 years for nonresidential real property (instead
of 39 years). Because the lengthening of the recovery period is comparatively trivial, real estate
businesses with a lot of debt (i.e., most of them) will likely make the § 163(j)(7) election. They
will continue to enjoy the tax arbitrage profits that accompany a full interest deduction with
depreciation that is faster than economic depreciation.
Problems
In each problem, describe how much Fiona (or Frank, as the case may be) can deduct in each
of Years 1 (the current year), 2, and 3. For ease, you may ignore all inflation adjustments under §
280F, § 179, and § 163(j)(3).
1. On January 20, Year 1, Fiona purchases a personal residence for $400,000.
2. On April 4, Year 1, Fiona purchases shares of High Tech stock for $400,000.
3. On September 24, Year 1, Fiona purchases a desk once used by Louis XIV for $400,000. She
30

The reference to “floor plan financing interest” refers to special rules applying to car dealerships who purchase their
inventory with debt.
31
My thanks to the late, great Professor Ed Kleinbard for this information.
32
See § 163(j)(3) (cross-referencing the $25 million gross receipts test in § 448(c)(1), indexed for inflation).

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uses it as her factory office desk (see 4.)
4. On March 2, Year 1, Fiona purchases land and a factory building for $12 million in which
she will produce widgets, with $2 million allocable to the land and $10 million allocable to the
building. The factory is already in service.
5. Same as 4., except that Fiona spends $1 million on a significant addition to the building,
which is placed in service on September 2, Year 2.
6. On May 12, Year 1, Fiona purchases a widget-making machine for use in her factory for $1.5
million, which she places into service immediately. This machine is the only business equipment
that she purchases this year. The IRS has assigned a class life of 7 years to the machine. Fiona
would like to deduct this cost as early as possible.
7. Same as 6., except that Fiona does not wish to deduct this cost as early as possible. (Why
might that be so?) She chooses not to make a § 179 election and affirmatively elects out of bonus
depreciation under § 168(k)(7).
8. Same as 7., except that Fiona sells the machine on April 24 of Year 3 for $900,000.
9. Fiona borrowed $10 million at 5% interest to finance in part her purchase of both the factory
and widget-making machine, paying $500,000 of interest on the loan this year. The widget factory
is not a “real property trade or business” within the meaning of § 469(c)(7)(C). Her gross receipts
are $30 million, and she has earned similar gross receipts in prior business ventures before her
purchase of the factory this year. Fiona’s aggregate deductions for business expenses (e.g., for
employee salary, utility costs, insurance, and the like), as well as the depreciation on her factory
and widget-making machine, total $20 million. Can she deduct all $500,000 of her business interest
expense under § l63(a) this year, or will § 163(j) limit her interest deduction?
10. On September 4, Year 1, Frank purchases a passenger automobile (weighing 3,200 pounds)
for $40,000, which he uses exclusively in his business. The car is the only new business property
that Frank purchases this year. How would your answer change (if at all) if Frank instead purchased
an SUV (weighing 7,000 pounds), instead, for $40,000? Assume that Frank does not elect out of
§ 168(k) bonus depreciation.
11. On January 8, Year 1, Frank purchases a secret formula owned by Fiona but no longer used
by her for use in his own business, paying $150,000 and placing it into service on the same date.

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Chapter 14: Capital Gains and Losses
In Chapter 12, you learned that the first step in analyzing the tax consequences of a property
disposition is to determine the § 1001 realized gain or loss (the difference between amount realized
and adjusted basis). The second step is to determine whether the realized gain is includable in
Gross Income under § 61(a)(3) or realized loss is recognized and deductible under § 165. Only if
the gain is includable or the loss is deductible is it necessary to go on to the third step:
characterizing the includable gain or deductible loss as ordinary, capital, or § 1231 gain or loss
(and determining why that characterization matters). This chapter explores that third step.
A gain or loss is capital if described in § 1222(1) through (4). The common ingredients found
in each of those four subsections provide that an otherwise includable § 1001 gain or otherwise
deductible § 1001 loss (under § 165) is capital only if the gain or loss arises from the “sale or
exchange” of a “capital asset.” Section 1221 defines capital asset. Moreover, § 1222 also confirms
that an includable capital gain or deductible capital loss is short term if the property sold or
exchanged was held for one year or less and long term if held for more than one year.
You were introduced in Chapter 1 to the two most important consequences that arise when a
gain or loss is characterized as capital because they had immediate relevance to many topics
already explored.
•

Otherwise deductible (under § 165) capital losses are treated less favorably than deductible
ordinary losses because only the former are subject to the § 1211(b) capital loss limitation
rule (cross-referenced in § 165(f)).

•

“Net capital gain,” as defined in § 1222(11), is treated more favorably than ordinary income
and gain because it is taxed at a preferential rate under § 1(h) when realized by individuals. 1

Part A. examines the § 1211(b) capital loss limitation (and the § 1212(b) carryover rule) more
closely. Part B. explores the asserted rationales for a tax preference for net capital gain, the
definition of net capital gain, and the planning possibilities implied by that definition. Part C
considers the § 1221 definition of capital asset, including the Arrowsmith doctrine, as well as the
sale or exchange requirement. Part D. considers the treatment of § 1231 gains and losses, as well
as so-called depreciation recapture under §§ 1245 and 1250. Finally, Part E. briefly describes the
various special rates applicable to net capital gain found in § 1(h).

A. Capital losses
A taxpayer who realizes more capital losses than capital gains in a given year cannot have any
hope of preferentially taxed net capital gain within the meaning of § 1222(11). The only question
at issue in this scenario is the extent to which the capital losses are deductible.
Section 165(f) reminds us that an otherwise deductible § 1001 loss—i.e., a loss described in §
165(c) in the case of an individual—is subject to limitation under § 1211 if the deductible loss is
1

The corporate rate schedule in § 11 has no counterpart to § 1(h), so net capital gain realized by corporations is not
subject to a reduced tax rate. Corporations are nevertheless subject to the deduction restriction (and carryover) for
capital losses, though these rules differ from those applied to individuals. See §§ 1211(a) and 1212(a).

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capital. Under the language in § 1211(b), the aggregate of otherwise deductible capital losses
(whether long term or short term) is allowed in the year realized only to the extent of the sum
of (1) the aggregate of realized and included capital gains (whether short term or long term)
and (2) up to $3,000 of included ordinary income. Any excess (undeducted) capital loss is
carried forward and treated as realized in each succeeding taxable year under § 1212(b) until
either the loss is deducted or the taxpayer dies. 2 Under § 62(a)(3), loss deductions are taken
above the line.
Section 1211(b) is needed so long as the law incorporates both the realization requirement (as
opposed to a mark-to-market system, described in Chapter 1) and a preferential rate for net capital
gain. It addresses the cherry-picking problem that would, in the absence of § 1211, otherwise allow
a taxpayer (1) to deduct what looks like a wealth decrease when in fact the taxpayer is wealthier
or (2) to engage in rate arbitrage by using capital losses to offset high-taxed ordinary income
instead of low-taxed capital gain.
To illustrate, assume that Lindsey, who earns $100,000 in wages each year, purchases both
Whiteacre and Blackacre for investment on January 1 of Year 1. By December 31 of Year 1,
Whiteacre has increased in value by $10,000, and Blackacre has decreased in value by $8,000. If
the realization requirement were abolished and Lindsey had to mark to market both Whiteacre and
Blackacre each year, she would include the $10,000 Whiteacre gain in her Gross Income (and
increase her Whiteacre basis by $10,000) and deduct the $8,000 Blackacre loss (and reduce her
Blackacre basis by $8,000), accurately reflecting her $2,000 net wealth increase for the year.
Because of the realization requirement, however, Lindsey has the power to choose when (and if)
to realize the Whiteacre gain and the Blackacre loss. Absent § 1211(b), Lindsey could choose to
realize and deduct only the $8,000 Blackacre loss (and not the $10,000 Whiteacre unrealized gain)
in Year 1, making it appear that she has suffered an $8,000 wealth reduction when, in fact, she has
actually enjoyed an economic net wealth increase of $2,000 for the year when both Blackacre and
Whiteacre are considered together. Moreover, absent § 1211(b), Lindsey could use that $8,000
deduction to offset $8,000 of her high-taxed wages, saving the $10,000 of capital gain to be taxed
at the low net capital gain rate in, say, Year 3 (a year in which she realizes no capital losses) by
waiting to sell Whiteacre until then.
In essence, § 1211(b) forces Lindsey to sell both Whiteacre and Blackacre if she wishes to fully
deduct the $8,000 Blackacre loss in Year 1. If Lindsey sells only Blackacre in Year 1 and realizes
no capital gain, she can deduct only $3,000 of her $8,000 realized loss and must carry forward the
remaining $5,000 undeducted loss under § 1212(b). If Lindsey again fails to sell Whiteacre in
Years 2 and 3, she could deduct only $3,000 of her $5,000 carryover loss in Year 2, and the
remaining $2,000 loss in Year 3. The $3,000 in capital losses that Lindsey is permitted to deduct
in excess of her realized and included capital gains each year is nothing more than a de minimis
rule intended to allow individuals to deduct small capital losses without the bother of carrying
them to future years. Nevertheless, the $3,000 de minimis rule is valuable for Lindsey, as it allows
capital losses to offset high-taxed income. (More on tax planning possibilities in Part B., below.)
How does Lindsey know whether any capital loss carryover should be treated as a long-term
2

Unused deductions at the time of a decedent’s death, including capital loss carryovers, cannot be transferred to the
decedent’s heirs for their use. Recall from Chapter 7 that, as described by Henry Simons, an income tax is not a tax
on income per se but rather is a tax imposed on people—as measured by their wealth accessions and wealth reductions
(representing their ability to pay). Do not feel too sorry for the heirs for being unable to deduct wealth decreases
suffered by others, however. Remember §§ 102 and 1014, which benefit heirs mightily.

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capital loss or as a short-term capital loss in any future carryover year? While its nature as a longterm loss or short-term loss is irrelevant under § 1211(b) in determining the deductibility of capital
losses, this determination might have an impact on possible net capital gain in the future year to
which she carries the loss. Lindsey needs to know whether any carryover loss under § 1212(b) is
considered short term or long term in future years.
As I have made clear many times before, I think that it is important for students to become
comfortable with pulling apart statutory language and figuring out what it means, which is why I
have always encouraged you to do so with respect to the relevant statutory language under study.
Every rule has its exceptions, however, and I do not think it is worth the trouble in connection with
§ 1212(b). You can take my word for it that I am accurately describing here the mechanics of §
1212(b).
To determine the nature of a capital loss carryover as short term or long term under §
1212(b), the taxpayer must net together any short-term capital gains and short-term capital
losses in the realization year and do the same with long-term capital gains and long-term
capital losses. The taxpayer’s capital loss carryover maintains the same character (as short
term or long term) as the taxpayer’s net loss position in the realization year.
For example, assume that Lindsey, who earns $100,000 in wages each year, realizes the
following includable gains and deductible losses (under § 165(c)) in Year 1:
short-term cap gain

short-term cap loss

long-term cap gain

long-term cap loss

$3,000

$10,000

$13,000

$12,000

Because Lindsey realizes more capital losses ($22,000) than capital gains ($16,000), she has no
hope of any preferentially taxed net capital gain. Her only questions are (1) the extent to which she
can deduct her capital losses under § 1211(b) and (2) the character of any capital loss carryover
under § 1212(b). The answer to the first question is that she can deduct $19,000 of her $22,000 in
aggregate capital losses, equal to the $16,000 in realized and included capital gains plus $3,000.
She must carry forward the remaining $3,000 of her otherwise deductible capital losses to Year 2
under § 1212(b). Moreover, because she realizes a $7,000 net short-term capital loss ($10,000
short-term capital loss less $3,000 short-term capital gain) and $1,000 net long-term capital gain
($13,000 long-term capital gain less $12,000 long-term capital loss) in Year 1, her $3,000 capital
loss carryover is treated as a short-term capital loss in Year 2 (the same as her net loss position in
the realization year).
What if Lindsey realizes a net loss in both her short-term and long-term columns? For example,
assume the same facts except that Lindsay realizes a $14,000 long-term capital loss instead of a
$12,000 long-term capital loss in Year 1.
short-term cap gain

short-term cap loss

long-term cap gain

long-term cap loss

$3,000

$10,000

$13,000

$14,000

As in the prior iteration, Lindsey can deduct $19,000 of her aggregate capital losses, equal to the
$16,000 in realized and included capital gains plus $3,000. She now has a $5,000 carryover loss
under § 1212(b), however, instead of a $3,000 carryover loss. In Year 1, Lindsey realized a $7,000
net short-term capital loss ($10,000 short-term capital loss less $3,000 short-term capital gain) and
a $1,000 net long-term capital loss ($14,000 long-term capital loss less $13,000 long-term capital
gain). The convoluted language in § 1212(b) provides that, when a taxpayer has both a net
short-term capital loss and net long-term capital loss in the realization year, the carryover
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loss is deemed to come first from the net long-term pot (to the extent thereof) and, if
necessary, from the net short-term pot. The first $1,000 of Lindsey’s $5,000 carryover loss is
treated as long-term capital loss in Year 2 (equal to her $1,000 net long-term capital loss in Year
1), with the remaining $4,000 treated as a short-term capital loss in Year 2. Lindsey would again
apply §§ 1211(b) to determine how much of these Year-2 losses (in addition to any other capital
losses actually realized in Year 2) could be deducted.
Problem
Jacob earns $100,000 in wages each year. In addition, he realizes and recognizes the capital
gains and losses listed below. Each of the realized and recognized capital losses are otherwise
deductible under § 165(c). Because Jacob’s capital losses exceed his capital gains each year, he
has no hope of preferentially taxed net capital gain, explored in the next subsection. But can he
fully deduct his capital losses? Describe how §§ 1211(b) and 1212(b) apply to Jacob in each year.
short-term cap gain short-term cap loss
Year 1
Year 2
Year 3

$2,000
3,000
1,000

$10,000
2,000
5,000

long-term cap gain
$5,000
0
4,000

long-term cap loss
$

0
6,000
5,000

B. Net capital gain
If capital gains exceed capital losses for the year, the taxpayer has a chance (though not the
certainty) of having preferentially taxed net capital gain. The extent of the tax preference for net
capital gain has varied widely over time, as shown in the chart below. 3

As illustrated above, there was no preference before 1922 and between 1987 and 1990. In the
1920s and early 1930s, and again since 1990, the top net capital gain rate was separately stated.
Between the mid-1930s and 1986, no separate statutory rate applied, but only a percentage of
capital gains was included in the tax base, effectively reducing the tax rate that applied. Since
WWII, when the income tax moved from a class tax to a mass tax, the maximum capital gains tax
3

The chart is from Roberton Williams, Tax Rates on Capital Gains, 124 TAX NOTES 251 (2012). Reprinted with
permission of Tax Analysts.

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rate has fluctuated in fairly significant ways—from 25% in the 1950s and 1960s to 35% in the
1970s (when the highest marginal rate on ordinary income was 91% and 70%, respectively) to
20% immediately before the Tax Reform Act of 1986 (when the highest marginal rate on ordinary
income was 50%). 4 As you read in Chapter 3, the 1986 Act increased the rate applicable to net
capital gain from 20% to 28% and reduced the highest marginal rate on ordinary income and gain
from 50% to 28% so that net capital gain was no longer taxed at a preferential rate beginning in
1987. That state of affairs lasted only three years, however. When the highest marginal rate on
ordinary income and gain was raised from 28% to 31% in the George H.W. Bush administration,
the 28% rate applicable to net capital gain remained unchanged, thus re-introducing a modest rate
differential once again. During the Clinton administration, the top rate on ordinary income
increased to 39.6% while the top rate applicable to most net capital gain was reduced to 20%.
During the George W. Bush administration, the top ordinary rate was reduced to 35%, and the top
net capital gain rate was generally reduced to 15% (and extended to certain dividend income).
The American Taxpayer Relief Act of 2012 restored the highest marginal rate on ordinary
income and gain to 39.6% and restored the 20% net capital gain rate for such gain within Taxable
Income exceeding $400,000 ($450,000 for married couples filing jointly). Net capital gain within
Taxable Income below those thresholds remains generally at 15% (or 0% for low-income
taxpayers). As you learned in Chapter 1, Part B., however, most net capital gain is concentrated in
high-income households. The Tax Cuts and Jobs Act of 2017, which reduced the highest marginal
rate on ordinary income and gain to 37%, did not change the capital gains rates.
Why is net capital gain taxed at a preferential rate?
The first issue in considering this question is to ask why net capital gain should be taxed more
lightly than labor income. Before the first Reagan-era tax legislation enacted in 1981, the highest
marginal rate on ordinary income other than labor income was 70%, but labor income was subject
to a maximum marginal rate of 50%. This preference meant that labor income could be taxed more
lightly than capital income in the form of interest, rents, royalties, and dividends. i.e., capital
income other than net capital gain. The now-repealed preferential rate for labor income may have
had its roots in notions that labor income not only preceded capital income but was more fleeting
in nature.
For example, President Abraham Lincoln’s State of the Union address on December 3, 1861,
contained the following passage: “Labor is prior to and independent of capital. Capital is only the
fruit of labor, and could never have existed if labor had not first existed. Labor is the superior of
capital, and deserves much the higher consideration.” 5 Even the extremely wealthy Treasury
Secretary Andrew W. Mellon, no knee-jerk liberal, 6 argued in the 1920s that earned income ought
4

The mechanism used prior to 1986 to effectuate the reduced capital gain tax rate was to allow exclusion of 60% of
realized net long-term capital gains (the excess of long-term capital gains over long-term capital losses). With a top
tax rate of 50%, the 60% exclusion resulted in an effective maximum capital gains tax rate of 20% (40% includable
amount of net long-term capital gains x .50 maximum tax rate). Congress replaced the exclusion method in 1986 with
§ 1(h), specifying tax rates for various types of net capital gain, explored in Part E., below.
5
See www.infoplease.com/t/hist/state-of-the-union/73.html.
6
For example, Al Gore, Sr., criticized the post-WWII income tax rate decreases proposed by Republicans as “right
out of the Andrew Mellon primer on special privilege.” JOHN F. WITTE, THE POLITICS AND DEVELOPMENT OF THE
FEDERAL INCOME TAX 132 (1985). Professor Michael Graetz refers to William Simon—President Ford’s Treasury
Secretary—as “probably the most conservative Treasury Secretary since Andrew Mellon.” MICHAEL GRAETZ, THE
DECLINE (AND FALL?) OF THE INCOME TAX 225 (1997). Mellon was the first to argue adamantly in the political arena
for supply-side reductions of high marginal rates on the wealthy as the “scientific” way to raise revenue through a

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to be more lightly taxed than capital income.
The fairness of taxing more lightly incomes from wages, salaries and professional
services than the incomes from business or from investments is beyond question. In
the first case, the income is uncertain and limited in duration; sickness or death
destroys it and old age diminishes it. In the other, the source of the income continues;
the income may be disposed of during a man’s life and it descends to his heirs.
Surely we can afford to make a distinction between the people whose only capital is
their mental and physical energy, and the people whose income is derived from
investments. Such a distinction would mean much to millions of American workers
and would be an added inspiration to the man who must provide a competence during
his few productive years to care for himself and his family when his earning capacity
is at an end. 7
E.R.A. Seligman of Columbia University, an influential early scholar on income taxation, also
supported “differentiating between earned and unearned income, on the grounds that unearned
income is a reliable symptom of greater freedom to choose how the income will be used.” 8
A tax credit equal to a portion of earned income was therefore introduced in 1924. While it
waxed and waned over the years, the idea was reinvigorated in 1969, when the top rate for earned
income was capped at 50%, while the top rate for other ordinary income was 70%. As noted above,
this preferential tax rate was repealed in the first Reagan-era tax legislation in 1981; the top rate
on ordinary was also reduced to 50% without further reduction in the maximum rate applicable to
labor income.
A second issue when considering the rate preference for net capital gain is to ask why net capital
gain should be taxed more lightly than other forms of capital income, such as interest, rents, and
royalties. The early reasoning was likely connected to doubts about whether capital appreciation
constituted “income” at all under early notions of that term borrowed from trust accounting, as
described in Chapter 1. Recall the example provided there. Father died 200 years ago. In his will
he directed that all of his land, rented to tenant farmers, be contributed to a trust. The trust
document instructed the trustee (who managed the trust property) to distribute the income from
the trust annually to his surviving wife for the rest of her life (a life estate), with the remainder
distributed to his son on his wife’s death. Upon his wife’s demise, the trust would distribute the
land to the son, and the trust (which would no longer own any property) would be dissolved.
Under trust law at the time, rent collected from the tenant farmers was income that was
distributed to the wife annually. If, however, the trustee decided to sell a plot of land for $100 that
had been purchased by Father before his death for, say, $75, the $25 profit from that sale was not
considered income to be distributed to the wife but rather part of the trust corpus, which was
eventually distributed to the son under his remainder interest. Does that mean that the $25 profit
should not constitute income for tax purposes, as well? Early on, some argued that it did. The
lower tax rate first imposed on such “capital gain” in the early 1920s can be viewed as a
compromise between the position that property gain did not constitute income at all and the
position that such gain is income in the same sense as other forms of realized wealth accessions.
growing economy. He analogized the “right” tax rate to the right “price” charged by a business to maximize overall
profit. See ANDREW W. MELLON, TAXATION: THE PEOPLE’S BUSINESS 93-107 (1924).
7
MELLON, supra note 6, at 56-58.
8
Stephen Utz, Ability to Pay, 23 WHITTIER L. REV. 867, 913 (2002).

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After George Schanz, Robert Haig, and Henry Simons succeeded in developing a tax-specific
meaning of the term income that would encompass all wealth accessions, including capital
appreciation, other reasons were developed over time (particularly by those who benefited from
it) to maintain the preference. Economist and Professor Leonard E. Burman has written extensively
on the topic, 9 and he provided a concise and effective summary of those reasons (and responses to
them) in testimony to both the House Ways and Means Committee and the Senate Finance
Committee on September 20, 2012, 10 concluding:
To summarize, while targeted relief from capital gains tax may be warranted for some
corporate stock, the current blanket income tax preference for capital gains is very
poorly targeted and, on balance, may do more harm than good to the economy. The
capital gains preference also creates gross inequities, significantly undermining the
progressivity of the income tax.
Capital gains reform was the lynchpin of the 1986 reform and several recent bipartisan
reform proposals. It could be an important element of the next tax reform. The best
option, in my view, would be to tax capital gains as ordinary income and use the
revenue gained to lower individual and corporate income tax rates. Reform might also
tackle the largest capital gains tax loophole—the non-taxation of capital gains held
until death. Mitigating this loophole could substantially reduce the lock-in effect and
help protect the capital gains tax base. 11
There is no doubt that the capital gains preference undermines the progressivity of the income
tax. Recall the data in Chapter 1, Part B., which showed how the concentration of net capital gain
and qualified dividends in the very highest income households results in lower effective tax rates
for the very wealthy than for the merely wealthy. “In 2010, the highest-income 20 percent realized
more than 90 percent of long-term capital gains according to the Tax Policy Center…. The top 1
percent realized almost 70 percent of gains and the richest 1 in 1,000 households accrued about 47
percent. It is hard to think of another form of income that is more concentrated by income.” 12 Only
1.1% of the tax preference accorded to net capital gain and qualified dividends is enjoyed by
taxpayers in the bottom 60%. 13
The preferential rate also significantly complicates the Code and encourages tax-motivated
transactions that seek to transform high-taxed ordinary income into low-taxed net capital gain.
Examples include tax shelters (described in Chapter 15) that seek ordinary deductions through
depreciation, interest, and depletion that offset high-taxed income but that are essentially recouped
through low-taxed capital gain on later sale of the shelter, as well as the transformation of hightaxed compensation income into low-taxed capital gain through “carried interest” arrangements or
founders stock, the appreciation on which represents a return on labor income.
[W]hen capital gains are taxed at much lower rates than other income, the tax code
9

See, e.g., LEONARD E. BURMAN, THE LABYRINTH OF CAPITAL GAINS AND TAX POLICY (1999).
See STATEMENT OF LEONARD E. BURMAN BEFORE THE HOUSE COMMITTEE ON WAYS AND MEANS AND THE SENATE
COMMITTEE ON FINANCE , TAX REFORM AND THE TAX TREATMENT OF CAPITAL GAINS, at
www.finance.senate.gov/imo/media/doc/092012%20Burman%20Testimony.pdf [hereinafter Burman, TESTIMONY].
11
Id. at 3.
12
Id. at 5.
13
See Annie Lowrey, Tax Credits or Spending? Labels. But in Congress, Fighting Words, N.Y. TIMES, March 18,
2013, at A1 and at www.nytimes.com/2013/03/18/business/economy/taxes-or-spending-budget-fight-in-congressfocuses-on-a-distinction.html?_r=0 (accompanying chart).
10

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needs complex rules to delimit the boundary between capital gains and other income.
In addition, complex anti-tax shelter provisions, such as the passive loss rule,
limitations on the deductibility of interest, and a host of other provisions are necessary
to deter abuse. Tax lawyers have told me that half the Internal Revenue Code is
devoted to defining the difference between capital gains and ordinary income. If
capital gains were taxed as ordinary income, much of that complexity could be
eliminated. 14
The most common modern-day rationales forwarded for a tax preference for net capital gain
are discussed below.
The double tax argument regarding capital returns
Those reading the subheading above might think that I am going to talk chiefly about shares of
corporate stock as capital assets and the double taxation that can occur if income earned by a
corporation is taxed both to the corporation under § 11 and to the owners of the corporation’s stock
when those profits are realized by the shareholders through the receipt of dividends or by sale of
the stock reflecting retained corporate earnings. 15 But I am not. The net capital gain rate preference
is not limited to shares of corporate stock but rather extends to all capital assets, as defined in §
1221, which includes such items as real estate, collectibles, patents, jewelry, gold and other
precious minerals, etc., so long as these assets are held by nondealers. In 2007, for example, “only
30 percent of long-term capital gains were on corporate stock or mutual funds…. [I]t’s likely that
most capital gains are from other sources.” 16 Indeed, the net capital gain rate reduction does not
apply to withdrawals from pension plans, § 401(k) accounts, and IRAs owning stock, and most
stock owned by average taxpayers below the top 1% are owned through such accounts.
Rather, this “double tax” argument is different. In Chapter 2, you learned that a common way
to describe how the market arrives at the fair market value (FMV) of an asset is to say that FMV
is the market’s best guess at the present, discounted value of the future stream of payments
expected to be generated by that asset. For example, the FMV of a plot of land that is rented to
tenant farmers may be calculated by discounting to present value the anticipated future stream of
rental payments expected to be paid by the tenant farmers to the land’s owner, coupled with the
present value of the future sales proceeds, including the anticipated future appreciation in the land.
Let’s say that the market’s best guess of this figure is $10,000, so Brenda is able to purchase the
land for $10,000 from its current owner in Year 1. If Brenda is prevented from immediately
deducting that $10,000 purchase cost (as she is under an income tax because the outlay is a
nondeductible capital expenditure), some argue that she is doubly taxed on that same $10,000 if
she is required to include the rents when received from the tenant farmers or the appreciation in
value that she realizes if she is able to sell the land for more than $10,000, as both the rents and
the appreciation were (or so the argument goes) effectively taxed to her previously when she was

14

Burman, TESTIMONY, supra note 10, at 6-7.
Subchapter C of the Internal Revenue Code, studied in a course exploring the taxation of business enterprises, is
nominally a double tax system in that corporate profits may be taxed under § 11 at the corporation level when earned
and then, when the after-tax profits are distributed as nondeductible dividends, to the shareholders under §§ 61(a)(7),
301(c)(1), and 316. In reality, most corporate-earned income is not doubly taxed. First, as you learned in Chapter 1,
Part B., about 70% of Subchapter C corporate stock is owned by tax-exempt shareholders, such as IRAs, pension
plans, § 401(k) plans, and foreign investors. Second, much corporate income escapes tax at the corporation level
through various mechanisms, including corporate tax expenditures and the international tax provisions.
16
Burman, TESTIMONY, supra note 10, at 10.
15

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denied a deduction of the $10,000 purchase cost.
In Chapters 2 and 3, you also studied rejoinders to this argument. More to the point for purposes
of this chapter, the “double tax” argument—even if you are persuaded by it—does not support a
reduced tax rate on capital gain but rather complete exemption of tax on all capital returns: capital
gain, interest, rents, royalties, etc. That is to say, the “double tax” argument is relied on chiefly by
consumption tax proponents who support either a wage tax on labor income only (explicitly
exempting capital returns from tax) or a cash-flow consumption tax.17 In short, a tax preference
for only one form of capital return (capital gain) cannot be defended using the double tax argument.
Lock-in effect
Some argue that the preferential taxation of net capital gain can be defended as reducing the socalled lock-in effect that arises because of the realization requirement. The argument is that owners
of appreciated property will hold on to it, rather than sell it to a new user who could operate the
property more efficiently, to avoid the tax that would accompany the sale, thus reducing overall
economic efficiency and aggregate societal wealth. Reducing the tax applicable to the gain thus
reduces the lock-in effect by encouraging sales that would otherwise not occur to those who would
put the property to a higher and better use, contributing to a more efficient economy.
The rejoinders to this argument are several. First, even if the lock-in effect is real and
significant, the argument that a new owner could use the property more efficiently than the current
holder could conceivably apply only to a narrow range of unique capital assets, including certain
tracts of land, patents, or the assets of a small business. Many capital assets, such as corporate
stock, works of art, or antiques and collectibles are simply passive investment assets.
Second, empirical data finds little evidence that the overall realization response is significantly
affected by the net capital gain rate. Evidence does show that short-term decisions regarding the
timing of a planned sale can be affected by scheduled changes in the rate (with increased sales, for
example, in late 1986 before the rate was scheduled to increase from 20% to 28% on January 1,
1987) but that the overall realization response reverts to a fairly constant norm over time. 18
Finally, § 1014 (the tax-free step up in basis at death, studied in Chapter 7) is far more powerful
in this respect. If policymakers are truly concerned that owners are not selling property to higher
and better users, making death a realization event (as in Canada), imposing a carryover basis on
property passed at death, or expanding mark-to-market taxation to easily valued property would
go much farther in ameliorating the lock-in effect than does a preferential net capital gain rate
during life, as indicated in Professor Burman’s earlier quoted comment.
Inflation gain
The net capital gain rate preference is often defended on the ground that the gain reflects in part
merely the effects of inflation and not a real increase in inflation-adjusted wealth. A reduced tax

17
As you learned in Chapter 2, a cash-flow consumption tax—under which non-consumption outlays are immediately
deducted (even if they would constitute nondeductible capital expenditures under income tax principles) and 100% of
the returns are included in the tax base—can reach the same end result as a tax that reaches only labor returns and
explicitly exempts the normal capital return (though it would reach the “supranormal return,” which is never taxed
under the wage tax paradigm).
18
See, e.g., Alan J. Auerbach, et al., Capital Gains Taxation and Tax Avoidance: New Evidence from Panel Data, in
DOES ATLAS SHRUG: THE ECONOMIC CONSEQUENCES OF TAXING THE RICH at 355 (Joel B. Slemrod ed. 2000)
[hereinafter ATLAS]; Jane Gravelle, Commentary on Chapter 11, in ATLAS, supra, at 389.

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rate compensates for the fact that gain is measured in nominal rather than inflation-adjusted dollars.
Inflation adjustments are incorporated into many parts of the Internal Revenue Code. The floors
and ceilings of each rate bracket found in § 1, for example, are increased each year to reflect
inflation so that an increase in income will not fall into a higher tax bracket if the increase merely
reflects a raise matching the increase in the chained consumer price index rather than a real increase
in purchasing power. Similarly, the Standard Deduction, the Personal Exemption and Dependent
Deduction (currently suspended), and many tax expenditure credits and deductions (as well as
phase-out floors pertaining to those credits and deductions) are indexed for inflation. But basis
(whether pertaining to Blackacre, a savings account, or any other debt instrument) is not indexed
for inflation. A portion of any includable capital return (whether in the form of gain, interest, rent,
etc.) may not actually represent an increase in inflation-adjusted wealth. The higher the inflation
rate and the longer the asset is held, the greater the inflation gain problem. If inflation is low and
an asset is not held for a long period of time, the problem of inflation gain is reduced. For this
reason, some argue that a reduced net capital gain rate should apply only to long-held assets (say,
a 5-year holding period? 10 years?), but notice that allowing only long-held assets to enjoy a rate
reduction would exacerbate the lock-in effect—discouraging sales in the short term to more
efficient users—if lock-in is, in fact, a serious problem.
To illustrate the inflation problem, let’s assume that Parker deposits $10,000 in a savings
account at National Bank on January 1 of Year 1 and that the account terms entitle Parker to receive
2% interest each year. Parker is a lender to National Bank, who is borrowing Parker’s money to
use in its business of lending to others (for, say, a home loan). On January 2 of Year 2, Parker
withdraws the $10,000 principal (a tax-free recovery of basis), as well as the $200 interest, and
spends the $10,200 on a lovely trip to London and Paris. (I’m jealous.) Under § 61(a)(4), Parker
must include in his Year-1 Gross Income the $200 interest, even if inflation for Year 1 is also 2%
so that his inflation-adjusted wealth remains unchanged between January 1 of Year 1 and January
2 of Year 2 when he withdraws the $10,200 principal and interest. Indeed, because Parker’s interest
is deemed realized as it accrues, Parker must include the $200 Year-1 interest even if he fails to
withdraw it in Year 2 but rather leaves it in the account to earn further interest.
Similarly, assume that Parker purchases Blackacre (a capital asset in his hands) on January 1 of
Year 1 for $10,000, that he sells Blackacre for $10,200 on January 2 of Year 2, and that inflation
is 2% during Year 1. Parker’s § 1001 realized gain under current law is $200 ($10,200 A/R less
$10,000 A/B), which he must include in his Gross Income under § 61(a)(3), even though his
inflation-adjusted wealth remains unchanged from its January 1, Year-1 level.
Finally, assume the same facts as immediately above except that Parker is a real estate dealer
so that Blackacre is inventory in his hands and not a capital asset. See § 1221(a)(1). Once again,
Parker would measure his wealth increase on the sale in nominal dollars, not inflation-adjusted
dollars, and he would include $200 in his Gross Income.
In each case, we could amend the law so that Parker’s basis in his savings account and
Blackacre, respectively, are increased for inflation each year so that any possible wealth accession
is measured in inflation-adjusted real terms instead of nominal terms. The 2% inflation in Year 1
would result in an increase in his savings account (loan) basis from $10,000 to $10,200, as well as
an increase in his Blackacre basis from $10,000 to $10,200. The $200 labeled “interest” paid into
his savings account would actually be a tax-free increase in his “principal,” and he would realize
no § 1001 gain when he sells Blackacre for $10,200, whether he holds Blackacre as a capital asset
or as inventory, as the sale price would equal his inflation-adjusted basis of $10,200.
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As these simple examples illustrate, introducing a reduced tax rate for net capital gain on the
argument that it ameliorates taxation of inflation gain is nonsensical. First, a rate reduction
applicable only to net capital gain (and not other forms of capital return) violates the neutrality
norm studied in Chapter 3, as every kind of capital income is subject to the inflation problem, not
merely capital asset gain. Indeed, capital gain is the form of capital return least in need of a
preferential rate to account for inflation’s effects because of the deferral privilege inherent
in the realization requirement, an economic benefit that does not accompany other forms of
capital return. Parker must include the $200 interest earned on his savings account annually as it
accrues and pay tax at ordinary income rates—even if he does not withdraw the interest from his
savings account but rather leaves it in the account to continue to earn more interest. Parker’s
savings account is taxed according to income tax principles because the increase in his savings
account (by $200) is taxed each year and thus the future interest earned on that $200 increase in
his account balance (if he fails to withdraw it) is earned on after-tax dollars. 19
In contrast, the appreciation in Parker’s Blackacre (whether held as a capital asset or as
inventory) is not taxed until sale or exchange. As described in Chapter 2, the realization
requirement is a subtle consumption tax feature embedded in current law because it allows a future
return to be earned on pre-tax dollars (the untaxed appreciation) during the ownership period.
Stated another way, apart from any preferential tax rate, § 1001 property gain is subject to
reduced taxation under consumption tax principles during the ownership period—even if it
is taxed at the same statutory rate as other types of income when finally realized—because
of deferral. In short, the deferral privilege arising under the realization requirement offsets
potential inflation gain in whole or in part. In short, if inflation is said to be at the heart of the
rate preference, the preference is directed at exactly the wrong kind of capital return.
Second, the net capital gain rate reduction does not depend on actual inflation rates and is the
same whether the capital asset has been held for one year and a day or for 50 years. The inflation
rate was negative for January through May 2015 and was .20% in August 2015 (at a time when
the maximum net capital gain rate was 20% and the top ordinary rate was 39.6%), while the
inflation rate was 12.61% in November of 1979 (when the net capital gain rate was 35% and the
top ordinary rate was 70%). 20 Rather than a tax rate reduction applied to nominal gain, the proper
cure for inflation gain is to index basis by the inflation rate each year so that only inflation-adjusted
wealth increases are taxed. As illustrated above, if inflation is 2% in the year, the basis of all assets
(whether a capital asset, inventory, a savings account, or any other form of debt instrument or loan)
would be increased by 2%, decreasing the amount of taxable capital return, whether that return is
in the form of § 1001 gain or, as in the case of Parker’s savings account, interest. But not only
would such a system be very complex to administer, 21 the optics would be difficult to explain to
voters because it could be perceived as a boon for lenders and a penalty for borrowers.
For example, assume that Sara and Jonathan purchase a home for $100,000 on January 1 of
Year 1, borrowing the entire $100,000 from National Bank at 5% interest each year ($5,000) until
the $100,000 loan principal is repaid in a single, balloon payment at the end of Year 10. Also
assume that inflation is 3% each year and that Sara’s and Jonathan’s interest payments satisfy the
19

Recall from Chapter 2 that, in order for an investment to be taxed according to income tax principles, both (1) the
investment must be made with after-tax dollars and (2) the return must be fully included. If either of those two
requirements is absent, the investment is accorded more preferential consumption tax treatment.
20
See http://inflationdata.com/inflation/Inflation_Rate/HistoricalInflation.aspx.
21
England introduced basis indexing in 1982 but repealed it in 1988 because of its complexity and tax-arbitrage
opportunities.

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definition of deductible “qualified residence interest” within the meaning of § 163(h)(3) (studied
in Chapter 17). Under current law, Sara’s and Jonathan’s home basis remains unchanged as time
passes, they can deduct 100% of their $5,000 interest payments each year under § 163(h)(3), and
National Bank must include 100% of the $5,000 annual interest payments under § 61(a)(4).
If current law were amended to index basis for inflation, however, both Sara’s and Jonathan’s
home basis and the bank’s $100,000 loan principal basis would increase by 3% each year. Upon
the payment and receipt of the $5,000 in nominal interest each year, $3,000 would be
recharacterized as principal payments ($100,000 x .03): nondeductible by Sara and Jonathan
(notwithstanding the interest label in their loan documents) and excludable as a principal receipt
by the bank (ditto). Can you imagine politicians trying to explain to voters why a portion of their
annual interest payment on their home loan is not really interest (regardless of what their loan
documents said) and thus not deductible, notwithstanding § 163(h)(3), thereby increasing their tax
burden? And can you imagine politicians trying to explain why banks are henceforth permitted to
exclude for income tax purposes a portion of each interest payment received from borrowers,
thereby reducing their tax burden?
Because of these political difficulties, what if all assets except debts (whether Parker’s loan to
National Bank in the form of his savings account or National Bank’s loan to Sara and Jonathan)
were indexed for inflation? That outcome would be even worse, as it would create enormous
arbitrage problems. To illustrate, assume that Luke purchases land for investment at a cost of
$100,000 on January 1 of Year 1, borrowing the entire $100,000 from National Bank at 3% interest
each year ($3,000). Also assume that Luke sells the land on January 2 of Year 2 for $103,000 and
repays his debt (both principal and interest) to National Bank.
If we ignore the tax consequences for a moment, we can see that Luke’s purchase, ownership,
and sale of the land is an economic wash for him. While he is able to sell the land for $103,000
after purchasing it for only $100,000 (entirely with borrowed money), Luke must use the entire
$103,000 obtained on the sale to repay the $103,000 of total principal ($100,000) and interest
($3,000) owed to National Bank. He walks away with nothing, neither suffering a wealth reduction
nor enjoying a wealth increase. His income tax consequences should also be a wash. In particular,
recall from Chapter 1 that a deduction under SHS income tax principles requires that the taxpayer
have suffered a wealth decrease.
What tax consequences would arise, however, if (1) inflation is 3% each year, (2) the land’s
basis is indexed for inflation, (3) the bank’s loan basis is not indexed for inflation, and (4) Luke
can deduct the interest that he pays to National Bank under § 163?
If we index Luke’s land basis for inflation, Luke’s initial $100,000 land basis would be
increased to $103,000 at the time of sale to account for the 3% annual inflation that occurred during
his ownership. When Luke sells for $103,000, he would realize neither a gain nor a loss under §
1001 ($103,000 A/R less $103,000 A/B, as increased for inflation). If National Bank’s debt basis
is not indexed for inflation but analyzed in nominal dollars, however, only $100,000 of the
$103,000 that Luke pays to National Bank is characterized as principal, while $3,000 would be
respected as interest, which we have stipulated that Luke would be permitted to deduct under §
163, offsetting other investment income that Luke realizes. Though Luke’s leveraged investment
was an economic wash, he would treat it for tax purposes as resulting in a wealth reduction if we
permitted him to index his land basis for inflation but did not require him to index debt basis.
The reduced tax burden that Luke would enjoy by deducting $3,000 that does not represent an

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actual wealth reduction suffered by him is essentially funded by other taxpayers. It would represent
pure “rent” in the manner defined in Chapter 3—a mere transfer of wealth from other taxpayers
(you and me) to Luke. Such a result would not only be unfair but economically inefficient, as it
would encourage such arbitrage behavior on the part of taxpayers, which does nothing to generate
wealth for the economy as a whole. The only way to avoid this result is to index both the land basis
and the debt basis for inflation or to index neither basis for inflation. Indexing only the land basis
but not the debt basis is both unfair and inefficient, violating the tax policy norms described in
Chapter 3 that should govern analysis of available tax policy choices.
Encouraging risk-taking entrepreneurship to stimulate economic growth
Some argue that a reduced tax rate applicable to net capital gain (and not other forms of capital
income, such as interest, rent, or royalties) is necessary to encourage more capital investment in
new and risky enterprises that ultimately lead to more robust economic growth. One obvious
rejoinder is that the net capital gain rate is not limited to new or incremental investment capital in
a new or growing business (which can expand the economy). First, the net capital gain rate can
apply to property that, by its nature, is limited in supply, where all the tax preferences in the world
cannot encourage the creation of “more,” such as land, old master paintings, antiques and
collectibles. Even in the case of traditional entrepreneurial risk capital, such as shares of stock in
a new corporation pursuing the next big idea, the net capital gain rate applies not only with respect
to new capital put at risk in the business but also to churning sales of old capital among previously
existing shareholders.
For example, assume that Rachel has a great new technology idea but no money to pursue it.
She convinces Victor Venture Capitalist to provide the initial $500,000 in capital for her to begin
pursuing the idea. Together, they form a corporation called Snapshot, with each taking shares.
Rachel (and the new staff that she hires with Victor’s capital infusion) develops the idea, and
eventually it takes off in the marketplace. Snapshot “goes public” by hiring an investment bank to
help it engage in an initial public offering of new shares for cash. The IPO is a hit, and Snapshot
raises an additional $30 million to expand the business. After this point in time, the outstanding
shares are now bought and sold frequently among members of the public, providing no additional
new capital to Snapshot.
The reduced net capital gain rate is not limited to the gain realized on the shares held by Rachel,
Victor, and the first buyers in the IPO (the cash from which went entirely to Snapshot as risk
capital). Rather, the reduced net capital gain rate applies to churning sales from one Snapshot
shareholder to another long after the IPO, as well—the money from which goes to the shareholderseller (and not to Snapshot).
A much better targeted tax expenditure in this regard is § 1202, which allows exclusion of all
or a portion of gain realized on the sale of “qualified small business stock” that is held for more
than 5 years. One of the many requirements for the exclusion to apply is that the stock must have
been acquired at original issue for cash or, in the case of Rachel, for services. This preference for
initial risk capital does not apply to churning transactions of old stock.
Moreover, it is not clear that a tax preference that arises only at the back end of an investment
(on sale) and only if the risky capital investment is a success (where the stock is sold at a gain) is
the best way to encourage more risk capital investment at the front end. A tax credit on the front
end (at the time of the investment) may be more effective in encouraging the intended behavior
change. At various times in our history, Congress has enacted (and repealed) various investment

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tax credits along this line. In addition, more new businesses fail than succeed, so a better targeted
tax expenditure in this regard is § 1244, which permits losses realized on later sale of certain shares
of original issue stock to be treated as ordinary losses instead of capital losses. Section 1244 allows
Victor to fully deduct his lost risk capital in the year realized (unhampered by § 1211(b)) with
respect to those far more numerous venture capital investments that fail (unlike his successful
investment in Snapshot). It also allows such losses to offset high-taxed ordinary income (such as
compensation, interest, rents), rather than Victor’s low-taxed, long-term capital gains (in the first
netting step in the net capital gain calculation, described below).
In short, §§ 1202 and 1244 are better targeted. An additional broad tax preference that applies
to all types of net capital gain is very poorly targeted and overbroad.
The more serious rejoinder is that empirical data do not support the proposition. While tax rates
were much higher in the 1950s on both ordinary income and capital gains than they were in the
2000s, economic growth rates were also much higher in the earlier period. 22 Professor Burman
examined the data for years between 1950 and 2011 and testified:
The heated rhetoric notwithstanding, there is no obvious relationship between tax rates
on capital gains and economic growth…. If low capital gains tax rates catalyzed
economic growth, we’d expect to see a negative relationship—high [capital] gains
rates, low growth, and vice versa—but there is no apparent relationship …. I’ve tried
lags up to five years and using moving averages, but there is never a … statistically
significant relationship.
I also posted [this conclusion] on my blog on Forbes.com and offered the [underlying]
data to all comers. A half dozen or so people, including at least one outspoken critic
of taxing capital gains, took me up on the offer, but nobody to my knowledge has been
able to tease a meaningful relationship between capital gains tax rates and GDP out of
the data.
Does this prove that capital gains taxes are unrelated to economic growth? Of course
not. Many other things have changed at the same time as tax rates on capital gains and
many other factors affect economic growth. But the [data] should dispel the notion
that capital gains taxes are a very important factor in the health of the economy.
Cutting capital gains taxes will not turbocharge the economy and raising them would
not usher in a depression. 23
Similarly, Anne Christensen and Angela Woodland conducted an empirical study examining
whether a correlation exists between job growth in particular (as opposed to economic growth in
general) and marginal tax rates, including the net capital gains rate, and they found no clear
correlation. 24
Bunching effect from the realization requirement
The final argument typically advanced to support a reduced tax rate for net capital gain is to
ameliorate the bunching effect, if any. Because of the realization requirement, the appreciation is
22

See generally Floyd Norris, Tax Reform Might Start with a Look Back to ‘86, N.Y. TIMES, Nov. 23, 2012, at B1 and
at www.nytimes.com/2012/11/23/business/a-starting-point-for-tax-reform-what-reagan-did.html (showing a chart
comparing economic growth and the capital gains rate preference during various periods).
23
Burman, TESTIMONY, supra note 10, at 12-13.
24
See Anne L. Christensen & Angela M. Woodland, Tax Rates and Jobs, 138 TAX NOTES 343 (2013).

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typically included in Gross Income entirely in one taxable year, instead of piecemeal over multiple
years as it economically accrues. A portion of gain that would otherwise have fallen within, say,
the 32% bracket each year under a mark-to-market system may be taxed at, say, 37% if taxed
entirely in the (later) realization year.
One rejoinder is that because most taxable capital gain is realized by taxpayers who are already
otherwise in the highest tax bracket, year after year, there is no bunching effect in the great majority
of cases. Moreover, for taxpayers below the top tax bracket, the deferral privilege accompanying
the realization requirement can offset the tax effect of any bunching effect. Finally, the accurate
response to any bunching effect that does exist is mark-to-market taxation or, if infeasible, income
averaging. For example, determining the appropriate tax applicable to gain realized entirely in
Year 4 could be computed by, say, hypothetically including 25% of the gain in each of Years 1, 2,
3, and 4. For a taxpayer already in the highest bracket each year, such an exercise would not reduce
the tax due in Year 4 on the realized gain. If, however, a taxpayer’s marginal dollars were taxed at
only 32% in Years 1, 2, and 3, figuring out the Year-4 tax on a large realized gain by looking back
at the rates that would have applied to it if 25% were included in each of Years 1 through 4 could
reduce the aggregate tax due on the gain in Year 4. In short, a blanket and substantial rate reduction
for all net capital gain is a vastly disproportionate response to any bunching effect in the real world.
The definition of net capital gain
You learned in Part A. that a taxpayer with more capital losses than capital gains has no hope
of any preferentially taxed net capital gain. But even a taxpayer with more capital gains than capital
losses may not have any preferentially taxed net capital gain. Not all capital gain is subject to the
§ 1(h) rate preference. Not even all long-term capital gain is subject to the rate preference.
Nevertheless, as explored below, a taxpayer must have at least some long-term capital gain to have
any hope of preferentially taxed net capital gain.
The preferential § 1(h) rates apply only to net capital gain, defined in § 1222(11) as the excess
of net long-term capital gain over net short-term capital loss. The excess-over language refers
to subtraction. More precisely stated, net capital gain is equal to [long-term capital gain less longterm capital loss] less [short-term capital loss less short-term capital gain]. That’s a lot of “less”es!
In effect, there are two netting steps. In the first, long-term capital gains and long-term capital
losses are netted together to arrive at a net long-term figure, and the same is done with short-term
capital gains and losses. At this point, the taxpayer must have some net long-term capital gain or
else the analysis stops; there can be no net capital gain without net long-term capital gain. If the
taxpayer does have net long-term capital gain, the taxpayer proceeds to the second netting step.
Net short-term capital loss (if any) reduces net long-term capital gain to arrive at net capital gain.
If the taxpayer’s net short-term position is not a loss (but rather a gain), the second-step reduction
is zero, meaning that the entire net long-term capital gain satisfies the definition of net capital gain.
Time for a few examples! In each case, Hallie realizes and recognizes the capital gains and
losses described below in a single year, and the capital losses are otherwise deductible under §
165(c). Assume that Hallie earns enough wage income to have any additional marginal income
taxed at 32% if it is not eligible for the § 1(h) rate preference applicable to net capital gain.
Example 1
short-term cap gain

short-term cap loss

long-term cap gain

long-term cap loss

$3,000

$5,000

$14,000

$10,000

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Hallie can fully deduct the $15,000 in aggregate capital losses because she has sufficient capital
gains to allow it under § 1211(b). Furthermore, Hallie has a $4,000 net long-term capital gain
($14,000 long-term capital gain less $10,000 long-term capital loss) and a $2,000 net short-term
capital loss ($5,000 short-term capital loss less $3,000 short-term capital gain), resulting in $2,000
of net capital gain within the meaning of § 1222(11).
Example 2
short-term cap gain
$0

short-term cap loss

long-term cap gain

long-term cap loss

$5,000

$10,000

$0

Hallie can fully deduct the $5,000 in aggregate capital losses under § 1211(b). Furthermore, Hallie
has a $10,000 net long-term capital gain ($10,000 long-term capital gain less $0 long-term capital
loss) and a $5,000 net short-term capital loss ($5,000 short-term capital loss less $0 short-term
capital gain), resulting in $5,000 of net capital gain within the meaning of § 1222(11).
Example 3
short-term cap gain

short-term cap loss

long-term cap gain

long-term cap loss

$7,000

$2,000

$2,000

$3,000

Hallie can fully deduct the $5,000 in aggregate capital losses under § 1211(b). Even though Hallie
realizes more capital gains than capital losses, she has no net capital gain. The first required
ingredient under § 1222(11) is net long-term capital gain, and Hallie has none. Rather, she realizes
a net long-term capital loss. The analysis stops. Although Hallie can deduct 100% of her $5,000
in aggregate capital losses under § 1211(b), the remaining $4,000 of capital gain will be subject to
her 32% rate that applies to any marginal gain or income not eligible for the § 1(h) rate preference.
Examining Example 3 closely, you can appreciate that the $4,000 of remaining capital gain
(after deducting her capital losses) is necessarily short-term gain, and Congress has never
permitted short-term capital gain to qualify for a preferential tax rate. Only long-term gain could
plausibly implicate the assorted rationales described in Part B., above, for a reduced tax rate, such
as bunching, inflation gain, risk capital, etc.
Example 4
short-term cap gain

short-term cap loss

long-term cap gain

long-term cap loss

$5,000

$0

$9,000

$1,000

Hallie can fully deduct the $1,000 in aggregate capital losses under § 1211(b). Furthermore, Hallie
has an $8,000 net long-term capital gain ($9,000 long-term capital gain less $1,000 long-term
capital loss) and no net short-term capital loss (her net short-term position is not a loss but rather
a gain), resulting in $8,000 of net capital gain within the meaning of § 1222(11). Her remaining
$5,000 in capital gain is necessarily short-term gain, subject to her 32% rate.
Planning possibilities regarding the timing of realized capital gains and losses
We have noted several times in this course that—all else being equal—taxpayers prefer to defer
Gross Income inclusions as long as possible and accelerate deductions as soon as possible to take
advantage of the ever-critical time value of money. But sometimes all else is not equal because of
(1) the rate preference accorded net capital gain and (2) the ability to use capital losses to offset
high-taxed short-term capital gain (in the first netting step described above) or high-taxed ordinary

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income (under the $3,000 § 1211(b) de minimis rule).
Taxpayers who have realized long-term capital gain often read in December year-end tax
planning articles found in the popular press that they should harvest sufficient capital losses before
year end to fully offset the long-term capital gains, thus effectively eliminating taxation of those
gains. But for the small investor, this may be bad advice. Rather than using capital losses to offset
potentially low-taxed, long-term capital gain, those losses are put to more efficient tax use by
deducting them against high-taxed, short-term capital gain or ordinary income to the extent
feasible. The tax saved by using capital losses to offset high-taxed income instead of low-taxed
income can more than offset the time-value-of-money cost from deferring a deduction for a year.
For example, assume that Ryan has already realized a $3,000 long-term capital gain in Year 1.
It is December of Year 1, and he is considering selling shares of corporate stock with an unrealized
long-term capital loss of $3,000. He believes the stock will maintain its value for a few weeks
longer so that he could sell in January of Year 2 if that would result in better tax consequences. He
does not believe, at this time, that he will realize any other capital gains or losses in Year 2. Should
Ryan realize that $3,000 capital loss in Year 1, effectively offsetting the $3,000 in long-term capital
gain, or should he wait and realize the $3,000 capital loss in Year 2? Assume that (1) Ryan’s
Taxable Income without regard to capital gains and losses is $100,000 in each year and that (to
keep the math simple) his ordinary Taxable Income is taxed at a flat 32% rate and (2) Ryan’s net
capital gain, if any, is taxed at 15% under § 1(h).
Notwithstanding the common wisdom that Ryan should realize and deduct his capital loss in
Year 1 (offsetting the realized capital gain) rather than delay the sale until Year 2, Ryan’s aftertax consequences would in fact be better if he waited until January of Year 2 to sell the loss stock.
Let’s see why.
If Ryan sells in Year 1
In Year 1, Ryan includes the $3,000 long-term capital gain, deducts the $3,000 long-term capital
loss, and has no net capital gain subject to the 15% preferential tax rate. His remaining $100,000
of Taxable Income results in a $32,000 tax in our simplified world in which his Taxable Income
is taxed at a flat 32% rate ($100,000 x .32).
In Year 2, Ryan has no capital gain to include or capital loss to deduct, again has $100,000 of
Taxable Income, and again pays $32,000 in tax ($100,000 x .32).
Over both years, Ryan pays $64,000 in aggregate tax.
If Ryan sells in Year 2
In Year 1, Ryan includes the $3,000 long-term capital gain and does not deduct the $3,000
unrealized loss, resulting in a $450 tax on the $3,000 of net capital gain under § 1(h) ($3,000 x
.15). In addition, Ryan owes $32,000 in tax on his remaining $100,000 of Taxable Income
($100,000 x .32). He would pay total tax of $32,450.
In Year 2, Ryan realizes the $3,000 capital loss, which he deducts under the § 1211(b) de
minimis rule against his high-taxed wage income, leaving $97,000 in Taxable Income. He pays tax
of $31,040 ($97,000 x .32).
Over both years, Ryan pays $63,490 in aggregate tax.
By waiting for a few weeks to sell the loss stock in January of Year 2 (instead of December of
Year 1), Ryan saves $510 in tax! This $510 represents the difference between the $450 in 15% tax
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that he paid on his $3,000 net capital gain in Year 1 and the $960 in Year-2 tax savings by
deducting the $3,000 capital loss against income that otherwise would have been taxed at 32%.
Of course, Ryan lost one year of time value of money by deferring his $3,000 deduction for one
year, so we would have to discount his $960 in Year-2 tax savings by the current discount rate,
which we shall assume is 3%. Using the present value table in Chapter 1, the present value of his
$960 Year-2 tax savings, when viewed from the perspective of Year 1 (which is when he is
considering whether or not to sell the loss stock), is $932.16 ($960 x .971). When viewed in Year1 present value terms, therefore, Ryan can effectively save $482.16 in tax by deferring the sale of
the loss stock from December of Year 1 to January of Year 2 ($932.16 present value of his future
Year-2 tax savings of $960 less $450 present cost of the Year-1 tax on his unreduced $3,000 net
capital gain)—more than enough to pay for your 30 minutes of tax advice. <grin>
Individual taxpayers should attempt to use capital losses whenever possible to offset hightax ordinary income under the § 1211(b) de minimis rule or high-tax, short-term capital gain
under the first netting step in the § 1222(11) definition of net capital gain rather than using
capital losses to offset potentially low-tax, long-term capital gain.
Step back and cogitate about that definition of net capital gain: net long-term capital gain less
net short-term capital loss. If Ryan has already realized a long-term capital gain and short-term
capital loss and is engaging in year-end tax planning, he may consider harvesting a like-amount of
short-term capital gain, if possible. In that way, he would accomplish two goals: (1) he would use
his short-term capital loss to offset short-term capital gain, which is high-tax income (not eligible
for the § 1(h) rate preference), and (2) he would protect his long-term capital gain (and thus net
capital gain).
There are, of course, exceptions to every rule, and Ryan should go ahead and harvest capital
losses to offset even low-tax net capital gain if the gains and losses are substantial, where the
$3,000 de minimis rule is cold comfort and the time-value-of-money cost of deferring deductions
for many years is large. For example, assume that Ryan has already sold Whiteacre at a $500,000
long-term capital gain in Year 1 and is considering whether to sell Blackacre, which has a built-in
capital loss of, say, $400,000, in Year 1 or to defer the sale of Blackacre until Year 2. You should
advise him to sell Blackacre in Year 1, even though the $400,000 capital loss would wholly offset
low-taxed net capital gain (instead of high-tax ordinary income or gain or short-term capital gain).
If Ryan deferred Blackacre’s sale until Year 2, he may die before fully deducting that $400,000
loss in $3,000 increments each year (absent further capital gain realizations).

C. The meaning of capital asset and sale or exchange
The introductory language in § 1221(a) defines capital assets as all property—whether held for
business, investment, or personal purposes—except those listed in the paragraphs that follow. This
approach can be criticized as allowing property to qualify for reduced taxation in an unexamined
fashion, even property that does not implicate any of the purported rationales for reduced taxation
discussed in Part B. The law could be improved if Congress instead specifically listed those
specific that do qualify as capital assets, with unlisted assets ineligible for preferential treatment.
The material below discusses the more significant § 1221 exceptions to capital asset treatment.
§ 1221(a)(1): the inventor or dealer exception
Inventory or other property “held by the taxpayer primarily for sale to customers in the ordinary
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course of his trade or business”—often referred to as the inventory or dealer exception—is not a
capital asset. Both taxpayers selling services and taxpayers selling inventory include ordinary
income and gain. The Supreme Court has held that the word “primarily” in § 1221(a)(1) means
“principally” or “of first importance.” 25 In many cases application of the inventory exception is
obvious, but sometimes property that was not inventory when originally acquired can become
inventory over time as the taxpayer’s activities change. Simply because property was a capital
asset when first acquired does not mean that it is forever protected as a capital asset.
BYRAM v. UNITED STATES
705 F.2d 1418 (5th Cir. 1983)
Before WISDOM, GEE, and REAVLEY, CIRCUIT JUDGES.
GEE, CIRCUIT JUDGE: “If a client asks you in any but an extreme case whether, in your opinion,
his sale will result in capital gain, your answer should probably be, ‘I don’t know, and no one else
in town can tell you.’” [1]
Sadly, the above wry comment on Federal taxation of real estate transfers has, in the twentyfive years or so since it was penned, passed from the status of half-serious aside to that of
hackneyed truism. Hackneyed or not, it is the primary attribute of truisms to be true, and this one
is: in that field of the law—real property tenure—where the stability of rule and precedent has
been exalted above all others, it seems ironic that one of its attributes, the tax incident upon
disposition of such property, should be one of the most uncertain in the entire field of litigation.
But so it is, and we are called on again today to decide a close case in which almost a million
dollars in claimed refunds are at stake. The trial court, sitting without a jury in this taxpayer’s suit
for refund, found the following facts:
During 1973, John D. Byram, the taxpayer, sold seven pieces of real property. Mr. Byram was
not a licensed real estate broker, was not associated with a real estate company which advertised
itself, and did not maintain a separate real estate office. He advertised none of the seven properties
for sale, nor did he list any of them with real estate brokers. To the contrary, all of the transactions
were initiated either by the purchaser or by someone acting in the purchaser’s behalf.
None of the properties sold was platted or subdivided. Byram devoted minimal time and effort
to the sales in question, occupying himself chiefly with his rental properties. Byram’s income for
1972 and 1973 included substantial amounts of rental income and interest income.
The district court’s findings do not reflect the following additional facts, which apparently are
not disputed by the parties. From 1971 through 1973, Byram sold 22 parcels of real property for a
total gross return of over $9 million and a net profit of approximately $3.4 million [Ed. Note: more
than $20 million in current dollars]. The seven properties at issue in this case sold for
approximately $6.6 million gross, resulting in a profit of approximately $2.5 million. Six of the
seven properties were held by Byram for periods ranging from six to nine months, intervals just
exceeding the then-applicable holding periods for long-term capital gains. The seventh property
25

See Malat v. Riddell, 383 U.S. 569 (1966).
Comment, Capital Gains: Dealer and Investor Problems, 35 Taxes 804, 806 (1957) quoted in 3B MERTENS, LAW
OF FEDERAL INCOME TAXATION § 22.138 n. 69 (Zimet & Weiss rev. 1958); Biedenharn Realty Co. v. U.S., 509 F.2d
171, 175 (5th Cir.1975), rev’d en banc, 526 F.2d 409 (5th Cir.), cert. denied, 429 U.S. 819 (1976); Thompson v.
Comm’r, 322 F.2d 122, 123 n 2 (5th Cir.1963); Cole v. Usry, 294 F.2d 426, 427 n.3 (5th Cir.1961).
[1]

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had been held for two years and six months.
Although, as noted above, Mr. Byram received substantial rent and interest income in 1973,
nevertheless his rental activities for that year resulted in a net tax loss of approximately $186,000.
He received rental income from only one of the seven properties sold in 1973. The record does not
reflect the exact relative amounts of income attributable to the sales in question and Byram’s other
activities.
Certain facts are disputed by the parties. The government asserts in its brief that Byram had
entered into contracts to sell at least three of the seven properties in issue before he actually
acquired them. Byram first responds that the record reflects only two such instances, not three; and
at oral argument the government appeared to concede the point. As to those two transactions,
Byram asserts that he acquired the right to purchase the properties by executing a contract before
he entered into a contract to sell them; it was only closing on the purchases that postdated his
contracts to sell. Finally, the government asserts, and Byram denies, that by virtue of Byram’s
civic activities in Austin, Texas, Byram’s business of selling real estate was well-known in the
community.
Based on its subsidiary findings indicated, the district court made ultimate findings that Byram
held each of the seven properties for investment purposes and not primarily for sale to customers
in the ordinary course of his trade or business. Judgment was therefore entered granting Byram the
capital gains treatment that he sought. The government brought this appeal.
Profits derived from the sale of “capital assets,” known as “capital gains,” are entitled to
favorable tax treatment under the Internal Revenue Code (the “Code”). The term “capital asset” is
defined in relevant part as “property held by the taxpayer,” not including property held “primarily
for sale to customers in the ordinary course of [the taxpayer’s] trade or business.” § 1221. The
district court found that Byram “was not engaged in the real estate business” during the relevant
years and that each of the seven properties in issue was held “for investment purposes and not
primarily for sale to customers in the ordinary course of [Byram’s] trade or business.”
Accordingly, the district court held that Byram was entitled to treat the profits from his 1973 sales
as capital gains and ordered an appropriate refund.
Our first task is to decide the correct standard by which to review the district court’s principal
finding that Byram’s holding purpose was for investment rather than for sale. The choice of a
standard will determine the outcome of many cases; if the issue is treated as factual, the district
court’s decision is final unless clearly erroneous, F.R.C.P. 52(a), but if a question of law is
presented, we may decide it de novo. [The Court decided that whether an asset is held primarily
for sale to customers in the ordinary course of business is a question of fact.]
The record and the district court’s findings of fact indicate that in determining Byram’s holding
purpose, the court considered all the factors this court has called the seven pillars of capital gains
treatment”:
(1) the nature and purpose of the acquisition of the property and the duration of the
ownership; (2) the extent and nature of the taxpayer’s efforts to sell the property; (3)
the number, extent, continuity and substantiality of the sales; (4) the extent of
subdividing, developing, and advertising to increase sales; (5) the use of a business
office for the sale of the property; (6) the character and degree of supervision or control
exercised by the taxpayer over any representative selling the property; and (7) the time
and effort the taxpayer habitually devoted to the sales.

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U.S. v. Winthrop, 417 F.2d 905, 910 (5th Cir.1969). Recent cases have placed particular emphasis
on four of these factors, noting that frequency and substantiality of sales is the most important
factor, and that improvements to the property, solicitation and advertising efforts, and brokerage
activities are also especially relevant considerations. Biedenharn Realty, 526 F.2d at 415-16;
Suburban Realty, 615 F.2d at 176. At the same time, it has been repeatedly emphasized that these
factors should not be treated as talismans. Winthrop, 417 F.2d at 911. Rather, “each case must be
decided on its own peculiar facts…. Specific factors, or combinations of them, are not necessarily
controlling.” Biedenharn Realty, 526 F.2d at 415 (quoting Thompson v. Comm’r, 322 F.2d 122,
127 (5th Cir.1963)).
The district court found most of the Winthrop factors absent in Byram’s case. Byram made no
personal effort to initiate the sales; buyers came to him. He did not advertise, he did not have a
sales office, nor did he enlist the aid of brokers. The properties at issue were not improved or
developed by him. The district court found that Byram devoted minimal time and effort to the
transactions. [11] The government does not contend that any of these findings are clearly erroneous.
Rather, the government argues that the frequency and substantiality of Byram’s sales, together
with the relatively short duration of his ownership of most of the properties, establishes that Byram
intended to hold the properties for sale in the ordinary course of his business. In light of our
decision regarding the standard of review, the government’s argument must be that the district
court clearly erred in finding these factors outweighed by the other relevant evidence. We cannot
reasonably say that the district court’s finding that Byram held his properties for investment was
clearly erroneous.
The record reveals that during a three-year period, Byram sold 22 parcels of real estate for over
$9 million, netting approximately $3.4 million profit. [12] Though these amounts are substantial by
anyone’s yardstick, the district court did not clearly err in determining that 22 such sales in three
years were not sufficiently frequent or continuous to compel an inference of intent to hold the
property for sale rather than investment. Compare Suburban Realty, 615 F.2d at 174 (244 sales
over 32-year period); Biedenharn Realty, 526 F.2d at 411-12 (during 31-year period, taxpayer sold
208 lots and twelve individual parcels from subdivision in question; 477 lots were sold from other
properties). This is particularly true in a case where the other relevant factors weigh so heavily in
favor of the taxpayer. ”Substantial and frequent sales activity, standing alone, has never been held
to be automatically sufficient to trigger ordinary income treatment.” Suburban Realty, 615 F.2d at
176. Moreover, Byram’s relatively short holding periods for some of the properties do not tip the
balance in favor of the government. Ranging from six to nine months, these periods exceeded the
[11]

This factor has been slighted in recent cases, not because it is unimportant, but because it was irrelevant to our
consideration of the activities of large corporate organizations. See, e.g., Suburban Realty, 615 F.2d 171; Houston
Endowment, 606 F.2d 77; Biedenharn Realty, 526 F.2d 409. However, in a case like the present one, where the
government seeks to show that an individual taxpayer is holding property for sale in a certain business, the quantum
of that individual’s activity becomes very relevant. Long before the proliferation of tests and factors engulfed the
capital gains field, this court made the common sense observation that the word “business” means “busyness; it implies
that one is kept more or less busy, that the activity is an occupation.” Snell v. Comm’r, 97 F.2d 891, 892, 21 A.F.T.R.
(P-H) 608 (5th Cir.1938); see also Stern v. U.S., 164 F. Supp. 847, 851 (E.D.La.1958) (“[A] court should not be quick
to put a man in business … simply because he has been successful in earning extra income through a hobby or some
other endeavor which takes relatively small part of his time.”), aff’d 262 F.2d 957 (5th Cir.), cert. denied, 359 U.S.
969 (1959). The district court was entitled to give great weight to Byram’s time and effort devoted to sales in
determining whether he held his property for sale in the ordinary course of his business.
[12]
Although only the seven sales completed in 1973 are at issue in this case, prior years’ activities are relevant to the
characterization of the 1973 transactions. See Thompson v. Comm’r, 322 F.2d 122, 127 (5th Cir.1963).

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then-applicable threshold for long-term capital gain treatment. In establishing those thresholds,
Congress clearly expressed its intent that sales of otherwise qualified capital assets held for six to
nine months be accorded capital gains treatment. To avoid frustration of that intent, a court should
avoid placing too much weight on duration of ownership where other indicia of intent to hold the
property for sale are minimal. [13]
Mr. Byram has presented us with a close case. Had we been called upon to try or retry the facts,
perhaps we would have drawn different inferences than did the district court. However, [o]ur
review of the evidence convinces us that the district court was not clearly erroneous in finding that
Byram held his properties for investment and not for sale in the ordinary course of his trade or
business.
____________________________________
In most of the other cases cited by the Byram court, the taxpayer lost. For example, the appellate
court overturned a taxpayer win at the trial level in Biedenharn Realty Co. v. United States. 26 The
taxpayer bought a 973-acre farm called Hardtimes Plantation in 1935 and farmed it for several
years. The nearby city of Monroe, Louisiana, developed and expanded toward Hardtimes, and the
taxpayer began subdividing and selling lots from the farm for development as early as 1939.
Between 1939 and 1966, the taxpayer sold 208 lots in 158 sales at a profit in excess of $800,000,
after adding paved roads, curbs, sewers, and utilities. Between 1964 and 1966 (the tax years in
question) the taxpayer sold 38 lots. The government did not dispute that Hardtimes was not held
for sale in the ordinary course of the taxpayer’s business when first acquired but argued that the
taxpayer’s activities changed to such an extent over time that the lots were described in §
1221(a)(1) when finally sold as residential lots in several named subdivisions. While the trial court
disagreed, the appellate court held in favor of the government, concluding:
We cannot write black letter law for all realty subdividers and for all times, but we do
caution in words of red that once an investment does not mean always an investment.
A simon-pure investor forty years ago could by his subsequent activities become a
seller in the ordinary course four decades later. The period of Biedenharn’s passivity
is in the distant past; and the taxpayer has since undertaken the role of real estate
protagonist. The Hardtimes Plantation in its day may have been one thing, but as the
plantation was developed and sold, Hardtimes became by the very fact of change and
activity a different holding than it had been at its inception. No longer could resort to
initial purpose preserve taxpayer’s once upon a time opportunity for favored treatment.
Today, § 1237 provides a very narrow “safe harbor” enabling an individual that subdivides real
property before sale to avoid dealer status if he (1) has not held the tract of land at issue for sale in
the ordinary course of his trade or business in the past, (2) does not hold other tracts for sale in the
ordinary course of business in the year of sale, (3) has held the tract of sold property for investment
purposes for at least 5 years (unless inherited) before subdividing it and engaging in advertising,
[13]
A variation of the argument based on short holding periods is that Byram’s execution of contracts to sell two
properties before acquiring title to them indicates lack of investment intent. The record shows that Byram contracted
to purchase one of the properties and a portion of the other before engaging to sell them. See Record, Volume IV, p.
304-07, 310; Plaintiffs’ Exhibits 15, 19, & 20. For these, the timing of passage of title is irrelevant for our purposes.
Even if we assume that Byram contracted to sell the remaining portion of property before acquiring it, our view of the
district court’s finding remains unaltered. Though this fact undoubtedly favors the government’s position, the district
court reasonably could have found it outweighed by the other evidence.
26
526 F.2d 409 (5th Cir. 1976).

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promotion, and other selling activities, and (4) has made “no substantial improvement that
substantially enhances the value of the lot or parcel sold.” Improvements made by the buyer,
related parties, certain lessees, and government entities are attributable to the selling taxpayer in
applying this test. Substantial improvements include utility lines, paved roads, and buildings.
Under Treas. Reg. § 1.1237-1(c)(3), improvements are not considered “substantial” unless they
increase the value of the land by more than 10%. Furthermore, under § 1237(b)(3), “water, sewer,
or drainage facilities or roads” are not considered substantial improvements if (1) the tract has been
held for at least 10 years, (2) the taxpayer can prove that the improvements were necessary to make
the lots marketable, and (3) the taxpayer does not increase the tract’s basis by the cost of the
improvements (or otherwise deduct the costs as expenses), thereby increasing the amount of
includable gain. Even if all of its requirements are satisfied, the § 1237 safe harbor fully applies
only to the first five lots or parcels sold from the tract of land. Section 1237(b)(1) provides that
any additional realized gain “shall be deemed to be gain from the sale of property held primarily
for sale to customers in the ordinary course of the trade or business to the extent of 5 percent of
the selling price.” Because of these stringent limitations, § 1237 appears to be little used.
While the authorities above all deal with real estate, it is important to note that the issue of
whether property first acquired as a capital asset has crossed the line to property held for sale in
the ordinary course of the taxpayer’s trade or business is not limited to real estate. 27
§ 1221(a)(2): certain property used in the taxpayer’s trade or business
Section 1221(a)(2) removes from capital asset treatment real or personal property used in the
taxpayer’s trade or business but only if, in the case of personal property, the property is
depreciable. Neither the non-depreciable land plowed and planted by a farmer in the business of
selling crops nor the depreciable equipment (and depreciable factory) used in a taxpayer’s
manufacturing business qualifies as a capital asset. In this fashion, the means of producing services
or inventory income are also denied capital asset treatment, just as the services and inventory
income themselves are denied preferential treatment.
Nevertheless, Congress used precisely the same language found in § 1221(a)(2) to describe socalled § 1231 property in § 1231(b) (with the added requirement that the property be held for more
than one year). Therefore, while such assets do not produce capital gain or loss, they can sometimes
produce gain or loss that is treated like long-term capital gain or long-term capital loss, as further
discussed below in Part D. Stay tuned.
§ 1221(a)(3): certain copyrights, works of art, musical compositions, and similar property
Suppose that Jacob is an artist who paints a canvas and sells it to an art gallery for $1,000,
which in turn sells the painting to one of its customers, a lawyer, for $2,500 in the ordinary course
of the gallery’s trade or business. The lawyer hangs the painting on her living room wall, but she
tires of it after a few years and sells it to a friend for $5,000, as Jacob’s reputation in the art world
has increased by then. What are the tax consequences of each of these three sales?
Jacob’s basis in the painting would be very low, equal to the nondeductible cost of the canvas
and paints (capital expenditures) that he used to create the work of art, say, $100. He realizes a
27

See, e.g., U.S. v. Hollis, 121 F. Supp. 191 (N.D. OH 1954). Mr. Hollis was a curator of the Cleveland Museum of
Art when he resigned to become an advisor to General MacArthur as Chief of the Arts and Monuments Division of
the Allied Forces in Japan. After the war, he began to sell many Japanese art objects from his home in Cleveland
Heights and attempted to report these sale gains as capital gain, but he lost. My thanks go to Professor Bridget
Crawford for bringing this case to my attention.

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$900 gain when he sells it to the gallery for $1,000. The gallery’s basis in the painting is its $1,000
cost under § 1012, and it realizes a $1,500 gain when it sells it to the lawyer for $2,500. Finally,
the lawyer’s basis in the painting is her $2,500 cost under § 1012, and she realizes a $2,500 gain
when she sells it to her friend for $5,000. Each of these taxpayers must include the realized gain
in Gross Income, as no nonrecognition applies, so each must determine the gain’s character.
As amended by the TCJA, § 1221(a)(3) provides that “a patent, invention, model or design
(whether or not patented), a secret formula or process, a copyright, a literary, musical, or artistic
composition, a letter or memorandum, or similar property” is not a capital asset if “held by” certain
taxpayers. 28 Under § 1221(a)(3)(A), the canvas is not a capital asset in Jacob’s hands, as his
personal efforts created the painting. Jacob’s $900 realized gain is ordinary, not capital, gain.
While not compensation per se under § 61(a)(1), Jacob’s § 1001 gain represents a return on his
personal effort akin to a labor return and is thus taxed at ordinary income rates. For the gallery, the
painting is described in § 1221(a)(1)—considered above—as the gallery held the painting for sale
in the ordinary course of its trade or business, resulting in $2,500 of ordinary gain. With respect to
the lawyer, the painting is not described in either § 1221(a)(1) or any of the subsections in §
1221(a)(3), which means that the painting is a capital asset in her hands under the introductory
clause of § 1221(a), resulting in $2,500 of capital gain when she sells it to her friend.
Suppose that Jacob gives the painting to his mother Lori as a birthday gift (instead of selling it
to the art gallery). A few years later, after Jacob has established a reputation in the art world, Lori
sells the painting to an art gallery for $5,000. What is the amount and character of Lori’s realized
gain under § 1001? Is Lori, like the lawyer, entitled to treat the painting as a capital asset because
she neither painted it nor held it as inventory? Because she obtained the painting by inter vivos
gift, Lori would take the same $100 basis that Jacob had under § 1015(a), resulting in a $4,900
realized gain when she sells the painting for $5,000. Even though Lori is not described in §
1221(a)(3)(A) because she did not paint the canvas herself, she is described in § 1221(a)(3)(C)
because her basis in the painting is determined “in whole or in part” by reference to Jacob’s basis,
and Jacob is described in § 1221(a)(3)(A). Lori’s $4,900 gain is ordinary gain. In short, Jacob’s
gift does not launder out the ordinary taint.
Suppose, instead, that Jacob does not give the painting to his mother while he was alive. Rather,
after a very long and fruitful life, Jacob dies and leaves the painting to his sister Becky in his will.
The painting is appraised at $20,000 at the time of Jacob’s death. Becky sells the painting 9 months
after Jacob’s death for $30,000 (after the usual bump in value caused by the artist’s death). What
is the amount and character of Becky’s § 1001 gain?
Becky does not take Jacob’s $100 basis under § 1015(a) but rather takes a basis equal to the
painting’s $20,000 appraised value at Jacob’s death under § 1014(a), resulting in a $10,000
realized gain on the sale for $30,000. Moreover, on these facts, Becky is described in neither
subsection (A) nor subsection (C) of § 1221(a)(3). Becky did not paint the painting herself, and
her basis was not determined “in whole or in part” by reference to Jacob’s basis in the painting.
Becky’s gain is capital gain! Moreover, even though she held the painting for only 9 months prior
28

The House bill would also have repealed § 1235, which generally provides capital gain treatment to the developer
of a patent even if the patent is transferred for a series of payments that mimic royalties (rather than sale consideration)
because measured by use of the patent. The Senate had no provisions on this issue. The Conference Report added selfcreated patents (and similar property) to § 1221(a)(3) but did not repeal § 1235. This combination appears to be
internally inconsistent. We shall have to wait for clarifying regulations (or a statutory fix) to reconcile amended §
1221(a)(3) and the continuing presence of § 1235.

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to its sale, she is deemed to have held it for more than a year under § 1223(9), so Becky’s gain is
long-term capital gain.
Finally, what is § 1221(a)(3)(B) all about? The history majors among you might know that the
first scandal of the Nixon administration involved this provision. To understand the genesis of its
enactment in 1969, we have to take a sneak preview of the amount of a § 170 charitable
contribution deduction when property is contributed in kind to an eligible charity or government
(examined in Chapter 17). You learned in Chapter 7 that the making of a gift is not a realization
event. When Mark contributes property with a basis of $100 and FMV of $500 to an eligible
charity, he does not realize the $400 of built-in gain under § 1001. If we wish to avoid allowing
Mark to enjoy a double tax benefit for the same dollars (both exclusion of the $400 built-in gain
and deduction of that same $400 built-in gain), his charitable contribution deduction should be
limited to his $100 basis in the contributed property, representing after-tax dollars, rather than the
property’s $500 FMV. Nevertheless, as you will learn in Chapter 17, Mark is permitted to deduct
the full $500 FMV of the property (enjoying a double tax benefit—both exclusion and deduction—
of the same $400 built-in gain) if, among other requirements, the property’s built-in gain represents
long-term capital gain (rather than ordinary gain or short-term capital gain).
Because of this favorable treatment accorded long-term capital gain property contributed to
charity or government, it had become common by the mid-1960s for Presidents of the United
States to contribute to the National Archives the papers that they collected over the years of their
public careers. President Nixon donated 21 boxes containing 41,300 items from his congressional
and vice presidential terms, such as speeches, correspondence, and audiotapes documenting the
1960 campaign, before December 31, 1969. 29 Because he had a $0 basis in the papers, the
contribution lawfully permitted him to deduct the FMV of the contributed items on his 1968 tax
return because the papers’ built-in gain would have constituted long-term capital gain had he sold
them, and the other requirements in § 170 allowing a full FMV deduction were satisfied.
In early 1969, Congress proposed amending the law by adding what is now § 1221(a)(3)(B),
which excludes letters, memoranda, and similar property from capital asset treatment if they are
held by “a taxpayer for whom such property was prepared or produced.” Because the papers held
by Nixon would no longer qualify as capital assets in his hands, his charitable contribution
deduction for any additional contributions to the National Archives would be limited to his basis
in the papers: $0. While President Nixon and others in the White House lobbied heavily against
the enactment of the provision, the Tax Reform Act of 1969 retained the provision, with an
effective date of July 25, 1969. Donations made after that date would not qualify for the FMV
deduction. President Nixon signed the law on December 30, 1969. Shortly before the tax filing
deadline in 1970, the President’s lawyer prepared documents backdated to March of 1969,
claiming that more than 1,000 boxes of additional papers were donated to the National Archives
at that time so that the President could take a full FMV deduction, even though the boxes were not
actually transferred until 1970. The Washington Post broke the story in June of 1973, and the Joint
Committee on Taxation investigated, concluding that President Nixon owed a total of $432,787 in
additional tax and interest for tax years 1969 to 1973. The President claimed that he had no
knowledge of the backdating and was not charged with a crime. In 1974, Congress enacted the
Presidential Recordings and Materials Preservation Act, which declared “official presidential
papers to be public property and the papers of all presidents beginning in 1981 to be the property
29

See Matthew G. Brown, The First Nixon Papers Controversy: Richard Nixon’s 1969 Prepresidential Papers Tax
Deduction, 26 ARCHIVAL ISSUES (2001) (describing this story).

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of the United States.” 30
You cannot make this stuff up!
§ 1221(b)(3): the election for self-created musical works
Enacted in 2005 as a temporary measure but made in permanent in 2006, § 1221(b)(3) is perhaps
the best example of the strength of sheer lobbying power. The Country Music Association lobbied
Congress heavily for this provision, 31 which permits song writers to elect to treat their songs as
capital assets, notwithstanding §§ 1221(a)(1) and (a)(3)(A) (though not for purposes of the
charitable contribution deduction). Why should the sale of self-created songs create low-tax capital
gain while the sale of self-created paintings or books do not? The legislative history contains a
single sentence: “The Congress believes it is appropriate to allow taxpayers to treat as capital gain
the income from a sale or exchange of musical compositions or copyrights in musical works the
taxpayer created.” 32 But why is it “appropriate”? The sale of a song’s copyright by the composer
represents a return on labor just as much as Jacob’s sale of his painting to the art gallery or an
author’s sale of her copyright to a book, both of which produce ordinary gain. Sigh….
§ 1221(a)(7): hedging transactions
To understand the history behind § 1221(a)(7), we need to take a little detour first to talk about
commodities futures contracts.
Commodities futures contracts were developed to reduce the risk of future price fluctuations
for buyers and sellers of commodities. Farmer Frank, who is planting corn today and wants to lock
in the price at which he can eventually sell it, can enter into a contract for future sale at a price
agreed to now. By doing so he would remove the risk that spot prices on the delivery date would
be lower. (The “spot” price is the price paid for an asset when the exchange of goods and money
between buyer and seller takes place in the present, i.e., “on the spot.”) Similarly, Paul Producer,
a corn syrup manufacturer wanting to lock in the price at which he can buy corn, can enter into a
contract for future delivery at a price agreed to now, removing the risk that spot prices on the
delivery date will be higher. Exchanges developed over which Farmer Frank and Paul Producer
could buy and sell these contracts to take advantage of interim price fluctuations. In other words,
commodities futures trading involves the buying and selling of contracts for the future delivery of
physical raw materials, such as corn, gold, copper, soybeans, and even livestock (cattle or pigs).
But the exchanges are not limited to those, like Frank and Paul, who might actually transfer and
take delivery of the underlying commodities that are the subject of the contract. Indeed, the bulk
of those who trade futures contracts over exchanges are speculators who are merely betting on
future price swings.
For example, assume that Samantha Speculator signs in to her online trading account at 10:00
a.m. on February 3 of Year 1 and buys one Year-1 June corn futures contract for the current market
price of $1.00 per bushel. Later that day, June corn futures contracts are now trading at $1.04 per
bushel, and Samantha sells the contract that she bought earlier that day. One corn futures contract
is 5,000 bushels, which means that Samantha actually paid $5,000 for her one corn futures contract
30

Id. at 10.
See Brody Mullins, Music to Songwriters’ Ears: Lower Taxes—Country Artist’s Group Presses Lawmakers to Slash
the Levy on Lyricists, at http://online.wsj.com/article/SB113322576138408618.html.
32
JOINT COMMITTEE ON TAXATION, GENERAL EXPLANATION OF TAX LEGISLATION ENACTED IN THE 109TH CONGRESS
277 (2007).
31

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(typically with borrowed money to a large extent), and she sells for $5,200, for a profit of $200.
What is the character of Samantha’s gain? Under § 1256, 60% of any gain or loss realized on
the sale of a regulated futures contract is treated as long-term capital gain or loss, and 40% is
treated as short-term capital gain or loss—regardless of how long Samantha owns the contract. In
addition, such contracts are marked to market at the end of each year. If Samantha buys a futures
contract on December 15 of Year 1 and sells it on January 10 of Year 2, she must mark the contract
to market on December 31, treat any gain or loss as 60% long term and 40% short term, and adjust
her basis in the contract, accordingly. When she sells on January 10 of Year 2, any further § 1001
realized gain or loss is again treated under the 60-40 rule.
Why are futures contracts sold at a gain treated so favorably, with ownership of mere minutes
creating 60% long-term capital gain? As Warren Buffett said, “There are so many ways to attack
the logic of it. It doesn’t make sense.” 33 This tax expenditure is scored to lose $5.5 billion in tax
revenue for the 5-year period from 2018 to 2022. But I digress….
Under § 1256, losses realized on the sale of a futures contract are capital losses (60% long-term
loss and 40% short-term loss), and you know from Part A. that capital losses that are otherwise
deductible under § 165 are nevertheless subject to the § 1211(b) limitation rule. Capital losses
(whether long term or short term) are deductible in the realization year only to the extent of realized
and recognized capital gains (whether long term or short term) plus, for individuals, up to $3,000
of included ordinary income.
Nevertheless, in a year before either § 1256 or § 1221(a)(7) was enacted (and commodities
futures contracts were treated as capital assets because not otherwise listed in the predecessor to §
1221), the Supreme Court held that some futures contracts were not capital assets if held as an
integral part of the taxpayer’s business operations. The taxpayer in Corn Products Refining
Company v. Commissioner 34 used between 35 and 60 million bushels of corn each year in the
manufacture of various products, including corn starch, syrup, and sugar, as well as their
byproducts, such as corn oil and animal feed. To partially hedge against unpredictable price swings
in corn, Corn Products bought corn futures contracts. Sometimes Corn Products actually took
delivery of corn under the futures contracts, but at other times it sold the futures contracts, realizing
either a gain or loss, just as Samantha did, above. In 1940, it realized a gain of approximately
$600,000 on such sales, while it realized a loss of approximately $110,000 in 1941. Corn Products
treated these gains and losses as capital gains and losses. The IRS, however, argued that the futures
contracts were ordinary assets in the hands of Corn Products, and the Supreme Court agreed.
Nor can we find support for petitioner’s contention that hedging is not within the
exclusions of [§ 1221]. Admittedly, petitioner’s corn futures do not come within the
literal language of the exclusions set out in that section. They were not stock in trade,
actual inventory, property held for sale to customers or depreciable property used in a
trade or business. But the capital-asset provision of [§ 1221] must not be so broadly
applied as to defeat rather than further the purpose of Congress. Congress intended
that profits and losses arising from the everyday operation of a business be considered
as ordinary income or loss rather than capital gain or loss. The preferential treatment
33

Andrew Ross Sorkin, An Addition to the List of Tax Loopholes, at http://dealbook.nytimes.com/2011/07/11/anaddition-to-the-list-of-tax-loopholes. Moreover, the amounts invested in such futures contracts is not trivial. One 2013
estimate put the value of futures contracts at $24 trillion. “The value of the American stock market is only $23 trillion.”
Swapping Bad Ideas, THE ECONOMIST, April 27, 2013, at 69.
34
350 U.S. 46 (1955).

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provided by [§ 1221] applies to transactions in property which are not the normal
source of business income. It was intended “to relieve the taxpayer from … excessive
tax burdens on gains resulting from a conversion of capital investments, and to remove
the deterrent effect of those burdens on such conversions.” Burnet v. Harmel, 287
U.S., at 106. Since this section is an exception from the normal tax requirements of
the Internal Revenue Code, the definition of a capital asset must be narrowly applied
and its exclusions interpreted broadly. This is necessary to effectuate the basic
congressional purpose. This Court has always construed narrowly the term “capital
assets” in [§ 1221]. See Hort v. Comm’r, 313 U.S. 28, 31; Kieselbach v. Comm’r, 317
U.S. 399, 403. 35
The Court distinguished between “speculative transactions in commodity futures,” on the one
hand, and “hedging transactions,” on the other, and held that “hedging transactions were
essentially to be regarded as insurance rather than a dealing in capital assets and that gains and
losses therefrom were ordinary business gains and losses.” 36
For many years thereafter, businesses who bought and sold commodities futures contracts
relating to their businesses attempted to walk a fine line in their attempts to capture the best of
both worlds, arguing that they held the futures contracts as hedges under Corn Products when they
sold the contracts at a loss (which would be ordinary, avoiding the § 1211 capital loss limitation
rule) and arguing that they held those contracts sold at a gain as mere speculators, garnering capital
gain treatment. As you can imagine, much litigation ensued, as courts were required to examine
the facts of each case to determine the business’s purpose in holding the contracts.
Moreover, taxpayers argued that Corn Products created an additional common law exception
to the definition of capital asset that went beyond commodities futures contracts. They argued that
any asset integrally related to the taxpayer’s business (rather than held for investment) was not a
capital asset under Corn Products, even though not otherwise described in § 1221. For example,
the taxpayer in Commissioner v. Bagley & Sewell Company 37 entered into a contract to sell two
paper-making machines to the government of Finland for $1.8 million. The government of Finland
required that Bagley & Sewell purchase and deposit into escrow U.S. Government bonds as
security for performance under the contract. Upon satisfactory completion of the contract, the
bonds were released to Bagley & Sewell, who then sold the bonds at a loss and sought to deduct
the loss as ordinary (unhampered by § 1211) under Corn Products. The IRS argued that the bonds
were capital assets because not described in § 1221’s list of exclusions, but the Second Circuit
agreed with the taxpayer, holding that the bonds were not capital assets under Corn Products
because they were integrally related to the performance of the taxpayer’s business contracts.
Finally, the Supreme Court clarified its prior Corn Products holding in Arkansas Best
Corporation v. Commissioner, 38 where it rejected the idea that Corn Products created a common
law exception to the definition of a capital asset. The Court wrote, “We conclude that Corn
Products is properly interpreted as standing for the narrow proposition that hedging transactions
that are an integral part of a business’s inventory-purchase system fall within the inventory
exclusion of § 1221[(a)(1)].”

35

Id. at 51-52.
Id. at 52-53.
37
221 F.2d 944 (2d Cir. 1955).
38
485 U.S. 212 (1988).
36

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The Court’s holding still did not address the whipsaw problem, however. Taxpayers who
realized losses on their inventory hedges could often claim that the hedge was an integral part of
the business’s inventory-purchase system (and thus were not capital assets under the inventory
exclusion in § 1221(a)(1) under Corn Products and Arkansas Best), while those who realized gains
could attempt to quietly include them as capital gains. Congress finally enacted § 1221(a)(7).
Today, a taxpayer who enters into a hedging transaction (such as purchasing a corn futures contract
to hedge against price fluctuations in corn when corn is a raw material in the manufacturing
process) must identify the contract as a hedge on the date of acquisition to avoid capital asset
treatment (under § 1256 if the hedge is in the form of a regulated futures contract). They cannot
quietly wait until they sell the hedge to decide whether to argue that the asset was—or was not—
integrally related to their inventory-purchase system.
Section 1221(a)(7) also extends the hedging exception beyond inventory hedges. Hedges
entered into to manage the risk of interest rate and foreign currency fluctuations that can affect the
taxpayer’s business, for example, can also be identified as hedges under § 1221(a)(7).
Whew!
The sale of a right to collect ordinary income in the future
A taxpayer selling his services or inventory (generating ordinary income) often has accounts
receivables, which represent amounts owed to them by customers who purchased goods or services
on credit. A taxpayer using the cash method of accounting will not include the ordinary income
until actually or constructively received, so the receivables will have a zero basis. A taxpayer not
wishing to wait until the future payment from the customer can sell the receivables in the
marketplace at a discount, with the buyer often called a “factor.” The factor then collects from the
customer. Under § 1221(a)(4), accounts receivables are not capital assets, so the gain on sale of
the receivables to the factor is ordinary.
The idea behind the capital asset exception for accounts receivables informs the analysis when
nonbusiness taxpayers similarly sell a future right to receive other types of ordinary income. For
example, a lottery winner may sell to a factor for a discounted lump sum the future right to collect
ordinary income over, say, 20 years. While taxpayers have often argued that their right to receive
future income is a capital asset so that their sale gain is capital gain, they have uniformly lost. 39
This line of analysis has particular relevance to the sale of a carved-out income interest in
property, where the selling taxpayer otherwise retains the underlying property. In Commissioner
v. P.G. Lake, 40 for example, the Supreme Court held that amounts received on the sale of a carvedout working interest in oil and gas wells (with the selling taxpayer otherwise retaining the land)
represented a substitute for the ordinary income that would have been earned on the wells by the
taxpayer absent the sale of the carved-out interest. 41
The sale or exchange requirement
The phrase “sale or exchange” in § 1222(1) through (4) is not defined in the statute or
regulations and has not had a major impact in the capital gains area. Nevertheless, common law
39

See, e.g., Lattera v. Comm’r, 437 F.3d 399 (3rd Cir. 2006).
356 U.S. 260 (1958).
41
Congress has now addressed the sale of certain carved-out income interests more comprehensively. For example,
the treatment of stripped bonds, where the owner of the bond sells only the right to future interest payments while
retaining the underlying bond and its right to principal repayments, is addressed in § 1286.
40

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has clarified that the requirement is generally not satisfied unless the property survives the transfer
in the hands of the other party; a transfer in which the property is extinguished or matures is not a
sale or exchange. 42 For example, while tenure held by college professors could feasibly be
considered a property right under state law, payment to a professor in consideration for his tenure
rights cannot generate capital gain because tenure does not survive the transaction as a property
right in the hands of the college, to be bestowed on another candidate. 43 Similarly, abandonment,
destruction, or theft of property is not a “sale or exchange.”
In some instances, the statute artificially satisfies the sale or exchange requirement by statutory
fiat so that a realized gain or loss can be capital. Here are a few of the more notable examples.
• Upon the liquidation of a corporation, the outstanding stock does not survive the transaction.
Nevertheless, the sale or exchange requirement is deemed satisfied under § 331(a) so that
the shareholders can treat their realized gains and losses (the difference between the
consideration received from the corporation in retirement of their stock and their adjusted
bases in the stock) as capital gain or loss rather than ordinary gain or loss.
• When a borrower repays a debt, the retired debt instrument does not survive the transaction
in the hands of the lender. Nevertheless, the sale or exchange requirement is deemed satisfied
under § 1271(a) so that the difference between the lender’s basis in the instrument and the
amount received on retirement (other than interest), if any, can be treated as capital gain or
loss.
• When a security or other debt instrument held for investment becomes worthless, the holder
can usually treat the worthlessness as arising on sale or exchange under §§ 165(g) or 166(d).
• If personal casualty gains exceed personal casualty losses (considered in Chapter 17), the
gains and losses are treated as arising on sale or exchange under § 165(h)(2)(B).
• The loss arising from the failure to exercise an option to buy a capital asset (equal to the
basis of the option) is deemed to arise from the sale or exchange of a capital asset on the day
the option expires under § 1234.
• An amount received by a lessee in cancellation of a lease is deemed to be an amount received
in exchange for the lease under § 1241.
The Arrowsmith doctrine
The taxpayer in Commissioner v. Arrowsmith 44 was an officer and shareholder of a corporation
that liquidated in 1940. The taxpayer had properly included in his 1940 Gross Income capital gain
equal to the difference between the liquidation proceeds that he received and his basis in the
corporation’s stock. For purposes of illustration, let’s assume that Arrowsmith had an A/B of
$30,000 in his stock and that he received $100,000 from the liquidating corporation, resulting in a
$70,000 realized gain. Even though the stock was a capital asset in Arrowsmith’s hands, his
realized gain would be ordinary absent § 331(a) because the stock does not survive the liquidation.
As you learned just above, however, § 331(a) steps in to artificially satisfy the sale or exchange
requirement in this situation, which means that Arrowsmith’s $70,000 realized gain was properly
42

See, e.g., General Artists Corp. v. Comm’r, 205 F.2d 360 (2d Cir. 1953); Comm’r v. Starr Bros, 204 F.2d 673 (2d
Cir. 1953); Comm’r v. Pittson Co., 252 F.2d 344 (2d Cir. 1958).
43
See, e.g., Foote v. Comm’r, 81 T.C. 930 (1983), aff’d, 751 F.2d 1257 (5th Cir. 1985).
44
193 F.2d 734 (2d Cir. 1952).

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treated as capital gain in 1940.
In 1944, however, Arrowsmith was called upon (as successor in interest under state law) to pay
a judgment rendered against the old corporation, which he could properly deduct in 1944 because
the outlay related to his prior stock investment (not to personal consumption). Let’s assume that
Arrowsmith paid $10,000 on this claim. The issue was whether the 1944 deduction was ordinary
because it did not arise on the “sale or exchange” of a “capital asset” under § 1222 (which he
preferred) or whether it was capital, subject to the § 1211(b) capital loss limitation rule.
The taxpayer’s argument was premised on the annual accounting principle. There was no sale
or exchange of a capital asset in 1944—only the payment of a claim.
The court held, however, that Mr. Arrowsmith’s $10,000 deduction should be treated as a
capital loss on the theory that, if the old corporation had properly paid the liability before
liquidating, he would have realized less capital gain (or even a capital loss) on the liquidation. That
is to say, suppose that the claim had ripened and the corporation had paid that $10,000 before the
liquidation. In that case, Mr. Arrowsmith would have received only $90,000 (instead of $100,000)
on the liquidation and, thus, would have included only $60,000 of capital gain instead of $70,000
in 1940. For this reason, the court concluded that the character of the Year-2 deduction was
determined by reference to the character of the Year-1 inclusion (on the liquidation) with which it
was transactionally linked. In a sense, Mr. Arrowsmith was forced to recapture $10,000 of capital
gain that, with the benefit of hindsight only, we now know was too much.
This characterization rule, now known as the Arrowsmith doctrine, provides a good segue to
the consideration of depreciation recapture, described in Part D., which you can think of as a
codification of the Arrowsmith doctrine in the particular context of a sale of depreciable property.

D. Section 1231 gains and losses and depreciation recapture
You learned in Part B. that § 1221(a)(2) excepts from the capital asset definition real and
depreciable personal property used in the taxpayer’s trade or business. Therefore, neither the land
tilled by a farmer growing crops, the factory building in which widgets are manufactured, nor the
widget-making machine in the factory are capital assets. Absent §§ 1231, 1245, and 1250, the
gains arising on sale or exchange of these assets would always be ordinary gain, ineligible for the
preferential rates in § 1(h), and the losses arising on sale or exchange of these assets would always
be ordinary losses, free from the § 1211 capital loss limitation rule. Section § 1231 (on both the
gain and loss sides) and §§ 1245 and 1250 (on the gain side only) can alter these characterizations.
§ 1231 gains and losses
Prior to 1938, assets used in business were treated as capital assets, contrary to current §
1221(a)(2). During the Great Depression, however, many businesses realized losses on the sale or
exchange of such business assets. These capital losses were difficult to deduct under the capital
loss limitation rule, and Congress responded in 1938 by enacting the predecessor to § 1221(a)(2),
removing assets used in business from capital asset treatment. 45 Because very few taxpayers
realized gains on the sale of such assets at this time in our history, § 1221(a)(2) operated chiefly
45

See Myron C. Grauer, A Case for Facilitation of a Collaborative Model of Statutory Interpretation in the Tax Area:
Lessons to be Learned from the Corn Products and Arkansas Best Cases and the Historical Development of the
Statutory Definition of “Capital Asset)s),” 84 KY. L.J. 1, 48-55 (1995-1996) (describing this evolution).

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to benefit taxpayers.
Then came WWII. In exercising its right under the 5th amendment to take private property for
public use so long as just compensation is paid, the Federal government appropriated many
business assets, particularly ships and WWI-vintage submarines, for the war effort (especially in
the early years of the war, before the massive building of new factories, ships, and submarines).
Many of these assets were fully depreciated in the hands of their former owners, with a zero or
low basis, and the taking (with FMV consideration) resulted in a substantial § 1001 realized gain.
With the top marginal rate on ordinary income and gain exceeding 90% during WWII, the formerly
beneficial § 1221(a)(2), which had operated mainly as a shield against the § 1211 capital loss
limitation rule, became a sword.
Congress could simply have repealed § 1221(a)(2), restoring assets used in business to their
pre-1938 status as capital assets, with the result that taxpayers realizing a gain on these takings
would likely have had the gain taxed at low rates. But then taxpayers would have lost the bright
side of § 1221(a)(2) if they sold such business assets at a loss. Congress responded to this situation
by enacting § 1231, which gave these taxpayers essentially the best of both worlds.
Section 1231(b) generally defines § 1231 property with precisely the same words found in §
1221(a)(2) with the additional requirement that the property must be held for more than one year. 46
If the taxpayer’s realized and recognized § 1231 gains exceed the taxpayer’s realized and
recognized § 1231 losses for the year, § 1231(a)(1) provides that the gains and losses are
“treated” like long-term capital gains and losses—even though the assets are not capital
assets (because described in § 1221(a)(2)). For this reason, they are sometimes called “quasi”
capital gains and losses. If § 1231(a)(1) applies, the taxpayer’s chances of having favorably taxed
net capital gain are very good (unless the taxpayer realizes a lot of real capital losses from other
sources). In contrast, if the taxpayer’s § 1231 losses equal or exceed the taxpayer’s § 1231
gains, § 1231(a)(2) provides that their real status as ordinary gains and losses will control. If
§ 1231(a)(2) applies, the taxpayer’s chances of avoiding the § 1211 capital loss limitation rule are
very good (unless the taxpayer realizes a lot of real capital losses from other sources). In other
words, it’s “heads I win, tails you lose” to the Federal Treasury!
Section 1231 is best seen as a provision enacted as an immediate response to the exigent
circumstances of WWII rather than as a provision grounded in tax theory. Nevertheless, once a
provision benefiting taxpayers is enacted, it is often very difficult to repeal, and § 1231 lingers on.
A relatively minor deviation from the best-of-both-worlds result was added in 1981 in the form
of the 5-year look-back rule in § 1231(c). The taxpayer’s net § 1231 gain for any taxable year (the
excess of § 1231 gains over § 1231 losses) is treated as ordinary gain (instead of long-term capital
gain) to the extent that it does not exceed the taxpayer’s favorably treated net § 1231 losses (which
were treated like ordinary losses) for the prior 5 years. In other words, to the extent that the
taxpayer benefited from avoiding the § 1211 capital loss limitation rule because of § 1231(a)(2) in
the prior 5 years, he has to give up the favorable treatment provided by § 1231(a)(1) in the current
year until all such favorably treated net § 1231 losses have been recaptured.
For example, assume that Craig realizes the following § 1231 gains and losses in Years 1
through 3 from the sale of assets used in his business, that additional ordinary income or gain
would be taxed at 28%, and that Craig realizes no real capital gains or losses in any year.
46

It also throws in additional property, such as certain timber, coal, livestock, and unharvested crops.

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Year 1
Year 2
Year 3

Chapter 14

§ 1231 gains

§ 1231 losses

$20,000
10,000
40,000

$15,000
17,000
10,000

Under § 1231(a)(1), Craig treats the $20,000 Year-1 gain as long-term capital gain and the
$15,000 Year-1 loss as long-term capital loss because his § 1231 gains exceed his § 1231 losses
for the year. Because Craig realizes no additional real capital gains or losses, Craig can fully deduct
his $15,000 loss, notwithstanding § 1211(b), and Craig has net capital gain of $5,000 under §
1222(11), eligible for a reduced tax rate under § 1(h).
In Year 2, Craig’s $10,000 gain and $17,000 loss are respected as the ordinary gains and losses
that they really are under § 1221(a)(2) because his § 1231 losses exceed his § 1231 gains under §
1231(a)(2). Craig can fully deduct his $17,000 loss, without regard to § 1211(b), effectively
offsetting not only the $10,000 gain but also $7,000 of ordinary income from other sources.
Absent § 1231(c), Craig would treat the $40,000 gain realized in Year 3 as entirely long-term
capital gain (and the $10,000 loss as long-term capital loss) under § 1231(a)(1) because his § 1231
gains exceed his § 1231 losses. His $10,000 loss would reduce $10,000 of his gain, and the
remaining $30,000 of net gain would qualify as net capital gain subject to a reduced tax rate under
§ 1(h). Under § 1231(c), however, Craig must treat $7,000 of his remaining $30,000 of net gain as
ordinary gain (equal to the $7,000 Year-2 net loss that escaped the grasp of § 1211(b)).
Finally, while rental property is often not considered business property (but rather investment
property) for other purposes unless significant services are provided by the lessor, some courts
have construed “business” in § 1231(b) more broadly. For example, the taxpayer in Wasnok v.
Commissioner 47 held only a single rental property for four years before it was sold at a loss. The
court concluded that the rental property was “business” property for purposes of § 1231(b), which
permitted the loss to be treated as an ordinary (not capital) loss under § 1231(a)(2). On the other
hand, the IRS issued a 1983 Technical Advice Memorandum opining that land rented to a tenant
who built, managed, and operated a hotel under a net lease (the lessee was responsible for taxes,
insurance, and maintenance) was not business property for the lessor for purposes of § 1231. 48
§§ 1245 and 1250 depreciation recapture
Sections 1245 and 1250, enacted in 1962, are commonly referred to as “depreciation recapture”
provisions. They trump all other characterization provisions, including § 1231 and the capital gain
provisions in §§ 1221 and 1222. 49 To the extent required under these provisions, realized gain on
the sale of depreciable § 1231 property or a depreciable capital asset is treated as ordinary gain.
Let’s consider § 1245 first.
Suppose that Jim purchases a widget-making machine for $1 million for use in his business,
properly deducts $700,000 in depreciation (reducing the machine’s basis to $300,000 under §
1016(a)(2)), and then sells the machine for $900,000. You learned in Chapter 13 that an important
tax expenditure component of the depreciation provisions is that the deductions are intentionally
frontloaded, allowing Jim to deduct his basis much faster than would occur under economic
depreciation and much faster than any actual reduction in the property’s FMV. While Jim’s
47

T.C. Memo. 1971-6.
See TAM 8350008 (Aug. 23, 1983).
49
See §§ 1245(d) and 1250(h).
48

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property lost only $100,000 in value, he was permitted to deduct $700,000 during his ownership
period. Nevertheless, the basis reduction required under § 1016(a)(2) ensures that the too-fast
depreciation will result in realized § 1001 gain if the property is sold before being used up in Jim’s
business. Jim realizes and recognizes a $600,000 gain on the sale ($900,000 A/R less $300,000
A/B), an amount precisely equal to the excess of the depreciation allowed to Jim during his
ownership years over the property’s actual loss in value.
Even though the § 1016(a)(2) basis reduction effectively recaptures the amount of excessive
depreciation, it does nothing about the possible character arbitrage. Jim’s $600,000 in excessive
depreciation deductions were ordinary deductions, offsetting high-tax ordinary income, while the
property sale would (absent § 1245) produce § 1231 gain, which would be treated like long-term
capital gain under § 1231(a)(1) if this is Jim’s only § 1231 transaction for the year.
This is where § 1245 steps in. In effect, § 1245(a) requires all realized gain on the disposition
of § 1245 property (non-real estate) up to the amount of prior depreciation and § 179
deductions to be characterized as ordinary gain. Only the remaining gain—if any—can be §
1231 gain or capital gain, as the case may be. To be specific, § 1245(a)(1) provides that the lower
of (1) recomputed basis or (2) amount realized (FMV in the case of a disposition other than by sale
or exchange) less A/B is ordinary gain. Recomputed basis, as defined in § 1245(a)(2), is the
taxpayer’s original cost basis (his current basis plus all § 179 and depreciation deductions taken
during his ownership period). When Jim sells the machine for $900,000, the lower of recomputed
basis ($1 million) and amount realized ($900,000) is the amount realized. The excess of this figure
($900,000) over the machine’s A/B ($300,000) is $600,000—100% of Jim’s realized gain—which
must be treated as ordinary gain under § 1245(a).
Section 1245 is a codification, of sorts, of the Arrowsmith doctrine in that we must characterize
a current-year gain by reference to the prior-years’ excessive depreciation that created that builtin gain. Jim realizes a gain on sale only because of the excessively generous depreciation
deductions (which reduces basis) in prior years. Therefore, we must characterize this current-year
gain by reference to the too-generous ordinary deductions taken in prior years, essentially
reversing the effect of those ordinary deductions. Because of the time value of money, however,
Jim is still better off than he would be if his earlier depreciation deductions were, instead, limited
to the actual $100,000 reduction in the machine’s FMV, producing no realized gain on sale.
Another way of saying this is that the prior (ordinary) depreciation deductions—offsetting hightax income—were appropriate in the year taken in the sense that they were based on the expectation
that the assets would be used up in Jim’s business, producing (ordinary) income. When that
expectation proves to be false because the asset is sold, rather than used up in the business, we do
not go back and take away what is now—with the benefit of hindsight only—known to be excessive
ordinary deductions, in a sense. Rather, we take care of the problem entirely in the year of sale under
the annual accounting principle by recharacterizing some or all of the resulting sale gain (which
might otherwise be taxed at a preferential rate) as ordinary gain. 50
Because most depreciable non-real estate—such as Jim’s business equipment—loses some
value after purchase (though not as much as allowed to be deducted under §§ 179 and 168), § 1245
50

The same sort of analysis informs § 61 debt-discharge income. As described in Chapter 10, a borrower who fails to
repay debt cannot file an amended return to include the borrowed loan principal in the year originally received (and
excluded). Exclusion in the receipt year was proper based on what was anticipated in the future: repayment with aftertax dollars. Rather, § 61 creates an income inclusion in the year the repayment obligation disappears.

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typically recharacterizes 100% of the realized gain as ordinary depreciation recapture, completely
supplanting § 1231 (or §§ 1221 and 1222 in the case of a capital asset). In the unusual case in
which the equipment appreciates in value after purchase, however, there may be some remaining
gain to analyze as § 1231 gain or capital gain after applying § 1245(a).
For example, assume the same facts except that Jim is able to sell the machine for $1,100,000
(instead of $900,000), realizing $800,000 of § 1001 gain ($1,100,000 A/R less $300,000 A/B).
Now the lower of recomputed basis ($1 million) and amount realized ($1,100,000) is the
recomputed basis. The excess of this figure ($1 million) over the machine’s $300,000 A/B is
$700,000. Only $700,000 (equal to 100% of the prior depreciation deducted by Jim) of the
$800,000 realized gain is ordinary depreciation recapture under § 1245(a). The remaining
$100,000 gain is § 1231 gain that will be treated like long-term capital gain under § 1231(a)(1) if
this is Jim’s only § 1231 transaction for the year.
While § 1245 is very powerful, § 1250 is essentially irrelevant today. Under § 1250(a) and
(b), realized gain on the disposition of § 1250 property (depreciable real estate, such as a
factory or rental real estate) is ordinary gain only to the extent of the excess of depreciation
actually taken by the taxpayer over the amount that would have been taken had the property
been depreciated using the straight-line method. Before the Tax Reform Act of 1986, real estate
could be depreciated using an accelerated method. Assume, for example, that a taxpayer purchased
a factory in 1980 for $1 million, properly deducted $600,000 using an accelerated depreciation
method (reducing the factory’s basis to $400,000), and sold the property in a later year for
$900,000, realizing a $500,000 § 1001 gain ($900,000 A/R less $400,000 A/B). Had the taxpayer
depreciated the factory using the straight-line method, assume that that the taxpayer would have
deducted only $400,000 (instead of $600,000). Under § 1250, the taxpayer’s $500,000 realized
gain would have been ordinary only to the extent of $200,000, equal to the excess of the $600,000
of depreciation actually taken over the $400,000 that would have been taken using the straightline method. The remaining $300,000 of realized gain would have been § 1231 gain.
One of the base-broadening measures adopted in 1986 to pay for the significant reduction in
marginal rates was requiring that all real estate be depreciated under the straight-line method, as
described in Chapter 13. After 1986, therefore, § 1250 depreciation recapture is zero for virtually
all real estate. Because § 1250 is basically deadwood, § 1231 has its greatest impact on the sale of
real estate, permitting rate arbitrage. Virtually all tax academics and economists propose extending
§ 1245 to real estate, 51 but remember the strength of the real estate lobby!
Problems
In addition to each of the transactions described below, Rebecca, who is unmarried, has
$100,000 of Taxable Income consisting of ordinary income (wages and rent). Can her capital
losses, if any, be fully deducted? Does she realize any net capital gain within the meaning of §
1222(11)? Notice that you must first analyze the tax consequences of each transaction individually.
a. Rebecca sells stock of Gaggle, Inc., for $100,000, which she purchased 2 years ago for
$90,000.
b. Rebecca sells stock of Blapple, Inc., for $20,000, which she purchased 3 years ago for
51

See, e.g., Richard L. Schmalbeck & Jay A. Soled, Reforming Real Estate Depreciation Recapture, 146 TAX NOTES
887 (2015).

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$40,000.
c. Rebecca made a bona fide loan of $30,000 to a friend 2 years ago. She received interest
payments on the loan, but she was informed by the Bankruptcy Court this year that the loan is
discharged by the court and that Rebecca will never receive the $30,000 loan principal.
d. Rebecca purchased rental real estate 10 years ago for $1 million, which she actively manages.
She properly deducted $350,000 in depreciation over the years before selling the property this
year for $1.2 million.
e. Rebecca purchased equipment for use in her business for $900,000 several years ago (before
§ 168(k) 100% bonus depreciation was enacted in the TCJA), so she was able to properly deduct
only $400,000 in depreciation before selling the equipment this year for $700,000.
f. Two years ago, she sold vacant land, which she held for investment and which had a $220,000
basis, to Mark for $300,000. She properly included $80,000 of long-term capital gain on her
tax return in the sale year. This year, Mark threatens to sue Rebecca when he finds toxic sludge
buried in one corner of the lot, as he suspects that Rebecca either was responsible for it or at
least knew about it at the time of sale and failed to disclose the problem. To avoid litigation,
Rebecca agrees to Mark’s demand that she pay him $30,000 to clean up the sludge.

E. The § 1(h) rates applicable to net capital gain
I think that it is more important for you to know that § 1222(11) net capital gain is subject to a
reduced tax rate under § 1(h) than to know precisely what that reduced tax rate may be in any
particular case. Nevertheless, I highlight below a few of the more important rules.
Prior to the TCJA, the net capital gain rate was tied to the taxpayer’s ordinary income and gain
tax brackets. Net capital gain (and qualified dividends) was taxed at 0% to the extent that it would
otherwise fall within the 10% and 15% ordinary income tax brackets, at 15% to the extent it would
otherwise fall within the 25%, 28%, 33%, or 35% brackets, and at 20% to the extent it would
otherwise fall within the 39.6% bracket. Net capital gain and qualified dividend income was added
to the taxpayer’s ordinary income last, meaning that once a taxpayer’s ordinary income exceeded
the 15% bracket, no part of net capital gain is eligible for the 0% tax rate, and so on.
While the TCJA did not change the 0%, 15%, and 20% net capital gain rates, those rates are no
longer tied to the ordinary income bracket thresholds under the TCJA. Rather, they continue to be
determined by what ordinary income tax bracket the net capital gain would have fallen within
under pre-TCJA law, which means that the transition between the 0%, 15%, and 20% rates can
fall in the middle of a post-TCJA tax bracket. Talk about unnecessary complexity! In any event,
for 2022, net capital gain (and qualified dividends) falling within the Taxable Income bands listed
below (added last, after ordinary income and gain) will be taxed at the corresponding rates listed
below. These thresholds are indexed for inflation.
Net Capital Gain Tax Rate

Single

Married Filing Jointly

0%
15%
20%

$0 to $41,675
$41,676 to $459,750
$459,751 and up

$0 to $83,350
$83,351 to $517,200
$517,201 and up

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For example, assume that, after taking deductions, a married couple has $300,000 of ordinary
income and $250,000 of net capital gain (none of which is unrecaptured § 1250 gain or collectibles
gain, as described below) in 2022, for total Taxable Income of $550,000. None of their net capital
gain is taxed at 0%, $217,200 is taxed at 15%, and the remaining $32,800 is taxed at 20%. 52
Because § 1250 is so weak, most real estate gain realized by nondealers produces long-term
capital gain or § 1231 gain that is treated like long-term capital gain under § 1231(a)(1) (if § 1231
gains for the year exceed § 1231 losses). Nevertheless, net capital gain arising from real estate is
subject to a maximum tax rate of 25% to the extent that it represents “unrecaptured § 1250 gain,”
which is the amount of realized gain that would have been ordinary depreciation recapture had §
1245 applied instead of § 1250. This special rate could be repealed if § 1245 were simply extended
to real estate, as it should be. (No policy reason justifies such tax rate arbitrage: permitting real
estate gain that represents prior depreciation deductions, which offset high-tax income, to be taxed
at any preferential rate.) In addition, net capital gain attributable to the sale or exchange of
“collectibles” qualifying as capital assets (because not held as inventory under § 1221(a)(1)) is
subject to a maximum tax rate of 28%.

52

Chapter 3 mentioned that taxpayers with “modified adjusted gross income” exceeding $200,000 ($250,000 for a
married couple filing jointly) can incur a 3.8% Medicare surtax on their net investment income, including but not
limited to net capital gain, enacted as part of health care reform in 2010. The rates described here do not include this
surtax.

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Chapter 15: Tax Shelters
What is a tax shelter? That question is a difficult one on which there is no broad agreement.
Nevertheless, I think it helpful to think of tax shelters as generally falling within two categories:
(1) the mismeasurement of SHS wealth increases and decreases or (2) an attempted conversion of
high-taxed ordinary income or gain into low-taxed capital gain (or other manipulation of the
applicable tax rate).
In each category, in turn, there are three types of response: (1) clearly intended by Congress
and permissible because of an economic, social policy, or administrative reason, i.e., they are tax
expenditures, (2) not intended by Congress and comprising a common pattern that lends itself well
to statutory amendment to address it, or (3) not intended by Congress and a one-off or idiosyncratic
transaction more efficiently addressed through individual adjudication and application of the
substance over form doctrine and its progeny, including the step transaction doctrine, sham debt,
tax ownership, the business purpose doctrine, and the economic substance doctrine. 1 Sometimes
certain tax shelters are first addressed through common law adjudication but then result in statutory
amendment, particularly if the shelter becomes common and clogs up the courts with expensive
and inefficient case-by-case litigation. Even the economic substance doctrine, itself, has been
codified, though the chief effect of its codification lies in the application of a strict liability penalty,
as described below. Part A. will explore the various common law doctrines that are used in
common law adjudication, and Part B. will consider a few of the more important statutory
responses to tax shelter activity.
You learned in Chapter 1 that SHS income comprises wealth increases less wealth
reductions but only if the wealth reduction does not represent personal consumption.
Moreover, you learned that a wealth reduction in the SHS sense means—in particular—a
business or investment outlay or loss of previously or concurrently taxed dollars, i.e., of aftertax dollars, to ensure that the same taxpayer does not enjoy a double tax benefit (both
exclusion and deduction) for the same dollars.
You have already studied numerous provisions that deviate from these core concepts, but these
deviations are clearly intended tax expenditures (whether wise or unwise). Simple examples are
contributions to § 401(k) plans, IRAs, and other qualified pension plans, which are accorded
consumption tax treatment, as described in Chapter 2. Some personal consumption expenses
(which would be nondeductible under either a pure income or pure consumption tax) are permitted
to be deducted under current law, such as qualified residence interest, charitable contributions, and
up to $10,000 of state and local income and real property taxes—all examined in Chapter 17.
Similarly, the amount of wages received in the form of employer-provided health insurance is
excludable from Gross Income, also discussed in Chapter 17, notwithstanding the Old Colony
Trust two-step (under which the compensation in the form of employer-provided health care costs
would be includable in Gross Income under § 61(a)(1) and the individual’s deemed payment of
the health care costs would be nondeductible under § 262(a) as a personal expenses). The receipt
1

In my view, each of these common law doctrines can be viewed as simply a variant of the substance over form
doctrine, but courts often treat them as separately identifiable doctrines. Because of the recent codification of the
economic substance doctrine and a strict-liability penalty that applies if the transaction is held to lack economic
substance, discussed infra, the treatment of these doctrines as separate and independent doctrines has significance.

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of a substantial gift or bequest represents a wealth increase evidencing ability to pay but is
nevertheless fully excludable under § 102, as you learned in Chapter 7. Property appreciation
represents a wealth increase under SHS principles, but (except for those properties required to be
marked to market each year under §§ 475 and 1256) this appreciation is not included in Gross
Income until a realization event occurs and, moreover, is completely forgiven at death. You learned
in Chapter 11 that untaxed borrowed principal can create basis immediately under Crane that can
generate depreciation deductions of before-tax (rather than after-tax) dollars, allowing a double
tax benefit for the same dollars to the same taxpayer (both exclusion and deduction) between the
time that the deductions are taken and the principal is repaid with after-tax dollars. You also
learned in Chapter 13 that statutory depreciation under current law is allowed at a rate that is much
faster than economic depreciation. Each of these examples represents a permissible
mismeasurement of SHS income in the sense that it is clearly intended by Congress.
But even though these deviations are intended in isolation, the attempted combination of the
last three in particular (the realization requirement, which ignores property appreciation during
ownership, the deduction of pre-tax dollars when borrowed funds generate expense and
depreciation deductions before principal repayment, and the front-loading of depreciation) has
often resulted in deduction of significant non-economic losses, resulting in both common law
challenges and statutory amendment.
As with some forms of mismeasurement of SHS wealth increases and decreases, some forms
of tax rate manipulation are clearly permissible (in the sense that they are intended by Congress).
You have already learned, for example, of several instances in which a return on labor is
permissibly treated as capital gain rather than (high-tax) labor income. In Chapter 14, for example,
you learned that the music composer can elect, if she wishes, to have the gain realized on the sale
of a composition treated as capital gain under § 1221(b)(3), but that the painter, sculptor, and
author are out of luck under § 1221(a)(3)(A). (Go figure ….) We can now add additional examples
to our list.
The gain realized by an entrepreneur who sells founders shares with a zero or low basis at a
large gain (while paying himself a low salary until then) reflects much of his personal work effort.
Yet, the sale gain is entirely capital gain.
Another example that has been much in the popular press in recent years is the taxation of socalled carried interest earned by private equity fund managers, who earn a return for their
management skills in picking and managing investments purchased almost entirely with other
people’s money (the fund’s investors), with only a nominal capital contribution by the managers.
Their arrangements with the funds (organized as partnerships) typically provide that their return
should be measured by two components (often referred to as “two and twenty”): (1) an amount
equal to 2% of the funds under management each year and (2) an amount equal to 20% of any
increase in the value of the fund assets each year (after a preferred return to the fund investors).
While these managers include the portion described in (1) as ordinary income under § 61(a)(1)
each year, they include the amount described in (2) as net capital gain or qualified dividend income
(taxed at 15% or 20%) to the extent that the income earned by the fund consists of such income 2—
notwithstanding that both components are used mainly as benchmarks in valuing the services that
they perform for the fund. In contrast, a corporate executive whose bonus is determined by how
much the corporation’s share price increases realizes ordinary income, whether paid in cash or in
2

They also can often defer the inclusion until future years.

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corporate shares under § 83. Why should private equity fund managers be treated differently? 3 The
example exploits the failure to adequately differentiate between a return on human capital (a labor
return) and a return on conventional capital. Many have called for reform, but so far to no avail.
But sometimes tax rate manipulation is unintended, resulting in statutory change or, in some
cases, common law adjudication. For example, §§ 1258, 1259, and 1260 are complex provisions
enacted in response to financial transactions that attempt to convert high-tax ordinary income into
low-tax net capital gain or that attempt to create transactions in which gain is not recognized while
certain hedging transactions (such as short sales against the box, forward contracts, and notional
principal contracts) effectively lock in the gain. These provisions are beyond the scope of the basic
income tax course, but they are indicative of the constant conversation between creative taxpayers
(and their advisors) and Congress in the tax-avoidance tango (to mix metaphors).
Policy concerns
Tax shelter activity can implicate the two main tax policy variables discussed in Chapter 3 that
affect the soundness of any tax system: fairness and economic efficiency. Recall that Congress
chose income as a tax base, as well as a progressive rate structure, because Congress decided that
these choices best represent the resources under the control of the taxpayer, which best represents
the taxpayer’s ability to pay tax. A mismeasurement of SHS income or a manipulation of the tax
rate can result in a misallocation of the tax burden across the members of the population in a
manner that deviates from ability to pay, which raises horizontal equity concerns if taxpayers with
similar economic income can pay radically different amounts of tax. Moreover, tax shelters exact
efficiency costs under the neutrality norm because they can alter taxpayer behavior, causing a
misallocation of resources across the economy and so diminishing aggregate societal wealth.
Most tax shelters reflect mere rent-seeking behavior of the sort described in Chapter 3—a mere
shift of wealth from the Treasury (i.e., other taxpayers, including you and me) to the tax shelter
owner (in the form of reduced tax) without an increase in aggregate societal wealth. In that sense,
much tax shelter activity is wasteful to the economy at large because it encourages the devotion of
resources to merely shifting wealth rather than creating new wealth. At the least, the tax law ought
not to encourage such waste.
Finally, tax shelters affect everyone because tax shelter activity that reduces revenue collection
results in statutory marginal tax rates that are higher than they otherwise would need to be to raise
$X, which further reduces economic efficiency. Remember—the less leaky the tax base (i.e., the
broader and the more impermeable the tax base), the lower tax rates can be, and the lower the rates,
the less likely the tax will interfere in economic behavior. At bottom, your effective and marginal
tax rates—particularly on labor income—are higher than they need to be because of tax shelter
activity (both permissible and not) engaged in by other taxpayers.
Many tax shelters involve the corporate, partnership, or international tax provisions of the
Internal Revenue Code and so are not easy to discuss in a course focused on taxation of the
individual. 4 This chapter nevertheless begins with an early tax shelter case involving an individual
3
See, e.g., Victor Fleischer, Two and Twenty: Taxing Partnership Profits in Private Equity Funds, 83 N.Y.U. L.REV.
1 (2008); Steven M. Davidoff. A Chance to End a Billion-Dollar Tax Break for Private Equity, at
http://dealbook.nytimes.com/2013/10/22/chance-to-end-billion-dollar-tax-break-for-private-equity/?_r=0. Those who
go on to study the taxation of business enterprises will study the partnership tax provisions at issue.
4
For example, the notorious so-called Boss (Bond Option Sales Strategy) and Son of Boss tax shelters essentially
attempted to create non-economic paper losses through the use of contingent debt coupled with a strained
interpretation of the rules in Subchapter K pertaining to partnerships. See IRS Offers Settlement for Son of Boss Tax

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and then explores a few examples from each of the categories described above to provide a general
understanding of both the phenomenon and responses to it. Those of you who go on to upper-level
tax courses will likely study other examples, as well as how the corporate, partnership, and
international tax provisions have evolved in attempts to address them. The resulting colloquy
between Congress and taxpayers inevitably results in additional statutory complexity.

A. Common law doctrines used in tax shelter litigation
Sham debt
Quoting the late Boris Bittker of Yale Law School, the Supreme Court noted in the first sentence
of footnote 7 of Tufts in Chapter 11: “The Commissioner’s choice in Crane ‘laid the foundation
stone of most tax shelters,’ Bittker, Tax Shelters, Nonrecourse Debt, and the Crane Case, 33 TAX
L. REV. 277, 283 (1978), by permitting taxpayers who bear no risk to take deductions on
depreciable property.”
Debt is often a key ingredient in packaged tax shelters because the receipt of borrowed principal
is excludable from Gross Income even though, at the same time, the debt generates deductions in
the form of interest and (often) basis depreciation (though depreciation was not at issue in the
Knetsch case immediately below). Moreover, the property ostensibly purchased with debt may
appreciate in value, but that appreciation goes untaxed until realized. For all of these reasons, the
taxpayers attempting to take these deductions have often not actually suffered a real SHS wealth
decrease in substance, i.e., have not suffered an economic loss.
As you read the material below, keep in mind that the potential for abuse involving debt is
highest when the debt is both (1) nonrecourse (limiting the taxpayer’s economic exposure to the
value of the securing collateral) and (2) extended by the other party to the transaction (often the
tax shelter promoter) rather than an independent third party. With that combination, the debt may
not be real in the sense that the tax shelter seller/lender may never expect repayment of the amount
nominally lent, but the pretend debt nevertheless generates deductions (or so the shelter buyer
hopes) with little risk of loss in view of the nonrecourse nature of the debt.
KNETSCH v. UNITED STATES
364 U.S. 361 (1960)
MR. JUSTICE BRENNAN delivered the opinion of the Court.
This case presents the question of whether deductions from Gross Income claimed on
petitioners’ 1953 and 1954 joint Federal income tax returns, of $143,465 in 1953 and of $147,105
in 1954, for payments made by petitioner, Karl F. Knetsch, to Sam Houston Life Insurance
Company, constituted “interest paid … on indebtedness” within the meaning of § 163(a) of the
Internal Revenue Code of 1954. The Commissioner of Internal Revenue disallowed the deductions
and determined a deficiency for each year. The petitioners paid the deficiencies and brought this
action for refund in the District Court for the Southern District of California. The District Court
rendered judgment for the United States, and the Court of Appeals for the Ninth Circuit affirmed.
Because of a suggested conflict with the decision of the Court of Appeals for the Fifth Circuit in

Shelter, at www.irs.gov/uac/IRS-Offers-Settlement-for-Son-of-Boss-Tax-Shelter.

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United States v. Bond, 258 F.2d 577, we granted certiorari.
On December 11, 1953, the insurance company sold Knetsch ten 30-year maturity deferred
annuity savings bonds, each in the face amount of $400,000 and bearing interest at 2½%
compounded annually. The purchase price was $4,004,000. Knetsch gave the Company his check
for $4,000, and signed $4,000,000 of nonrecourse annuity loan notes for the balance. The notes
bore 3½% interest and were secured by the annuity bonds. The interest was payable in advance,
and Knetsch on the same day prepaid the first year’s interest, which was $140,000. Under the
Table of Cash and Loan Values made part of the bonds, their cash or loan value at December 11,
1954, the end of the first contract year, was to be $4,100,000. The contract terms, however,
permitted Knetsch to borrow any excess of this value above his indebtedness without waiting until
December 11, 1954. Knetsch took advantage of this provision only five days after the purchase.
On December 16, 1953, he received from the company $99,000 of the $100,000 excess over his
$4,000,000 indebtedness, for which he gave his notes bearing 3 ½% interest. This interest was also
payable in advance and on the same day he prepaid the first year’s interest of $3,465. In their joint
return for 1953, the petitioners deducted the sum of the two interest payments, that is $143,465, as
“interest paid … within the taxable year on indebtedness,” under § 23(b) of the 1939 Code [the
predecessor to § 163(a)].
The second contract year began on December 11, 1954, when interest in advance of $143,465
was payable by Knetsch on his aggregate indebtedness of $4,099,000. Knetsch paid this amount
on December 27, 1954. Three days later, on December 30, he received from the company cash in
the amount of $104,000, the difference less $1,000 between his then $4,099,000 indebtedness and
the cash or loan value of the bonds of $4,204,000 on December 11, 1955. He gave the company
appropriate notes and prepaid the interest thereon of $3,640. In their joint return for the taxable
year 1954 the petitioners deducted the sum of the two interest payments, that is $147,105, as
“interest paid … within the taxable year on indebtedness,” under § 163(a) of the 1954 Code.
The tax years 1955 and 1956 are not involved in this proceeding, but a recital of the events of
those years is necessary to complete the story of the transaction. On December 11, 1955, the start
of the third contract year, Knetsch became obligated to pay $147,105 as prepaid interest on an
indebtedness which now totalled $4,203,000. He paid this interest on December 28, 1955. On the
same date he received $104,000 from the company. This was $1,000 less than the difference
between his indebtedness and the cash or loan value of the bonds of $4,308,000 at December 11,
1956. Again he gave the company notes upon which he prepaid interest of $3,640. Petitioners
claimed a deduction on their 1955 joint return for the aggregate of the payments, or $150,745.
Knetsch did not go on with the transaction for the fourth contract year beginning December 11,
1956, but terminated it on December 27, 1956. His indebtedness at that time totalled $4,307,000.
The cash or loan value of the bonds was the $4,308,000 value at December 11, 1956, which had
been the basis of the “loan” of December 28, 1955. He surrendered the bonds and his indebtedness
was canceled. He received the difference of $1,000 in cash.
The contract called for a monthly annuity of $90,171 at maturity (when Knetsch would be 90
years of age) or for such smaller amount as would be produced by the cash or loan value after
deduction of the then-existing indebtedness. It was stipulated that if Knetsch had held the bonds
to maturity and continued annually to borrow the net cash value less $1,000, the sum available for
the annuity at maturity would be $1,000 ($8,388,000 cash or loan value less $8,387,000 of
indebtedness), enough to provide an annuity of only $43 per month.

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The trial judge made findings that “there was no commercial economic substance to the . . .
transaction,” that the parties did not intend that Knetsch “become indebted to Sam Houston,” that
“no indebtedness of [Knetsch] was created by any of the … transactions,” and that “no economic
gain could be achieved from the purchase of these bonds without regard to the tax consequences
....” His conclusion of law, based on this Court’s decision in Deputy v. du Pont, 308 U.S. 488, was
that “while in form the payments to Sam Houston were compensation for the use or forbearance
of money, they were not in substance. As a payment of interest, the transaction was a sham.”
We first examine the transaction between Knetsch and the insurance company to determine
whether it created an “indebtedness” within the meaning of § 163(a) of the 1954 Code, or whether,
as the trial court found, it was a sham. We put aside a finding by the District Court that Knetsch’s
“only motive in purchasing these 10 bonds was to attempt to secure an interest deduction.” As was
said in Gregory v. Helvering, 293 U.S. 465, 469, “The legal right of a taxpayer to decrease the
amount of what otherwise would be his taxes, or altogether avoid them, by means which the law
permits, cannot be doubted…. But the question for determination is whether what was done, apart
from the tax motive, was the thing which the statute intended.”
When we examine “what was done” here, we see that Knetsch paid the insurance company
$294,570 during the two taxable years involved and received $203,000 back in the form of “loans.”
What did Knetsch get for the out-of-pocket difference of $91,570? In form he had an annuity
contract with a so-called guaranteed cash value at maturity of $8,388,000, which would produce
monthly annuity payments of $90,171, or substantial life insurance proceeds in the event of his
death before maturity. This, as we have seen, was a fiction, because each year Knetsch’s annual
borrowings kept the net cash value, on which any annuity or insurance payments would depend,
at the relative pittance of $1,000. Plainly, therefore, Knetsch’s transaction with the insurance
company did “not appreciably affect his beneficial interest except to reduce his tax….” Gilbert v.
Comm’r, 248 F.2d 399, 411 (dissenting opinion). For it is patent that there was nothing of
substance to be realized by Knetsch from this transaction beyond a tax deduction. What he was
ostensibly “lent” back was in reality only the rebate of a substantial part of the so-called “interest”
payments. The $91,570 difference retained by the company was its fee for providing the facade of
“loans” whereby the petitioners sought to reduce their 1953 and 1954 taxes in the total sum of
$233,297.68. There may well be single-premium annuity arrangements with nontax substance
which create an “indebtedness” for the purposes of § 23(b) of the 1939 Code and § 163(a) of the
1954 Code. But this one is a sham.
____________________________________
Mr. Knetsch borrowed (on a nonrecourse basis, entirely eliminating any economic risk to him)
all but $91,570 of the cost incurred both to purchase the $4,004,000 annuity initially and to fund
the aggregate $290,570 in (ostensibly deductible) interest payments owed for each of the two years
at issue. The second paragraph of the opinion recites that the annuity contract would earn a 2½%
interest return from the insurance company, while Mr. Knetsch agreed to pay 3½% interest to the
insurance company on the borrowed amounts. Why would he borrow at 3½% interest to purchase
an investment paying a 2½% return? Taxes aside, this investment is a sure economic loser!
If the scheme worked, however, Mr. Knetsch’s before-tax sure loser would turn into an aftertax big winner, with the “profit” coming entirely from the Treasury (i.e., other taxpayers). To be
specific (math alert!), the 1953 interest deduction of $143,465 would have saved him
approximately $130,553 in tax if the income from other sources that was sheltered with the
deduction would have otherwise been taxed at 91%. (The top marginal tax rate in 1953 and 1954
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was 91%.) Similarly, the 1954 interest deduction of $147,105 would have saved him
approximately $133,866 in tax. Because those Year-2 savings would have occurred one year in
the future as of 1953, however, we must discount the future tax savings to their present value in
Year 1 in order to determine Mr. Knetsch’s anticipated after-tax profit from his $91,570 initial
investment, measured as of Year 1. Under the present value table in Chapter 1, the Year-1 present
value of the Year-2 tax savings using a 3% discount rate (interest rates were relatively low in these
years) would have been $129,984 ($133,866 x .971). Thus, measured as of Year 1, the present
value of Mr. Knetsch’s tax savings would have totaled $260,537 ($130,553 plus $129,984). After
subtracting his $91,570 cash investment, he would have earned an after-tax profit of $168,967,
measured as of Year 1—a rate of return of 185% on his $91,570 cash investment!
But the aggregate $290,570 of ostensible interest payments did not represent a real SHS wealth
decrease suffered by Mr. Knetsch. Indeed, the $91,570 that he paid to the insurance company was
merely—in substance—a fee to the company to help him to create the appearance of a $290,570
wealth decrease. Neither the annuity’s increase in value nor the putative borrowed cash used to
fund the interest payments were included in Mr. Knetsch’s Gross Income (under the realization
requirement and borrowing exclusion, respectively). Mr. Knetsch ostensibly borrowed against this
untaxed appreciation to fund the deductible interest payments owed to the insurance company (the
other party to the transaction in this seller-financed transaction) each year. In short, Mr. Knetsch’s
attempted deductions were funded by untaxed dollars, resulting in a double tax benefit for the same
dollars (exclusion and deduction) that only mimicked a wealth reduction—all at no economic risk.
Mr. Knetsch is a “rentier,” whose putative investment represented inefficient rent-seeking
behavior, i.e., an attempt to merely shift wealth to himself (from other taxpayers) rather than to
create new wealth for the economy as a whole. Had his attempt succeeded, well-advised taxpayers
would have duplicated it, resulting in ever more wealth shifting, ever more lost tax revenue, and
ever more pressure to increase marginal rates to make up the lost revenue from non-rentiers, with
no increase in aggregate societal wealth. The resulting allocation of the country’s aggregate tax
burden would not be measured by real wealth accessions and reductions but by mere paper
shuffling. Not only would this result in a misallocation of the tax burden across the members of
the population in a manner inconsistent with both ability to pay and horizontal equity; it would
also result in sheer economic waste. That $91,570 fee paid to the insurance company to create the
appearance of a wealth reduction would do much more good to the economy if it were invested in
real, productive activity, which increases GDP.
The Supreme Court recited the lower court’s holding that “there was no commercial economic
substance to the … transaction,” but the Court appeared to rely primarily on the sham debt doctrine
(rather than the economic substance doctrine, described below) in concluding that the nonrecourse
debt, which was extended by the tax shelter seller, i.e., the insurance company, was a sham—not
real debt. Because there was no real debt, there could be no interest to deduct in substance.
Mr. Knetsch purchased his tax shelter investment directly, but many others are owned through
limited partnerships or LLCs, as in Estate of Franklin, below. Those of you who go on to study
the taxation of business enterprises will learn that partnerships and LLCs are transparent entities
for tax purposes, meaning that the entity is not subject to tax, itself (as are so-called C
corporations). Rather, the entity’s net profit (excess of Gross Income over deductions) or—in the
case of a tax shelter—net loss (excess of deductions over Gross Income) is allocated to each partner
or LLC owner for inclusion (or deduction) on his or her individual tax return. In this way a tax
shelter’s losses can be easily shared by many investors (and bought and sold) efficiently, offsetting

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income from unrelated wages or other profitable investments on each owner’s individual tax
return. Moreover, because of the nature of limited partnership and LLC interests, the partners’ or
LLC owners’ exposure to real economic risk of loss is limited.
As in Knetsch, the property seller in Estate of Franklin was also the nonrecourse lender that
financed the sale to the buyer, where—as indicated above—the potential for abuse is highest. A
third-party lender can be an independent check on the underlying economics of the transaction, as
a third-party lender is not typically willing to lend more than the purchased property is worth. A
lender who is also the seller of the property, in contrast, has no reason not to ostensibly lend as
much as possible to the buyer/borrower, creating (depreciable) basis under Crane for the buyer, as
well as high (deductible) interest payments. The seller/lender may know that the loan amount is
fictional and will never be collected in full, as no rational borrower would be willing to fully repay
a nonrecourse loan that substantially exceeds the fair market value (FMV) of the property security.
During the interim, however, the buyer/borrower can enjoy inflated deductions—if the shelter
works. Moreover, although the (inflated) nonrecourse debt would be included in amount realized
on a later sale by the buyer (or foreclosure transfer) under Tufts, 5 as you learned in Chapter 11, the
resulting gain may well be low-tax capital gain or § 1231 gain, while the prior inflated depreciation
and interest deductions were ordinary, offsetting high-tax income. (Recall from Chapter 14 that
there is no depreciation recapture for real estate, as there is for non-real estate under § 1245.) This
state of nirvana occurs, however, only if the tax shelter transaction is respected.
ESTATE OF FRANKLIN v. COMMISSIONER
544 F.2d 1045 (9th Cir. 1976)
SNEED, CIRCUIT JUDGE: This case involves another effort on the part of the Commissioner to
curb the use of real estate tax shelters. In this instance he seeks to disallow deductions for the
taxpayers’ distributive share of losses reported by a limited partnership with respect to its
acquisition of a motel and related property. These “losses” have their origin in deductions for
depreciation and interest claimed with respect to the motel and related property. These deductions
were disallowed by the Commissioner on the ground either that the acquisition was a sham or that
the entire acquisition transaction was in substance the purchase by the partnership of an option to
acquire the motel and related property on January 15, 1979. The Tax Court held that the transaction
constituted an option exercisable in 1979 and disallowed the taxpayers’ deductions. We affirm this
disallowance although our approach differs somewhat from that of the Tax Court.
The interest and depreciation deductions were taken by Twenty-Fourth Property Associates
(hereinafter referred to as Associates), a California limited partnership of which Charles T.
Franklin and seven other doctors were the limited partners. The deductions flowed from the
purported “purchase” by Associates of the Thunderbird Inn, an Arizona motel, from Wayne L.
Romney and Joan E. Romney (hereinafter referred to as the Romneys) on November 15, 1968.
Under a document entitled “Sales Agreement,” the Romneys agreed to “sell” the Thunderbird
Inn to Associates for $1,224,000. The property would be paid for over a period of ten years, with
interest on any unpaid balance of seven and one-half percent per annum. “Prepaid interest” in the
amount of $75,000 was payable immediately; monthly principal and interest installments of
5

Recall from Chapter 11 that the relief from nonrecourse debt on the transfer of property creates § 1001(b) amount
realized under Tufts to the full extent of the debt, even if the nonrecourse debt exceeds the property’s value, contrary
to the bifurcated approach adopted in the case of excess recourse debt that is discharged on transfer.

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$9,045.36 would be paid for approximately the first ten years, with Associates required to make a
balloon payment at the end of the ten years of the difference between the remaining purchase price,
forecast as $975,000, and any mortgages then outstanding against the property.
The purchase obligation of Associates to the Romneys was nonrecourse; the Romneys’
only remedy in the event of default would be forfeiture of the partnership’s interest. The sales
agreement was recorded in the local county. A warranty deed was placed in an escrow account,
along with a quitclaim deed from Associates to the Romneys, both documents to be delivered
either to Associates upon full payment of the purchase price, or to the Romneys upon default.
The sale was combined with a leaseback of the property by Associates to the Romneys;
Associates therefore never took physical possession. The lease payments were designed to
approximate closely the principal and interest payments with the consequence that with the
exception of the $75,000 prepaid interest payment no cash would cross between Associates and
Romneys until the balloon payment. The lease was on a net basis; thus, the Romneys were
responsible for all of the typical expenses of owning the motel property including all utility costs,
taxes, assessments, rents, charges, and levies of “every name, nature and kind whatsoever.” The
Romneys also were to continue to be responsible for the first and second mortgages until the final
purchase installment was made; the Romneys could, and indeed did, place additional mortgages
on the property without the permission of Associates. Finally, the Romneys were allowed to
propose new capital improvements which Associates would be required to either build themselves
or allow the Romneys to construct with compensating modifications in rent or purchase price.
In holding that the transaction between Associates and the Romneys more nearly resembled an
option than a sale, the Tax Court emphasized that Associates had the power at the end of ten years
to walk away from the transaction and merely lose its $75,000 “prepaid interest payment.” It also
pointed out that a deed was never recorded and that the “benefits and burdens of ownership”
appeared to remain with the Romneys. Thus, the sale was combined with a leaseback in which no
cash would pass; the Romneys remained responsible under the mortgages, which they could
increase; and the Romneys could make capital improvements. [2] The Tax Court further justified its
“option” characterization by reference to the nonrecourse nature of the purchase money debt and
the nice balance between the rental and purchase money payments.
Our emphasis is different from that of the Tax Court. We believe the characteristics set out
above can exist in a situation in which the sale imposes upon the purchaser a genuine indebtedness
within the meaning of section 167(a), which will support both interest and depreciation deductions.
They substantially so existed in Hudspeth v. Commissioner, 509 F.2d 1224 (9th Cir. 1975), in
which parents entered into sale-leaseback transactions with their children. The children paid for
the property by executing nonnegotiable notes and mortgages equal to the fair market value of the
property; state law proscribed deficiency judgments in case of default, limiting the parents’ remedy
to foreclosure of the property. The children had no funds with which to make mortgage payments;
instead, the payments were offset in part by the rental payments, with the difference met by gifts
from the parents to their children. Despite these characteristics this court held that there was a bona
fide indebtedness on which the children, to the extent of the rental payments, could base interest
deductions. See also American Realty Trust v. U.S., 498 F.2d 1194 (4th Cir. 1974); Manuel D.

[2]

There was evidence that not all of the benefits and burdens of ownership remained with the Romneys. Thus, for
example, the leaseback agreement appears to provide that any condemnation award will go to Associates. Exhibit 6F, at p. 5.

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Mayerson, 47 T.C. 340 (1966).
In none of these cases, however, did the taxpayer fail to demonstrate that the purchase price
was at least approximately equivalent to the fair market value of the property. Just such a failure
occurred here. The Tax Court explicitly found that on the basis of the facts before it the value of
the property could not be estimated. 64 T.C. at 767-768. [4] In our view this defect in the taxpayer’s
proof is fatal.
Reason supports our perception. An acquisition such as that of Associates if at a price
approximately equal to the fair market value of the property under ordinary circumstances would
rather quickly yield an equity in the property which the purchaser could not prudently abandon.
This is the stuff of substance. It meshes with the form of the transaction and constitutes a sale.
No such meshing occurs when the purchase price exceeds a demonstrably reasonable estimate
of the fair market value. Payments on the principal of the purchase price yield no equity so long
as the unpaid balance of the purchase price exceeds the then-existing fair market value. Under
these circumstances the purchaser by abandoning the transaction can lose no more than a mere
chance to acquire an equity in the future should the value of the acquired property increase. While
this chance undoubtedly influenced the Tax Court’s determination that the transaction before us
constitutes an option, we need only point out that its existence fails to supply the substance
necessary to justify treating the transaction as a sale ab initio. It is not necessary to the disposition
of this case to decide the tax consequences of a transaction such as that before us if in a subsequent
year the fair market value of the property increases to an extent that permits the purchaser to
acquire an equity.
Authority also supports our perception. It is fundamental that “depreciation is not predicated
[4]

The Tax Court found that appellants had “not shown that the purported sales price of $1,224,000 (or any other price)
had any relationship to the actual market value of the motel property . . ..” 64 T.C. at 767.

Petitioners spent a substantial amount of time at trial attempting to establish that, whatever the actual market value of
the property, Associates acted in the good faith belief that the market value of the property approximated the selling
price. However, this evidence only goes to the issue of sham and does not supply substance to this transaction. “Save
in those instances where the statute itself turns on intent, a matter so real as taxation must depend on objective realities,
not on the varying subjective beliefs of individual taxpayers.” Lynch v. Comm’r, 273 F.2d 867, 872 (2d Cir. 1959).
See also Bornstein v. Comm’r, 334 F.2d 779 (1st Cir. 1964); MacRae v. Comm’r, 294 F.2d 56 (9th Cir. 1961).
In oral argument it was suggested by the appellants that neither the Tax Court nor they recognized the importance of
fair market value during the presentation of evidence and that this hampered the full and open development of this
issue. However, upon an examination of the record, we are satisfied that the taxpayers recognized the importance of
presenting objective evidence of the fair market value and were awarded ample opportunity to present their proof;
appellants merely failed to present clear and admissible evidence that fair market value did indeed approximate the
purchase price. Such evidence of fair market value as was relied upon by the appellants, viz. two appraisals, one
completed in 1968 and a second in 1971, even if fully admissible as evidence of the truth of the estimates of value
appearing therein does not require us to set aside the Tax Court's finding. As the Tax Court found, the 1968 appraisal
was “error-filled, sketchy” and “obviously suspect.” 64 T.C. at 767 n.13. The 1971 appraisal had little relevancy as to
1968 values. On the other side, there existed cogent evidence indicating that the fair market value was substantially
less than the purchase price. This evidence included (i) the Romney's purchase of the stock of two corporations, one
of which wholly-owned the motel, for approximately $800,000 in the year preceding the “sale” to Associates
($660,000 of which was allocable to the sale property, according to Mr. Romney’s estimate), and (ii) insurance policies
on the property from 1967 through 1974 of only $583,200, $700,000, and $614,000. 64 T.C. at 767-768.
Given that it was the appellants' burden to present evidence showing that the purchase price did not exceed the fair
market value and that he had a fair opportunity to do so, we see no reason to remand this case for further proceedings.

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upon ownership of property but rather upon an investment in property. Gladding Dry Goods Co.,
2 BTA 336 (1925).” Mayerson, supra at 350. (italics added). No such investment exists when
payments of the purchase price in accordance with the design of the parties yield no equity to the
purchaser. Cf. Decon Corp., 65 T.C. 829 (1976); David F. Bolger, 59 T.C. 760 (1973); Edna
Morris, 59 T.C. 21 (1972). In the transaction before us and during the taxable years in question
the purchase price payments by Associates have not been shown to constitute an investment in the
property. Depreciation was properly disallowed. Only the Romneys had an investment in the
property.
Authority also supports disallowance of the interest deductions. This is said even though it has
long been recognized that the absence of personal liability for the purchase money debt secured
by a mortgage on the acquired property does not deprive the debt of its character as a bona fide
debt obligation able to support an interest deduction. Mayerson, supra at 352. However, this is no
longer true when it appears that the debt has economic significance only if the property
substantially appreciates in value prior to the date at which a very large portion of the purchase
price is to be discharged. Under these circumstances the purchaser has not secured “the use or
forbearance of money.” See Norton v. Comm’r, 474 F.2d 608, 610 (9th Cir. 1973). Nor has the
seller advanced money or forborne its use. See Bornstein v. Comm’r, 334 F.2d 779, 780 (1st Cir.
1964); Lynch v. Comm’r, 273 F.2d 867, 871-872 (2d Cir. 1959). Prior to the date at which the
balloon payment on the purchase price is required, and assuming no substantial increase in the fair
market value of the property, the absence of personal liability on the debt reduces the transaction
in economic terms to a mere chance that a genuine debt obligation may arise. This is not enough
to justify an interest deduction. To justify the deduction the debt must exist; potential existence
will not do. For debt to exist, the purchaser, in the absence of personal liability, must confront a
situation in which it is presently reasonable from an economic point of view for him to make a
capital investment in the amount of the unpaid purchase price. See Mayerson, supra at 352. [6]
Associates, during the taxable years in question, confronted no such situation. Compare Crane v.
Comm’r, 331 U.S. 1, 11-12 (1947).
Our focus on the relationship of the fair market value of the property to the unpaid purchase
price should not be read as premised upon the belief that a sale is not a sale if the purchaser pays
too much. Bad bargains from the buyer’s point of view—as well as sensible bargains from buyer’s,
but exceptionally good from the seller’s point of view—do not thereby cease to be sales. See
Comm’r v. Brown, 380 U.S. 563 (1965); Union Bank v. U.S., 152 Ct. Cl. 426, 285 F.2d 126, 128
(1961). We intend our holding and explanation thereof to be understood as limited to transactions
substantially similar to that now before us.
__________________________________
What tax consequences were the parties hoping to create in Estate of Franklin? Please do not
be intimidated by the math to follow. I do not expect you to be able to replicate this sort of analysis.
I walk you through it only to illustrate roughly what the parties were attempting to accomplish,
i.e., to illustrate the economics of their attempted tax shelter.
Footnote 4 of the case tells us that Wayne and Joan Romney6 had purchased the motel (in part
[6]

Emphasis on the fair market value of the property in relation to the apparent purchase price animates the spirit, if
not the letter, of Rev. Rul. 69-77, 1969-1 C. B. 59.
6
Professor James Edward Maule of Villanova University School of Law, who engages in genealogy as a hobby,
determined that Governor, Presidential candidate, and now Senator Mitt Romney was the “half-first-cousin-onceremoved” of Wayne Romney. Email submission to Taxprof, a closed, Internet discussion group for tax law professors

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with borrowed money) for $660,000 7 a little more than a year before the 1968 sale to Associates
Partnership for $1,224,000, with Associates ostensibly borrowing the entire amount with a
nonrecourse loan extended from the Romneys. Associates paid only $75,000 of “prepaid interest”
in 1968. The annual debt service on the $1,224,000 note that Associates owed to the Romneys
consisted mostly of interest, with only small amounts of principal paid each year until a balloon
payment of nearly $1 million was due in Year 10. To simplify the discussion, we can assume that
the entire $1,224,000 was due to be paid in Year 10. (This small change does not alter the
economics much and makes the analysis shorter and simpler.)
As an aside, the Romneys would have been better off to negotiate with Associates to
characterize that 1968 payment of $75,000 as a down payment in their contract rather than as
prepaid interest. Let’s see why.
Under the § 453 installment sale rules that you studied in Chapter 12, the Romneys would
recognize their § 1001 gain on the ostensible sale to Associates only as payments are received—
mostly in Year 10 (if that payment occurred at all, which is unlikely). Let’s assume, for example,
that the Romneys deducted $60,000 in depreciation with respect to the property during their one
year of ownership before its ostensible sale to Associates, leaving them with a $600,000 A/B at
the time of sale. Their § 1001 realized gain would have been $624,000 ($1,224,000 A/R less
$600,000 A/B). Under § 453(c), however, the amount of recognized gain to be included by the
Romneys in any year would be equal to:
Payments Received in the Year x

Gross Profit
Total Contract Price

If the $75,000 that the Romneys received in 1968 were a down payment (rather than prepaid
interest), they would have recognized a portion of their §1001 realized gain equal to:
$75,000

x

$624,000
$1,224,000

=

$38,235

Even if this gain were taxed at the top capital gain rate of approximately 25% in the late 1960s,
they would have owed only approximately $9,500 in tax, leaving them with a tidy $65,550 of aftertax cash in hand in Year 1 for participating in the transaction. In Year 10, Associates would clearly
have defaulted on the remaining balloon payment because of the economics of the deal, and the
Romneys would foreclose, retaking title. Section 1038 is a special provision that applies in the
case of a repossession of real property in a seller-financed sale. Under it, the Romneys would have
been denied a § 166 bad-debt deduction (which you studied in Chapter 10) for the unpaid
remaining balance of the note. Moreover, they would be required to recharacterize all or a portion
of the payments received from Associates prior to Year 10 as gain (rather than tax-free recovery
of basis) equal to the lesser of (1) the total realized gain ($624,000) or (2) the total payments
previously received ($75,000) less previously reported gain ($38,235), or $36,765. In other words,
the Romneys would have been retroactively denied treating any of the $75,000 payment received
in 1968 as tax-free basis recovery. Taxed at the 25% capital gains rate, they would have owed
additional tax in Year 10 of $7,353 ($36,765 x .25). If we use a discount rate of 7% (interest rates
were much higher in the late 1960s) under the present value table in Chapter 1, the Year-1 presentvalue cost of that future Year-10 tax would have been approximately $3,735 ($7,353 x .508). In
at AALS-accredited law schools, Feb. 12, 2012 (copy on file with author).
7
Actually, they bought the stock of two corporations, one of which owned the motel, but for purposes of illustration
we can simplify these facts, as this nuance makes no difference to the ultimate analysis.

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short, the Romneys’ after-tax profit—measured in Year 1 (1968)—would have been equal to the
$75,000 cash received from Associates less the present value tax cost of $13,235 ($9,500 paid in
Year 1 plus the $3,735 present value cost of the $7,353 paid in Year 10), or $61,765. To put this
figure into perspective, that figure is approximately $457,000 in current dollars.
Because the parties did not designate the $75,000 as a down payment but rather as prepaid
interest, however, the Romneys would have included no part of their realized § 1001 gain in 1968
under § 453(c) because they received no purchase price payments in that year. Rather, they would
have included the entire $75,000 “prepaid interest” as ordinary income under § 61(a)(4). If we
assume that this interest fell within the highest 70% tax bracket, the Romneys would have owed
$52,500 in tax, leaving them an after-tax profit of $22,500. To put that figure into perspective, that
figure is approximately $166,000 in current dollars—not nearly as favorable. 8 But Associates was
better off characterizing the $75,000 payment as “prepaid interest” rather than as a down payment
because the interest would have been deductible under § 163(a), whereas the down payment would
not, and Associates clearly had more bargaining power (or more sophisticated advice).
Associates immediately leased the property back to the Romneys in a “net lease” arrangement,
under which the lessee (rather than the lessor) is responsible for maintenance and repair costs,
insurance, and real estate taxes. The lease payments due from the Romneys to Associates
essentially mirrored the debt service payments due to them, so neither possession of the property
nor cash changed hands (other than the $75,000 prepaid interest). While the interest deemed
received from Associates each year would be included in the Romneys’ Gross Income under §
61(a)(4), they would also have been entitled to deduct the lease payments deemed paid to
Associates each year under § 162(a), which means that the only tax consequences for the Romneys
from this sale/leaseback transaction, if respected, would have been the ones described above.
What was Associates (and its partners) really buying? Tax deductions! If Associates were
respected as the real owner of the hotel, what would be its net loss each year (excess of deductions
over Gross Income), which generally could be deducted on the individual tax returns of the
partners? Associates would include in Gross Income the rent deemed paid by the Romneys under
§ 61(a)(5), but the partnership would also be permitted to deduct the interest deemed paid to the
Romneys in approximately the same amount under § 163(a). So far, the partnership has no net loss
to allocate to its partners. But don’t forget (1) the $75,000 Year-1 prepaid interest deduction and,
more important, (2) the depreciation of the $1,244,000 basis created under Crane!
In essence, the depreciation deductions allowed each year to Associates, as owner of the
property, would create a net loss (excess of deductions over Gross Income) that would be allocated
among the partners and deducted on their individual tax returns, sheltering income from other
sources, such as the income from the partners’ medical practices—even though the partners
suffered no real SHS wealth decrease beyond the $75,000 paid to the Romneys. You learned in
Chapter 13 that residential rental property must be depreciated today using the straight-line method
over 27.5 years under § 168. These current rules would generate a depreciation deduction of
approximately $44,500 each year. Under the law at the time, however, the property would have
been depreciated over a much shorter period and using a front-loaded accelerated depreciation
8

When Associates defaulted in Year 10, § 1038 would once again have applied, denying the Romneys a § 166 baddebt deduction for the unpaid $1,224,000 balance of the note, but they would have had no prior tax-free recovery of
basis to recharacterize as gain under §1038. In other words, because the only cash received by the Romneys was
prepaid interest under our simplifying assumption, § 1038 would not have resulted in any tax-free basis recovery
recapture on default in Year 10.

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method, permitting Associates to take much larger deductions in the early years. Indeed, why
didn’t Associates offer to pay $2 million for the property? $10 million? If respected, the higher the
price, the better! While Associates would also realize a larger gain under Tufts on the foreclosure,
the gain would have been deferred (reducing its effective cost) and would have been taxed at
approximately 25% as either real capital gain or § 1231 quasi capital gain, while the depreciation
deductions would have offset income otherwise taxed at rates as high as 70% each year. 9
Assume, for example, that the building would have been fully depreciated by Year 10 when
Associates failed to pay the $1,224,000 million balloon payment. Under Tufts, the foreclosure
transfer back to the Romneys would generate a $1,224,000 million § 1001 gain ($1,224,000
million A/R under Tufts equal to the debt relief less $0 A/B). If taxed at 25%, the partners would
collectively owe $306,000 in tax. If we use a discount rate of 7% under the present value table in
Chapter 1, the Year-1, present value cost of that future Year-10 tax would have been $155,448
($306,000 x .508). As of Year 1, the present value of the tax savings arising from deducting
$1,224,000 million in depreciation deductions over 10 years, offsetting income otherwise taxed at
70% ordinary income tax rates, would have been far, far higher.
Even if we assume simple straight-line depreciation (rather than the front-loaded, accelerated
depreciation to which they would have been entitled at the time), the partners would have
collectively deducted $122,400 each year of the 10-year period, saving $85,680 in tax each year,
if we assume that the sheltered income would otherwise have been taxed at 70% ($122,400 x .70).
Over 10 years, the nominal tax saved would have been $856,800. Because those savings occur
over time, however, we must discount the future tax savings to their present value to calculate the
after-tax profit for Associates from this deal as of Year 1. The Year-1 sum of the present values of
each year’s anticipated tax savings from depreciation using a 7% discount rate would have been
$643,885. 10 Add the $52,500 tax saved in Year 1 from deducting the $75,000 in prepaid interest
($75,000 x .70), and Associates realized total tax savings of $696,385, measured as of Year 1.
When the smoke clears, what is the partners’ collective after-tax profit from this deal, measured
in Year 1? The $696,385 present value of their tax savings less the $155,448 present value cost of
their Year-10 tax due on the Tufts gain realized on the transfer back to the Romneys less the
$75,000 in cash that they paid to the Romneys to participate in the deal equals $465,937—more
than $3.4 million in current dollars. That figure represents a rate of return of more than 620% on
their $75,000 cash investment—even better than what Mr. Knetsch attempted to obtain!
But it did not work. Just as with Mr. Knetsch, the net losses did not represent real SHS wealth
decreases suffered by the medical doctor/partners. Indeed, the $75,000 that they paid to the
Romneys was merely a fee to help them to create the appearance of significant wealth decreases.
The Ninth Circuit Court of Appeals relied on the sham debt doctrine in holding that no sale actually
occurred by focusing on the substantially overstated purchase price.
Tax ownership
What if the purchase price in Estate of Franklin had equaled the actual FMV of the property
9

Indeed, surtaxes of 5.25% in 1968, 7% in 1969, and 1.75% in 1970, which were added to the top 70% rate, likely
would have increased the partners’ tax savings in those three years beyond that described in the text.
10
This figure is arrived at by adding together the present values, as of Year 1, of each year’s tax savings: $85,680 for
Year 1, $80,110.80 for Year 2 ($85,680 x .935), $74,798.64 for Year 3 ($85,680 x .873), $69,914.88 for Year 4
($85,680 x .816), $65,373.84 for Year 5 ($85,680 x .763), $61,089.84 for Year 6 ($85,680 x .713), $57,062.88 for
Year 7 ($85,680 x .666), $53,378.64 for Year 8 ($85,680 x .623), $49,865.76 for Year 9 ($85,680 x .582), and
$46,609.92 for Year 10 ($85,680 x .544).

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but Associates leased the property back to the Romneys for, say, 50 years—the entire anticipated
useful life of the property? Would the transaction have been respected as a real sale to Associates
(entitling Associates to the depreciation deductions as owner of the property) because the purchase
price was no longer highly inflated?
The Ninth Circuit quoted language from the Tax Court opinion concluding that “the ‘benefits
and burdens of ownership’ appeared to remain with the Romneys.” This test is commonly used to
determine “tax ownership.” Aside from any sham debt problem, the nominal owner of the property
for purposes of state law may not be considered the owner for purposes of Federal income
taxation—i.e., may not be the taxpayer entitled to the property’s depreciation deductions—if the
benefits and burdens of ownership have not shifted to the nominal owner. This issue most often
arises in sale/leaseback transactions, but it can also arise in other contexts. 11 If the lease term
equaled the entire remaining useful life of the property, would the benefits and burdens of
ownership really have shifted to Associates? No. The Romneys would have received nothing back
of value when the lease term expires. What if Associates, anticipating this problem, had leased the
premises to the Romneys for only, say, 20 years, but the lease also provided that at the end of the
lease term the Romneys would have an option to extend the lease for 30 more years at a bargain
price that makes the exercise of their renewal option virtually certain?
Revenue Procedure 2001-28 12 contains the most recent guidelines that the IRS will use for
purposes of issuing a private letter ruling to taxpayers requesting assurance that a proposed
sale/leaseback transaction will be respected for Federal income tax purposes. For example, to
obtain a favorable advance ruling, the purported owner/lessor (Associates in the Estate of Franklin
case) must have, at minimum, 20% of the cost of the property placed “at risk” throughout the lease
term. Amounts “at risk” include, for example, the cash down payment or third-party recourse debt.
Moreover, the property must be expected (at the beginning of the lease term) to have at least 20%
of its anticipated useful life remaining at the end of the lease term and must be expected to be
worth at least 20% of what it was worth at the beginning of the lease term. For these purposes, the
lease term includes all renewals (except those only at the option of the lessee at fair rental value at
the time of the renewal). Finally, the purported owner/lessor must “represent and demonstrate that
it expects to receive a profit from the transaction, apart from the value of or benefits obtained from
the tax deductions, allowances, credits, and other tax attributes arising from such transaction,” i.e.,
that he reasonably anticipates an overall economic profit, as well as a positive cash flow.
The business purpose doctrine
The case of Gregory v. Helvering 13 is one that students who go on to study corporate
reorganizations in an upper-level tax course will surely read. While the details of the particular
transaction are beyond the basic tax course, we need not dwell on the particulars of the transaction
to understand that Mrs. Gregory tried to transform high-tax ordinary income into low-tax capital
gain (along with some tax-free recovery of basis, to boot) and was thwarted in her attempt in a
case that produced the so-called business purpose doctrine.
Mrs. Gregory was the sole owner of a corporation that, in turn, owned stock of the Monitor
Securities Corporation (MSC stock) as a portfolio investment. Mrs. Gregory wished to sell the
11

See, e.g., Granite Trust Co. v. U.S., 238 F.2d 670 (1st Cir. 1956) (considering whether the benefits and burdens of
ownership shifted on a purported sale of corporate stock in contemplation of a liquidation, which essentially returned
the stock buyer’s cash with a small profit for the buyer’s cooperation).
12
2001-1 C.B. 1156.
13
293 U.S. 465 (1935), aff’g 69 F.2d 809 (2d Cir. 1934).

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MSC stock and found a buyer for it. How could Mrs. Gregory obtain the MSC stock from her
corporation in order to sell it? As sole owner of the corporation, she could simply cause the
corporation to declare and pay a dividend to her of the MSC stock, which she could then sell to
her buyer. But this straightforward transaction would have produced a dividend for Mrs. Gregory
at a time when dividends were not eligible to be taxed under the preferential tax rate applicable to
net capital gain but rather were treated as plain vanilla (high-tax) ordinary income. Mrs. Gregory
wanted low-tax capital gain (and some tax-free recovery of basis). She purported to engage in a
series of transactions in which a new corporation was momentarily created and shortly thereafter
liquidated in a manner that, under the law in effect at the time, could conceivably produce her
desired result of transferring the MSC stock to her hands at only the cost of low-tax capital gain
(and even some tax-free recovery of basis, to boot).
Judge Learned Hand of the Second Circuit Court of Appeals penned the language that tax
shelter purveyors have quoted ever since:
[A] transaction otherwise within an exception of the tax law, does not lose its
immunity because it is actuated by a desire to avoid or, if one choose, to evade,
taxation. Anyone may so arrange his affairs that his taxes shall be as low as
possible; he is not bound to choose that pattern which will best pay the Treasury;
there is not even a patriotic duty to increase one’s taxes. 14
What the purveyors typically downplay is that Judge Hand ruled against Mrs. Gregory, and the
Supreme Court affirmed. Judge Hand was referring to substantively arranging one’s economic
affairs (e.g., waiting to sell appreciated stock until Day 366 instead of selling on Day 365 in order
to obtain the reduced tax rate for net capital gain), not creating meaningless transactions that do
not fairly reflect the underlying substance of what was done. Notwithstanding the attempt to dress
up the transaction in the guise of a corporate reorganization, which would have produced her
desired result, both the Second Circuit Court and Supreme Court concluded that the corporation
had no business purpose in arranging the transfer of the MSC stock to Mrs. Gregory in such a
convoluted manner. In effect, the Court treated the corporation’s transfer of the MSC stock to Mrs.
Gregory in substance, though not in form, as a simple dividend, taxed as ordinary income in full.
Ever since, both courts and the IRS have invoked the business purpose doctrine to reject the form
of a transaction in favor of looking at the underling substance of what actually occurred when there
is no purpose germane to the taxpayer’s business (aside from favorable tax consequences) for
structuring the transaction in the manner chosen.
The economic substance doctrine
The 1990s and first decade of the 21st century saw a significant increase in the number of tax
shelters marketed particularly to corporations. These corporate tax shelters are sometimes uniquely
designed to take advantage of a particular tax characteristic of the potential buyer. For example, if
a corporation sells a subsidiary corporation at a substantial capital gain, the corporation might be
approached with a shelter purporting to manufacture a substantial capital loss (to offset the recently
realized capital gain) that does not require the buyer to suffer a real wealth decrease or expose the
buyer to significant (if any) economic risk of loss. The marketers often insert nondisclosure clauses
in their contracts so that they can market the shelter to other corporations. Nevertheless, if and
when such shelters come to the attention of the government (sometimes in unmarked packages
sent anonymously), the government may challenge the transaction by invoking the economic
14

Gregory, 69 F.2d at 810.

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substance doctrine. Most of these shelters pertain to the mismeasurement of SHS income, and they
typically involve corporate, partnership, and international tax provisions beyond the scope of the
basic tax course. Nevertheless, there is one simple, older case that illustrates well the economic
substance doctrine and which involved an individual.
In Goldstein v. Commissioner, 15 Tillie Goldstein and her husband were retired and living on his
pension of approximately $780 per year and $125 in interest from savings accounts when Tillie
won $140,218.75 in the Irish Sweepstakes in 1958 (more than $1.2 million in current dollars). In
1958, Taxable Income between $140,000 and $160,000 of a married couple filing jointly fell in
the 81% tax bracket, between $120,000 and $140,000 in the 78% bracket, between $100,000 and
$120,000 in the 75% bracket, and so on. 16 Their son Bernard, who was a certified public
accountant, volunteered to help in “investing the sweepstakes proceeds and in minimizing the 1958
tax consequences … of the sudden increase in her income for that year.” 17 After consulting with
an attorney and several brokerage houses, he arranged for his mom to borrow $465,000 from the
First National Bank of Jersey City and $480,000 from the Royal State Bank of New York, with
both loans at 4% interest. The borrowed cash and some of the sweepstakes winnings were used to
buy $1 million of U.S. Treasury notes paying between ½% and 1½% interest, which were due to
mature in 1961 and 1962. Both loans were recourse, but in each case Tillie nevertheless provided
a security interest in the Treasury notes to the banks.
Taxes aside, these investments were a clear economic loser when viewed from a pre-tax
perspective. Indeed, contemporaneous documents created by Bernard (which were introduced by
the government) estimated that his mother’s before-tax economic loss, equal to the excess of the
4% interest that she had to pay to the banks and the ½% to 1½ % interest that she was to receive
on the Treasury notes (plus appreciation, if any, in the value of the notes), would be about
$18,500. 18 But what did Tillie then do? In 1958—the same year in which she included the
sweepstakes winnings in her Gross Income—she used the remainder of her winnings to prepay the
interest due for the next 1½ years on one loan and for nearly 3 years on the other, deducting the
$81,396.61 aggregate prepaid interest under § 163(a). (Section 163(d), explored in Part B., did not
then exist.) A few years later, Tillie instructed the banks to sell the Treasury notes to repay the
loans. The $18,500 economic loss that Bernard anticipated would be more than made up with the
anticipated tax savings of more than $55,000 arising on the prepaid interest deduction. 19 In short,
her after-tax profit would have effectively come from the Treasury. Once again, Tillie (and her
son Bernard) engaged merely in rent-seeking behavior, an attempt to shift wealth from other
taxpayers to Tillie rather than to create new wealth in the economy.
The Second Circuit considered the debts to be bona fide and not a sham (as in Knetsch and
Estate of Franklin) because (1) the money was borrowed from third-party banks rather than from
the U.S. government (the seller of the Treasury bonds—the investment purchased with the
borrowed money), (2) the loans were recourse, and (3) the Treasury bonds were pledged as
collateral security for a significant period of time. Nevertheless, the Second Circuit Court of
15

364 F.2d 734 (2d Cir. 1966).
See http://taxfoundation.org/article/us-Federal-individual-income-tax-rates-history-1913-2013-nominal-andinflation-adjusted-brackets (containing historical tax brackets).
17
Goldstein, 364 F.2d at 736.
18
Tillie actually ended up realizing a $25,091 economic loss because some of the Treasury notes lost value with an
increase in interest rates generally.
19
Her tax deficiency was stated at the Tax Court level as $55,193.34. This amount represents the tax saved from the
prepaid interest deduction that the Commissioner sought to deny her.
16

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Appeals affirmed the Tax Court’s denial of Tillie’s prepaid interest deduction under what has come
to be known as the economic substance doctrine.
[T]he Tax Court was justified in concluding that petitioner entered into the [bank]
transactions without any realistic expectation of economic profit and “solely” in order
to secure a large interest deduction in 1958 which could be deducted from her
sweepstakes winnings in that year. This conclusion points the way to affirmance in the
present case.
We hold … that Section 163(a) … does not permit a deduction for interest paid or
accrued in loan arrangements like those before us that cannot with reason be said to
have purpose, substance, or utility apart from their anticipated tax consequences.
…
Section 163 … should not be construed to permit an interest deduction when it
objectively appears that a taxpayer has borrowed funds in order to engage in a
transaction that has no substance or purpose aside from the taxpayer’s desire to obtain
the tax benefit of an interest deduction: and a good example of such purposeless
activity is the borrowing of funds at 4% in order to purchase property that returns less
than 2% and holds out no prospect of appreciation sufficient to counter the unfavorable
interest rate differential…. Indeed, to allow a deduction for interest paid on funds
borrowed for no purposive reason, other than the securing of a deduction from income,
would frustrate Section 163(a)’s purpose; allowing it would encourage transactions
that have no economic utility and that would not be engaged in but for the system of
taxes imposed by Congress. See Knetsch v. U.S., 264 U.S. at 367.
In many instances transactions that lack all substance, utility, and purpose, and which
can only be explained on the grounds that the taxpayer sought an interest deduction in
order to reduce his taxes, will also be transparently arranged as “shams.”… The
present case makes plain, however, that these rationales are distinct from each other,
and that a court need not always first label a loan transaction a “sham” in order to deny
a deduction for interest paid in connection with the loan…. It follows therefore from
the foregoing, and from the Tax Court’s finding as a matter of “ultimate” fact that the
petitioner entered into the [bank] transactions without any expectation of profit and
without any other purpose except to obtain an interest deduction, and thus the Tax
Court’s disallowance of the deductions in this case must be affirmed. 20
Under the economic substance doctrine, as it was developed by most courts under the common
law, the taxpayer seeking to defend the structure of a tax shelter transaction had the burden of
showing (1) a nontrivial chance of pre-tax economic profit (How much? Is a peppercorn of profit
enough?) and (2) a non-tax motive (such as a business purpose) for engaging in the transaction.
Also typically present in these transactions is the lack of any real risk of significant economic loss.
In other words, these taxpayers desire the tax benefits without incurring a meaningful chance that
they could lose much money in the transaction. Notice that the investment property that was
purchased in Goldstein was Treasury notes—among the safest of investments (at least until recent
debt ceiling shenanigans).
Congress codified the economic substance doctrine in 2010 when it enacted § 7701(o). Under
§ 7701(o), a transaction must satisfy a two-pronged, conjunctive test to qualify as having economic
20

Id. at 740-42.

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substance: (1) the transaction must change in a meaningful way (apart from Federal income tax
effects) the taxpayer’s economic position, and (2) the taxpayer must have a substantial purpose
(apart from Federal income tax effects) for entering into the transaction. If the possibility of pretax profit is relied upon to satisfy these requirements, the taxpayer must show that “the present
value of the reasonably expected pre-tax profit from the transaction is substantial in relation to the
present value of the expected net tax benefits that would be allowed if the transaction were
respected.” And you thought that all of that present value analysis illustrated earlier in this chapter
was an unnecessary waste of time! In a unique provision, § 7701(o)(5)(C) provides that
determining whether the economic substance doctrine is relevant to a transaction “shall be made
in the same manner as if this subsection had never been enacted.” In other words, the new provision
is not intended to either expand or diminish the scope of transactions that implicate the doctrine.
So why did Congress enact it? In the same legislation, Congress adopted a strict liability penalty
in § 6662(b)(6) that applies to transactions that lack economic substance within the meaning of §
7701(o). Was Congress merely after the additional revenue obtained under the new penalty? Some
say codification was justified to bring uniformity in application of the doctrine among the various
courts, though others believe that Congress wished to be able to score the tax revenue arising on
enforcement of the doctrine to pay for statutory tax reductions elsewhere that one or another
member of Congress wished to introduce in a revenue-neutral fashion. The revenue obtained each
year upon the routine application of common law doctrines by courts cannot be counted as revenue
that can “pay for” other revenue-losing provisions that Congress wishes to enact by statute. By
codifying the doctrine, however, the same revenue that would have been obtained under the
common law doctrine is now considered to have arisen because of the change in statutory law,
allowing it to count (in addition to the new revenue obtained under the new penalty) toward paying
for revenue-losing amendments to the Code enacted in the same legislation.
The various civil (and criminal) penalties that can be imposed on taxpayers who fail to comply
with their obligations under the Internal Revenue Code are typically studied in a course devoted
to examining tax procedures, tax penalties, and (at some law schools) tax crimes. Nevertheless, a
brief introduction to the topic places the economic substance strict liability penalty into context.
One of the most common tax penalties is the 20% penalty imposed under § 6662(a) on any
“substantial understatement of income tax,” defined with respect to individuals as the greater of
$5,000 or 10% of the tax due for the year. If, however, the taxpayer either (1) has “substantial
authority” for the position taken on the return (even though that position turns out to have been
incorrect) or (2) discloses the details of the transaction on his or her tax return, the penalty is
excused—unless the transaction is a tax shelter. 21 For this purpose, a tax shelter is defined in §
6662(d)(2)(C)(ii) as a partnership or other entity, an investment plan or arrangement, or any other
plan or arrangement “if a significant purpose of such partnership, entity, plan, or arrangement is
the avoidance or evasion of Federal income tax.” Under § 6662(d)(3), the Secretary of Internal
Revenue has the authority to publish so-called listed transactions in the Internal Revenue Bulletin
or Federal Register that he or she believes qualifies as a tax shelter under these rules. Finally, §
6664(c)(1) excuses the 20% penalty if the taxpayer can show that “there was a reasonable cause”
for the understatement and that “the taxpayer acted in good faith.”
These rules go out the window for any transaction that fails the economic substance test under
§ 7701(o). First, § 6662(b)(6) subjects any transaction failing § 7701(o) “or failing to meet the
21

See §§ 6662(d)(2)(B) and (C).

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requirements of any similar rule of law” to the 20% penalty without regard to the amount of
understatement. Second, § 6664(c)(2) denies the reasonable cause exception for any transaction
failing § 7701(o). Third, § 6662(i) increases the 20% penalty to 40% if the taxpayer fails to disclose
the details of the transaction on his or her tax return. When the smoke clears, a taxpayer that runs
afoul of § 7701(o) is subject to a 20% strict liability penalty that is increased to 40% with failure
to disclose the transaction on the tax return.
Because of the significance of this new penalty regime imposed by Congress, the IRS
announced in 2010 22 that any proposed strict liability economic substance penalty raised in audit
must be reviewed and approved by the appropriate Director of Field Operations to ensure
consistent administration of the penalty among taxpayers. In addition, in 2011 the IRS announced 23
that the economic substance penalty should be imposed only with respect to transactions that fail
to satisfy § 7701(o) and should not be imposed due to the application of any other “similar rule of
law” or judicial doctrine, such as the step transaction or substance over form doctrines,
notwithstanding the § 6662(b)(6) language quoted above. At the same time, it issued guidelines
for its examiners to consider in assessing whether or not to recommend the new penalty, including
whether or not the transaction is highly structured, contains unnecessary steps, creates a
meaningful pre-tax economic change in present value terms, generates deductions that are not
matched by an equivalent economic wealth reduction, and more.

B. Statutory tools in combatting tax shelters
While Knetsch and similar cases were making their way through the courts, Congress got into
the game by enacting § 264(a)(2) in 1954, which explicitly denies interest deductions incurred on
debt to purchase single-premium annuity contracts after March 1, 1954. One of the arguments
made by Mr. Knetsch was that the enactment of § 264(a)(2) for contracts purchased after March
1, 1954, implicitly blessed interest deductions on debt incurred to purchase single-premium
annuity contracts before that date. The Court rejected the argument (in a portion of the opinion not
reprinted above) by reasoning that new § 264(a)(2) denied deductions on real debt and that its
enactment was irrelevant to sham debt of the type at issue in Knetsch.
Similarly, Congress enacted § 461(g) after Goldstein and similar cases. Tillie’s prepaid interest
would not be entirely deductible in Year 1 today in any event. See § 461(g). In essence, § 461(g)
accurately characterizes prepaid interest as a nondeductible capital expenditure, the basis of which
must be properly amortized over the term of the loan. If 461(g) had been operative in 1958, Tillie’s
tax shelter would have been unsuccessful without regard to the economic substance doctrine.
These statutory amendments show how Congress can sometimes enact a statutory provision to
make case-by-case, common law adjudication unnecessary when it (1) suspects that an abusive
transaction that has come to its attention is beginning to be replicated by others and (2) believes
that a statutory change can be crafted that would adequately target the specific transaction at issue.
The § 163(d) investment interest deduction rules
Before examining § 163(d), let’s review a topic that you first explored in Chapter 2.
Suppose that Emma borrows $50,000 from National Bank and uses the entire $50,000 to
22

See www.irs.gov/Businesses/Codification-of-Economic-Substance-Doctrine-and-Related-Penalties.
See www.irs.gov/Businesses/Guidance-for-Examiners-and-Managers-on-the-Codified-Economic-SubstanceDoctrine-and-Related-Penalties.
23

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purchase § 103 bonds issued by the state of Ohio, the interest on which is excludable from Emma’s
Gross Income. Emma is denied her § 163 interest deduction under § 265(a)(2) because she used
100% of the borrowed money to buy the § 103 bonds.
If a capital return is excluded from the tax base, no deductions are necessary to avoid doubly
taxing the same dollars to the same taxpayer, as you learned in Chapter 2. Because the capital
return (in the form of interest) on the § 103 bonds is excluded from Gross Income, § 265(a)(2)
properly denies the deduction of the interest expense that Emma incurs to produce it—the interest
with respect to the National Bank loan. If § 265(a)(2) did not deny Emma her interest deduction,
the deduction would necessarily offset (shelter) income from other sources because the § 103 bond
purchased with the borrowed cash does not, itself, produce includable Gross Income.
So let’s change the facts to take § 265(a)(2) out of the picture. Suppose that Emma uses the
$50,000 borrowed from National Bank to purchase, say, growth stocks from corporations that
retain their profits (rather than distributing them as dividends) to expand the corporations’
businesses. Emma realizes no other interest, dividends, or capital gain. Because the type of income
that will be generated by the growth stocks (§ 1001 gain on eventual sale) is not exempt from tax
(unlike the interest paid on § 103 bonds), § 256(a)(2) is irrelevant to Emma’s potential interest
deduction under § 163. But notice that Emma does not currently realize any includable Gross
Income with respect to the growth stocks. Even though the stock appreciates in value each year
(reflecting the undistributed corporate profits), the appreciation in value—though representing a
SHS wealth increase—is ignored under the realization requirement. If she is nevertheless permitted
to deduct the interest payments made to National Bank each year under § 163(a), we would
mismeasure her SHS changes in wealth with respect to this investment. The interest deductions, if
allowed, would necessarily shelter income from other sources, such as her wages.
Enter § 163(d), which prevents this sheltering effect. To be specific, § 163(d)(1) permits the
deduction of “investment interest” in any year only to the extent of “net investment income” for
the year, with the excess carried over to future years under § 163(d)(2), to be deducted when
sufficient investment income is earned to permit it. Investment interest is identified under rather
elaborate tracing rules in Treas. Reg. § 1.163-8T. In essence, if the amount borrowed was used to
purchase investment property other than § 103 bonds (rather than business or personal-use
property), the interest is investment interest. Section 163(d)(3)(B) specifically excepts interest used
to purchase a personal residence in which the taxpayer resides (which is governed by § 163(h)(3),
instead, studied in Chapter 17) and interest incurred in any passive activity, which is governed by
§ 469, explored shortly. Similarly, § 163(d)(4)(D) excludes § 469 passive income and deductions
from being taken into account in determining “net investment income.” As you will shortly learn,
under § 469(e)(1), interest, dividends, annuities, royalties, and capital gain arising on the sale or
exchange of property producing such income are not considered passive. It is with respect to these
kinds of income (and interest incurred on debt used to purchase property producing these kinds of
income) that § 163(d) applies, made explicit by the cross-reference to § 469(e)(1) in §
163(d)(5)(A)(i). In short, income and deductions (including interest) arising in a § 469 passive
activity are wholly governed by § 469, with § 163(d) having no effect.
A significant exception applies, however, to the statement just above that dividends and capital
gain arising on the sale or exchange of property producing interest dividends, annuities, and
royalties is “investment income” that can permit the deduction of investment interest. Net capital

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gain and qualified dividends 24—both of which can be taxed at 15% or 20% instead of the
taxpayer’s higher ordinary rate—are taken into account in computing “net investment income”
only if the taxpayer expressly elects to use this income as “investment income” under §
163(d)(4)(B). The purpose of this rule is to prevent the taxpayer from engaging in tax-rate
arbitrage.
Assume, for example, that Mary, whose marginal ordinary income is otherwise taxed at 32%,
borrows $10,000 at 5% interest to purchase shares of stock for $10,000. One year and one day
later, after the stock has appreciated by 5%, Mary sells it for $10,500 and uses the sale proceeds
to repay the $10,000 debt principal and $500 interest owed. The transaction is an economic wash.
Economically, Mary is no better off or worse off (no wealthier or less wealthy) than if she did not
engage in this transaction in the first place. The transaction, therefore, should be a wash for tax
purposes, as well. If, however, Mary is allowed to claim both that her $500 gain is net capital gain
that is taxed at only 15% (generating a $75 tax) and that her $500 interest expense is deductible
against her 32% taxed income, such as her wages (saving $160 in tax), she would realize an aftertax profit of $85, consisting once again of dollars coming from the Treasury, not from any real
economic profit. Section 163(d)(4)(B)(iii) prevents this result. If she wants to use her $500 gain as
“investment income” that allows her to currently deduct her $500 of investment interest under §
163(d), she cannot also use that same $500 gain toward creating net capital gain. In other words,
§ 163(d)(4)(B)(iii) creates a matching rule. Because “qualified dividends” are also subject to the
net capital gain rate under § 1(h)(11), the same rule applies to such dividend income.
Here is another example. Assume that Eli borrows $100,000 at 5% interest in Year 1 to purchase
various investment assets, including stocks, bonds (none of which are § 103 bonds), and a patent
(which produces royalty income). In Year 1, he pays $5,000 in interest and receives $2,000 in
interest on his bonds, $1,000 in royalties, and $1,700 in dividends on his stocks (no § 1001 gain).
In Year 2, Eli pays the same $5,000 in interest on the loan and realizes $2,000 in interest, $6,000
in royalties, and no dividends or §1001 gains. How much of his $5,000 interest can Eli deduct in
each of Years 1 and 2 under § 163(d)?
In Year 1, Eli’s “net investment income” is either $4,700 or $3,000, depending on whether Eli
elects under § 163(d)(4)(B) to treat his $1,700 in dividend income as investment income for
purposes of § 163(d), giving up the reduced tax rate that could otherwise apply to that income
under § 1(h)(11)(D). Should he make the election? If he does, he can deduct $4,700 of his $5,000
in investment interest, carrying forward $300 to Year 2 under § 163(d)(2). If he does not, he can
deduct only $3,000 of his $5,000 interest, carrying forward $2,000. Eli would have to weigh the
time-value-of-money cost of deferring $1,700 of his interest deduction to a future year with the
preferential net capital gain rate that he would surrender if he uses his interest deduction to offset
this otherwise low-tax income. That interest deduction would be better used to offset high-tax
interest or royalty income (or short-term capital gain). In other words, the planning considerations
are similar to those we considered in the last chapter regarding the timing of capital loss
realizations. How good is Eli’s crystal ball?
Let’s suppose that Eli knew in Year 1 that he would be receiving a considerably larger (high24

Dividends are subject to the same reduced tax rate (either 15% or 20%) that generally applies to net capital gain if
they satisfy the definition of “qualified dividends” within the meaning of § 1(h)(11). Even though dividends can be
subject to the same reduced tax rate that applies to net capital gain, dividends are not real capital gain. For example,
dividends do nothing to help a taxpayer with a large capital loss carryover under § 1212(b) to deduct those carryovers
under § 1211(b).

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tax) royalty payment in Year 2, so he decides not to make the election to treat his qualified dividend
income as § 163(d) investment income. Eli deducts only $3,000 of his $5,000 interest, carrying
forward the remaining $2,000 to Year 2, and he would enjoy the net capital gain rate on his $1,700
in dividend income. In Year 2, he deducts the entire $7,000 of interest (both the $5,000 paid in
Year 2 and the $2,000 carried forward from Year 1) against high-tax interest and royalty income
because $7,000 is less than his $8,000 in net investment income.
Problem
In Year 1, Samantha borrows $100,000 from National Bank. Under the loan terms, she will pay
5% interest each year ($5,000) until Year 10, when the $100,000 principal will be repaid. She uses
$20,000 to buy a § 103 bond from the city of Cleveland, $60,000 to buy corporate bonds, and
$20,000 to buy corporate stocks (the only properties in her investment portfolio in Year 1).
Samantha incurs no investment expenses other than the annual $5,000 interest payments. How
much of the $5,000 interest can she deduct in Year 1 if she realizes the following amounts? Do not
forget § 163(d)(4)(B)(iii) and the sentence following it.
Year 1: $1,100 in interest from the Cleveland bonds
$3,600 in interest on the corporate bonds
$600 in qualified dividends received on the corporate stock
In Year 2, Samantha buys a patent, which produces royalty income for her investment portfolio,
using her past savings (rather than debt). She once again pays $5,000 in interest on her loan. How
much can Samantha deduct in Year 2 if she realizes the following amounts?
Year 2: $1,100 in interest from the Cleveland bonds
$3,600 in interest on the corporate bonds
$2,000 in net capital gain from the sale of corporate stock
$1,000 in royalty income
_________________________________
The § 465 at-risk rules and § 469 passive activity loss rules
The combination of several features of the tax law made the broad marketing of real estate and
other tax shelters a growing problem in the 1970s and early1980s: (1) Crane, which permits
untaxed borrowed money to create basis that can generate depreciation deductions immediately,
before principal repayment with after-tax dollars, (2) nonrecourse debt, which limits the taxpayer’s
economic risk of loss, (3) accelerated depreciation, which frontloads deductions and offsets hightaxed ordinary income while generating low-taxed capital or § 1231 gain on later disposition, (4)
the realization requirement, which ignores property appreciation until realized, and (5) limited
partnerships, which allows both the easy sharing of net losses and the easy sale of ownership
interests. Some blame the profusion of ugly strip malls built during this period across the country
(which would not have been built on their own merits) on this proliferation of tax shelter activity.
It became common for ordinary doctors, dentists, lawyers, architects, and other upper-middle-class
taxpayers to arrive home from work to find a limited partnership tax shelter prospectus in their
mailboxes, promising large annual tax deductions each year, many times the amount of the
required cash investment after just a few years. Because of the nature of limited partnership

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interests, the buyer’s economic risk was limited to the cash that he or she invested. 25 The net losses
allocated to the limited partners consisted mainly of depreciation created with before-tax Crane
basis, interest, and other expense deductions in excess of the Gross Income generated by the
property. Common examples include real estate, oil and gas wells, even the making of bad B
movies (which could be amortized really quickly at the time).
Congress reacted to this phenomenon first by enacting the § 465 at-risk rules in 1976 and then,
ten years later, enacting the § 469 passive activity loss rules in 1986, both of which can defer some
deductions to future years to prevent a sheltering effect, much like § 163(d).
Under §§ 465(a)(1) and (b)(5), individuals and closely held C corporations may deduct the
net loss (the excess of deductions over Gross Income) arising from an activity 26 for the year
only to the extent of the aggregate amount that the taxpayer has “at risk” in the activity, as
reduced by net losses deducted in prior years. In other words, a dollar at risk in the activity can
justify deduction of a dollar of net loss only once. In general, § 465(b) provides that amounts
considered at risk include only the cash and the A/B of property contributed by the taxpayer to the
activity, as well as recourse debt borrowed for use in the activity.
Assume, for example, that Michael is a professional baseball player who plays outfield for a
major league team and who earns $10 million each year. Michael also owns a substantial
investment portfolio of stocks and bonds that generates $50,000 in dividends, interest, and capital
gains each year. Michael wishes to shelter some of his baseball earnings and portfolio investment
income from tax, and he buys an apartment building for $1 million (its FMV), using $50,000 in
cash and borrowing $950,000 from National Bank on a recourse basis at 5% annual interest, with
the principal due in a balloon payment in Year 10. During each of his first two years of ownership,
the property generates $70,000 in rent, $47,500 in interest deductions, $40,000 in depreciation,
$10,000 in real estate taxes, $9,000 in insurance costs, and $3,500 in maintenance costs (a total of
$90,000 in deductions). Notice that Michael need not contribute any additional cash flow to the
activity beyond his initial $50,000 investment, as the $70,000 rent is sufficient to pay the $70,000
out-of-pocket costs each year equal to the interest, real estate taxes, insurance, and maintenance
costs each year. While depreciation is deductible, it does not represent a cash-flow outlay. Michael
must include the $70,000 rent in his Gross Income under § 61(a)(5) each year, but that $70,000 is
effectively offset entirely by deductions each year, generating no net additional tax liability for
him. Can he use the remaining $40,000 net loss (the excess of the $110,000 in aggregate deductions
over the $70,000 of Gross Income generated by the activity) to offset (i.e., shelter) income from
his baseball salary and investment portfolio in Years 1 and 2?
If Michael had to worry only about § 465, the answer would be “yes.” His at-risk amount for
Year 1 is $1 million, consisting of the $50,000 cash that he invested and the $950,000 in recourse
debt, which is sufficient to allow him to deduct the entire $40,000 net loss (offsetting his income
unrelated to the rental property). At the beginning of Year 2, his at-risk amount is reduced to
$960,000 ($1 million at risk at the beginning of Year 1 less $40,000 net loss deducted in Year 1),
which again is sufficient to permit Michael to deduct his $40,000 Year-2 net loss (again offsetting
25

The fine print may have informed the taxpayer of the Tufts gain that would be realized on later sale of the tax shelter
ownership unit, but many taxpayers often overlooked this fine print and were angry when they were informed in the
sale year of the resulting gain that they had to include on their tax returns—even if it was low-tax capital gain. For
that reason, some argued that § 469, in particular, could be defended as consumer protection legislation.
26
For the first two years after enactment, § 465 applied only to certain types of activities listed in § 465(c)(1), but it
was extended to all business and investment activities under § 465(c)(3) for years after 1978.

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unrelated income). His at-risk amount at the beginning of Year 3 is $920,000 ($960,000 at risk at
the beginning of Year 2 less $40,000 net loss deducted in Year 2). Section 465 is obviously not a
bar to Michael’s sheltering of unrelated income with his real estate net losses.
How would § 465 apply if the $950,000 debt were nonrecourse instead of recourse? Absent §
465(b)(6), Michael’s at-risk amount in Year 1 would be limited to the $50,000 cash that he
contributed to the activity. While this figure would be sufficient to permit deduction of his entire
Year-1 $40,000 net loss (sheltering unrelated income), his at-risk amount at the beginning of Year
2 would be only $10,000 ($50,000 at risk at the beginning of Year 1 less $40,000 net loss deducted
in Year 1), permitting deduction of only $10,000 of his $40,000 Year-2 net loss. The $30,000 that
is rendered nondeductible is not lost, however. Rather, it is carried forward under § 465(a)(2) until
such time as Michael’s at-risk amount increases sufficiently to permit deduction. On our facts, that
would not likely happen until Michael paid the $950,000 balloon payment due in Year 10 on the
nonrecourse debt—a contribution of additional cash to the activity.
Enter § 465(b)(6). By now, I am sure that you won’t be surprised to learn that the real estate
lobby worked hard for this provision! Under it, “qualified nonrecourse financing” in connection
with the holding of real estate (only) is considered at risk. To satisfy the definition, the nonrecourse
financing must generally be extended by an independent third party (such as a bank) rather than a
related party or the tax shelter seller. In short, “qualified nonrecourse financing” is treated as
though it were recourse debt for purposes of determining the amount at risk in the activity. Because
Michael’s loan was extended by National Bank, his nonrecourse debt would satisfy this definition,
and § 465 would not bar Michael’s net losses from sheltering unrelated income.
Because both (1) § 465 was so impotent in denying deduction of net losses against unrelated
income (at least in the case of real estate) and (2) Congress needed to broaden the tax base in 1986
to pay for significant marginal rate reductions (from a top rate of 50% to 28%), Congress added §
469 in 1986 and required real estate to be depreciated using the straight-line method over longer
periods.
Treas. Reg. § 1.469-2T(d)(6) provides that § 465 applies before § 469, but § 465 did not limit
Michael’s ability to fully deduct the real estate net losses against unrelated income. We finally
need to move on to § 469. Let’s drive along the § 469 roadmap to see how it affects Michael.
Sections 469(a)(1)(A) and (2) deny individuals and closely held C corporations the ability
to deduct any “passive activity loss,” or PAL, arising in the year. What is a PAL? Under §
469(d)(1), a PAL is defined, in essence, as the excess of passive activity deductions over passive
activity Gross Income arising in all of the taxpayer’s passive activities. 27 Like §§ 465 and
163(d), 469, § 469 does not deny all deductions but rather prevents only the sheltering effect—the
ability of the net loss (the excess of deductions over Gross Income) to shelter nonpassive income.
While $70,000 of Michael’s aggregate $110,000 in deductions would be allowable even if § 469
otherwise applies (enough to offset the $70,000 in Gross Income generated by the rental real
estate), Michael’s $40,000 net loss from the rental real estate may be disallowed, which would
prevent him from using the net loss (the excess deductions) to shelter his baseball income.
What is a passive activity—an oxymoron if ever I heard one? Subject to important exceptions
noted below, §§ 469(c)(1) and (6) provide that a passive activity is any business or investment
activity in which the taxpayer does not “materially participate,” and § 469(h)(1) defines material
27

Recall from the last section that interest incurred in a passive activity, as well as income generated in a passive
activity, are not analyzed under § 163(d) but rather are swept into § 469 entirely.

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participation as involvement that is “regular, continuous, and substantial.” Treas. Reg. § 1.4695T(a) describes seven alternative tests that are used in determining whether these standards have
been met, the most important of which is participation for more than 500 hours in the year. Section
469(h)(2) provides, however, that participation only as a limited partner is generally per se
passive—regardless of the nature of the activity conducted by the limited partnership or the
number of hours devoted to the activity by the limited partner. More important for Michael, §§
469(c)(2) and (4) provide that a rental real estate activity (even if held directly rather than through
a limited partnership) is also generally per se passive. These last two rules reflect the central place
that both real estate tax shelters and limited partnerships had in driving enactment of § 469. Fulltime real estate professionals (including Donald Trump) were incensed that no exception was made
for real estate professionals, and Congress added (c)(7) in 1993 in response. Under it, real estate
activities will not be considered per se passive if both (1) more than one-half of the taxpayer’s
work hours for the year are performed in real estate business activities in which the taxpayer
materially participates and (2) more than 750 hours are spent in such activities in the year.
In sum, a passive activity is any trade or business (or an activity with respect to which §
212 deductions can be taken under § 469(c)(6)(B)), in which the taxpayer does not materially
participate — or — which is a rental real estate activity (absent the real estate professional
exception) — or — any activity held through a limited partnership interest.
Under these rules, Michael’s $40,000 net loss arising with respect to this rental real estate in
each of Years 1 and 2 (described above) are nondeductible PALs that cannot be used to offset
either his labor income (from playing baseball) or the income generated by his investment portfolio
because his baseball career means that he clearly fails the § 469(c)(7) tests for real estate
professionals. “Wait,” you say. “Investing in stocks and bonds seems awfully passive to me! Isn’t
the $50,000 in interest, dividends, and capital gains passive income that can absorb passive
deductions?” No. Read § 469(e)(1). If Michael’s $40,000 net loss were prevented from sheltering
only his labor income and not income from his investment portfolio, it would be a feeble tool,
indeed, as most of the tax shelter buyers that Congress intended to reach also realized such income.
Section 469 would be only a minor speed bump on the road to deducting net losses against
unrelated income. For purposes of § 469, therefore, interest, dividends, annuities, royalties, and §
1001 gain arising on the disposition of property producing such income are not considered passive.
Michael does not lose his $40,000 net loss, however. Under § 469(b), he carries it forward each
year until either (1) he earns sufficient passive income in excess of passive deductions to absorb it
or (2) he disposes of the tax shelter in a taxable sale or exchange under § 469(g).
When Michael eventually sells the rental real estate, any remaining nonrecourse debt will
augment his § 1001(b) amount realized under Tufts (Chapter 11), likely producing a sizable § 1001
gain. 28 This § 1001 gain will be passive gain (because it does not arise from the sale of property
producing interest, dividends, annuities, or royalties under § 469(e)(1)), which will absorb any
carryover PALs. If the gain is insufficient to allow deduction of all carryover PALs generated in
previous years by the sold tax shelter, the carryover PALs are nevertheless allowed to be deducted
in full in the year of sale under § 469(g), which would offset unrelated income. Why? Section 469
is not intended to disallow the deduction of real SHS wealth decreases. Rather, § 469 is intended
merely to defer deduction of the net loss (the sheltering effect) until such time as we can be sure
28

Gain is very likely, even if the property does not appreciate in value but rather merely maintains or even loses value.
As you learned in Chapter 13, his depreciation deductions, which reduce his basis under § 1016(a)(2), will in virtually
all cases exceed any reduction in the property’s value.

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that it does, indeed, represent a real economic loss. We can know whether or not the carryover
losses represent real economic losses only upon final disposition of the tax shelter. Many real
estate tax shelters like Michael’s are actually not economic losers over time. Rather, the problem
is that they frontload deductions (funded with pre-tax debt dollars under Crane) in such a way that
makes it appear that the taxpayer has lost wealth in the SHS sense. Indeed, Michael may actually
be wealthier each year from his rental real estate if the property is appreciating in value, but the
appreciation is ignored under the realization requirement.
Notice that § 469 does not generally operate on an activity-by-activity basis. Rather, passive
Gross Income from all passive activities are used to absorb passive deductions arising from all
passive activities, with the resulting net loss (if any) constituting the nondeductible PAL. At the
same time, however, § 469(g) operates on an activity-by-activity basis. Taxpayers with more than
one tax shelter need to maintain good records in order to show how much of an overall PAL
carryover is properly attributable to the particular tax shelter that is sold if the resulting sale gain
is insufficient to absorb the PAL carryover properly attributable to that shelter.
One final provision is worthy of mention: § 469(i). While rental real estate activities are per se
passive (except in the case of the professional able to satisfy the tests in § 469(c)(7)), Congress
nevertheless wished to extend a de minimis rule to the small rental real estate investor. Under §§
469(i)(1) and (2), a taxpayer that “actively” participates (as opposed to “materially” participates)
in a rental real estate activity can deduct up to a $25,000 PAL each year, subject to a phase-out
rule based on Adjusted Gross Income (AGI). The legislative history underlying this provision
indicates that active participation is a lower standard than material participation and can be
satisfied by management activities “such as approving new tenants, deciding rental terms, and
arranging services and repairs.” 29 To limit the provision to the small investor § 469(i)(3) reduces
the $25,000 allowable PAL by 50% of the excess of the taxpayer’s AGI over $100,000, so
taxpayers with an AGI of at least $150,000 (including Michael) lose all benefit from § 469(i).
For purposes of applying the phase-out rule, AGI is measured before determining how much
(if any) of the PAL is allowable under § 469(i), itself. Moreover, remember that passive deductions
not exceeding passive Gross Income are allowable without regard to § 469; only the net loss (the
excess of passive deductions over passive Gross Income) is potentially disallowed under § 469.
Also recall from Chapter 1, Part B., that deductions attributable to property producing rental
income are taken above the line, directly from Gross Income in reaching AGI, under § 62(a)(4).
In effect, taxpayers can ignore the tax shelter’s Gross Income in determining AGI for purposes of
the § 469(i)(3) phase-out rule because the tax shelter’s clearly allowable deductions without regard
to § 469(i) (equal to that Gross Income) will precisely offset that Gross Income above the line.
For example, contrary to our facts above, suppose that Michael is not a baseball player but
rather a lawyer, who has $120,000 in AGI from his law practice. With respect to the rental real
estate, he (1) realizes $40,000 in gross rental income, (2) incurs $35,000 in interest, insurance, and
repair expenses, as well as $25,000 in deprecation (a total of $60,000), and (3) selects the tenants
and arranges all repairs. Michael has a $20,000 PAL equal to the excess of his $60,000 in aggregate
passive deductions over his $40,000 in passive Gross Income. Before applying § 469(i), Michael
will add to his Gross Income the $40,000 in rent, but he will also be permitted to deduct $40,000
of his $60,000 in aggregate deductions under §§ 162, 163, 167, and 168 without regard to § 469,
and this $40,000 will be deducted above the line under the authority of § 62(a)(4). Michael’s AGI
29

McCormack v. Comm’r, T.C. Summary Op. 2013-9 (Feb. 11, 2013),
www.ustaxcourt.gov/InOpHistoric/mccormacksumm.sum.WPD.pdf.

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is still $120,000 before determining how § 469(i) applies to the $20,000 PAL.
Absent § 469(i), Michael would have to carry his $20,000 PAL forward under § 469(b).
Because Michael satisfies the more lenient active participation test in § 469(i)(1), however, he can
potentially deduct all or a portion of his $20,000 PAL because it is less than the $25,000 ceiling in
§ 469(i)(2). But that $25,000 ceiling is reduced by $10,000, which is 50% of the amount by which
Michael’s AGI before applying § 469(i) ($120,000) exceeds $100,000. Michael’s applicable
ceiling is therefore reduced from $25,000 to $15,000. When the smoke clears, Michael can deduct
only $15,000 of his $20,000 PAL (above the line under § 62(a)(4)), which means that $15,000 will
offset unrelated income from his law practice or investment portfolio of stocks and bonds. He
must, alas, carry forward the remaining $5,000 PAL for use in future years.
Section 461(l)
Prior to the TCJA, a taxpayer with a business generating more deductions than gross income
who both materially participated in the business (avoiding § 469) and had sufficient amounts at
risk (avoiding § 465) could use the net loss to offset unrelated income in the same year, whether
that unrelated income arose from another business, from investment, from a prize, or whatever.
For example, assume that John, who is single, has a substantial investment portfolio, which earns
$600,000 of dividends, interest, and capital gains this year (or perhaps he wins a $600,000 lottery
prize). Because John purchased a lot of business equipment for his sole proprietorship this year,
which could be immediately expensed under § 168(k), the business generated $1.3 million in
deductions and only $700,000 in Gross Income. Neither §§ 469 nor 465 apply to John because he
materially participates in his business and has plenty at risk. Prior to 2018, his $600,000 net loss
from his business could offset his $600,000 of nonbusiness income, and John would owe no tax.
The TCJA enacted § 461(l), which can now limit John’s ability to deduct his business net loss
against his nonbusiness income, though it’s difficult to infer any tax policy rationale for new §
461(l). If John both actively participates in the business and has sufficient amounts at risk, and yet
the business generates a tax loss, what tax policy rationale justifies preventing John from using his
$600,000 business loss against his investment income in measuring John’s net wealth accession
(and thus ability to pay tax) for the year? Even though difficult to justify, in 2018 new § 461(l)
permitted taxpayers to offset no more than $250,000 ($500,000 for a joint return) of nonbusiness
income with business net losses. The $250,000 and $500,000 figures are indexed for inflation for
years after 2018. For 2022, the amounts are $270,000 and $540,000, respectively. Under § 461(l),
therefore, John can deduct no more than $270,000 of his $600,000 business net loss against his
nonbusiness income, which means that John still has $330,000 of Taxable Income. The undeducted
business net loss creates a § 172 net operating loss carryover, discussed in Chapter 20, which may
offset John’s future business income (only).
All income and deductions from all of John’s trades or businesses are aggregated in applying §
461(l). That is to say, § 461(l) is not applied separately to each of John’s separate businesses. What
constitutes nonbusiness income, which cannot be offset by his net business loss, for purposes of §
461(l)? What if John’s $600,000 of unrelated income was not from investments or a lottery prize
but salary from his job as an employee? Can his net loss from his sole proprietor business offset
his salary income received as an employee under new § 461(l)?
Providing services as an employee has long been accepted as a trade or business. When enacted
in the TCJA, § 461(l) did not define “trades or businesses” in a special way just for purposes of
that section. For example, while § 67(g) temporarily denies deduction of § 162 unreimbursed

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employee business expenses, the TCJA did not go further and say that providing services as an
employee no longer qualifies as a trade or business at all. Indeed, new § 199A(d), also enacted in
the TCJA and discussed in Chapter 1, Part B., specially carves out “the trade or business of
performing services as an employee” from the definition of “qualified trade or business” for
purposes of that section (only), implying that providing services as an employee otherwise
remained a trade or business generally after enactment of the TCJA. Nevertheless, the CARES
Act, enacted in 2020 in response to the pandemic, amended § 461(l) to provide that wage income
does not count as business income for purposes of § 461(l). Even if John’s net loss survives §§ 465
and 469, he can offset no more $270,000 of his wages in 2022 with the net loss from his sole
proprietorship.
Through (1) the new § 199A 20% deduction for business income other than employee wage
income, (2) the complete disallowance of all unreimbursed employee business expenses under §
67(g) (even to the extent exceeding the 2% floor), and the new § 461(l) restriction that prevents
wage earners from deducting their net losses from a side business against their wages (above the
§ 461(l) limit), the 116th Congress has displayed a particular animus against those who earn their
living as employees of others.
Section 461(l) expires at the end of 2025.
Problems
In each of the problems below, advise your clients regarding the extent to which they can
currently deduct in each of Years 1 and 2 the described amounts.
1. Monica is a sole proprietor dentist who has an AGI, without regard to the limited partnership
investment described here, of $140,000 each year, including not only her salary as a dentist but
also $10,000 in interest each year on corporate bonds. After reading a prospectus that she found in
her mailbox one day, she purchases one limited partnership unit in a California windmill energy
project for $5,000 in cash. The partnership uses the cash paid by the many limited partner investors,
coupled with significant amounts of nonrecourse debt lent by the entity marketing the tax shelter,
to build and operate a windmill farm near the Sierra Nevada mountain range.
At the end of each of Years 1 and 2, Monica receives a Schedule K-1 in the mail that informs
her that the partnership suffered a net loss for each year (excess of deductions over Gross Income)
and that her share of this net loss in each year is $3,000. Assume that no rule in Subchapter K
(pertaining to the taxation of partners) prevents Monica from deducting this $3,000 net loss on her
individual tax returns in Years 1 and 2. The letter accompanying the Schedule K-1 reminds
Monica, however, that she should consult her tax advisor to determine the extent to which
provisions outside Subchapter K affect her ability to deduct her allocated net losses.
2. Jim, an electrical engineer working as an employee for a firm, has a $140,000 AGI each year,
without regard to the investment described here. On January 1 of Year 1, Jim buys a duplex for
$300,000, paying $50,000 in cash and borrowing $250,000 from National Bank on a nonrecourse
basis (using the duplex as security) at 5% interest for a 30-year term. The property is already rented
to tenants when Jim buys it. After a few months, one tenant informs Jim that he will not be
renewing his lease when it ends shortly. Jim advertises the unit, but unfortunately it takes seven
months to find a suitable new tenant, decreasing Jim’s aggregate rent receipts for the year.

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In Year 1, Jim receives $22,000 in aggregate rent from his tenants and pays $16,000 to National
Bank on the loan, of which $13,000 is interest, with the remaining amount constituting principal
repayment. Depreciation under § 168 for Year 1 is $10,400. 30 Jim hires a company to maintain the
landscaping on the property and to clear the snow in the winter. He had to call a plumber to fix the
plumbing in one unit and an electrician to replace some faulty wiring in the other unit. (An
electrical engineer knows nothing about replacing faulty wiring!) Jim pays a total of $3,000 in
these and other maintenance expenses for the year, and he pays $2,000 in property insurance.
In Year 2, Jim receives $29,000 in aggregate rent from his tenants. He pays $16,000 to National
Bank on the loan, of which $12,500 is interest, and incurs depreciation of $11,000. Unfortunately,
his maintenance expenses increase to $5,000 this year because of some unexpected repairs, and he
pays $2,000 in property insurance.
3. Erik, who is single, earns $800,000 from his sole proprietor law firm. He also runs a side
business taking and selling travel photographs, but his photography business generates a
$300,000 net loss. (As a sneak preview of Chapter 18, assume that Erik’s photography activity is
respected as a true business, rather than a hobby, under § 183.) Erik has sufficient amounts at
risk to avoid § 465 and materially participates in the activity, avoiding § 469. Can he use his net
loss from his photography business to offset his law practice income? What if he did not own his
own law practice but worked as an employee of a law firm?

30

This amount is less than the approximately $11,000 that he will generally deduct in each of the other years because
of the mid-month convention for Year 1 that applies to real estate under § 168(d)(2), as you learned in Chapter 13.

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Unit VI:
Distinguishing Between IncomeProducing Activities and Personal Consumption
and the Personal Consumption Tax Expenditures
Introduction to Chapters 16 through 19
In Chapter 1, you learned that a current expense, § 1001 loss, or depreciation should be deducted
only if the expense, loss, or depreciation is incurred in an income-producing activity (business or
investment) if we seek to reach a tax base of SHS income. In Chapter 2, you learned that even a
consumption tax base, as an alternative to an income tax base, requires taxation of personal
consumption. How do we distinguish between income-producing activities, on the one hand, and
personal consumption, on the other?
Chapter 16 explores the tax consequences pertaining to both the acquisition of and loss of
human capital. In particular, the costs of acquiring human capital in the form of education
challenges the dividing line between income-production activities and personal consumption. In
Chapter 3, you learned that the current Internal Revenue Code contains numerous provisions—
referred to as tax expenditures—which allow personal consumption outlays to reduce the tax base
through deductions, credits, or gross income exclusions that are inconsistent with either an SHS
income tax base or a consumption tax base. These tax expenditures lose nearly $1 trillion of
revenue each year, resulting in marginal tax rates that are higher than they would otherwise need
to be to raise the same $X in revenue. Significant tax expenditures are found in the education
sphere. What justifies them? In light of their justifications, are they well-crafted provisions to meet
those ends without losing revenue unnecessarily (requiring rates to be higher)? To what extent are
these tax preferences effectively captured by other actors in the marketplace through the price
mechanism?
Chapter 17 examines the major personal tax expenditures surrounding home ownership,
personal casualty losses, health care, charitable contributions, and more.
Chapter 18 considers gambling losses and so-called hobby losses. If these activities are placed
in the personal consumption sphere, should deductions nevertheless be allowed if Gross Income
is earned in the activity (unlike in the case of most personal consumption activities)? If deductions
are denied, would the same dollars be twice taxed to the same taxpayer, undermining a
fundamental precept of a tax on income? Should that precept matter if the taxpayer is engaging in
the activity for fun rather than profit?
Chapter 19 explores a slightly different issue from that considered in Chapter 18. Even when
there is no doubt that an activity rises to the level of a trade or business, which outlays should be
allocated to that business, and which should be allocated to the taxpayer’s personal sphere? This
chapter considers, for example, business travel expenses, entertainment expenses incurred in a
business context, so-called home office deductions, and similar issues.

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Chapter 16: On Human Capital
What is human capital and how do we distinguish it from other forms of capital, such as
financial capital (e.g., shares of stock in a corporation or a corporate bond) or tangible capital (e.g.,
plants and equipment)? Just as financial capital and physical capital can earn a return, so can
human capital—in the form of labor income, i.e., a return earned on one’s personal effort.
Human capital refers literally to the human body and all of the attributes of an individual that
allow him or her to earn services income. Much human capital is inherited through good genes,
such as an able body, physical attractiveness, height (with research showing that the more
attractive and taller earn more than the less attractive and shorter), and a functioning mind. Other
aspects of human capital are an unknowable mix of genes, environment, and effort, such as IQ,
creativity, sociability, the ability to work diligently, to work cooperatively with others, to lead, and
to focus on and complete tasks efficiently. Human capital is even affected by how well the child
has chosen his or her parents, with research showing that those born into wealthy families tend to
earn significantly higher incomes than those born in poverty. That is to say, it is not surprising to
learn that human capital is affected by social and family connections. Some human capital,
however, can be purchased, with the most important of these examples being education and skills
training. All of these facets contribute to allowing the person to earn personal services income.
How do we distinguish between human capital and other forms of capital? You cannot sell your
human capital and thereby divest yourself of it, as you can with non-human capital, such as
business equipment or corporate stock. I can share my human capital with you—my knowledge of
the income tax—but I do not thereby divest myself of that knowledge. Nevertheless, human capital
can sometimes create a property interest that can be bought and sold in the marketplace, such as
goodwill or a patent owned by the inventor of the patented process (as opposed to a later purchaser
of that same patent, who holds it as conventional capital). The inability to differentiate easily
between the return on human capital and the return on conventional capital in some contexts leads
to difficulties throughout the Internal Revenue Code—particularly in the case of differentiating
capital gain from ordinary income, as discussed in the previous two chapters.
Part A. of this chapter will focus on one aspect of human capital: education costs. To what
extent should tuition scholarships be excluded from Gross Income? When an employer pays for
an employee’s education, to what extent should this compensation be excluded? Are the education
tax expenditures justified? Well crafted? To what extent should tuition costs be deducted as a
business expense?
Part B. will explore the tax consequences of receiving a settlement or jury award on account of
the loss of human capital.

A. Education costs
Education costs implicate both (1) wealth accessions (possible § 61 Gross Income) when the
taxpayer obtains a scholarship from an educational institution or a fringe benefit from an employer
that pays for the taxpayer’s education costs and (2) wealth reductions (possible deductions or
credits) when the taxpayer pays for education costs herself. With respect to the latter, they also
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implicate the line between an income-producing activity (deductions generally allowed) and
personal consumption (deductions generally disallowed under either a pure SHS income tax or
pure consumption tax).
Human capital acquisition costs are generally relegated to the personal sphere, including
education costs, because the acquisition of human capital is inextricably intertwined with the
taxpayer’s personal life. Even though education augments the taxpayer’s ability to earn income
in exchange for services, it also inevitably brings personal benefits, as well, including the ability
to consume life more fully as one’s mind is opened to art, music, literature, history, political
thought, psychology, etc. Research shows that education even contributes significantly toward
one’s ability to meet a life mate. Many of the tax-reducing provisions attributable to education
costs in the Internal Revenue Code are therefore properly categorized as tax expenditures, a
concept that you first learned about in Chapter 3.
Because tax expenditures are not normative income tax provisions, i.e., they are not necessary
to measure income accurately, how do we evaluate the wisdom or folly of a particular tax
expenditure or evaluate its efficacy as a policy matter? The answer: cost-benefit analysis, which is
not an easy task. In cost-benefit analysis, the policy analyst must define the goal of this particular
government action and ask whether the tax expenditure is the best means (in the sense of economic
efficiency, fairness, and administrative ease) to accomplish that goal. Could the goal be better
accomplished outside the tax system or inside the tax system? Recall that only about 60% of
households earn enough to owe income tax, which means that delivering social spending through
the Internal Revenue Code fails to reach many households unless they take the form of a refundable
tax credit. If the tax system is going to be used, is the goal with respect to a higher education tax
expenditure to provide a subsidy (to those having trouble financing education) or to change
behavior (to increase the number of students attending college)? In light of that answer, how should
the provision be structured to deliver the benefits to the targeted population? Tax expenditures
often have complex definitions, income ceilings, and phase-out rules—all in order to limit the
indirect government spending to the targeted population. In employing cost-benefit analysis, the
policy analyst must also be concerned with windfall losses (rewarding people for engaging in
behavior that they would have engaged in anyway) if the goal of the tax expenditure is to change
behavior and upside-down benefits (with more of the lost revenue absorbed by high-income
families than low-income families) if the goal is to provide a subsidy. Finally, we need to discuss
capture through the price mechanism.
On the face of the statute, the education deductions and credits are aimed at the student or the
student’s family. The exclusion for employer-provided health care in § 106 (discussed in the next
chapter) is aimed at the employee on the face of the statute. The deduction of qualified residence
interest in § 163(h)(3), exclusion of home sale gain under § 121, and deduction of real estate
property taxes under § 164(a)(1) (all discussed in the next chapter) are each aimed at the home
owner. And so on. These tax benefits, however, can often be captured by other actors in the
marketplace through the price mechanism. The more broadly available a tax expenditure, the more
easily it can be captured by raising the price of the purchased asset or service at large. If a tax
benefit is limited to a small, select population, providers find it difficult to raise prices generally.
In the context of the education tax expenditures, capture can mean that universities are able to
raise tuition to higher levels than they would be able to charge absent the tax expenditure. When
the Hope Credit (now replaced with the American Opportunity Tax Credit) was first enacted in
1997, for example, California community colleges charged an average annual tuition of less than

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$1,500, and they immediately raised their tuition to the $1,500 that could be credited each year
under § 25A at the time. Even in the case in which tuition is already higher than the amount
currently creditable, the very existence of § 25A can result in tuition inflation, as universities
generally raise tuition to capture all or part of the benefit. Whether that is a good or bad
development may depend on what the university or college does with the extra tuition dollars. If
the institution uses them to replace reductions in state funding (in the case of a public university),
the Federal dollars merely maintain the status quo. If it uses the increased tuition to provide more
scholarship dollars to needy students, perhaps the capture is a good thing. If it uses the increased
tuition to raise professors’ salaries, perhaps not so much….
The primary tax expenditures pertaining to education (some of which are explored through the
problems below) are: 1
•

The § 117(a) exclusion for certain scholarships

•

The § 117(d) exclusion for certain tuition waivers for employees of educational institutions

•

The § 127 exclusion for tuition benefits paid by employers who are not educational
institutions

•

The § 25A(b) American Opportunity Tax Credit (AOTC)

•

The § 25A(c) Lifetime Learning Credit

•

The § 221 deduction for interest on education loans (taken above the line under § 62(a)(17)

Recall that, under a pure SHS income tax, borrowed principal is excluded from Gross Income,
repaid principal is not deducted, and personal consumption interest is not deductible. The § 221
deduction is a tax expenditure. Recall also, however, that under a cash-flow consumption tax
borrowed principal would be included, and repaid principal as well as interest would both be
deducted. Finally, recall from Chapter 3 that the current Internal Revenue Code generally functions
as a consumption tax for the middle class because the primary savings of most middle-class
taxpayers (retirement savings in qualified pension plans, § 401(k) accounts, and IRAs, built-in
gain in a primary residence, and life insurance) are accorded consumption tax treatment under
current law. The Code functions more as an income tax for wealthier taxpayers, whose savings
exceed the limits that can be protected from taxation under current law.
Professor Larry Zelenak has provocatively suggested that students be permitted to elect to treat
their student loans under cash-flow consumption tax principles. 2 Because they would include the
borrowed principal in their low- or no-earning student years, perhaps much of the borrowed funds
could be sheltered from taxation under the Standard Deduction, with the remainder falling in the
lowest tax brackets. In their later, higher-earning years, they would be permitted to deduct not only
the interest (as under current § 221, within limits) but also repaid principal, offsetting Gross
Income that would otherwise be taxed under higher marginal rates than applied in the earlier
borrowing year, reducing the aggregate tax paid over time. In short, many students could benefit
by shifting tax base inclusions from higher-bracket years to lower-bracket years by taxing at the
earlier of consumption (with borrowed funds) or income (the repayment of the borrowed funds),
1

Prior to 2021, eligible taxpayers could effectively elect between deducting tuition and fees under § 222 or crediting
them under § 25A. In December 2020, Congress repealed the § 222 deduction but also increased the § 25A phaseout threshold for the Lifetime Learning Credit by conforming it to the § 25A AOTC threshold.
2
See Lawrence Zelenak, Debt-Financed Consumption and a Hybrid Income-Consumption Tax, 64 TAX LAW REV. 1
(2010).

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notwithstanding the time value of money. Currently, however, students are deprived of that choice
and must exclude borrowed principal and not deduct repaid principal.
Problems
Read §§ 117 (exclusion of certain scholarships and tuition reductions), 127 (exclusion of certain
employer-paid education), and 25A (the AOTC in § 25A(b) and the Lifetime Learning Credit in §
25A(c)) and consider the extent to which they apply to John, Janice, or Jerry this year in each of
the following problems. Notice that the § 25A(d) phase-out threshold of $80,000 modified AGI
($160,000 for married taxpayers filing jointly) is not adjusted for inflation. Helpful hint: Unlike
the dollar-for-dollar phase-out rule that you encountered in §§ 179(b)(2) and 469(i), the § 25A
phase-out decreases the percentage of the credit available once the income threshold is exceeded.
If relevant, assume that any educational institution is described in both § 170(b)(1)(A)(ii) and §
481 of the Higher Education Act of 1965.
1. It is December 2022, and this year John completed the spring semester of his sophomore year
and the fall semester of his junior year at Yowl University, which awarded to him a full tuition
scholarship (otherwise priced at $50,000), free room and board (otherwise priced at $10,000), and
$5,000 toward required books and supplies each academic year.
2. Same as 1., except that the terms of John’s scholarship will require him to work for 10 hours
each week in the cafeteria at no pay as a condition of receiving a portion of his scholarship.
Cafeteria workers who are not students earn $100 for 10 hours of work. With John working for 14
weeks during each of the spring and fall semesters in 2022, he would have been paid $2,800 if the
work were not part of his scholarship conditions. See § 117(c). How should the institution draft
the terms of the work requirement to maximize John’s exclusion?
3. Same as 2., except that John is offered only a full tuition scholarship valued at $50,000 (no
room and board or books scholarship). How will § 25A be relevant to these changed facts? Because
John is a full-time student, his AGI is low (from a part-time job).
4. Janice, who has an undergraduate degree in computer programming, works at High Tech
Corp., which creates and sells sophisticated, individualized software to clients. In 2022, her
modified AGI is $90,000. The corporation pays up to $3,000 annually toward tuition for any
employee, as well as the dependent of any employee, who enrolls at an accredited institution of
higher education. Janice enrolls part-time at the local community college, where she takes a course
in studio painting for fun, paying $500. High Tech reimburses her for this expense.
5. Same as 4., except that Janice’s employer is High Tech University, where she is a professor
in computer science. High Tech U. allows any of its employees to enroll in courses at High Tech
U. at no charge, and Janice enrolls as a non-degree student in the course in studio painting for fun.
Other (non-employee) students must pay $1,000 for the course.
6. Same as 4., except that Janice’s son, Jerry, is enrolled full-time at State U. Janice, who is a
single mom, pays $8,000 in tuition in 2022 for Jerry: $4,000 in January for the spring semester of
his junior year and $4,000 in August for the fall semester of his senior year. High Tech Corp.
reimburses Janice for $3,000 of these expenses.

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7. Same as 6., except that Janice is married to Jerry’s dad (Jack), and together Janice and Jack
have “modified AGI” of $150,000.
Treas. Reg. § 1.162-5: education costs as § 162 business expenses
As described at the beginning of this section, education costs are generally allocated to the
taxpayer’s personal life. For this reason, education outlays usually create neither immediately
deductible business expenses under § 162 nor basis that can be amortized over the taxpayer’s
working life under § 167. 3 Nevertheless, a narrow category of costs can be deducted as § 162
business expenses if they satisfy the standards in Treas. Reg. § 1.162-5.
These regulations use by analogy the distinction explored in Chapter 4 between a repair expense
(immediately deductible expense) and an improvement (nondeductible capital expenditure) under
capitalization theory more generally. That is to say, these regulations attempt to identify those
costs that seek merely to repair education already in place (potentially deductible business
expenses under § 162) from those costs that create significant new human capital (nondeductible).
If an outlay merely repairs previously existing education used by the taxpayer in her business, the
benefit to her business life can reasonably be considered primary, with the benefit to her personal
life (the acquisition of new human capital) only incidental.
To be specific, Treas. Reg. § 1.162-5(a) requires that the education must satisfy one of two
alternative tests to be potentially deductible as § 162 business expenses. The education must
(1) maintain or improve skills required by the individual in his employment or
other trade or business, or
(2) meet the express requirements of the individual’s employer, or the
requirements of applicable law or regulations, imposed as a condition to the
retention by the individual of an established employment relationship, status, or
rate of compensation.
Such outlays pay for education that merely repairs skills already in place. If neither threshold
test is satisfied, the analysis stops, and no deduction is allowed.
If one of the two tests above is met, the analysis proceeds to the next level, under which the
deduction will nevertheless be disallowed if it is described in Treas. Reg. §§ 1.162-5(b)(2) or (3).
No deduction is allowed for education that meets one of the threshold tests if it also
(1) is required in order to meet the minimum education requirements for
qualification in the taxpayer’s employment or other trade or business, or
(2) will lead to qualifying the taxpayer in a new trade or business.
Such outlays pay for education that represents a capital expenditure with a long life. For this
reason, they are disallowed as primarily benefitting the taxpayer’s personal life (under the usual
rule that education costs are placed in the taxpayer’s personal sphere).
Finally, even if the education satisfies Treas. Reg. § 1.162-5, the taxpayer must also satisfy the
remaining § 162 requirements, including that the expense be incurred in “carrying on” a trade or
3

Indeed, deduction of such expenses would largely be a regressive move, as higher earners typically pay more higher
education costs than do lower earners. The lost income would have to be paid for with higher tax rates, which would
likely mean higher tax rates on all, not just the higher earners who are taking the deductions.

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business. Taxpayers who have not yet established themselves in business, 4 or who have left
employment for a substantial time, cannot deduct business expenses. Nevertheless, it is well
established that the deduction for education expenses is not limited to those who continue to work
at the same time that they are incurring education costs (as, say, a part-time student). Once a
taxpayer establishes herself in business, she can deduct education business expenses even if she
quits her job and attends school on a full-time basis before returning to the same or similar
employment. 5 The taxpayer is essentially deemed to continue carrying on her prior business during
the schooling hiatus.
The one aspect of the regulations described above that has by far led to the most litigation is
the rule denying deduction for education leading to qualifying the taxpayer for a new trade or
business. The authorities are inconsistent and constantly in flux. The analysis depends on how
broadly one defines the scope of a particular trade or business in the first place. Examples provided
in the Treasury regulations imply that education leading merely to specialization within a larger
field should not be considered as leading to a new trade or business. For example, education
allowing an elementary school teacher to move to secondary school teaching, allowing a classroom
teacher to become a guidance counselor or principal, or allowing a math teacher to become a
science teacher does not lead to qualifying the taxpayer for a new trade or business. 6 Similarly,
education allowing a psychiatrist to specialize in psychoanalysis does not lead to qualifying the
taxpayer for a new trade or business 7 nor does education leading a general dentist to specialize in
orthodontia. 8
But what one adjudicator considers specialization another may consider a completely different
business, which reinforces the point that whether education leads to qualifying the taxpayer for a
new trade or business depends first on how broadly one defines the scope of the particular trade or
business. If, for example, the scope of the business is defined as “law,” education leading to
specialization within that larger field of law should not be considered education leading to a new
trade or business. If, on the other hand, tax law is considered to be a different trade or business
from criminal law, education allowing a criminal law lawyer to change to a tax law practice would
be education qualifying the taxpayer for a new trade or business.
The Tax Court has adopted a “tasks and activities” test in defining the scope of a trade or
business, which seems inconsistent with the Regulations and rulings described above that
conclude, for example, that a guidance counselor is not in different trade or business from a
classroom teacher. The tasks and activities engaged in by a guidance counselor on a day-to-day
basis are clearly different from the tasks and activities engaged in by a classroom teacher.
Moreover, although the court recites the tasks and activities test in Sharon, below, the court does
not extensively compare the actual tasks and activities performed by Mr. Sharon in his New York
law practice with those he performed in his California law practice before concluding that the
4

As described in Chapter 13, certain start-up costs that otherwise qualify as current business expenses but are incurred
before a new business opens must be capitalized and can be amortized under § 195. To be eligible for § 195
amortization the outlay must be one that, if incurred in connection with an existing operating business, would be
allowable as a deduction for the taxable year in which paid or incurred. Therefore, § 195 amortization is not generally
relevant to education costs.
5
See, e.g., Rev. Rul. 68-591, 1968-2 C.B. 73 (allowing deduction of education expenses incurred by teacher who left
her position to pursue a graduate degree as a full-time student for one academic year).
6
See Treas. Reg. § 1.162-5(b)(3)(i).
7
Treas. Reg. § 1.162-5(b)(3)(ii), Ex. (4).
8
Rev. Rul. 74-78, 1974-1 C.B. 44.

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education costs for a California bar review course led to qualifying him for a new trade or business.
Why?
SHARON v. COMMISSIONER
66 T.C. 515 (1976) (reviewed), aff’d, 591 F.2d 1273 (9th Cir. 1978) (per curiam)
SIMPSON, JUDGE: Due to concessions, the following issues remain for decision: … [(1)] whether
the petitioners are entitled to amortization deductions under section 167(a)(1) with respect to
certain educational and other expenses incurred to enable the petitioner Joel A. Sharon to obtain a
license to practice law in the State of New York; [(2)] whether the petitioners may deduct or
amortize costs incurred by the petitioner Joel A. Sharon in taking the California bar examination
and miscellaneous expenses incurred in obtaining admission to courts in that State; [and (3)]
whether the petitioners may deduct under section 162, or amortize pursuant to section 167, the cost
of petitioner Joel A. Sharon’s admission to the Supreme Court of the United States.
FINDINGS OF FACT
The petitioner attended Brandeis University from September 1957 to June 1961 and received a
bachelor of arts degree upon his graduation. After graduation from Brandeis University, the
petitioner entered Columbia University School of Law, receiving a bachelor of laws degree in June
1964. In order to be eligible to take the New York bar examination, the petitioner was required to
graduate from a fully accredited 4-year undergraduate institution and give evidence of his
successful completion of 3 years of study at an accredited law school.
The petitioner expended a total of $210.20 in gaining admission to practice law in the State of
New York. This amount included $175.20 for bar review courses and materials related thereto and
a New York State bar examination fee of $25.
The petitioner was admitted to practice law in the State of New York on December 22, 1964.
Thereafter, he was employed as an attorney by a law firm in New York City until 1967 [where he
practiced tax law], when he accepted a position in the Office of Regional Counsel, Internal
Revenue Service, and moved to California.
Although not required by his employer to be a member of the California bar, the petitioner
decided to become a member of that State’s bar after moving there. However, he found that the
study of California law, which he undertook in preparation for the California bar examination, was
helpful in his practice of law as an attorney in the Regional Counsel’s office. The petitioner spent
[$801, including $230 for a California bar review course.]
In 1969, the petitioner also spent a total of $11 in order to be admitted to practice before the
U.S. District Court for the Northern District of California and the U.S. Court of Appeals for the
the Ninth Circuit. The petitioner’s employer required only that he be admitted to practice before
the U.S. Tax Court.
In 1970, the petitioner incurred expenses in connection with his admission to the U.S. Supreme
Court. The petitioner’s employer did not require that he be admitted to practice before the U.S.
Supreme Court but did assist him in this matter. The Chief Counsel of the IRS personally moved
the admission of a group of IRS attorneys, including the petitioner. Furthermore, two of his
supervisors signed his application as personal references. During 1970, the U.S. Supreme Court
rules required a personal appearance before it in Washington, D.C., to be admitted to practice.

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On their return for 1969, the petitioners claimed a deduction for “Dues and Professional
Expenses” of $492. The Commissioner disallowed $385 of such deduction on the grounds that the
disallowed portion was not a deductible business expense, but was a nondeductible capital
expenditure. On their return for 1970, the petitioners claimed a deduction of $313.35 for the cost
of petitioner Joel A. Sharon’s admission to practice before the U.S. Supreme Court. The
Commissioner also disallowed such deduction. In addition to challenging the disallowed
deductions, the petitioners alleged in their petition that they were entitled to amortize or depreciate
the cost of petitioner Joel A. Sharon’s education. The Commissioner denied this allegation in his
answer.
OPINION
Amortization of License to Practice Law in New York
The issue to be decided is whether the petitioner may amortize the cost of obtaining his license
to practice law in New York. The petitioner contends that he is entitled under section 167 to
amortize the cost of such license over the period from the date of his admission to the bar to the
date on which he reaches age 65, when he expects to retire. In his cost basis of this “intangible
asset,” he included the costs of obtaining his college degree ($11,125), obtaining his law degree
($6,910), a bar review course and related materials ($175.20), and the New York State bar
examination fee ($25). As justification for including these education expenses in the cost of his
license, he points out that, in order to take the New York bar examination, he was required to have
graduated from college and an accredited law school.
The petitioners rely upon section 1.167(a)-3 of the Income Tax Regulations, which provides in
part:
If an intangible asset is known from experience or other factors to be of use in the
business or in the production of income for only a limited period, the length of which
can be estimated with reasonable accuracy, such an intangible asset may be the subject
of a depreciation allowance. * * *
There is no merit in the petitioner’s claim to an amortization deduction for the cost of his
education and related expenses in qualifying himself for the legal profession. His college and law
school expenses provided him with a general education which will be beneficial to him in a wide
variety of ways. See James A. Carroll, 51 T.C. 213, 216 (1968). The costs and responsibility for
obtaining such education are personal. Section 1.262-1(b)(9) of the Income Tax Regulations
provides that expenditures for education are deductible only if they qualify under section 162 and
section 1.162-5 of the regulations. In the words of section 1.162-5(b), all costs of “minimum
educational requirements for qualification in * * * employment” are “personal expenditures or
constitute an inseparable aggregate of personal and capital expenditures.” There is no “rational”
or workable basis for any allocation of this inseparable aggregate between the nondeductible
personal component and a deductible component of the total expense. Fausner v. Comm’r, 413
U.S. 838, 839 (1973). Such expenses are not made any less personal or any more separable from
the aggregate by attempting to capitalize them for amortization purposes. David N. Bodley, 56 T.C.
1357, 1362 (1971); Nathaniel A. Denman, 48 T.C. 439, 446 (1967); Huene v. U.S., 247 F. Supp.
564, 570 (S.D. N.Y. 1965). Since the inseparable aggregate includes personal expenditures, the
preeminence of section 262 over section 167 precludes any amortization deduction. Cf. Comm’r
v. Idaho Power Co., 418 U.S. at 17; Bodzin v. Comm’r, 509 F.2d at 681. The same reasoning
applies to the costs of review courses and related expenses taken to qualify for the practice of a

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profession. William D. Glenn, 62 T.C. 270, 274-276 (1974).
In his brief, the petitioner attempts to distinguish our opinion in Denman by asserting that he is
not attempting to capitalize his educational costs, but rather, the cost of his license to practice law.
Despite the label which the petitioner would apply to such costs, they nonetheless constitute the
costs of his education, which are personal and nondeductible. Moreover, in his petition, he alleged
that the capital asset he was seeking to amortize was his education.
There remains the $25 fee paid for the petitioner’s license to practice in New York. This was
not an educational expense but was a fee paid for the privilege of practicing law in New York, a
nontransferable license which has value beyond the taxable years, and such fee is a capital
expenditure. Cf. Arthur E. Ryman, Jr., 51 T.C. 799 (1969); Glenn L. Heigerick, 45 T.C. 475 (1966);
S.M. Howard, 39 T.C. 833 (1963); O.D. 452, 2 C.B. 157 (1920). The Commissioner has limited
his argument to the educational expenses and apparently concedes that the fee may be amortized.
License to Practice Law in California
The next issue to be decided is whether the petitioner may deduct or amortize the expenses he
incurred in gaining admission to practice before the State and Federal courts of California. The
Commissioner disallowed the amounts paid in 1969 to take the attorney’s bar examination in
California and the amounts paid for admission to the bar of the U.S. District Court for the Northern
District of California and for admission to the U.S. Court of Appeals for the Ninth Circuit. He
determined that such expenses were capital expenditures. In his brief, the petitioner argues for a
current deduction only if the costs of his license to practice in California are not amortizable.
It is clear that the petitioner may not deduct under section 162(a) the fees paid to take the
California attorney’s bar examination and to gain admission to practice before two Federal courts
in California. In Arthur E. Ryman, Jr., supra, an associate professor of law sought to deduct as an
ordinary business expense the cost of his admission to the bar of the State in which he resided. We
held that since the taxpayer could reasonably expect the useful life of his license to extend beyond
1 year, the cost of such license was a capital expenditure and not a currently deductible business
expense.
In connection with his alternative claim that he be allowed to amortize the costs of acquiring
his license to practice law in California, the petitioner asserts that such costs total $801. Such
amount includes the cost of a California bar review course, registration fees, and other items
specified in our Findings of Fact. However, the petitioner is in error in including the cost of his
bar review course, $230, in the capital cost of his license to practice in California.
It is clear that the amount the petitioner paid for the bar review course was an expenditure “made
by an individual for education” within the meaning of section 1.162-5(a) of the Income Tax
Regulations. See William D. Glenn, 62 T.C. 270, 273-274 (1974); sec. 1.162-5(b)(2)(iii), example
(3), Income Tax Regs. Although the petitioner was authorized to practice law in some jurisdictions
when he took the California bar review course, such course was nevertheless educational in the
same sense as the first bar review course. The deductibility of such educational expenses is
governed by the rules of section 1.162-5 of the regulations.
Nor may the petitioner treat the payment for the California bar review course as a part of the
costs of acquiring his license to practice in California. Educational expenses which are incurred to
meet the minimum educational requirements for qualification in a taxpayer’s trade or business or
which qualify him for a new trade or business are “personal expenditures or constitute an
inseparable aggregate of personal and capital expenditures.” Sec. 1.162-5(b), Income Tax Regs.
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We find that the bar review course helped to qualify the petitioner for a new trade or business so
that its costs are personal expenses.
We have previously adopted a “commonsense approach” in determining whether an educational
expenditure qualifies a taxpayer for a “new trade or business.” Kenneth C. Davis, 65 T.C. 1014,
1019 (1976); William D. Glenn, 62 T.C. at 275; Ronald F. Weiszmann, 52 T.C. 1106, 1110 (1969),
affd. 443 F.2d 29 (9th Cir. 1971). If the education qualifies the taxpayer to perform significantly
different tasks and activities than he could perform prior to the education, then the education
qualifies him for a new trade or business. William D. Glenn, supra; Ronald F. Weiszmann, supra.
Thus, we have held that a professor of social work is in a different trade or business than a social
caseworker. Kenneth C. Davis, supra. A licensed public accountant is in a different trade or
business than a certified public accountant. William D. Glenn, supra. A registered pharmacist is in
a different trade or business than an intern pharmacist, even though an intern performs many of
the same tasks as a registered pharmacist, but under supervision. Gary Antzoulatos, T.C. Memo.
1975-327.
Before taking the bar review course and passing the attorney’s bar examination, the petitioner
was an attorney licensed to practice law in New York. As an attorney for the Regional Counsel,
he could represent the Commissioner in this Court. However, he could not appear in either the
State courts of California, the Federal District Courts located there, nor otherwise act as an attorney
outside the scope of his employment with the IRS. See Cal. Bus. & Prof. Code sec. 6125 (West
1974); 20 Op. Cal. Atty. Gen. 291 (1952). If he had done so, he would have been guilty of a
misdemeanor. Cal. Bus. & Prof. Code sec. 6126 (West 1974). Yet, after receiving his license to
practice law in California, he became a member of the State bar with all its accompanying
privileges and obligations. He could appear and represent clients in all the courts of California. By
comparing the tasks and activities that the petitioner was qualified to perform prior to receiving
his license to practice in California with the tasks and activities he was able to perform after
receiving such license, it is clear that he has qualified for a new trade or business. Consequently,
the expenses of his bar review course were personal and are not includable in the cost of his license
to practice law in California.
It is true that even before he became a member of the bar of California, the petitioner was
engaged in the business of practicing law. Cf. David J. Primuth, 54 T.C. 374 (1970). However, in
applying the provisions of section 1.162-5 of the regulations to determine whether educational
expenses are personal or business in nature, it is not enough to find that the petitioner was already
engaged in some business—we must ascertain the particular business in which he was previously
engaged and whether the education qualified him to engage in a different business. Before taking
the bar review course and becoming a member of the bar of California, the petitioner could not
generally engage in the practice of law in that State, but the bar review course helped to qualify
him to engage in such business.
The Commissioner does not argue that the capital expenditures incurred in obtaining his license
to practice law in California may not be amortized. In a series of cases, the courts have held that
the fees paid by physicians to acquire hospital privileges are not current business expenses but are
capital expenditures amortizable over the doctor’s life expectancy. Walters v. Comm’r, 383 F.2d
922, 924 (6th Cir. 1967), affg. a Memorandum Opinion of this Court; Glenn L. Heigerick, 45 T.C.
475, 478-479 (1966); S.M. Howard, 39 T.C. 833, 838-839 (1963); compare Wells-Lee v. Comm’r,
360 F.2d 665, 672-673 (8th Cir. 1966), revg. and remanding in part a Memorandum Opinion of
this Court. We hold that the petitioner may treat the costs of acquiring his license to practice in

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California in a similar manner. Although the petitioner testified that he would retire at age 65 if he
were financially able to do so, such testimony is not sufficient to establish the shorter useful life
for which he argues.
Supreme Court Admission
The [next] issue to be decided is whether the petitioner may either deduct or amortize the cost
of gaining admission to practice before the U.S. Supreme Court. The petitioner deducted the travel
costs he incurred in 1970 in traveling to Washington, D.C., to be personally present for the
Supreme Court admission, as required by that Court’s rules. The Commissioner disallowed the
deduction and argued in his brief that such expenditures were capital in nature since the petitioner
acquired an asset with a useful life beyond 1 year.
In his brief, the petitioner concedes that he may not deduct the costs he incurred if we find that
his license to practice before the Supreme Court is an intangible asset with a useful life of more
than 1 year. For the same reasons that we have concluded that the petitioner’s New York and
California licenses were intangible assets with a useful life of more than 1 year, we also hold that
his Supreme Court license is an intangible asset with a useful life exceeding 1 year. Thus, the
petitioner may not deduct under section 162 the cost of obtaining such license. We find that the
intangible asset acquired by becoming a member of such bar was used by the petitioner in 1970
and hold that he may amortize the costs of acquiring such asset over his life expectancy.
IRWIN, J., dissenting: I disagree with that portion of the majority opinion which holds that
petitioner may not treat the payment for the California bar review course as a part of the cost of
acquiring his license to practice law in California. In the past, we have indeed adopted a
“commonsense approach” in determining whether an educational expenditure qualifies a taxpayer
for a new trade or business. Kenneth C. Davis, 65 T.C. 1014, 1019 (1976); William D. Glenn, 62
T.C. 270, 275 (1974); Ronald F. Weiszmann, 52 T.C. 1106, 1110 (1969), affd. 443 F.2d 29 (9th
Cir. 1971). However, I think we depart from that approach when we hold that an attorney, licensed
to practice law in New York, qualifies for a new trade or business when he obtains a license to
practice law in California. In William D. Glenn, supra at 275, we stated:
We have not found a substantial case law suggesting criteria for determining when the
acquisition of new titles or abilities constitutes the entry into a new trade or business
for purposes of section 1.162-5(c)(1), Income Tax Regs. What has been suggested,
and we uphold such suggestion as the only commonsense approach to a classification,
is that a comparison be made between the types of tasks and activities which the
taxpayer was qualified to perform before the acquisition of a particular title or degree,
and those which he is qualified to perform afterwards. Ronald F. Weiszmann, 52 T.C.
1106, 1110 (1969), affd. 443 F.2d 29 (C.A. 9, 1971). Where we have found such
activities and abilities to be significantly different, we have disallowed an educational
expense deduction, based on our finding that there had been qualification for a new
trade or business. Ronald F. Weiszmann, supra. [Emphasis supplied.]
In my view there is no difference in the types of tasks and activities which petitioner was
qualified to perform before and after he acquired his California license. By virtue of being licensed
to practice in California, petitioner could perform the same types of tasks and activities in that state
as he was already qualified to perform in New York. In this regard, respondent takes the position
that once an individual is qualified to teach in State A, a college course taken in order to qualify
for a teaching position in State B is neither a minimum educational requirement of his trade or

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business nor education qualifying him for a new trade or business. Rev. Rul. 71-58, 1971-1 C.B.
55. I would similarly conclude that once an individual is qualified to practice law in one State, a
bar review course taken in preparation for the bar exam of another State is not education leading
to qualification for a new trade or business.
___________________________________
While the court denied any expense or amortization deduction with respect to Mr. Sharon’s
education costs, it did allow him to amortize the costs incurred to obtain his state law licenses
(which are not education costs) over his remaining life expectancy. Today, the license satisfies the
definition of a “section 197 intangible” under § 197(d)(1)(D), allowing such costs to be amortized
over 15 years. If the lawyer is not an employee of another, the § 197 amortization deduction is
taken above the line under § 62(a)(1), as you learned in Chapter 1, Part B. For the employee lawyer,
however, the § 197 deduction is not listed in § 62 unless reimbursed, rendering it an Itemized
Deduction and, because § 197 is also not listed in § 67(b), a “miscellaneous itemized deductions”
(or MID), now effectively nondeductible under § 67(g) after the TCJA.
With respect to the bar review (education) costs, Mr. Sharon had practiced as a tax lawyer in
New York before moving to California, so there was no doubt that he satisfied the threshold
“carrying on” requirement in § 162. Nevertheless, the Tax Court majority disallowed deduction of
the costs that he paid for the California bar review course because the education led to qualifying
him to be licensed as a California lawyer—which the majority concluded was a new trade or
business within the meaning of Treas. Reg. § 1.162-5(b)(3)—even though he likely performed the
same sorts of tasks and activities as a tax lawyer in California that he performed as a tax lawyer in
New York. The Tax Court appears to hold that education leading to a job that is licensed is
automatically categorized as education leading to a new trade or business. Similarly, education
leading to the J.D. degree leads to qualifying for a new trade or business even when undertaken by
an accountant who has no intention of practicing law and who performs similar tasks and activities
after earning her J.D. as she performed before earning it. 9 And education undertaken by a public
accountant that allows her to become a “certified public accountant” leads to a new trade or
business. 10 Why should licensure alter the analysis so dramatically? Is not a license merely a
manifestation of the acquired human capital?
An LL.M. degree is an advanced law degree (typically in a specialty area, including tax) earned
after the J.D. degree. LL.M. degrees are not required to practice in a specialty area and do not lead
to any special licensure. 11 533 For example, most tax lawyers do not have LL.M. degrees in tax,
though some do (particularly if they were unable to take a panoply of tax courses at the J.D. level).
Similarly, an MBA degree does not lead to licensure. For this reason, taxpayers have had greater
success in deducting these education costs so long as the taxpayer has established herself in
business prior to the education (satisfying the § 162 “carrying on” requirement) and so long as she
returns to the same or similar job (performing the same sorts of “tasks and activities”). For

9

See Treas. Reg. § 1.162-5(b)(3)(ii), Ex. (1).
See Glenn v. Comm’r, 62 T.C. 270 (1974).
11
An exception is when a foreign lawyer who earns his first law degree abroad enrolls in an LL.M. program in the
U.S. Without the LL.M., the foreign lawyer could not take a U.S. bar exam because he did not earn a degree from an
ABA-accredited law school. See, e.g., Valle v. Comm’r, T.C. Summary Opinion 2018-51 (denying deduction of LL.M.
costs to attend NYU, which permitted foreign lawyer to take the New York bar exam).
10

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example, the taxpayers won in Blair v. Commissioner 12 and Allemeier v. Commissioner, 13 each
allowing deduction of MBA expenses, as well as Ruehmann v. Commissioner 14 and PLR 9112003
(Dec. 18, 1990), each allowing deduction of LL.M. expenses.
In other cases, however, the Tax Court appears to take a more discerning approach to the “tasks
and activities” test that downplays the inference drawn from the Treasury regulations that
education leading to mere specialization within a larger field does not lead to a new trade or
business. The Tax Court denied deduction of LL.M. expenses in Hudgens v. Commissioner, 15 for
example. After earning his J.D. degree, Mr. Hudgens worked for an accounting firm in the tax
area. After obtaining his tax LL.M. degree, Mr. Hudgens worked for a trust company where he
engaged in some of the same activities, but the Tax Court concluded that these activities were
ancillary to managing client assets and acquiring new clients—a new trade or business.
The Tax Court appeared to come to inconsistent conclusions in Foster v. Commissioner 16 and
Singleton-Clarke v. Commissioner, 17 both of which are small tax cases that cannot be cited as
precedent under § 7463(b) and both of which dealt with MBA costs. Prior to obtaining her MBA
at Harvard, Ms. Foster worked for a beverage company “as a project manager on the upgrade of a
milk factory” in Sydney, Australia. During her MBA studies, she worked at the Snapple beverage
company as a “corporate strategy consultant,” where she “completed marketing projects related to
beverage consumption in the United States and to Snapple strategy and profitability.” After she
completed her MBA, she accepted the job of “vice president of marketing” at a beverage company
in California. The Tax Court denied deduction of her MBA expenses because she did not work in
“marketing” prior to matriculating into the MBA program. The fact that she worked in the beverage
industry both before and after earning her MBA and that she worked as a corporate strategy
consultant, including with respect to marketing projects, at a beverage company during her studies
were not sufficient to show that the MBA did not qualify her for a new trade or business. The Tax
Court also upheld a § 6662 accuracy-related penalty.
Ms. Singleton-Clarke, on the other hand, was permitted to deduct the $14,787 cost of earning
an on-line MBA degree with a specialization in Health Care Management (MBA/HCM) from the
University of Phoenix. During the three years (from 2005 through 2008) that Ms. SingletonClarke, a registered nurse, pursued her on-line degree, she worked as a quality control coordinator
at three successive hospitals and nursing homes after more than 20 years in direct patient care and
nursing management. Each position required that she be a registered nurse but did not require an
advanced degree. The Tax Court noted that an MBA degree, unlike a law degree, does not lead to
attaining a professional license, confirming the trend that a degree leading to professional licensure
may lead to a conclusion that the education qualifies the taxpayer for a new trade or business for
that reason alone. The Tax Court reviewed MBA cases that denied deduction as well as those that
allowed deduction and reiterated that the “tasks and activities” test was controlling. In holding for
the taxpayer, the court noted that Ms. Singleton-Clarke “worked for 1 year as a quality control
coordinator and had more than 20 years of directly related work experience, gaining vast clinical
and managerial knowledge in acute and subacute health care settings, before beginning at the
University of Phoenix MBA/HCM program” and concluded that “the MBA/HCM may have
12

T.C. Memo. 1980-488.
T.C. Memo. 2005-207.
14
T.C. Memo. 1971-57.
15
T.C. Memo. 1997-33.
16
T.C. Summary Opinion 2008-22.
17
T.C. Summary Opinion 2009-182.
13

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improved petitioner’s preexisting skill set, but objectively, she was already performing the tasks
and activities of her trade or business before commencing the MBA.”
The taxpayer also won in Kopaigora v. Commissioner. 18 He was employed as a senior assistant
controller for the Marriott hotel in Los Angeles International Airport, where he managed
employees (including hiring and training activities), prepared financial reports and budgets,
analyzed financial data, and ensured compliance with reporting requirements. He enrolled in an
Executive MBA program at Brigham Young University in 2010, flying to Salt Lake City on the
weekends for classes. In 2011, he was terminated from his Marriott position for reasons that were
later found to be unjustified. One month after completing his EMBA degree in 2012, he was hired
as Vice President of Finance at Drivett Financial Services, where he supervised a team of
employees (including hiring and training activities) responsible for auditing, accounting for taxes,
preparing reports, and enforcing internal controls. Applying the tasks and activities test, the Tax
Court held that the EMBA did not lead to qualifying the taxpayer for a new trade or business.
Can you articulate a coherent principal underlying the Tax Court’s approach to the business
issue under Treas. Reg. § 1.162-5? At the least, taxpayers wishing to deduct the costs of postgraduate education that does not lead to licensure should be encouraged to return to the same job,
or take a job as close as possible to it, for a period subsequent to completing the education.
Education costs that are deductible as business expenses encompass travel expenses, as well,
under Treas. Reg. § 1.162-5(e) if the education takes place away from the taxpayer’s home city.
The taxpayer can deduct not only tuition or registration costs but also the costs for transportation
to the place of education, lodging while there (even for extended periods of time, so long as she
expects to and does return within one year), and meal costs. The 50% reduction that normally
applies to meal expenses in § 274(n)(1) does not apply to restaurant meals through 2022, thanks
to § 274(n)(2)(D). 19
Finally, notice that most of the cases described above involved not sole proprietors but rather
employees, who were attempting to deduct their education expenses themselves, as they were not
reimbursed by their employers. If they succeeded in establishing deductibility, the deductions
would be not only Itemized Deductions but MIDs. When these cases were litigated, MIDs could
be deducted to the extent exceeding 2% of the taxpayer’s AGI, but today they would be entirely
disallowed under § 67(g). If the taxpayer is an employee and her employer directly pays the costs,
the employee can exclude the benefit under either § 132(d) (working condition fringe). If the
employer reimburses these costs if initially paid by the employee, the employee could exclude
under Treas. Reg. § 1.62-2(c) (described in Chapter 1, Part B.) only if the amount is otherwise
deductible under Treas. Reg. § 1.162-5.
Problems
1. Jonah, who is unmarried and practices law as a sole proprietor, is in the 24% tax bracket. He
attends the ABA Section of Taxation meeting in Washington DC, paying $250 in registration fees,
$500 in air fare, $600 in hotel costs, $200 for restaurant meals, and $50 in taxi fares. What can
Jonah deduct under Treas. Reg. § 1.162-5? What if Jonah were an employee (associate) of a law
firm, which did not reimburse him for these costs? Should Jonah take the § 25A Lifetime Learning
18

T.C. Summary Opinion 2016-35.
The one-year rule for business travel expense is found in the middle sentence of the paragraph following § 162(a)(3).
Section 162 deductions for meal and travel expenses are considered more generally in Chapter 19.
19

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Credit, instead?
2. Jeanine, who is single, is in the 12% tax bracket. She can find no other work with her English
major undergraduate degree than working the night shift at a convenience store as she contemplates
whether she should attend graduate school. She also earns extra money as a dog walker. She begins
to advertise her services as a dog groomer, as well, and her client base expands sufficiently to
enable her to quit her job and live solely on her dog-related earnings. She realizes that she needs
more training, however, and (abandoning any thought of grad school) she enrolls in a course to
learn advanced grooming techniques for show dogs, paying $1,000 for the 6-month course.
a. What can she deduct under Treas. Reg. § 1.162-5? Should Jeanine take the § 25A Lifetime
Learning Credit, instead? (Assume that the program is described in § 481 of the Higher
Education Act of 1964.)
b. What if dog grooming is a licensed profession in Jeanine’s state?

B. Compensation received on account of the loss of human capital
Recall that a cash receipt is not a wealth accession within the meaning of § 61 to the extent that
it represents tax-free basis (or capital) recovery. Assume that Mel destroys Meghan’s automobile.
Meghan had purchased it for $20,000, but it was worth $8,000 when destroyed. Meghan sues Mel,
and she receives $8,000 from Mel’s insurance company in settlement of her claim. The $8,000 that
she receives is not a wealth accession but rather a tax-free recovery of basis created when she spent
$20,000 to purchase the automobile—a nondeductible capital expenditure. In other words, that
$8,000 represents dollars that were already taxed to Meghan and should not be taxed to her a
second time under SHS income tax principles. 20
Alternatively, assume that Mel destroys an original Renoir painting that hung on Meghan’s
living room wall. Meghan had purchased it for $1 million, but it was worth $2.5 million when
destroyed. Meghan sues Mel, and she receives $2.5 million from him in settlement of her claim.
While $1 million is tax-free basis recovery, the remaining $1.5 million is newly realized wealth
for Meghan, which she must include in her Gross Income. 21
What tax consequences arise if we move our inquiry from damaged tangible property to
damaged human capital—a damaged body or mind? Mel injures Meghan by hitting her with his
car. She sues him for her physical injuries in tort, settling for $500,000 in compensatory damages,
such as lost past and future wages and pain and suffering. Meghan has no basis in her body,
representing previously taxed dollars. Nevertheless, in the early days of the income tax, the lumpsum award received on account of personal injuries was thought by some to be a tax-free “capital”
receipt rather than an “income” receipt, though early authorities were inconsistent on this point.
Excerpt from Murphy and the Evolution of “Basis” 22
Deborah A. Geier
20

Indeed, Meghan suffered a $12,000 § 1001 loss when she recovered only $8,000 of her $20,000 basis in the car.
The loss is a nondeductible personal loss, however, under § 165(c)(3).
21
Can Meghan elect nonrecognition under § 1033? Recall from Chapter 12 how strictly the standard “similar or related
in service or use” is interpreted, perhaps making it difficult for her to find eligible replacement property.
22
113 TAX NOTES 576 (2006). Reprinted with permission of Tax Analysts.

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In the modern use of the term, “capital” (when it is used in connection with the income tax) is
synonymous with “basis.” Thus, a return of capital means a (tax-free) recovery of basis. In the
early days of the income tax, however, basis (or capital) was not well understood as having the
core function of being a running record of previously taxed dollars. Indeed, the term “income” had
no early tax meaning of its own. But the terms income and capital had developed meanings in the
worlds of business accounting and trust accounting, and some early tax authorities appeared to
borrow from these fields in trying to determine the meaning of income for purposes of the income
tax until it became apparent that the different purposes of these other fields ill served a tax purpose.
For example, trust accounting distinguished between “capital” receipts and “income” receipts.
A trust might provide that its income be distributed to Mary for life with remainder to John. Under
early trust accounting principles, a non-periodic lump sum contribution to the trust would be
considered “not income” to be distributed to Mary but rather a “capital” receipt that would be
invested (and which would eventually go to John) in order to produce future income (for
distribution to Mary). Moreover, if the trust purchased stock for $100, sold it for $150, and bought
new stock for $150, the $50 gain might not be considered income to be distributed to Mary but
rather might be considered capital to be invested to produce future income.
Notice that the role of the term income in those contexts had nothing to do with ensuring that
dollars were not twice taxed our doubly deducted or exempted from a tax. The trust principles
were simply a set of rules that determined who got what from the trust between the life estate and
remainder. It took time for the term income to evolve as a tax concept. Thus, basis (or capital) was
initially (and crudely) thought essentially to be synonymous with value—simply because
purchased property took a cost basis (as under current section 1012), which was essentially a basis
equal to value.
[A] 1918 Opinion of the Attorney General [19] and a subsequent Treasury Decision of the same
year [20] conclude[ed] that proceeds of an accident insurance policy were not income. I believe it
was this antiquated notion that basis meant the taxpayer’s fair market value in his or her body,
which could be recovered free of tax as a return of capital, that led to these early decisions. The
crucial language in the Attorney General Opinion provides:
[I]n a broad, natural sense the proceeds of the policy do but substitute, so far as they
go, capital which is the source of future periodical income. They merely take the place
of capital in human ability which was destroyed by the accident. They are therefore
“capital” as distinguished from “income” receipts.
Thus, the Opinion smacked strongly of the distinction between “capital” receipts and “income”
receipts that had developed in trust accounting. This non-periodic lump sum was like the trust
contribution that does not go to the life-estate recipient as “income” but rather is “capital” that will
be invested to produce future income (or will be distributed to the remainderman). The way to
capture this non-tax notion in the tax world was to conclude that it was a tax-free return of
“capital,” where the taxpayer’s body was the capital, and its basis was fair market value,
determined by the damage award itself. [21] In short, the notion of “tax-free return of capital” was
[19]

31 Op. Att’y Gen. 304, 308 (1918).
T.D. 2747, 20 Treas. Dec. Int. Rev. 457 (1918).
[21]
The notion that personal injury damage awards were tax-free “capital” receipts was not uniform, however. [T]here
were other authorities in this early time period concluding that personal injury damages were, indeed, includable in
Gross Income. See …T.D. 2135, 17 Treas. Dec. 39, 42 (1915) and T.D. 2570, 19 Treas. Dec. 321, 323 (1917)).
[20]

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not yet well understood to mean a return of previously taxed dollars.
Similarly, under these early notions pertaining to capital receipts and basis, property received
as a gift (and excluded under the predecessor to section 102) was permitted to take a “cost” basis
under the predecessor to section 1012 equal to fair market value. Propertied families realized that
periodically making inter vivos gifts of appreciated property among family members resulted in a
fresh, fair-market-value basis to the recipient upon each gift, even though the transfer was not a
realization event to the transferor. This allowed the recipient to sell the gifted property at no gain
(or at a gain equal only to the appreciation occurring since the gift)….
Congress began to appreciate that basis or capital as a tax term of art (as opposed to its meaning
in trust or business accounting) must reflect only dollars that have already been taxed. It thus
enacted the predecessor to section 1015 in 1921, which generally requires a carryover basis
(previously taxed dollars) to the recipient when appreciated property is transferred as an inter vivos
gift, not a fair market value basis. It wasn’t long before a taxpayer argued that Congress’s
enactment was unconstitutional under the 16th Amendment in that it deprived the recipient of a fair
market value basis in the “capital” receipt. In Taft v. Bowers, [22] however, the Supreme Court
upheld the constitutionality of the new basis rule that allowed basis to reflect only previously taxed
dollars, notwithstanding prior practice.
The taxpayer’s counsel specifically made the argument that the receipt of the gift was a “capital”
receipt that must, under the Constitution, take a fair market value basis to prevent any part of the
value from creating gain (and thus income) when converted to cash:
[U]ntil the Revenue Act of 1921 became effective, the Department laid down the rule
that gain on the sale of property acquired by gift could be computed only by taking
into consideration the value of the gift when it was acquired. This was an express
recognition by the Treasury Department that a gift is a capital transaction … and that
the donee can have “gain” only to the extent that the proceeds in his hands exceed the
value of his capital at the time of acquisition. [23]
And later:
[T]he corpus of the gift is capital in the hands of the donee at the time of its receipt.
But the mere conversion of such capital into money does not constitute income…. An
amount sufficient to restore the capital value that existed at the commencement of the
taxing period must be withdrawn from the gross proceeds in order to determine
whether there has been a gain or loss, and the amount of the gain, if any. [24]
But the Court upheld the constitutionality of the new basis rule, notwithstanding that it was
inconsistent with early notions of “income” and “capital” that were borrowed from business and
trust accounting. The term capital was permitted to evolve as a tax concept that protected tax
values. The new rule meant that capital meant basis, and a tax-free return of capital meant only a
tax-free return of basis where basis meant previously taxed dollars. Thus, the 16th Amendment
does not require that basis must equal fair market value that can be recovered free of tax just
because it was commonly thought in 1913 that “capital” receipts could be received free of tax at a
time when capital did not necessarily mean previously taxed income. Rather, Congress is
[22]

278 U.S. 470 (1929).
Id. at 471-72 (emphasis added).
[24]
Id. at 476 (emphasis added).
[23]

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empowered to change the basis rule to ensure that it reflects only previously taxed income; the 16th
Amendment is no bar.
___________________________________
The early (though inconsistent) rulings concluding that personal injury awards perhaps did not
constitute Gross Income led to the enactment of the predecessor to § 104(a)(2) in 1918, which
provided explicit statutory authority to exclude awards received “on account of personal injuries
or sickness.” This statutory exclusion was a sleepy little provision garnering little attention prior
to 1955 because, even absent the statutory exclusion, the scope of the Gross Income residual clause
was itself interpreted narrowly under Eisner v. Macomber. 23 As described in Chapter 6, Eisner v.
Macomber interpreted the residual clause to reach a receipt only if it could be traced back to labor,
capital, or both combined. A personal injury award is not a return for services rendered (labor) or
on invested capital (such as interest, rent, a royalty, or a capital gain on the sale of an asset). In
other words, even in the absence of the § 104(a)(2) predecessor, personal injury awards were often
not considered Gross Income in the first place under the § 61(a) residual clause.
All that changed in 1955, however, when Glenshaw Glass 24 was decided. As recounted in
Chapter 6, Glenshaw Glass replaced Macomber’s source-based interpretation of the scope of the
residual clause with one more consistent with SHS principles. Instead of asking whether the receipt
could be traced back to labor or capital, the Glenshaw Glass Court asked only whether the taxpayer
has been enriched by interpreting the residual clause to reach all accessions to wealth, clearly
realized, over which the taxpayer has complete dominion. With no basis in one’s body, the injured
party receiving a personal injury award after 1955 would include it in Gross Income—unless the
newly important § 104(a)(2) statutory exclusion applied. Suddenly, litigation exploded as courts
attempted to define the term “personal injuries or sickness.”
Under a now-withdrawn Treasury Regulation, an injury was determined to be “personal” if the
cause of action sounded in tort rather than in contract. Many modern causes of action, however,
are created by statute, with no prior history in either contract or tort law, such as personal causes
of action under the Civil Rights Act pertaining to race and sex discrimination, under the Age
Discrimination in Employment Act, under the Fair Labor Standards Act, under state and Federal
whistleblower statutes, under § 1983 pertaining to suits against state government employees and
others acting “under color of state law” for civil rights violations, etc. The authorities were
divergent and difficult to reconcile. The Supreme Court granted certiorari in 1992 in United States
v. Burke, 25 a sex discrimination suit under the Civil Rights Act, in an attempt to bring order to the
analysis and held that a statutory cause of action sounds in tort (and thus can generate excludable
damages under § 104(a)(2)) only if the statutory remedies are broad, as in common tort actions.
Because only back pay could be awarded in Ms. Burke’s statutory suit, the Court concluded it did
not sound in tort, which meant that § 104(a)(2) exclusion was not available.
The Supreme Court heard two more § 104(a)(2) cases in short order. In Commissioner v.
Schleier, 26 the Court held that the liquidated damages available under the Age Discrimination in
Employment Act were not sufficiently broad to be categorized as sounding in tort. The Court held
in O’Gilvie v. United States 27 that punitive damages could not be excluded even in a case sounding
23

252 U.S. 189 (1920).
348 U.S. 426 (1955).
25
504 U.S. 229 (1992).
26
515 U.S. 323. (1995).
27
519 U.S. 79 (1996).
24

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in tort because they were not awarded “on account of” the personal injury within the meaning of
§ 104(a)(2) but, rather, “on account of” the tortfeasor’s egregious conduct.
Finally, Congress acted in 1996, amending § 104(a)(2) in two significant ways. First, it codified
O’Gilvie by inserting the parenthetical “other than punitive damages.” Second, it inserted the word
“physical” twice. Today, § 104(a)(2) provides authority to exclude personal injury damages only
if they are awarded on account of “personal physical injuries or physical sickness.” The legislative
history clarified the extent to which an injury could be considered physical. 28
The … bill provides that the exclusion from Gross Income only applies to damages
received on account of a personal physical injury or physical sickness. If an action has
its origin in a physical injury or physical sickness, then all damages (other than
punitive damages) that flow therefrom are treated as payments received on account of
physical injuries or physical sickness whether or not the recipient of the damages is
the injured party. For example, damages (other than punitive damages) received by an
individual on account of a claim for loss of consortium due to the physical injury or
physical sickness of such individual’s spouse are excludable from Gross Income. In
addition, damages (other than punitive damages) received on account of a claim of
wrongful death continue to be excludable from taxable income as under present law.
The … bill also specifically provides that emotional distress is not considered a
physical injury or physical sickness. [56] Thus, the exclusion from Gross Income does
not apply to any damages received (other than for medical expenses as discussed
below) based on a claim of employment discrimination or injury to reputation
accompanied by a claim of emotional distress. Because all damages received on
account of physical injury or physical sickness are excludable from Gross Income, the
exclusion from Gross Income applies to any damages received based on a claim of
emotional distress that is attributable to a physical injury or physical sickness. In
addition, the exclusion from Gross Income specifically applies to the amount of
damages received that is not in excess of the amount paid for medical care attributable
to emotional distress.
The matters described in the second quoted paragraph are found in the last two sentences in §
104 (in the paragraph appearing after subsection (5)), which you should read now. 29 For example,
Marta files suit alleging sex discrimination because of a hostile work environment. Marta’s
treatment by her employer is so distressing that she seeks psychological counseling to deal with
the emotional distress that she experiences, for which she owes $10,000 in treatment costs. When
she settles for compensatory damages of $500,000 in the same year, no portion would be
excludable absent the last two sentences of § 104 because her injury was not a physical one.
Nevertheless, she can exclude the $10,000 that pays for her emotional distress counseling costs
because they would qualify for deduction under § 213 as medical expenses. This provision was
not in the original bill but rather was added only by the conference committee—likely because no
part of the $10,000 would exceed the steep 7.5% floor found in § 213(a) (discussed in the next
chapter) for deduction in light of the substantial damage award itself.

28

H.R. CONF. NO. 104-737, at 300 (1996).
It is intended that the term emotional distress includes symptoms (e.g., insomnia, headaches, stomach disorders)
which may result from such emotional distress.
29
See also Treas. Reg. § 1.104-1(c)(1).
[56]

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Moreover, new Treas. Reg. § 1.104-1(c)(2) confirms that whether the cause of action sounds in
tort is now irrelevant, as is the scope of remedies, effectively interring the Supreme Court’s
analysis in Burke and Schleier.
Finally, in Revenue Ruling 98-37 30 the IRS withdrew Revenue Ruling 74-77 31 as obsolete. The
withdrawn ruling had previously concluded that amounts received as damages for alienation of
affection or for surrender of custody of a child were not includable in Gross Income.
§ 104(a)(2) as tax expenditure
As a cash receipt that does not represent basis recovery, personal injury awards would be
includable under a pure SHS income tax. What justifies the § 104(a)(2) exclusion under the costbenefit policy analysis relevant to a tax expenditure (described in Part A.)? After all, a taxpayer
who is physically injured by an uninsured party (and who receives no compensation for her
injuries) cannot deduct her lost past and future wages because (as discussed in Chapter 10) the
taxpayer has no basis to deduct in failed expectations to obtain income. Deduction of dollars that
were never included in Gross Income would provide a double tax benefit (exclusion and deduction)
of the same dollars to the same taxpayer, violating fundamental precept (2), described in Chapter
1, Part A. In contrast, an injured taxpayer who receives compensation for those same lost past and
future wages is treated more favorably if she can exclude the damages under § 104(a)(2).
Who really benefits from the § 104(a)(2) exclusion? Recall the discussion of capture in Part A.
of this chapter. Assume that (1) all personal injury awards were includable in Gross Income, (2)
the jury is instructed of this fact, (3) an injured plaintiff produces evidence establishing that his net
(after-tax) pay from lost past and future wages would have been, absent the injury, $500,000, and
(4) the jury is instructed that any award will be taxed at an effective rate of 30% (with income
straddling several brackets). How much would the jury presumably award to make the plaintiff
whole? An award of $714,285 would make the victim whole with $500,000 in hand after paying
a 30% tax of $214,285. How much will the jury award if it is informed that the taxpayer is
permitted to exclude 100% of these compensatory damages? In light of your answers, is current §
104(a)(2) consistent with tort policy? The same tax consequences will also shape settlement
discussions with the tortfeasor, as the vast majority of cases are never tried before a jury but rather
settled. You are probably not surprised to learn that business interests lobbied against the 1996
narrowing of the § 104(a)(2) exclusion, as the narrowing effectively increased settlement costs for
defendants in non-physical (but personal) injury cases.
If § 104(a)(2) treats compensated injured parties more favorably for tax purposes (excluded
income) than uncompensated injured parties (denied deductions), and if it benefits tortfeasors more
than plaintiffs (who could be made whole regardless of whether or not the damages are includable
by a gross-up in the damage amount), why does the § 104(a)(2) exclusion persist? Its most usual
rationale was stated memorably by Professor Phillip D. Oliver: 32
The real reason that section 104[(a)(2)] is part of the law—whatever the tax theorists
may say about it—is the idea that tort victims should be pitied rather than taxed. But
if society is being solicitous of folks who are injured, why pick the most fortunate
subset—injured folks who, unlike most victims of personal injury, receive monetary
30

1998-2 C.B. 182.
1974-1 C.B. 33.
32
Professor Oliver wrote these words in a discussion over Taxprof, a listserve for tax law professors over which we
ramble on about all sorts of tax issues. E-mail on file with author.
31

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compensation? And, given the vagaries of the tort system ... why give the biggest tax
benefit to the most fortunate sub-subset, those who are fortunate enough both to be
injured by a deep pocket and to be able to convince a jury to award massive damages?
... Repeal of 104[(a)(2)] would merely recognize that compensated victims are better
off than uncompensated victims. They are also better off than the still larger
contingency of people who suffer as a result of natural causes, but are unable to sue
God.
Even though repeal could hurt tortfeasors more than their injured victims, the optics look bad to
the general public not familiar, as you now are, with deeper policy analysis.
Determining the excludable amount: deducted medical costs, structured settlements,
prejudgment interest, and punitive damages
Suppose that (1) Mel physically injures Meghan in Year 1, (2) she incurs and pays $12,000 of
uninsured medical expenses in Year 1 because of her injuries, (3) she is able to deduct only $2,000
of this amount under § 213 (examined in the next chapter), equal to the portion of the $12,000
exceeding the § 213 AGI floor, and (4) Meghan receives a $200,000 settlement in Year 3. This
award reflects, in part, a reimbursement of the $12,000 Year-1 medical expenses.
Because Meghan’s injury is a physical one, § 104(a)(2) authorizes her exclusion of
compensatory (but not punitive) damages. She is not, however, entitled to enjoy a double tax
benefit—both deduction and exclusion—of the same dollars. The introductory language in §
104(a) before paragraph (1) requires that Meghan include the first $2,000 of her award. 33 Even
though Meghan must include $2,000 in Year 3, do not lose sight of the fact that she still is
effectively not taxed on this amount; the tax benefit simply took place in the earlier year through
the vehicle of her medical expense deduction. For example, if both Meghan’s payment of medical
expenses and her receipt of the settlement had occurred in the same taxable year (rather than in
different taxable years), Meghan would have been denied a medical expense deduction under §
213(a) because her expenses would have been “compensated for by insurance or otherwise.”
(Emphasis added.) Because she would have been denied a medical expense deduction, she would
fully exclude under § 104(a)(2) the compensatory damages received in the same taxable year.
Returning to our original facts, where Meghan deducted $2,000 of her medical expenses in Year
1 and received a $200,000 damage award in Year 3, she would be able to exclude all but the first
$2,000 from Gross Income, assuming that no part of the award constitutes punitive damages (or
prejudgment interest, mentioned below). If Meghan invests the lump sum and earns 2% interest
equal to $4,000 each year, the $4,000 interest is not excludable under § 104(a)(2); rather, the
interest return on her investment is included under § 61(a)(4). Suppose, however, that Meghan and
Mel agree that he will not pay the $200,000 to Meghan but rather will purchase an annuity for
$200,000 that he will continue to own but that will pay to Meghan—as the annuity beneficiary—
approximately $2,000 each month for the next 10 years. Over this period, Meghan will effectively
receive under the annuity contract not only the original $200,000 annuity purchase price but also
a 2% return (the same 2% return described above). On these changed facts, Meghan can exclude
the entire amount received each month (after including the first $2,000, equal to the previously
deducted medical expenses)—even to the extent of the implicit interest component. Her exclusion
authority is the phrase “whether as lump sums or as periodic payments” in § 104(a)(2).
33

See Rev. Rul. 75-230, 1975-1 C.B. 93 (requiring allocation of an award first to previously deducted medical
expenses).

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This arrangement is called a structured settlement and, because of the ability to essentially
transform an includable investment return (if Meghan invested the $200,000 herself) into an
excludable investment return, structured settlements are quite common in the case of physical
injury awards. Meghan and Mel must be careful, however, to ensure that Mel (or Mel’s insurance
company) is the annuity owner, with Meghan’s only rights limited to being the payee-beneficiary
under the annuity. If Mel purchases the annuity but transfers outright ownership of it to Meghan,
she must include the annuity investment return, as she would be considered to be in constructive
receipt of the $200,000 amount, which she then used to purchase the annuity. 34
As the plaintiffs in Jarndyce v. Jarndyce can tell you, 35 lawsuits can take many years before
being reduced to judgment. In addition to any damages, prejudgment interest may be added to the
award to compensate the plaintiff for the time value of money between the time of the injury and
the time reduced to judgment. The Tax Court and various Circuit Courts of Appeal have held that
prejudgment interest is includable in Gross Income under § 61(a)(4) and not excludable as part of
the damage award under § 104(a)(2) because the amount is received “on account of” the delay in
payment and not “on account of” the injuries within the meaning of § 104(a)(2). 36
Finally, how do we know whether any of the $200,000 that Mel pays to Meghan constitutes
includable punitive damages under the first parenthetical in § 104(a)(2)? If no punitive damages
are requested in the original complaint, the issue is resolved easily, as it is if punitive damages are
requested, the matter goes to a jury, and the jury explicitly awards (or fails to award) punitive
damages. In the case in which punitive damages are requested in the plaintiff’s complaint but the
suit is settled without trial, the matter is more ambiguous. As you can imagine, the parties would
rarely recite in their settlement agreement that any amount is allocable to punitive damages. If they
did, the physically injured plaintiff would thereby acknowledge that this portion of the damage
award is includable in Gross Income, and the tortfeasor would thereby admit to conduct so
egregious as to deserve a punitive damage payment. If the settlement agreement is silent, the IRS
may be successful in allocating the same percentage of the aggregate settlement payment to
punitive damages as the plaintiff requested in her original complaint, which means that plaintiff
lawyers should be aware of this possibility when drafting the complaint (and should avoid silence
in the settlement agreement on this issue). If a plaintiff requests in his complaint $1 million in
compensatory damages for a physical injury and $2 million in punitive damages (twice the amount
of compensatory damages), a settlement for, say, $600,000 that fails to state the nature of the
settlement may be held to consist of $200,000 of compensatory damages and $400,000 of punitive
damages in any later tax litigation. 37 At bottom, it is a factual issue in the later tax litigation.
In Bagely v. Commissioner, 38 for example, a jury awarded to the plaintiff $1 million in
compensatory damages and $1.725 million in punitive damages. After a motion for a new trial
made by the defendant was granted, the parties settled for $1.5 million in damages, and the
settlement agreement specifically stated that none of the $1.5 million constituted punitive
34

See Rev. Rul. 79-220, 1979-2 C.B. 74. Students interested in reading about an example of such an arrangement can
take a sneak preview of the Ford Motor Company case in Chapter 21, Part B., infra, which considers the timing of the
tortfeasor’s business expense deductions for the settlement payments.
35
See CHARLES DICKENS, BLEAK HOUSE (1853).
36
See, e.g., Kovacs v. Comm’r, 100 T.C. 124 (1993); Chamberlain v. U.S., 401 F.3d 335 (5th Cir. 2005); Francisco v.
U.S., 267 F.3d 303 (3d Cir. 2001); Rozpad v. Comm’r, 154 F.3d 1 (1st Cir. 1998); Brabson v. U.S., 73 F.3d 1040 (10th
Cir. 1996).
37
See, e.g., Rev. Rul.. 85-98, 1985-2 C.B. 51.
38
121 F.3d 393 (8th Cir. 1997).

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damages. In the subsequent tax litigation, the Tax Court reasoned that the settlement included the
entire $1 million that the previous jury found was owed in compensatory damages and concluded
that the remaining $500,000 of the $1.5 million settlement should be allocated to punitive damages.
The Eighth Circuit Court of Appeals upheld the Tax Court’s factual determination.
In the more usual case in which a settlement is reached without a jury’s opinion regarding
whether punitive damages are warranted under the particular facts at issue, the parties’ agreement
that the settlement consists exclusively of compensatory damages will not likely be disturbed in
later tax litigation absent unreasonableness of the allocation on its face. For example, assume that
plaintiff’s physical injury is minor but the tortfeasor’s behavior that caused the injury is
particularly outrageous, causing the plaintiff to request nominal compensatory damages (say,
$10,000) but large punitive damages (say, $10 million). A settlement for $2 million that recites
that the entire amount comprises compensatory damages would be considered unreasonable on its
face in tax litigation challenging 100% exclusion.
The treatment of attorney fees
You learned in Chapters 2 and 15 that interest incurred on a loan used to buy § 103 bonds
(which earn tax-exempt interest) is not deductible—even if the taxpayer has sufficient includable
investment income from other sources to otherwise allow the deduction under § 163(d)—because
both excluding the return and deducting the costs of earning that return would produce a double
tax benefit for the same dollars. Review § 256(a)(2). You also learned in Chapter 1, however, that
the costs incurred to produce an includable return must reduce the tax base to ensure that the same
dollars are not taxed twice to the same taxpayer. Sometimes this value is honored by allowing
expense deductions in reducing Gross Income (or AGI) to Taxable Income. Sometimes, however,
basis can offset a receipt so that only the net wealth accession enters § 61 Gross Income in the first
place. For example, if Marcy purchases Blackacre for $100 (a nondeductible capital expenditure
creating a $100 basis) and later sells it for $150, only $50 of the $150 is includable in Gross Income
under §§ 1001(a) and 61(a)(3). Marcy is permitted to use her basis as an offset in determining §
61 Gross Income in the first place because her $100 outlay on purchasing Blackacre is so clearly
and intimately associated solely with the receipt of the later Blackacre sales proceeds.
In the case of expense outlays, in contrast, the relationship between any particular cost and any
particular cash receipt is often much more ambiguous, so Congress adopted the deduction
mechanism (as opposed to the basis offset mechanism) to avoid doubly taxing the same dollars to
the same taxpayer. The netting does not occur at the Gross Income stage under § 61 (as it did with
respect to Blackacre and its basis) but rather later in the process of reaching Taxable Income. In
Chapter 1, for example, John was a dentist who paid salary to his dental assistant. Rather than
attempting to tie the dental assistant’s salary cost to any particular patient’s bill payment, offsetting
the salary outlay against the revenue received from the patient and including only the net
difference, John must include the entire amount received from the patient in his § 61 Gross Income
and then later in the calculation process deduct the salary paid to his dental assistant under § 162
in reaching Taxable Income. (Note, by the way, that John’s analysis is unaffected by whether the
dental assistant must include the salary that she receives from John in her own § 61 Gross Income
under § 61(a)(1)). Because John is not an employee of another, his § 162 expense deductions are
taken above the line under § 62(a)(1)(A), ensuring that every dollar of his dental assistant’s salary
expense will, in fact, reduce his Taxable Income.
On the other hand, John may have some deductions that are not only Itemized Deductions
(because not listed in § 62) but also MIDs (because also not listed in § 67(b)). For example, perhaps
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John pays $100 each year to rent a safety deposit box to hold rare gold coins that John holds for
investment purposes. While the $100 would be deductible under § 212(2) as an expense incurred
“for the management, conservation, or maintenance of property held for the production of
income,” this § 212 deduction is not listed in § 62 and so is an Itemized Deduction. Moreover, it
would also be a § 67 MID (because § 212 is not listed in § 67(b)), which is100% nondeductible
after the TCJA. See § 67(g). Even before the TCJA, MIDs were completely nondeductible for
purposes of the Alternative Minimum Tax (AMT) under § 56(b)(1)(A)(i). Review Chapter 1, Part
B., if this analysis sounds unfamiliar to you.
Are attorney fees attributable to an includable damage award (an award that is not excludable
under § 104(a)(2)) expenses, or do they create basis, which offsets that award in determining § 61
Gross Income? If the former, the plaintiff would fully include the damage award in § 61 Gross
Income—encompassing the portion paid to the attorney as well as the profit portion—just as John
fully included the amounts received from his patients, encompassing the portion paid to his dental
assistant as well as his profit portion. Then the plaintiff would deduct the attorney fees, to the
extent allowable, as an expense—just as John deducted his dental assistant’s salary—under either
§ 162(a) (if incurred in connection with the plaintiff’s business) or § 212(1) (if the suit is
unconnected to the plaintiff’s business). If, however, this § 212(1) deduction or § 162 deduction
(as the case may be) is a MID, it is nondeductible after the TCJA under § 67(g).
Even before the TCJA rendered MIDs wholly nondeductible under the regular income tax,
plaintiffs with includable damage awards who were subject to the AMT (which has long
disallowed deduction of all MIDs) began to argue that the portion of awards paid to their attorney
was not includable in their § 61 Gross Incomes in the first place. Our dentist John cannot argue
that he need not include a patient’s payment in his § 61 Gross Income just because he used the
receipt to pay his (deductible) dental assistant’s salary, however. Are plaintiffs paying attorney
fees on a different footing?
In Commissioner v. Banks, 39 the taxpayer sued his former employer for employment
discrimination under the Civil Rights Act after being dismissed from his job. The parties settled
for a total of $464,000. Of that amount, $150,000 was paid to Mr. Banks’s attorney under a
contingent fee arrangement. Because the injuries complained of were not physical, Mr. Banks
could not exclude any portion of the award under § 104(a)(2). Mr. Banks was also subject to the
AMT for the year, which meant that—if those fees must be treated as expenses—his expense
deduction was disallowed under the AMT under § 56(b)(1)(A)(i). To avoid deduction
disallowance, Mr. Banks netted the attorney fee against the gross award and included in Gross
Income only the $314,000 net amount.
Mr. Banks made several arguments for the proposition that the portion of the award paid to his
attorney was not includable in his Gross Income in the first place, but the Supreme Court rejected
them all. For example, the Court rejected the argument that state attorney lien laws effectively
assigned the award to the attorney to the extent of his fees. The Court responded that state attorney
lien statutes merely provide attorneys with a security interest in their clients’ awards in order to
ensure prompt payment of their fees. The Court also rejected the argument that the fee arrangement
resulted in a successful assignment of income under the assignment-of-income doctrine generally.
Citing Lucas v. Earl and Horst, among other cases that you studied in Chapter 8, the Court
concluded that Mr. Banks “cannot exclude an economic gain from Gross Income by assigning the
39

543 U.S. 426 (2005).

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gain in advance to another party.” At bottom, the Court concluded that Mr. Banks merely paid his
attorney for services rendered from his (100% includable) damage award, just as our dentist John
paid his dental assistant for services rendered from his (100% includable) patient receipts. In short,
if these costs are categorized as expenses, neither Mr. Banks nor John can net together the inflow
and outflow and include only the net profit in Gross Income in the first place.
But is Mr. Banks and our dentist John really in the same position in view of Mr. Banks’s
deduction denial? After all, John can clearly fully deduct his dental assistant salary under § 162
(above the line under § 62) without limit. As a matter of SHS income tax theory, denying deduction
(or a basis offset) with respect to Mr. Banks’s costs, which directly produced includable Gross
Income, is clearly wrong, just as it would be wrong to deny our dentist John an expense deduction
for his dental assistant’s salary or to deny a basis offset on a sale of Blackacre. In each case, the
taxpayer is doubly taxed on the same dollars if the gross proceeds are fully included in the tax base
without an explicit deduction (or basis offset) that reduces the amount taxed to a net profit.
Congress could have cured this problem in several ways. If the costs must be considered
expenses, Congress could have either made all such expense deductions above the line under § 62
or, if they must be itemized, amended § 67 to remove them from MID status to that they could be
deducted by those who itemize deductions.
There is another way to think about this issue, however. An alternative analysis would
categorize these attorney fees as capital expenditures that create basis in the (hoped-for) damage
award, rather than as current expenses. Review Treas. Reg. § 1.263(a)-4(e), for example, which
requires certain transaction costs to be capitalized rather than treated as expenses. Similarly, as
you will learn in Chapter 18, bets placed in a gambling casino create basis, which can offset
gambling winnings in measuring Gross Income; they are not treated as expenses under § 212. If
attorney fees are capitalized, the basis would then offset the gross award at the Gross Income stage,
with only the excess included in § 61 Gross Income.
Because the outlay for attorney fees incurred because of a single litigated case is so closely and
intimately linked to that particular hoped-for receipt, this argument is entirely persuasive, in my
view. These costs are unlike those incurred by John for his dental assistant’s salary, where the
connection between any particular patient’s payment and the dental assistant’s salary is arbitrary,
making the expense route (rather than the basis offset route) the only administratively feasible one.
These attorney fees are more like the placed bets in a gambling casino, which create basis that can
offset gambling winnings.
Unfortunately, this capital expenditure argument was not developed at the trial or Court of
Appeals stage in Banks but rather was made in amicus briefs for the first time only at the Supreme
Court level, which is why the Court declined to consider it. It did not reject the argument on its
merits, however. It said only: “These arguments, it appears, are being presented for the first time
to this Court. We are especially reluctant to entertain novel propositions of law with broad
implications for the tax system that were not advanced in earlier stages of the litigation and not
examined by the Courts of Appeals. We decline comment on these supplementary theories.” 40
Could a lower court adopt this reasoning in a newly litigated case where the basis argument is
well developed? Or did Congress implicitly conclude that these outlays are expenses rather than
capital expenditures creating basis as a matter of law when it amended § 62 by adding subsections
(a)(20) and (e)? We have seen this negative inference issue—a common problem in statutory
40

Banks, 543 U.S. at 438.

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interpretation—many times before in this course.
Sections 62(a)(20) and (e) were adopted before the Supreme Court’s decision in Banks, but
those provisions did not apply to Banks because the transaction pre-dated the amendments, which
were effective prospectively only. But the Supreme Court described this development in its
opinion, which means that it knew that Congress made some attorney fees deductible above the
line (if they are categorized as expenses), and yet the Court did not reject the amicus brief’s basisoffset argument on the merits by concluding that, even though raised late procedurally, Congress
has indicated its intent that all attorney fees are necessarily expenses rather than capital
expenditures, as evidenced by then-new §§ 62(a)(20) and (e). For this reason, the capital
expenditure argument under Treas. Reg. § 1.263(a)-4(e) (and by analogy to gambling bets) remains
a possibility for taxpayers to argue in new litigation that develops the argument at the trial level.
With § 67(g) now suspending all MIDs, making this issue more important than ever, perhaps
some taxpayer will now take up the argument in a case not described in § 62(e), which is the only
context where the distinction between treating these fees as capital expenditures rather than
expenses makes a practical difference.
An initial consideration in determining the tax consequences of settlement proceeds is to
determine the nature of the claim for which the settlement proceeds are received. In Amos, below,
the court decided that the settlement was only partly received on account of the physical injury
claim. What was the nature of the remaining payment? And how does the court allocate the
settlement amount between these two components?
AMOS v. COMMISSIONER
T.C. Memo. 2003-329
CHIECHI, JUDGE: Respondent determined a deficiency of $61,668 in petitioner’s Federal income
tax (tax) for 1997.
The only issue remaining for decision is whether the $200,000 settlement amount that petitioner
received in 1997 in settlement of a claim is excludable under section 104(a)(2) from petitioner’s
Gross Income for that year. We hold that $120,000 is excludable and that $80,000 is not.
FINDINGS OF FACT
During 1997, petitioner was employed as a television cameraman. In that capacity, on January
15, 1997, petitioner was operating a handheld camera during a basketball game between the
Minnesota Timberwolves and the Chicago Bulls. At some point during that game, Dennis Keith
Rodman (Mr. Rodman), who was playing for the Chicago Bulls, landed on a group of
photographers, including petitioner, and twisted his ankle. Mr. Rodman then kicked petitioner.
(We shall refer to the foregoing incident involving Mr. Rodman and petitioner as the incident.)
On January 15, 1997, shortly after the incident, petitioner was taken by ambulance for treatment
at Hennepin County Medical Center. Petitioner informed the medical personnel at that medical
center (Hennepin County medical personnel) that he had experienced shooting pain to his neck
immediately after having been kicked in the groin, but that such pain was subsiding. The Hennepin
County medical personnel observed that petitioner was able to walk, but that he was limping and
complained of experiencing pain. The Hennepin County medical personnel did not observe any
other obvious signs of trauma. Petitioner informed the Hennepin County medical personnel that
he was currently taking pain medication for a preexisting back condition. The Hennepin County
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medical personnel offered additional pain medications to petitioner, but he refused those
medications. After a dispute with the Hennepin County medical personnel concerning an unrelated
medical issue, petitioner left Hennepin County Medical Center without having been discharged by
them.
While petitioner was seeking treatment at Hennepin County Medical Center, he contacted Gale
Pearson (Ms. Pearson) about representing him with respect to the incident. Ms. Pearson was an
attorney who had experience in representing plaintiffs in personal injury lawsuits. After subsequent
conversations and a meeting with petitioner, Ms. Pearson agreed to represent him with respect to
the incident.
On January 15, 1997, after the incident and petitioner’s visit to the Hennepin County Medical
Center, petitioner filed a report (police report) with the Minneapolis Police Department. In the
police report, petitioner claimed that Mr. Rodman had assaulted him.
On January 16, 1997, petitioner sought medical treatment at the Veterans Affairs (VA) Medical
Center. The medical personnel at that medical center (VA medical personnel) took X-rays of
petitioner’s back. Petitioner complained to the VA medical personnel about his groin area, but he
did not advise them that he was experiencing any symptoms related to that complaint. The VA
medical personnel determined that there was no swelling of, but they were unable to ascertain
whether there was bruising around, petitioner’s groin area. The VA medical personnel gave
petitioner some pain medication and told him to continue taking his other prescribed medications.
The VA medical personnel prepared a report regarding petitioner’s January 16, 1997 visit to the
VA Medical Center. That report indicated that, except for certain disk problems that petitioner had
since at least as early as February 14, 1995, “the vertebrae are intact and the remaining disk spaces
are normal.”
Very shortly after the incident on a date not disclosed by the record, Andrew Luger (Mr. Luger),
an attorney representing Mr. Rodman with respect to the incident, contacted Ms. Pearson. Several
discussions and a few meetings took place between Ms. Pearson and Mr. Luger. Petitioner
accompanied Ms. Pearson to one of the meetings between her and Mr. Luger, at which time Mr.
Luger noticed that petitioner was limping. Shortly after those discussions and meetings, petitioner
and Mr. Rodman reached a settlement.
On January 21, 1997, Mr. Rodman and petitioner executed a document entitled
“CONFIDENTIAL SETTLEMENT AGREEMENT AND RELEASE” (settlement agreement).
The settlement agreement provided in pertinent part:
For and in consideration of TWO HUNDRED THOUSAND DOLLARS ($200,000),
the mutual waiver of costs, attorneys’ fees and legal expenses, if any, and other good
and valuable consideration, the receipt and sufficiency of which is hereby
acknowledged, Eugene Amos [petitioner], on behalf of himself, his agents,
representatives, attorneys, assignees, heirs, executors and administrators, hereby
releases and forever discharges Dennis Rodman, the Chicago Bulls, the National
Basketball Association and all other persons, firms and corporations together with
their subsidiaries, divisions and affiliates, past and present officers, directors,
employees, insurers, agents, personal representatives and legal counsel, from any and
all claims and causes of action of any type, known and unknown, upon and by reason
of any damage, loss or injury which heretofore have been or heretoafter may be
sustained by Amos arising, or which could have arisen, out of or in connection with

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an incident occurring between Rodman and Amos at a game between the Chicago
Bulls and the Minnesota Timberwolves on January 15, 1997 during which Rodman
allegedly kicked Amos (“the Incident”), including but not limited to any statements
made after the Incident or subsequent conduct relating to the Incident by Amos,
Rodman, the Chicago Bulls, the National Basketball Association, or any other person,
firm or corporation, or any of their subsidiaries, divisions, affiliates, officers, directors,
employees, insurers, agents, personal representatives and legal counsel. This
Agreement and Release includes, but is not limited to claims, demands, or actions
arising under the common law and under any state, Federal or local statute, ordinance,
regulation or order, including claims known or unknown at this time, concerning any
physical, mental or emotional injuries that may arise in the future allegedly resulting
from the Incident.
*
*
*
*
*
*
*
It is further understood and agreed that the payment of the sum described herein is not
to be construed as an admission of liability and is a compromise of a disputed claim.
It is further understood that part of the consideration for this Agreement and Release
includes an agreement that Rodman and Amos shall not at any time from the date of
this Agreement and Release forward disparage or defame each other. It is further
understood and agreed that, as part of the consideration for this Agreement and
Release, the terms of this Agreement and Release shall forever be kept confidential
and not released to any news media personnel or representatives thereof or to any other
person, entity, company, government agency, publication or judicial authority for any
reason whatsoever except to the extent necessary to report the sum paid to appropriate
taxing authorities or in response to any subpoena issued by a state or Federal
governmental agency or court of competent jurisdiction * * * Any court reviewing a
subpoena concerning this Agreement and Release should be aware that part of the
consideration for the Agreement and Release is the agreement of Amos and his
attorneys not to testify regarding the existence of the Agreement and Release or any
of its terms.
* * * * * * *
It is further understood and agreed that Amos and his representatives, agents, legal
counsel or other advisers shall not, from the date of this Agreement and Release,
disclose, disseminate, publicize or instigate or solicit any others to disclose,
disseminate or publicize, any of the allegations or facts relating to the Incident,
including but not limited to any allegations or facts or opinions relating to Amos’
potential claims against Rodman or any allegations, facts or opinions relating to
Rodman’s conduct on the night of January 15, 1997 or thereafter concerning Amos. In
this regard, Amos agrees not to make any further public statement relating to Rodman
or the Incident or to grant any interviews relating to Rodman or the Incident. * * *
It is further understood and agreed that any material breach by Amos or his attorney,
agent or representative of the terms of this Agreement and Release will result in
immediate and irreparable damage to Rodman, and that the extent of such damage
would be difficult, if not impossible, to ascertain. To discourage any breach of the
terms of this Agreement and Release, and to compensate Rodman should any such
breach occur, it is understood and agreed that Amos shall be liable for liquidated

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damages in the amount of TWO HUNDRED THOUSAND and No/100 Dollars
($200,000) in the event such a material breach occurs. Amos agrees that this sum
constitutes a reasonable calculation of the damages Rodman would incur due to a
material breach.
It is further understood and agreed, that, in the event Rodman or Amos claim a material
breach of this Agreement and Release has occurred, either party may schedule a
confidential hearing before an arbitrator of the American Arbitration Association for
a final, binding determination as to whether a material breach has occurred. If, after
the hearing, the arbitrator finds that Amos has committed a material breach, the
arbitrator shall order that Amos pay the sum of $200,000 in liquidated damages to
Rodman. * * *
Amos further represents, promises and agrees that no administrative charge or claim
or legal action of any kind has been asserted by him or on his behalf in any way relating
to the Incident with the exception of a statement given by Amos to the Minneapolis
Police Department. Amos further represents, promises and agrees that, as part of the
consideration for this Agreement and Release, he has communicated to the
Minneapolis Police Department that he does not wish to pursue a criminal charge
against Rodman, and that he has communicated that he will not cooperate in any
criminal investigation concerning the Incident.
Amos further represents, promises and agrees that he will not pursue any criminal
action against Rodman concerning the Incident, that he will not cooperate should any
such action or investigation ensue, and that he will not encourage, incite or solicit
others to pursue a criminal investigation or charge against Rodman concerning the
Incident.
Petitioner filed a tax return (return) for his taxable year 1997. In that return, petitioner excluded
from his Gross Income the $200,000 that he received from Mr. Rodman under the settlement
agreement. In the notice that respondent issued to petitioner with respect to 1997, respondent
determined that petitioner is not entitled to exclude from his Gross Income the settlement amount
at issue.
OPINION
We must determine whether the settlement amount at issue may be excluded from petitioner’s
Gross Income for 1997. Petitioner bears the burden of proving that the determination in the notice
to include the settlement amount at issue in petitioner’s Gross Income is erroneous. See Rule
142(a); Welch v. Helvering, 290 U.S. 111, 115, 78 L. Ed. 212, 54 S. Ct. 8 (1933).
Section 61(a) provides the following sweeping definition of the term “Gross Income”: “Except
as otherwise provided in this subtitle, Gross Income means all income from whatever source
derived.” Not only is section 61(a) broad in its scope, Commissioner v. Schleier, 515 U.S. 323,
328, 132 L. Ed. 2d 294, 115 S. Ct. 2159 (1995), exclusions from Gross Income must be narrowly
construed, id.; U.S. v. Burke, 504 U.S. 229, 248, 119 L. Ed. 2d 34, 112 S. Ct. 1867 (1992).
Section 104(a)(2) on which petitioner relies provides that Gross Income does not include:
(2) the amount of any damages (other than punitive damages) received (whether by
suit or agreement and whether as lump sums or as periodic payments) on account of
personal physical injuries or physical sickness;

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Where damages are received pursuant to a settlement agreement, such as is the case here, the
nature of the claim that was the actual basis for settlement controls whether such damages are
excludable under section 104(a)(2). U.S. v. Burke, supra at 237. The determination of the nature
of the claim is factual. Robinson v. Comm’r, 102 T.C. 116, 126 (1994), affd. in part, revd. in part,
and remanded on another issue 70 F.3d 34 (5th Cir. 1995); Seay v. Comm’r, 58 T.C. 32, 37 (1972).
Where there is a settlement agreement, that determination is usually made by reference to it. See
Knuckles v. Comm’r, 349 F.2d 610, 613 (10th Cir. 1965), affg. T.C. Memo. 1964-33. If the
settlement agreement lacks express language stating what the amount paid pursuant to that
agreement was to settle, the intent of the payor is critical to that determination. Knuckles v.
Comm’r, supra; see also Agar v. Comm’r, 290 F.2d 283, 284 (2d Cir. 1961), affg. per curiam T.C.
Memo. 1960-21. Although the belief of the payee is relevant to that inquiry, the character of the
settlement payment hinges ultimately on the dominant reason of the payor in making the payment.
Agar v. Comm’r, supra; Fono v. Comm’r, 79 T.C. 680, 696 (1982), affd. without published opinion
749 F.2d 37 (9th Cir. 1984). Whether the settlement payment is excludable from Gross Income
under section 104(a)(2) depends on the nature and character of the claim asserted, and not upon
the validity of that claim. See Bent v. Comm’r, 87 T.C. 236, 244 (1986), affd. 835 F.2d 67 (3d Cir.
1987); Glynn v. Comm’r, 76 T.C. 116, 119 (1981), affd. without published opinion 676 F.2d 682
(1st Cir. 1982); Seay v. Comm’r, supra.
The dispute between the parties in the instant case relates to how much of the settlement amount
at issue Mr. Rodman paid to petitioner on account of physical injuries. It is petitioner’s position
that the entire $200,000 settlement amount at issue is excludable from his Gross Income under
section 104(a)(2). In support of that position, petitioner contends that Mr. Rodman paid him the
entire amount on account of the physical injuries that he claimed he sustained as a result of the
incident.
Respondent counters that, except for a nominal amount (i.e., $1), the settlement amount at issue
is includable in petitioner’s Gross Income. In support of that position, respondent contends that
petitioner has failed to introduce any evidence regarding, and that Mr. Rodman was skeptical
about, the extent of petitioner’s physical injuries as a result of the incident. Consequently,
according to respondent, the Court should infer that petitioner’s physical injuries were minimal.
In further support of respondent’s position to include all but $1 of the settlement amount at issue
in petitioner’s Gross Income, respondent contends that, because the amount of any liquidated
damages (i.e., $200,000) payable by petitioner to Mr. Rodman under the settlement agreement was
equal to the settlement amount (i.e., $200,000) paid to petitioner under that agreement, Mr.
Rodman did not intend to pay the settlement amount at issue in order to compensate petitioner for
his physical injuries.
On the instant record, we reject respondent’s position. With respect to respondent’s contentions
that petitioner has failed to introduce evidence regarding, and that Mr. Rodman was skeptical
about, the extent of petitioner’s physical injuries as a result of the incident, those contentions
appear to ignore the well-established principle under section 104(a)(2) that it is the nature and
character of the claim settled, and not its validity, that determines whether the settlement payment
is excludable from Gross Income under section 104(a)(2). See Bent v. Comm’r, supra; Glynn v.
Comm’r, supra; Seay v. Comm’r, supra. In any event, we find below that the record establishes
that Mr. Rodman’s dominant reason in paying the settlement amount at issue was petitioner’s
claimed physical injuries as a result of the incident.
With respect to respondent’s contention that Mr. Rodman did not intend to pay the settlement

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amount at issue in order to compensate petitioner for his physical injuries because the amount of
liquidated damages (i.e., $200,000) payable by petitioner to Mr. Rodman under the settlement
agreement was equal to the settlement amount (i.e., $200,000) paid to petitioner under that
agreement, we do not find the amount of liquidated damages payable under the settlement
agreement to be determinative of the reason for which Mr. Rodman paid petitioner the settlement
amount at issue.
On the record before us, we find that Mr. Rodman’s dominant reason in paying the settlement
amount at issue was to compensate petitioner for his claimed physical injuries relating to the
incident. Our finding is supported by the settlement agreement, a declaration by Mr. Rodman (Mr.
Rodman’s declaration), and Ms. Pearson’s testimony.
The settlement agreement expressly provided that Mr. Rodman’s payment of the settlement
amount at issue
releases and forever discharges * * * [Mr.] Rodman * * * from any and all claims and
causes of action of any type, known and unknown, upon and by reason of any damage,
loss or injury * * * sustained by Amos [petitioner] arising, or which could have arisen,
out of or in connection with * * * [the incident].
Mr. Rodman stated in Mr. Rodman’s declaration that he entered into the settlement agreement
“to resolve any potential claims” and that the settlement agreement was intended to resolve
petitioner’s “claim without having to expend additional defense costs.” The only potential claims
of petitioner that are disclosed by the record are the potential claims that petitioner had for the
physical injuries that he claimed he sustained as a result of the incident. Furthermore, Ms. Pearson
testified that Mr. Rodman paid the entire settlement amount at issue to petitioner on account of his
physical injuries. As discussed below, Ms. Pearson’s testimony that Mr. Rodman paid that entire
amount on account of petitioner’s physical injuries is belied by the terms of the settlement
agreement. Nonetheless, her testimony supports our finding that Mr. Rodman’s dominant reason
in paying petitioner the settlement amount at issue was to compensate him for claimed physical
injuries relating to the incident.
We have found that Mr. Rodman’s dominant reason in paying petitioner the settlement amount
at issue was to compensate him for his claimed physical injuries relating to the incident. However,
the settlement agreement expressly provided that Mr. Rodman paid petitioner a portion of the
settlement amount at issue in return for petitioner’s agreement not to: (1) Defame Mr. Rodman,
(2) disclose the existence or the terms of the settlement agreement, (3) publicize facts relating to
the incident, or (4) assist in any criminal prosecution against Mr. Rodman with respect to the
incident (collectively, the nonphysical injury provisions).
The settlement agreement does not specify the portion of the settlement amount at issue that
Mr. Rodman paid petitioner on account of his claimed physical injuries and the portion of such
amount that Mr. Rodman paid petitioner on account of the nonphysical injury provisions in the
settlement agreement. Nonetheless, based upon our review of the entire record before us, and
bearing in mind that petitioner has the burden of proving the amount of the settlement amount at
issue that Mr. Rodman paid him on account of physical injuries, we find that Mr. Rodman paid
petitioner $120,000 of the settlement amount at issue on account of petitioner’s claimed physical
injuries and $80,000 of that amount on account of the nonphysical injury provisions in the
settlement agreement. On that record, we further find that for the year at issue petitioner is entitled
under section 104(a)(2) to exclude from his Gross Income $120,000 of the settlement amount at

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issue and is required under section 61(a) to include in his Gross Income $80,000 of that amount.
__________________________________
Although Amos did not involve a claim of sexual harassment, the TJCA amended § 162 by
adding new subsection (q), which denies deduction of any “settlement or payment related to sexual
harassment or sexual abuse if such settlement or payment is subject to a nondisclosure agreement,”
as well as “attorney’s fees related to such settlement or payment.” While the language could be
read to deny deduction of attorney fees paid by the sexual harassment victim as well as the
perpetrator in the case of a nondisclosure agreement, the IRS has issued a statement that “recipients
of settlements or payments related to sexual harassment or sexual abuse, whose settlement or
payment is subject to a nondisclosure agreement, are not precluded by section 162(q) from
deducting attorney’s fees related to the settlement or payment, if otherwise deductible.” 41
Problems
1. Confidentiality clauses like the one in Amos are common. What might the attorneys who
drafted the settlement agreement have done to avoid the necessity for the Tax Court to divine how
much of the aggregate award was due to the physical injury claim and how much was consideration
paid for the confidentiality clause? Why may they have avoided the solution that you devised?
In view of the Tax Court’s allocation, how would Mr. Amos have treated the amount paid to
Ms. Pearson, his attorney, from the $200,000 award, which you should assume was 25% (or
$50,000)? In particular, describe the tax consequences if the attorney fee outlay is categorized as
an expense. Review §§ 162(a), 212(1), 62(a)(20) and (e), 67(g), and 265(a)(1). Alternatively,
describe the tax consequences of the attorney fee outlay if it is categorized as a nondeductible
“capital expenditure” that creates basis, instead.
2. Linda, a young business executive, is injured in Year 1 by a malfunctioning snow blower
operated by her husband Larry. The blower’s blade flies off just as she walks in front of him on
their driveway on the way to her parked car, deeply slicing her femoral artery (and the muscles) in
her thigh. Linda almost bleeds to death. By the time she reaches the hospital, she has lost so much
blood that she is in a coma. Linda eventually recovers, but she suffers some lingering cognitive
deficiencies as a result of the lack of oxygen, and she requires extensive physical therapy to
rehabilitate the use of her leg. Linda and her husband sue the snow blower manufacturer. They
request punitive damages when they discover that the manufacturer had learned of the defect that
caused the blade to fly off but had not recalled the blowers to fix them. Their complaint requests
the following amounts:
•
•

$10 million in lost past and future income;
Reimbursement of $100,000 of medical expenses, $20,000 of which are properly deducted
in Year 1 under § 213;
• $20 million in pain and suffering;
• $100,000 in loss of consortium for Larry; and
• $10 million in punitive damages.
The case is tried before a jury in Year 3, which awards Linda and Larry $20 million in

41

See https://www.irs.gov/newsroom/certain-payments-related-to-sexual-harassment-and-sexual-abuse

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compensatory damages but no punitive damages.
a. The manufacturer has gone bankrupt, so Linda and Larry receive nothing and pay nothing to
their lawyer, who worked on a contingent-fee basis.
b. The manufacturer pays $15 million to Linda and Larry and $5 million to their lawyer under
their contingent fee arrangement. Linda and Larry invest the $15 million in Treasury bonds
maturing in 10 years, earning 2% annual interest.
3. Same as 2.b., except that Linda and Larry settle with the manufacturer before trial for $20
million. Under their settlement agreement, (1) the entire amount is allocated to compensatory
damage, (2) the manufacturer must pay $5 million of the $20 million to Linda and Larry’s lawyer,
and (3) the manufacturer’s insurance company must purchase an annuity for $15 million, with
Linda and Larry designated as the sole beneficiaries of the annuity, under which they will be paid
approximately $1.67 million annually for 10 years, reflecting a 2% return.
4. Same as 3., except that the attorneys who drafted the settlement agreement fail to state that
the settlement comprises entirely compensatory damages. What risk arises on this failure?

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Chapter 17: Homes, Health, Charity, and More
This chapter considers a few of the largest and most important personal consumption tax
expenditures that pertain to individuals. Here are a few of the more notable tax expenditures under
the income tax aimed at individuals and their anticipated revenue costs for 2018 and for the fiveyear period from 2018 to 2022 (in billions). 1

Employer-provided pension plans and IRAs
Exclusion of employer-provided health care
Reduced rate on net capital gain and qualified dividends
Child Tax Credit
Earned Income Tax Credit
Step-up in basis at death
Capital gains exclusion for sales of primary residences
Deduction of mortgage interest on owner-occupied residences

2018

2018-2022

$239.1
146.1
128.7
103.8
70.1
37.4
34.6
33.7

1,306.0
869.6
655.7
595.7
363.6
204.4
186.5
163.2

Most of the personal consumption tax expenditures that take the form of a deduction are
categorized as Itemized Deductions, as described in Chapter 1, Part B., which means that those
who take the Standard Deduction, instead, do not benefit from these deductions.
As you consider each topic, remember the cost-benefit analysis that applies to tax expenditures
described in Chapter 16, Part A. What is the goal sought to be accomplished? Is that goal better
accomplished inside or outside the tax system? If the tax system is used, is the provision crafted
well to avoid windfall losses (if intended to change behavior) or to target the intended beneficiaries
(if intended as a subsidy)? Is the distribution of the tax expenditure’s benefits among income
groups fair? Is the benefit likely to be captured by other actors in the marketplace through the price
mechanism? Remember always that these provisions, because they are not costless, mean that tax
rates are higher than they otherwise would be to raise $X in revenue, so they affect every taxpayer,
not just those who benefit from these provisions.

A. Owner-occupied housing
Owner-occupied housing is one of the most tax-preferred investments in the U.S. economy,
encompassing (1) the exclusion of imputed income, (2) the § 163(h)(3) itemized deduction of
qualified residence interest, (3) the § 121 exclusion of gain realized with respect to a principal
residence, (4) the § 164(a)(1) itemized deduction of real property taxes for homeowners (capped
at $10,000 for all state and local taxes in the aggregate), and (5) the §§ 108(a)(1)(E) and (h)
exclusion of certain § 61debt-discharge income realized with respect to a principal residence.
The exclusion of imputed income with respect to owner-occupied housing
While you may be somewhat familiar from the popular press with the deductions for qualified
1

www.jct.gov/publications.html?func=fileinfo&id=5149. These revenue estimates do not incorporate the revenue loss
under the payroll taxes (Social Security and Medicare) pertaining to the exclusions for employer-provided health care
and retirement savings.

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residence interest and real property taxes (as well as the exclusion of certain home sale gain), the
exclusion for imputed income pertaining to owner-occupied housing may be a new concept to you.
But the qualified residence interest and property tax deductions are tax expenditures only because
imputed income from owner-occupied housing is not included in Gross Income. Remember that
deductions are normatively required to measure SHS income accurately if and only if the
investment return is includable in the tax base. If the return is excluded, deductions should be
disallowed, just as they are under § 265(a)(2) for interest paid on a loan used to buy § 103 bonds
(the interest on which is excludable) and under § 265(a)(1) for attorney fees incurred to generate
compensatory damages that are excludable under § 104(a)(2) (if those fees are expenses rather
than capital expenditures creating basis).
Here is a description from a CBO report: 2
Net Imputed Rental Income. People receive economic benefits by purchasing
homes and residing in them, but they are unaccustomed to assigning a dollar value to
those benefits. For example, one of the touted advantages of buying a home is that
homeowners no longer pay rents to landlords. But viewed from another perspective,
homeowners’ incomes increase by the value of the shelter and other services that they
receive from their investment in owner-occupied housing.
Imputed rental income is the analog to the actual rental income on which landlords
are taxed. When a person buys a house and rents it out, he or she receives rental income
from the tenant. If instead of renting out the house, the owner lives in it, no rent is paid
from one party to another, but the owner-occupant receives the same value of housing
services as the renter would have. Thus, the owner-occupant effectively receives the
same rental income as when he or she rents it to another, but the income is in the form
of housing services.
Gross Income of the homeowner thus includes the amount that an owner-occupied
home would rent for if it were rented to a tenant. Net rental income would be that gross
rent less expenses, such as maintenance and operating expenses, mortgage interest
payments, property taxes, and an allowance for actual depreciation of the structure.
Because the tax code does not require that owners compute the net rental income from
their home and include it in adjusted Gross Income, that omission is treated by the
Treasury Department as a tax expenditure in the Federal budget. However, people do
not observe how much imputed rent they receive, and thus taxing that income would
present administrative challenges….
Deduction for mortgage interest. The deductibility of mortgage interest is
considered a tax expenditure only because the tax code does not require that owners
include the imputed gross rental value of their home as income. If that imputed rent
were included, then mortgage interest would be a legitimate business deduction, just
as it is for landlords….
Deduction for Property Tax. Homeowners who itemize are allowed to deduct
property taxes levied by state and local governments. As with the deduction for
mortgage interest, this deduction would be a legitimate business expense rather than a

2

Larry Ozanne, CONGRESSIONAL BUDGET OFFICE, Taxation of Owner-Occupied and Rental Housing, at
www.cbo.gov/sites/default/files/cbofiles/attachments/11-2-2012-Taxation_of_Housing.pdf.

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tax expenditure if owners were required to include their imputed gross rent as income.
Compare Greg and Greta. Each lives in rented apartments at a cost of $12,000 annually when
each inherits $100,000 from a deceased grandparent. Greg uses his $100,000 to purchase a house
that he rents to a tenant for $12,000 annually, while Greta uses her $100,000 to purchase a house
that she moves into herself (allowing her to cease paying rent). Greg receives $12,000 from his
tenant and pays $12,000 to his landlord (an economic wash), but Greg must include in Gross
Income the $12,000 rent that he receives from his tenant, and he cannot deduct (under § 262(a))
the $12,000 rent that he, in turn, continues to pay to his own landlord. Greta does not receive
$12,000 and does not pay $12,000 (an economic wash). Each owns a $100,000 home and
consumes $12,000 in housing each year, but Greg must include $12,000 in Gross Income, while
Greta does not. Greta is permitted to exclude the $12,000 of imputed income that she enjoys in
kind by living in the house herself (rather than renting it to a paying tenant).
Tax policy critiques of the home ownership tax expenditures
While, as suggested in the excerpt, it would be virtually impossible as a political matter to tax
imputed income from owner-occupied housing in the U.S., 3 the other owner-occupied housing
subsidies are perennial topics for reform. The current income tax treatment of owner-occupied
housing is recognized by virtually all economists to be dysfunctional. Eugene Steuerle, for
example, observes that “theorists of all types … especially do not like the ways that the current
income tax system favors owner-occupied housing over other forms of capital investment.” 4 He
notes that “[i]n a number of economic models, this is one of the larger sources of inefficiency
arising from the income tax.” 5 Martin Sullivan is blunt when he says that “nowhere is the surrender
of economic principles to political expediency more complete than in the U.S. tax policy for
housing.” 6 The distortions are well known. As Sullivan pithily summarized them, while focusing
in particular on the deduction for home mortgage interest:
The economic case against the mortgage interest deduction is clear-cut. It is a huge
subsidy that causes massive efficiency-draining distortions in the economy. Capital
and saving channeled by the tax code into housing is largely drawn from the business
sector. The mortgage interest deduction means the economy has less business capital,
lower productivity, lower real wages, and a lower standard of living.… Most
economists understand—but hate to waste their breath explaining—that probably the
most sure-fire way to improve the competitiveness of the American economy is to
repeal the mortgage interest deduction.
What does the economy get in return for its sacrifice? For the most part, just bigger
houses. 7

3

While never taxed in the U.S., imputed income from owner-occupied housing was more commonly taxed in
European countries, such as Spain, Denmark, Austria, France, Greece, Ireland, Norway, and the U.K., in an effort to
reduce income and wealth inequality. One report states that, as of 2008, only Italy and Holland continued to tax such
income. See www.ecineq.org/milano/WP/ECINEQ2009-112.pdf at Table A.2. A more recent article, however,
mentions Switzerland as continuing to tax imputed income from owner-occupied housing, measured by looking at
market rents for similar properties. See Robert J. Shiller, Owning a Home Isn’t Always a Virtue, at
www.nytimes.com/2013/07/14/business/owning-a-home-isnt-always-a-virtue.html?_r=0.
4
C. EUGENE STEUERLE, CONTEMPORARY U.S. TAX POLICY 241 (2004).
5
Id. at 257 n.5.
6
Martin A. Sullivan, The Economics of the American Dream, 106 TAX NOTES 407, 407 (2005).
7
Id.

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A 2005 CBO study8 concluded that the average tax rate on owner-occupied housing is a negative
5.1% (because of the tax subsidies described here), while the average tax rate on all capital returns
is 13.8%. That big divergence violates the neutrality norm (recall Chapter 3, Part B.) in a huge
way. The resulting misallocation of capital across the economy exacts efficiency costs, making us
less wealthy as a nation than we otherwise would be. If the efficiency costs are thought to be
necessary in pursuing the quest of increasing the homeownership rate, we are sorely disappointed
there, as well. Homeownership rates in similar economies, such as Canada and Australia, are
virtually identical to that in America, even though no deduction for home mortgage interest is
permitted in those countries. Moreover, the value of the subsidies has changed dramatically over
the past several decades as tax rates and interest rates have fluctuated, but the homeownership rate
has remained remarkably constant at 66 to 69%.
The deductions for qualified residence interest and real property taxes are also suspect on
fairness grounds. The upside-down nature of these subsidies is well known. “Nearly 80% of the
benefits from the mortgage interest and property tax deductions go to the top 20% of taxpayers in
terms of income …. Only 5% of the benefits go to people in the bottom 60% of the income scale—
those who may be struggling to own a home.” 9 Because of the decrease in the number of itemizers
from 30% to about 9% or 10% with the changes made by the TCJA, those numbers should be even
more pronounced going forward. Below is a chart that showed the anticipated shift in the shares
of the tax benefit enjoyed from the qualified residence interest deduction as a result of the TCJA,
which shows that the top 5% captures more of the benefit than before, with those below the top
5% losing ground. 10

8

See CONGRESSIONAL BUDGET OFFICE, TAXING CAPITAL INCOME: EFFECTIVE RATES AND APPROACHES TO REFORM,
Oct., 2005, at www.cbo.gov/sites/default/files/cbofiles/ftpdocs/67xx/doc6792/10-18-tax.pdf.
9
James R. Hagerty, Housing Sector Seeks No Tax Remodeling, WALL ST. J., Jan. 31, 2005, at A2.
10
Howard Gleckman, The TCJA Shifted The Benefits of Tax Expenditures to Higher-Income Households, at
www.taxpolicycenter.org/taxvox/tcja-shifted-benefits-tax-expenditures-higher-income-households. Reprinted with
permission.

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Edward L. Glaeser and Jesse M. Shapiro published an extensive empirical study on the effects
of the home mortgage deduction, concluding that “the home mortgage interest deduction is a
particularly poor instrument for encouraging home ownership because it is targeted at the wealthy,
who are almost always homeowners.” 11 They found that the deduction “serves mainly to increase
housing consumption [by encouraging people to buy larger houses than they otherwise would
absent the deduction] and to change the progressiveness of the tax code.” 12
Glaeser and Shapiro focus on both the positive and negative externalities of encouraging people
to own more housing by buying larger houses than they otherwise would. While they found some
evidence that owning a home and owning a larger home encourages “aesthetic externalities” (e.g.,
good home maintenance and gardening), 13 they found far more evidence of negative externalities.
For example, the encouragement to buy ever larger homes hurts inner cities with older, smaller
housing. And because it disproportionately encourages spending on housing among the wealthy
rather than the poor, it increases segregation by income. 14
The benefit of these tax preferences for owner-occupied housing is, on the face of the statute,
ostensibly aimed at the home owner. The more broadly available the tax expenditure, however,
the more likely it is to be captured (at least in part) by other actors in the marketplace
through the price mechanism. That is to say, another possible side effect of the tax subsidies for
owner-occupied housing is that they get captured by sellers and lenders through higher home prices
and higher before-tax interest rates. If only a small segment of buyers were accorded the tax benefit
(such as first-time home buyers), sellers and banks would be less able to capture the benefit through
the price mechanism, as posted prices cannot be segregated by buyer (with a higher posted price
for first-time buyers and a lower price for those who get no benefit from the tax expenditure).
American homeowners pay “significantly higher mortgage rates, roughly 1.5 percentage points
more, than those in Europe. That means that even if homeownership is a worthy policy goal,
subsidizing mortgages is not the way to do it.” 15 The increase in the Standard Deduction and new
$10,000 cap on the amount of deductible state and local taxes under the TCJA, which reduces the
number of itemizers able to take advantage of the qualified residence interest deduction, may
reduce this capture problem somewhat.
The real estate industry strongly lobbies against reducing these tax preferences, arguing that
housing prices would fall (indirect evidence of the capture problem), though most economists
believe that the effect would be temporary and would result in a more efficient allocation of
resources across the economy. 16 For example, England phased out its home mortgage interest
deduction over a 12-year period ending in 2000, and housing prices did not dramatically fall.
The § 163(h)(3) deduction of qualified residence interest
The current deduction for qualified residence interest can be seen as an accident of history.
11

Edward L. Glaeser & Jesse M. Shapiro, The Benefits of the Home Mortgage Interest Deduction, in 17 TAX POL’Y
& THE ECONOMY 37, 40 (James M. Poterba ed., 2003).
12
Id.
13
Id. at 52-56 and 64-65.
14
Id. at 58-59.
15
Agnes T. Crane, Five Prized Myths About Mortgages, N.Y. TIMES, Feb. 7, 2011, at B2.
16
See Jane G. Gravelle, Effects of Flat Taxes and Other Proposals on Housing: An Overview, CONGRESSIONAL
RESEARCH SERVICE REPORT FOR CONGRESS, at www.environmentors.org/NLE/CRSreports/economics/econ-32.cfm
(stating housing tax preferences encourage an inefficient overinvestment in housing and consequent underinvestment
in business assets and that any reduction in housing prices with repeal of preferences would likely be transitory).

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The [qualified residence interest deduction] was not originally placed in the Federal
tax code to subsidize home ownership. When the modern Federal income tax was
enacted [in 1913], all interest payments were made deductible on the grounds that
interest payments were an expense of earning business and investment income. The
deduction had little effect on housing investment before World War II because only
the very highest income individuals paid any income tax. The extension of the income
tax to middle-class families and the increase in home ownership that accompanied the
post-World War II economic boom, however, turned the [qualified residence interest
deduction] into a major subsidy for middle- and upper-middle-income homeowners.
For decades it has enjoyed broad political support, often characterized as a critical
support for the American Dream of homeownership. 17
In other words, before 1986, home mortgage interest was deductible only because all interest (even
personal consumption interest) was deductible. When Congress amended § 163 in the Tax Reform
Act of 1986 to generally disallow deduction of personal consumption interest (such as interest paid
on credit card debt), it crafted the special deduction for “qualified residence interest” so that the
deduction of most interest paid on home mortgage debt would remain deductible.
Before considering possible reform of the qualified residence interest deduction, let’s explore
its mechanics. While § 163(a) contains those magic words “there shall be allowed a deduction” for
interest paid or accrued during the taxable year, we have already seen in connection with § 163(d)
investment interest (discussed in Chapter 15) that other subsections under § 163 reduce or
eliminate the blanket § 163(a) language. Here, we examine personal consumption interest (other
than the § 221 deduction for certain student loan interest).
Read §§ 163(h)(1) and (2)(D). While the former appears to disallow deduction of all “personal
interest,” the latter defines “personal interest” in such a way that it does not apply to “qualified
residence interest,” as defined in (h)(3), meaning that interest satisfying that definition is
deductible under § 163(a) notwithstanding § 163(h)(1). The deduction is an Itemized Deduction
(because not listed in § 62) but not a MID (because listed in § 67(b)(1)).
Under § 163(h)(3), interest is qualified residence interest after the TCJA only if it is paid on
“acquisition indebtedness,” defined in §§ 163(h)(3)(B). The pre-2018 rule permitting certain home
equity indebtedness to qualify is suspended through 2025. Under § 163(h)(3)(B), acquisition
indebtedness has (1) a use test, (2) a security test, and (3) a $750,000 ceiling, reduced from $1
million in the TCJA, though the $1 million ceiling continues to apply to grandfathered debt
incurred before 2018.
Under the use test, acquisition indebtedness must be used to construct, acquire, or substantially
improve a “qualified residence” of the taxpayer. A qualified residence is the taxpayer’s principal
residence plus one other personal residence designated by the taxpayer, such as the taxpayer’s
vacation or weekend home. 18 While no Treasury Regulations tell us the meaning of “substantially
improve” for this purpose, the IRS borrows from Treas. Reg. § 1.263(a)-3(d)—which you
examined in Chapter 4 and which distinguishes between an “improvement” and a mere “repair”—
17

Margery Austin Turner, Eric Toder, Rolf Pendall, and Claudia Sharygin, How Would Reforming the Home Mortgage
Interest Deduction Affect the Housing Market?, at www.taxpolicycenter.org/UploadedPDF/412776-How-WouldReforming-the-Mortgage-Interest-Deduction-Affect-the-Housing-Market.pdf [hereinafter URBAN INSTITUTE]. See
also Dennis J. Ventry, The Accidental Deduction: A History and Critique of the Tax Subsidy for Mortgage Interest,
73 LAW & CONT. PROB. 233 (2009) (describing this history in more detail).
18
See § 163(h)(4)(A)(i).

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and takes the position that an improvement is substantial if it significantly adds to the value of the
home, prolongs the home’s useful life, or adapts it to a new use. Repairs that merely maintain the
home in good condition, such as repainting the home, are not substantial improvements. If,
however, painting is part of a renovation that substantially improves the home, the painting costs
can be considered part of the cost of the improvements. 19
In Voss v. Commissioner, 20 the co-owners of the couple’s two residences were members of a
California Registered Domestic Partnership. Recall from Chapter 8 that such partners are not
currently considered married for Federal income tax purposes and must file separate returns. On
their individual returns, each deducted the maximum interest paid on acquisition indebtedness,
which would today be $750,000 (for $1.5 million in total). The IRS claimed that the cap applied
on a per-residence basis (not per taxpayer). While the Tax Court agreed with the government, the
9th Circuit Court of Appeals reversed, noting that the statute reduced the cap by 50% for married
couples filing separate returns, which would have been unnecessary if the cap applied per residence
rather than per taxpayer. In addition the § 36 first-time home buyer credit (now expired) of $8,000
was similarly reduced to $4,000 for married couples filing separately, but § 36 went on to provide
that unmarried co-owners must allocate the $8,000 between them on their separate returns. No
such similar language appears for unmarried co-owners in § 163(h)(3).
To illustrate the mechanics of the cap in the context of a married couple filing jointly, assume
that Sara and Jonathan are married and purchase a home in which they will live on January 1 of
Year 1 for $1 million, paying $100,000 in cash and borrowing $900,000, which is secured by the
home. They make 11 monthly payments in Year 1 (consisting in part of principal repayment and
in part of interest), reducing their principal balance to $800,000 by the end of Year 1. Because no
more than $750,000 can qualify as acquisition indebtedness, Jonathan and Sara cannot deduct the
interest allocable to the loan principal exceeding that amount and must complete an IRS worksheet
to determine this amount. Jonathan and Sara can, if they wish to keep their calculations simple,
use their loan’s highest balance during the year ($900,000 in their case), but they are also permitted
to use their average balance, which will allow them to deduct more of their interest because each
payment reduces their principal balance in the most common form of level-payment loan. 21 Once
their loan balance is reduced to $750,000, 100% of the interest will thereafter satisfy the definition
of qualified residence interest, and they will be able to deduct 100% of their interest.
Finally, the last sentence of § 163(h)(3)(B)(i) adds that debt incurred to refinance acquisition
indebtedness is itself acquisition indebtedness to the extent of the principal balance of the
refinanced loan. If Jonathan and Sara refinance their loan in order to take advantage of a lower
interest rate when their balance is, say, $600,000, then $600,000 of the new debt is acquisition
indebtedness. If they borrow $700,000 at the time of refinancing in order to use the extra $100,000
cash to substantially improve their home, the entire $700,000 would qualify as acquisition
indebtedness: the first $600,000 would qualify under the refinancing provision, and the remaining
$100,000 would qualify under the use test. If, instead, the extra $100,000 is used to purchase a car,
pay down credit card debt, and take a trip to Rome, the extra $100,000 could not qualify as
acquisition indebtedness, and the interest paid on the last $100,000 is not deductible.
19

See www.irs.gov/publications/p936/ar02.html#en_US_2011_publink1000229991.
796 F.3d 1051 (9th Cir. 2015).
21
On our facts, the worksheet would show that their average balance for Year 1 was $850,000, equal to the sum of
their $900,000 balance at the beginning of the year and their $800,000 balance at the end of the year ($1.7 million)
divided by 2. The IRS worksheet takes taxpayers through the process fairly painlessly.
20

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Problems
1. In January of this year, Joyce and Jane, who are married, purchase a one-bedroom condo in
Manhattan for $1 million, paying $400,000 in cash and borrowing $600,000, secured by a
mortgage on the condo. They pay $24,000 in interest on this loan this year. On April 1, they
purchase a second, small cottage in the Hamptons (on Long Island) for $500,000, paying $350,000
in cash and borrowing $150,000, secured by a mortgage on the home. They pay $6,000 in interest
on this loan this year. How much of the aggregate $30,000 interest paid on their Manhattan condo
loan and Hamptons cottage loan can they deduct this year under § 163(h)(3)?
2. Same as 1., except that Joyce and Jane purchase only the Hampton home, not the Manhattan
condo. (They rent their Manhattan condo, instead.) After purchasing the Hampton home in April,
they had no plans to renovate the home, as they liked its gently worn appearance. At least, they
thought they did. By September, they are tired of the look and decide that it needs substantial
improvements, after all. They hire an architect, designer, and contractor to design and construct a
substantial addition to the home, as well as to renovate the old kitchen and bathrooms, substantially
increasing the value of the cottage. The entire project cost is $400,000, all of which is funded by a
second mortgage on the home, secured by the home. In addition to the $6,000 interest paid on the
first mortgage this year, they paid $16,000 interest on the second mortgage. How much of their
aggregate $22,000 interest can they deduct this year under § 163(h)(3)?
3. Boyce and Bonnie have owned their home, now worth $300,000, for 15 years, and they are
proud of the fact that they just recently paid off the original 15-year mortgage. Bonnie was a stayat-home mom, but Boyce lost his job two years ago and is still looking for a new job. Bonnie found
a part-time job to supplement Boyce’s unemployment insurance payments, but Bonnie’s job does
not provide health insurance coverage for the family. While he and Bonnie were able to stay on
the health insurance policy of Boyce’s old employer for the first year and a half after his layoff,
they were uninsured when their 16-year-old daughter Bridget was diagnosed with a devastating
kidney disease earlier this year. The doctors gave Boyce and Bonnie little hope that Bridget would
survive without a kidney transplant. Fortunately, a donor kidney became available, Bridget
underwent the transplant and follow-up care, and she is doing well. The bad news is that the
hospital and other bills for her care—even after being very substantially reduced by the hospital
after many months of negotiation and providing documentation of their financial situation—totaled
$200,000, and Boyce and Bonnie pay these bills by taking out a new mortgage on their home in
June, secured by the home. They pay $5,000 in interest on the mortgage for the last 6 months of
this year. How much of this $5,000 can they deduct under § 163(h)(3)?
_______________________________________
As noted above, most economists deeply dislike the qualified residence interest deduction on
efficiency grounds, and our exploration above also notes fairness concerns, with the bulk of the
tax benefits disproportionately enjoyed by high-income taxpayers. The Urban Institute studied the
anticipated effects of three possible reforms: (1) eliminating the deduction entirely, (2) capping
the amount of debt eligible to produce deductible qualified residence interest at $500,000, and (3)
fully replacing the deduction with a refundable 15% tax credit, subject to a $25,000 cap regarding
the amount of interest that would be eligible for the 15% credit. Under the last reform, a dollar of
interest would provide the same 15 cents of tax savings for taxpayers in the 28% and 37% brackets,
for example. The maximum tax savings for taxpayers paying at least $25,000 in mortgage interest

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in a year would be $3,750 ($25,000 x .15). With respect to each proposed reform, the study
simulated the change in tax liability for the bottom quintile, middle quintile, 80th to 99th percentile,
and the top 1%. The reform that would produce the least change in tax burdens would be the
second: merely capping the amount of eligible debt at $500,000. The most progressive change
would replace the deduction with a 15% credit, capped at $25,000 of interest, which would actually
reduce the tax burden of the bottom and middle quintiles while increasing the tax burden for the
top 20%—the quintile that benefits the most under the current-law deduction approach. 22
The § 121 exclusion of gain on the sale or exchange of a principal residence
Prior to 1997, the Code contained two, separate provisions under which § 1001 gain realized
on the sale or exchange of a principal residence could go unrecognized. Under old § 1034 (now
repealed), realized gain on the sale of a principal residence could go unrecognized so long as the
taxpayer reinvested the entire sale proceeds in a new principal residence of equal or higher price
within a specified period of time. If the taxpayer spent less than the entire sale proceeds of the first
house when purchasing the second, the realized gain had to be recognized to the extent of the
retained cash. Moreover, the basis of the newly purchased residence had to be reduced by any
unrecognized gain, preserving it for possible future reckoning. In other words, repealed § 1034
was a rollover provision that operated mechanically very much like § 1033 (pertaining to
involuntary conversion gain), studied in Chapter 12.
Because many retirees could not take advantage of old § 1034 when they sold the big, family
home and either rented or purchased a much smaller (and less expensive) retirement home, old §
121 (prior to its amendment in 1997) provided a one-time, elective exclusion of no more than
$125,000 of realized gain on the sale of a principal residence if the sellers were at least 55 years
old—regardless of whether the taxpayer purchased a new home. If they did purchase a new home,
their basis in the new home was not reduced by the unrecognized gain. In other words, old § 121
was a complete forgiveness provision (unlike old § 1034).
In 1997, Congress repealed § 1034 and greatly expanded § 121. No longer is it a one-time
election, no longer is its use restricted to those aged 55 or older, and no longer is the amount
excluded capped at $125,000. Like old § 121, however, the excluded gain on the sale of house 1
is completely forgiven rather than merely deferred through a basis reduction in newly purchased
house 2. Indeed, the seller need not purchase a house 2; she can rent without losing the exclusion.
Therefore, while old § 1034 (like current § 1033) was a consumption tax provision of the cashflow consumption tax variety (allowing deferral of income until withdrawn from investment and
consumed), § 121 is a consumption tax provision of the wage tax variety (explicitly excluding the
capital return)—both of which were described in Chapter 2.
Section 121 generally exempts $250,000 of § 1001 realized gain ($500,000 for married
taxpayers filing jointly) on the sale, exchange, or destruction by casualty of a residence if the
taxpayer has both owned and lived in the residence as his “principal” residence for at least two of
the five years prior to sale. 23 While § 163(h)(3) allows interest allocable to two homes to satisfy
the definition of deductible “qualified residence interest,” the exclusion for home sale gain is
limited to the sale of the taxpayer’s principal residence (if she has more than one).
To the extent that the gain is realized by casualty and exceeds the $250,000 (or $500,000) § 121
22
23

Those interested in viewing these results in chart form can see them at URBAN INSTITUTE, supra note 17.
See §§ 121(a), (b)(1) & (2), and (d)(5)(A).

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limit, the remaining gain can be deferred (though not forgiven) under § 1033 if the taxpayer
otherwise satisfies its terms. Under § 121(d)(5)(B), for purposes of applying § 1033, the “amount
realized” is reduced by the amount excluded under § 121.
For example, assume that Lois, who is unmarried and lives in California, suffered a complete
destruction of her fully insured principal residence by wildfire. Because Lois had purchased the
home 20 years ago, the destroyed house had a $200,000 basis but was worth $600,000 when
destroyed. Lois realizes a $400,000 gain under § 1001 when she receives $600,000 in insurance
proceeds, $250,000 of which she can exclude under §§ 121(a), (b)(1), and (d)(5)(A). If she decides
to rent, Lois must include the remaining $150,000 of realized gain in her Gross Income under §
61(a)(3). If, however, she uses a portion of the insurance proceeds to purchase a new principal
residence for, say, $400,000 and makes a timely election under § 1033, the remaining $150,000
gain can go unrecognized, as well. Her § 1001 “amount realized” for purposes of the § 1033
analysis only is $350,000, equal to the $600,000 in insurance proceeds received less the $250,000
that she properly excluded under § 121. 24 Because she rolled over this entire $350,000 deemed
amount realized into the purchase of her new home (costing $400,000), none of the remaining
$150,000 of her realized gain must now be recognized, but she must reduce her $400,000 cost
basis in the new home by this unrecognized gain (to $250,000) under § 1033(b)(2).
In general, taxpayers cannot take advantage of § 121 more than once in any 24-month period.25
If, however, a taxpayer sells a principal residence within 24 months of a prior sale because of a
change in employment, certain health reasons, or certain “unforeseen circumstances,” 26 the
taxpayer may be eligible to use § 121, but the relevant ceiling ($250,000 or $500,000) will be
reduced by a fraction, the numerator of which is the number of months of qualifying use since the
prior sale and the denominator of which is 24 months. 27
For example, assume that Becky, who is unmarried, sells a home, properly excludes her realized
gain under § 121, and immediately moves into her newly purchased home. Twelve months later,
Becky’s employer unexpectedly requires her to move to a new office in another state and purchases
her home from her as part of the relocation package. If Becky realizes a gain on this second sale,
her § 121 exclusion ceiling is reduced by 50% because she owned and lived in the most recently
sold home for only 12 months of the usually required 24 months. Becky could exclude no more
than $125,000 of realized gain (rather than $250,000).
If a taxpayer converts (depreciable) rental property to his personal residence (or properly
depreciates a portion of the home’s basis under the § 280A home office deduction, studied in
Chapter 19), § 121(d)(6) has long provided that the portion of realized gain (on a later sale) equal
to the prior depreciation deductions is not eligible for exclusion. In addition, Congress amended §
121 in 2008 by adding § 121(b)(5) in an effort to prevent taxpayers with multiple residences from
serially moving into each for two-year periods prior to each sale, making each their “principal”
residence. Prior to this amendment, taxpayers could easily convert a second vacation home into a
principal residence simply by moving into it full time for two years prior to sale.
Section 121(b)(5) now requires inclusion of gain attributable to periods of “nonqualified use.”
In general, nonqualified use is any use of the home other than as the principal residence of the
24

See § 121(d)(5)(B).
See § 121(b)(3)(A).
26
The list of unforeseen circumstances includes, for example, divorce, death, or multiple births from the same
pregnancy, among other circumstances. See Treas. Reg. § 1.121-3(e).
27
See §§ 121(c)(1) and (2).
25

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taxpayer or the taxpayer’s spouse or former spouse but does not include periods after vacating the
home as a principal residence. The amount that fails to qualify for exclusion is the same proportion
of the total realized gain as the period of nonqualified use (not counting the period after moving
out) bears to the total ownership period (counting the period after moving out). The legislative
history provides two examples: 28
Example 1: Assume that an individual buys a property on January 1, 2009, for
$400,000 and uses it as rental property for two years, claiming $20,000 of depreciation
deductions. On January 1, 2011, the taxpayer converts the property to his principal
residence. On January 1, 2013, the taxpayer moves out, and the taxpayer sells the
property for $700,000 on January 1, 2014. As under present law, $20,000 of gain
attributable to the depreciation deductions is included in income. Of the remaining
$300,000 gain, 40% of the gain (2 years divided by 5 years), or $120,000, is allocated
to nonqualified use and is not eligible for exclusion. Since the remaining gain of
$180,000 is less than the maximum gain of $250,000 that may be excluded, gain of
$180,000 is excluded from Gross Income.
Example 2: Assume that an individual buys a principal residence on January 1, 2009,
for $400,000, moves out on January 1, 2019, and on December 1, 2021, sells the
property for $600,000. The entire $200,000 gain is excluded from Gross Income, as
under present law, because periods after the last qualified use do not constitute
nonqualified use.
Even though the period after vacating the home is not counted as nonqualified use, remember
that the seller must nevertheless satisfy the threshold requirement that she live in the home as her
principal residence for at least two of the five years prior to sale to be eligible for any exclusion
under § 121(a). For example, assume that Mona, after three years of living in her home, moves out
and rents the house to tenants. Four years later, she sells the house. Although Mona owned the
home for seven years, and although no part of the period after she moved out of the home is counted
as nonqualified use, Mona cannot exclude any part of her gain under § 121(a) because she did not
live in the home as her principal residence for at least two of the five years prior to sale.
Problem
Charles and Claire are married and both work in Manhattan as a lawyer and investment banker,
respectively. They purchase a condo in Manhattan, their principal residence, on September 5,
2011, for $2 million and their weekend home in the Hamptons on April 1, 2013, for $1 million.
When Charles and Claire both retire in 2015, they sell their Manhattan condo for $2.5 million and
move into their Hamptons home full time on April 1, 2015, spending $300,000 on a large addition
and major renovations. In the winter of 2018, they decide that the cold winters are too much. They
vacate the Hamptons home on April 1, 2018, moving to Florida and putting the home on the market
for $2.3 million. Unfortunately, it sits on the market for many months until the couple finally
agrees to reduce the price, and it finally sells on April 1, 2019, for $1.9 million. What are the
couple’s tax consequences?

28

JOINT COMMITTEE ON TAXATION, TECHNICAL EXPLANATION OF DIVISION C OF H.R. 3221, THE “HOUSING
ASSISTANCE TAX ACT OF 2008,” 63-64,
at www.thetaxbook.com/updates/thetaxauthority_update_service/pdf/govdocs/tech_pl110-289.pdf.

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The §§ 108(a)(1)(E) and (h) exclusion of principal residence § 61 debt-discharge income
The dot-com stock bubble occurred roughly from the mid to late 1990s. After that bubble burst,
many investors were wary of stocks but needed a place to invest. (Recall mention of the “global
savings glut” in Chapter 3.) The 1997 expansion of § 121 made headlines, and many investors—
looking for a new place to invest their savings—decided that personal residences were just what
the doctor ordered in light of the tax-free nature of the return under newly expanded § 121 if one
moves into the home for merely two years. Also in the early 21st century, mortgage lenders began
to relax (or completely obliterate) their previous underwriting standards in order to obtain
mortgages that they could then bundle together as the property security underlying mortgagebacked securities and collateralized debt obligations, which were then sold to investors, often with
ratings by the Big 3 rating agencies (Moody, Standard and Poor, and the Fitch Group) that belied
the underlying risk inherent in the property security (the underlying mortgages). The combination
of these events resulted in the perfect storm, with housing prices shooting up between 2000 and
2006, followed by a crash in values. Only in recent years have home values recovered.
Home loans under the laws of most states (including Ohio) are recourse loans. In the past,
lenders rarely exercised their rights to enforce deficiency judgments beyond foreclosing on the
property security, though some do. That is to say, lenders rarely attempted to place liens on other
property owned by the taxpayer or, if state law permits, to garnish wages. As a short review of the
rules that you learned in Chapter 12, the following results pertaining to recourse debt would usually
arise on the transfer of a principal residence in a foreclosure action or a reduction of the principal
amount in a debt workout without a transfer.
• If the home is transferred and the cancelled debt does not exceed the fair market value of the
home, the entire debt relief is § 1001(b) amount realized under Crane, creating a realized §
1001(a) gain that could be excluded to the extent provided in § 121 or a realized loss that
would be nondeductible under § 165(c)(3) (depending on the home’s basis).
• If the home is transferred, the cancelled debt exceeds the home’s FMV, and the lender
cancels the remaining debt in excess of the home’s FMV, the debt relief creates § 1001(b)
amount realized to the extent of the home’s FMV (often creating a nondeductible loss) and
§ 61 debt-discharge income to the extent that it exceeds the home’s FMV under Treas. Reg.
§ 1.1001-2(a) and Rev. Rul. 90-16.
• If the principal amount of the debt is reduced in a debt workout without a transfer of the
home, the reduced debt creates § 61 debt-discharge income.
The borrower’s realized § 61 debt-discharge income, if any, can be excluded if the taxpayer is
insolvent within the meaning of § 108(d)(3), with the exclusion limited to the extent of the
taxpayer’s insolvency immediately before the discharge. Review §§ 108(a)(1)(B) and (a)(3)
(explored in Chapter 11, Part B.) Not all taxpayers can take advantage of the insolvency exclusion,
however, particularly if they have substantial savings in retirement plans, such as an IRA or §
401(k) account. Yet, one could argue that—under the unusual market conditions existing after the
bubble burst—the discharged debt in excess of the home’s FMV should not be considered
“income” as a normative matter because it did not represent personal consumption by the taxpayer
but rather the unusual market gyrations at the time.
The argument is expressed in the following excerpt. For purposes of illustration, it assumes that
Tom purchased a primary residence for $5,000 in cash plus $195,000 in recourse debt in 2005,
resulting in a $200,000 cost basis. When the unpaid principal balance remained $195,000 on his
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interest-only loan, Tom discovers that his home’s FMV is reduced to $170,000 in 2007. He
defaults on the debt, and the lender forecloses, taking title to the property.
Excerpt from Before the Senate Committee on Finance, At a Hearing
on “The Housing Decline: The Extent of the Problem and Potential Remedies” 29
Deborah A. Geier
Because [the proposed legislation] effectively applies only to solvent taxpayers, the central
question is whether the solvent taxpayer is deserving of any exclusion here. The key to
understanding this analysis, in turn, is the treatment of the loss on the deemed sale of the residence
in the first step of the bifurcated treatment. Recall that, in our hypothetical, Tom’s transfer in
foreclosure results in a $30,000 nondeductible personal loss (the difference between the home’s
$170,000 value at the time of the transfer in foreclosure and Tom’s $200,000 original purchase
price) and $25,000 of debt-discharge income (the difference between the $195,000 debt owed and
the $170,000 value of the house transferred to settle the debt). The problem arises here chiefly
because personal residences are categorized for tax purposes entirely as personal-use assets
providing personal consumption. Wealth used in consumption should not reduce the tax base under
income tax principles. Thus, personal residences are not depreciable (as are business and
investment real estate), and losses on sale are not deductible. In contrast, if Tom had bought stock
instead of a personal residence with the debt, his $30,000 loss would be deductible.
In a more normal market for personal residences, this categorization of personal residences as
personal-use assets that cannot produce deductible losses is generally a good rule. If a home loses
value in such a market (when most homes at least maintain nominal value, if not appreciate), the
reason is usually because the owner failed to maintain the home or made idiosyncratic changes
that she liked but which the market abhorred. That is to say, the value loss is usually due to personal
consumption of the taxpayer, just as use of a personal-use car, which reduces its value, reflects
personal consumption of the driver. In that case, the value loss reflects personal consumption and
thus should remain in the taxpayer’s tax base. Application of the usual rule results in this treatment:
the loss is nondeductible and the debt, which effectively paid for this personal consumption, results
in includable Gross Income if the debt is discharged.
But in the current unusual market conditions, the value loss of the personal residence does not
likely reflect personal consumption of the taxpayer. The loss in value wasn’t consumed by Tom
but rather was an artifact of this unusual market. Tom still cannot deduct the loss, however.
In other words, the problem arises here chiefly because the Internal Revenue Code, in effect,
assumes that any loss in value of a personal residence is due to personal consumption rather than
market forces unrelated to the taxpayer’s consumption. That is usually true and thus a good rule.
Historically, most well-maintained homes at least retain nominal value over time. But today the
unusual market conditions mean that in many cases the loss in value is due to market conditions
(as occurs with investment property like stocks and bonds) and not to any personal consumption
of the taxpayer. Thus, the only way to properly measure this taxpayer’s wealth is to conclude that
the debt-discharge income should not be taxed.[21]
29

http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1333896.
Temporarily making deductible a realized loss on a foreclosure transfer of a personal residence (because not
representing personal consumption in this unusual market) combined with inclusion of the debt-discharge income by
[21]

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In an ideal world, we would identify those value losses resulting from consumption by the
taxpayer and those resulting from market forces unrelated to consumption by the taxpayer. Those
debt discharges resulting from the former would result in includable income by the solvent
taxpayer, whereas those debt discharges resulting from the latter would not. Because I do not think
it would administratively feasible to make such identifications, however, I believe that the
[proposed legislation] should be made temporary. The current market conditions are unusual.
Because most home value losses today are more likely due to these market conditions rather than
due to personal consumption, it might be administrable “rough justice” to allow all such debtdischarge income to be excluded without a specific showing that the home’s loss in value was due
solely to market conditions rather than personal consumption. But that will not be true forever; the
home market will eventually revert to the historical norm where most well-maintained homes at
least hold their nominal value (if not actually appreciate over time). When that happens, most value
loss, if it occurs, will be due to personal consumption and thus any resulting realized debtdischarge income should be includable by the solvent taxpayer.
How long such a temporary measure should last depends on how long it is anticipated that the
market will continue to experience across-the-board value reductions that do not represent personal
consumption by owners. This is a non-tax empirical prediction outside my expertise.
I also argue that the pending bill is correct to allow exclusion only for discharged acquisition
indebtedness (including second mortgages … to the extent that [the debt] was used to substantially
improve the home). It would not allow exclusion of discharged home equity debt used to fund
personal consumption. I believe that treatment is correct, as such debt is tantamount to credit card
debt that just happens to be secured by the home. If such debt is cancelled, the justification for
exclusion described above (that the debt relief does not likely reflect personal consumption by the
taxpayer) disappears.
__________________________________
Congress subsequently enacted §§ 108(a)(1)(E) and (h) in 2007 as a temporary provision, but
Congress thereafter extended its original sunset date multiple times. In late 2020, it was extended
through 2025, even though home prices are generally rising substantially. Under its current
iteration, solvent taxpayers can exclude up to $750,000 ($375,000 in the case of married taxpayers
filing separate returns) of § 61 debt-discharge income realized on the discharge of debt satisfying
the definition of “acquisition indebtedness” under 163(h)(3), with a concomitant reduction in the
principal residence’s basis. Under § 108(h)(4), the exclusion for discharged qualifying principal
residence indebtedness comes last. IRS Publication 4681 provides the following example to
illustrate this rule. 30
Ken incurred recourse debt of $800,000 when he bought his main home for
$880,000. When the FMV of the property was $1 million, Ken refinanced the debt
for $850,000. At the time of the refinancing, the principal balance of the original
mortgage loan was $740,000. Ken used the $110,000 he obtained from the

solvent taxpayers would not be an adequate remedy, as it would do nothing for the owner who remains in his home
after a debt workout with his lender. The loss in home value, which convinces the lender to reduce the debt, is not
“realized” absent a transfer of the home, and thus the loss could not be deducted in any event. Amendment to § 108
would, in contrast, provide appropriate relief to both taxpayers who transfer in foreclosure and taxpayers who have
their debt reduced in a workout but who retain their home.
30
https://www.irs.gov/forms-pubs/about-publication-4681.

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refinancing ($850,000 minus $740,000) to pay off his credit cards and to buy a new
car.
About 2 years after the refinancing, Ken lost his job and was unable to get
another job paying a comparable salary. Ken's home had declined in value to
between $600,000 and $650,000. Based on Ken's circumstances, the lender agreed
to allow a short sale of the property for $620,000 and to cancel the remaining
$115,000 of the outstanding $735,000 debt. Under the ordering rule, Ken can
exclude only $5,000 of the canceled debt from his income under the exclusion for
canceled qualified principal residence indebtedness ($115,000 canceled debt minus
the $110,000 amount of the debt that wasn't qualified principal residence
indebtedness). Ken must include the remaining $110,000 of canceled debt in
income on Schedule 1 (Form 1040), line 8 (unless another exclusion applies).
Problem
What are the tax consequences arising on Tom’s transfer of his principal residence, described
just before the Senate Finance Committee testimony excerpt, if the foreclosure transfer occurs in
2025? In 2026 (if Congress does not again extend the provision)? Assume that Tom is not insolvent
because of his tax-preferred § 401(k) retirement account.

B. Personal casualty and theft losses
You have learned that a pure SHS tax base is generally intended to reach amounts spent on
personal consumption via deduction disallowance. Personal-use property is not depreciable under
§ 167(a), and § 1001 losses arising on the sale or exchange of personal-use property are generally
not deductible under § 165(c)(3), as those losses represent personal consumption rather than
income-production costs. Only costs incurred to produce includable Gross Income should be
deductible in order to prevent the same dollars from being doubly taxed to the same taxpayer.
Nevertheless, § 165(c)(3) has long permitted certain realized losses with respect to personaluse property to be deducted (subject to severe restrictions found in § 165(h)) if and only if the loss
arises from “fire, storm, shipwreck, or other casualty, or from theft,” rather than from sale or
exchange. Through 2025, the TCJA limits the personal casualty loss deduction to taxpayers whose
loss occurred in a Presidentially declared disaster area resulting from a natural disaster.
The keys to ascertaining the purpose underlying the allowance for any personal casualty loss
deduction are the floors found in §§ 165(h)(1) and (h)(2)(A). First, under § 165(h)(1), only the
amount of a personal casualty loss exceeding $100 is potentially deductible. Second—and more
important—the aggregate of personal casualty losses that exceed $100 can generally be deducted
only to the extent of (1) realized and recognized personal casualty gains 31 (if any), and (2) the
portion of the remainder that exceeds 10% of the taxpayer’s AGI. Because of these floors
(particularly the steep 10% floor), only personal casualty losses that are relatively extraordinary in
amount (compared to the taxpayer’s AGI) are effectively deductible under § 165(c)(3). Therefore,
the deduction for personal casualty losses under § 165(c)(3) is best understood as resting on ability
31

Recall from Chapter 12 that taxpayers can elect under § 1033 to avoid recognizing realized personal casualty gains
to the extent that they roll over the amount realized on the casualty into property “similar or related in service or use”
within a certain time period.

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to pay policy grounds rather than on normative tax theory (the definition of SHS income). Stated
another way, routine personal casualty losses reflect the expected vicissitudes of everyday life,
which require no deviation from SHS principles. An extraordinary loss, however, reflects a
reduced ability to contribute to the fisc in that year—even though the loss represents what would
otherwise be nondeductible personal consumption.
Determining the amount and character of a personal casualty loss and whether it is an
Itemized Deduction or Above-the-Line Deduction
Suppose that Claire purchases a rare vase dating from the Ming Dynasty for $600,000, which
she places on the mantel in her living room to enjoy. Claire is not a dealer in Ming Dynasty vases,
so she holds the vase as a capital asset. Many years later, the vase is appraised at $1 million, shortly
after which a hurricane breaks open her windows and smashes the vase, shattering it into hundreds
of pieces (beyond repair). The President declares the area a disaster area. Unfortunately, Claire’s
insurance for the vase has lapsed. Before applying the floors in § 165(h), what is the proper
measure of Claire’s loss?
The $400,000 increase in the vase’s value since Claire’s purchase was never included in
Claire’s Gross Income because of the realization requirement. In order to avoid a double tax benefit
(both exclusion and deduction) for the same dollars, Claire’s loss should be limited to her $600,000
basis, and § 165(b) confirms this result. (Only if Claire were forced to include in Gross Income
that increase in value each year under a mark-to-market system would she thereby create additional
basis to deduct on the vase’s eventual destruction).
Suppose, instead, that the damage is less severe. Instead of hundreds of pieces, the vase is
broken into three large segments, and an art restorer painstakingly repairs the piece at a cost of
$100,000. After the damage but before the restoration, the pieces are appraised at only $200,000
(down from $1 million), and the appraiser determines that this $800,000 loss in value is attributable
entirely to the casualty, rather than to a general market decline in the value of Ming Dynasty
vases. 32 After the restoration, the piece is appraised at $400,000. Two questions arise. First, what
is the amount of Claire’s personal casualty loss? Second, how must Claire treat the $100,000 cost
incurred to restore the piece?
Because 80% of the property’s value was destroyed by reason of the casualty, the conceptually
correct answer to the first question would start with a deduction (before applying § 165(h)) of only
80% of her $600,000 basis ($480,000). In this way, the destruction would be deemed to come
proportionately from each of the unrealized appreciation (not deductible) and her basis
(deductible). Claire is treated more favorably, however, under Treas. Reg. § 1.165-7(b), which
provides that the measure of Claire’s loss is equal to the lesser of (i) the reduction in FMV arising
from the casualty or (ii) the property’s basis. The reduction in value arising from a casualty must
generally be obtained by “competent appraisal,” though repair costs can serve as a proxy in certain
circumstances. 33 On these facts, Claire would use the appraisals, as they show a larger loss in value
than was incurred in repair costs. The amount described in (i) is $800,000 ($1 million FMV
immediately before the casualty less the $200,000 FMV immediately afterward), and the amount
described in (ii) is $600,000 (the vase’s basis). Claire’s deduction (before applying § 165(h)) is
equal to her entire $600,000 basis, just as though the property were completely (instead of only
partially) destroyed. How fortunate for Claire!
32
33

See Treas. Reg. § 1.165-7(b)(2)(i).
See Treas. Reg. § 1.165-7(2)(ii).

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Assume that Claire’s AGI is $400,000 (without regard to the personal casualty loss, itself) and
that Claire realizes no personal casualty gains for the year. Under § 165(h)(1), Claire’s $600,000
deduction is first reduced to $599,900. Claire’s allowable loss deduction under § 165(h) is an
Itemized Deduction (but not a MID because of § 67(b)(3)) rather than one taken above the line
under § 62(a)(3) in reaching AGI because § 62(a)(3) applies only if the loss is realized by “sale or
exchange.” Claire’s AGI remains $400,000 for purposes of applying § 165(h)(2), under which her
deduction is further reduced by 10% of her $400,000 AGI ($40,000) to $559,900. Even though
Claire holds the vase as a capital asset, her Itemized Deduction is an ordinary one because the loss
does not arise from the “sale or exchange” of a capital asset but rather arises from a casualty event.
Claire avoids the § 1211(b) capital loss limitation rule.
Claire clearly will itemize her deductions this year because her personal casualty loss deduction
alone exceeds her Standard Deduction, so Claire will benefit from this deduction. Because Claire
is permitted to deduct $559,900 of her basis, she must reduce her $600,000 basis by this amount
(to $40,100) to prevent her from using this basis a second time as an offset against amount realized
on any future sale or exchange (to avoid a double tax benefit for the same dollars). Under Treas.
Reg. § 1.263(a)-3(k)(1)(iii), Claire must then capitalize the $100,000 restoration cost, increasing
her basis to $140,100.
How would these results change if Claire also realizes and recognizes a personal casualty gain
in the same year? Suppose, for example, that Claire has two Ming Dynasty vases (instead of one),
both of which are knocked off the mantel by the hurricane winds. The first (Vase 1), which is
uninsured, is the one described above, producing a $600,000 loss before applying § 165(h). The
second (Vase 2) was purchased for $400,000, was appraised at $700,000 immediately before the
casualty, and is destroyed in the accident. Unlike Vase 1, however, Vase 2 is fully insured, and
Claire receives an insurance check for $700,000 after filing a claim, producing a $300,000 personal
casualty gain under § 1001 ($700,000 A/R less $400,000 A/B). Because Claire does not purchase
a new Ming Dynasty vase with the insurance proceeds, she is unable to avoid recognizing this
$300,000 realized gain under § 1033, which increases her AGI (for the moment) from $400,000
to $700,000 for the year. How much of her $600,000 personal casualty loss arising on the damage
to Vase 1 can Claire deduct under § 165(h)?
As in the prior case, Claire’s $600,000 personal casualty loss with respect to Vase 1 is first
reduced by $100 to $599,900 under § 165(h)(1). The deductible portion of this $599,900 loss is
determined in two steps. First, under § 165(h)(2)(A)(i), Claire can deduct $300,000 (equal to her
personal casualty gain), and she takes this deduction above the line under the authority of §
165(h)(5)(A)—just enough to perfectly offset her includable $300,000 personal casualty gain.
Therefore, her AGI for purposes of applying § 165(h)(2)(A)(ii) remains only $400,000 (instead of
$700,000). Second, under § 165(h)(2)(A)(ii), Claire can deduct $259,900 (the excess of the
remaining $299,900 loss over 10% of her $400,000 AGI) as an Itemized Deduction.
In sum, Claire (1) fully includes her $300,000 personal casualty gain in Gross Income, (2)
deducts $300,000 of her $599,900 personal casualty loss above the line (effectively offsetting the
$300,000 Gross Income inclusion), and (3) deducts $259,900 of the remaining loss as an Itemized
Deduction. Once again, none of the gains and losses are capital (notwithstanding that Claire holds
the vases as capital assets) because the “sale or exchange” requirement under § 1222 is failed.
Rarely does a taxpayer realize more personal casualty gains than losses. For the sake of
illustration, however, suppose that Claire realizes a $600,000 personal casualty loss (reduced to
$599,900 under § 165(h)(1)) with respect to Vase 1 and a $700,000 personal casualty gain (instead
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of $300,000) with respect to Vase 2. First, the 10% floor in § 165(h)(2)(A)(ii) does not apply, as
§ 165(h)(2)(A) expressly applies only in the more usual case in which personal casualty losses
exceed personal casualty gains, so Claire can fully deduct the $599,900 personal casualty loss.
Second, both the gains and losses are treated as capital gains and losses under § 165(h)(2)(B),
notwithstanding that they do not arise from a sale or exchange. Because the gains exceed the losses,
§ 1211(b)’s capital loss limitation rule should not be a hindrance in this case, unless Claire has
significant capital losses from other sources, as well. If Claire realizes no other capital gains and
losses for the year, and if she held both vases for more than one year before the casualty event, the
net casualty gain is, in effect, preferentially taxed net capital gain within the meaning of §
1222(11), as described in Chapter 14.
Finally, § 165(i) allows Claire to elect to deduct the loss in the year preceding the casualty (Year
1) by filing an amended return, allowing her to obtain a tax refund just when it can best be used
(Year 2, the year of the disaster). Absent this rule, Claire must wait until the filing season
commences for the disaster year (Year 3) to file a return that obtains the benefit of the deduction.
Problem
Scott and Sally own a boat, which they purchased several years ago for $60,000 and use for
recreational purposes. They had it appraised earlier this year for insurance purposes at $40,000,
but they had not yet obtained coverage when a hurricane damages the boat, and the President
declares the area to be a disaster area. After the storm, Scott and Sally have the boat appraised at
$30,000. They pay $7,000 to repair the storm damage. Without regard to any possible casualty loss
deduction, their AGI is $70,000.
a. How much, if any, can Scott and Sally deduct under §§ 165(c)(3) and (h)?
b. How would your answer change if they also receive an insurance check in the same year for
$8,000 to compensate them for the loss of Sally’s insured diamond engagement ring in the
hurricane disaster, which Scott had purchased years ago for $6,000? They decide not to
purchase another diamond ring with the insurance payment but rather to use the money for a
romantic trip to Paris.

C. Health care
America spends far more—at least 5 percentage points of GDP more—on health care than does
most other developed nations, with approximately half spent in the private sector and half in the
public sector (primarily Medicare and Medicaid). The chart below shows spending as a percentage
of GDP in 2017 or the nearest year for which data is available. 34 The U.S. is at the far left.

34

OECD Health Statistics 2018, Spending on Health: Latest Trends, at www.oecd.org/health/health-systems/HealthSpending-Latest-Trends-Brief.pdf. Reprinted with permission.

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Though we spend significantly more, we do not necessarily get more bang for our buck, with
data showing that our “actual quality of health is no better than in countries that spend a fraction
of what we spend on healthcare. A major reason for that is that we simply spend more for the same
procedures and drugs and have far higher administrative overhead than countries with single-payer
systems.” 35 Of course, these price differentials are captured as income by various health care
market participants (doctors and other health care providers; insurance companies; medical device
manufacturers, owners, and operators; pharmaceutical companies; etc.), creating strong and
powerful interests that resist change. In a competitive market, providers would compete on price,
bringing down overall costs, but the U.S. health care market does not operate like other U.S.
consumer markets for, say, TV sets.
“In the U.S., we like to consider health care a free market,” said Dr. David
Blumenthal …. “ but it is a very weird market, riddled with market failures.” …. If
the American health care system were a true market, the increased volume of
colonoscopies—the numbers rose 50 percent from 2003 to 2009 for those with
commercial insurance—might have brought down the costs because of economies
of scale and more competition. Instead, it became a new business opportunity. 36
Why bring these matters up in a textbook on the individual income tax? The exclusions from
Gross Income for employer-provided health care under §§ 105(b) and 106 have long been
identified as significant contributing factors in these market failures, and the Internal Revenue
Code has been more recently used as a tool in the “consumer-driven movement” toward health
care cost containment with the introduction of health savings accounts coupled with highdeductible insurance plans. Before we discuss these provisions, however, let’s first consider the §
213 deduction for certain medical expenses, which stands on a different footing.
The § 213 deduction for certain medical costs

35
36

Bruce Bartlett, U.S. Taxes and Government Benefits in an International Context, 127 TAX NOTES 1429, 1430 (2012).
Id.

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Section 213(a) provides that the uncompensated costs for medical care of the taxpayer, as well
as of his or her spouse and dependents, can be deducted to the extent that the aggregate exceeds
7.5% of AGI. As explored in Chapter 8, members of a civil union or registered domestic
partnership are not considered married for Federal income tax purposes, so medical expenses paid
by Mary for health care provided to her civil partner Monica could be deducted by Mary (to the
extent exceeding the AGI floor) only if Monica qualifies as Mary’s dependent.
The 7.5% floor serves the same purpose here as in the case of personal casualty and theft losses,
described in Part B. That is to say, the § 213 deduction for uncompensated medical expenses is
best understood as resting on ability to pay policy grounds rather than on normative tax theory (the
definition of SHS income). Routine medical expenses reflect the expected vicissitudes of everyday
life. An extraordinary amount of medical expenses relative to income, however, reflects a reduced
ability to contribute to the fisc in that year—even though the costs represent what would otherwise
be nondeductible personal consumption.
The § 213 deduction is an Itemized Deduction but is not a § 67 MID (because § 213 has its own
floor). Because of both the steep 7.5% floor and the small portion of taxpayers who can itemize
deductions after the TCJA, few tax returns show a § 213 deduction. Nevertheless, let’s consider
the broad outline of the sorts of costs that are potentially deductible under § 213.
“Medical care” is defined in § 213(d)(1)(A) as encompassing costs paid “for the diagnosis, cure,
mitigation, treatment, or prevention of disease, or for the purpose of affecting any structure or
function of the body.” The disease need not be physical. Treas. Reg. § 1.213-1(d)(1)(ii) specifically
mentions costs incurred to ameliorate a “mental defect or illness,” including costs paid to a
psychiatrist or psychologist. Additional subsections explicitly list health and dental insurance
premiums, including qualified long-term care insurance (subject to certain age-related limits),
certain transportation costs (including lodging) incurred to travel to the place of treatment, and
prescription drugs. While cosmetic surgery literally affects a “structure” of the body, Congress
added § 213(d)(9) in 1990 to deny deduction unless the surgery is necessary to “ameliorate a
deformity arising from … a congenital abnormality, a personal injury resulting from an accident
or trauma, or disfiguring disease.” For example, the IRS states that the cost of breast reconstruction
surgery after a mastectomy for breast cancer is deductible but that the cost of breast augmentation
surgery merely to improve personal appearance is not. 37
In O’Donnahbain v. Commissioner, 38 the Tax Court held in a reviewed decision (with 8 judges
in the majority, 5 judges concurring, and 3 judges dissenting) that gender identity disorder is a
“disease” within the meaning of § 213(d)(1)(A), that the costs for Ms. O’Donnahbain’s hormone
therapy and male-to-female sex reassignment surgery were incurred for the treatment of the disease
and so were generally deductible. The court also held, however, that her breast augmentation
surgery was nondeductible cosmetic surgery within the meaning of § 213(d)(9) because the surgery
was directed at improving her appearance rather than meaningfully treating the disease.
Notice that § 213(a) uses the word “expenses,” which you have learned is a tax term of art to
mean current wealth decreases, i.e., the opposite of capital expenditures (a mere change in the form
in which wealth is held rather than a current wealth decrease). Treas. Reg. § 1.213-1(e)(iii)
recognizes that “[c]apital expenditures are generally not deductible for Federal income tax
purposes.” Nevertheless, the regulation further provides that an outlay that otherwise satisfies the
37
38

See IRS Publication 502 at www.irs.gov/pub/irs-pdf/p502.pdf.
134 T.C. 34 (2010).

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definition of medical care “shall not be disqualified merely because it is a capital expenditure.”
Examples provided in the regulation include eyeglasses, a seeing-eye dog, artificial teeth and
limbs, and a wheelchair. The reason for this rule is that the long-lived asset would not otherwise
be depreciable under §§ 167 and 168 because it is a personal-use asset. In effect, these costs are
treated as though they were expenses (rather than capital expenditures) for purposes of § 213.
A medical capital expenditure that permanently improves other property, such as a personal
residence, may be deductible as a medical expense—if it otherwise satisfies the definition of
medical care—but only to the extent that the cost exceeds the increase in value to the underlying
property. Here is the example provided in the same regulation.
Such a situation could arise, for example, where a taxpayer is advised by a physician
to install an elevator in his residence so that the taxpayer’s wife who is afflicted with
heart disease will not be required to climb stairs. If the cost of installing the elevator
is $1,000 [the low cost reflecting this 1960s vintage regulation] and the increase in the
value of the residence is determined to be only $700, the difference of $300 … is
deductible as a medical expense.
The regulation also confirms that the cost of maintaining and repairing such improvements are
generally 100% deductible, even if less than 100% of the original installation cost was deductible.
The §§ 105(b) and 106 exclusions for employer-provided health care (and the § 162(l)
deduction for the self-employed)
Absent §§ 105(b) and 106, amounts paid by an employer for employee health care would be
treated under the Old Colony Trust two-step as (1) received by the employee (includable in Gross
Income under § 61(a)(1) as compensation for services rendered) and (2) paid by the employee to
the insurance company or other health care provider (deductible under § 213 only to the extent
exceeding 7.5% of AGI). Sections 105(b) and 106, however, provide authority for employees to
exclude 100% of health care purchased or provided by their employers, with no floor or ceiling. 39
As indicated in the chart at the beginning of this chapter, the exclusions for employer-provided
health care is one of the most expensive tax expenditures in the Code, expected to lose more than
$800 billion in the five-year period from 2018 and 2022. Moreover, self-employed individuals are
permitted to deduct 100% of the cost of health insurance premiums as a business expense under §
162(l) 40 (and to exclude benefits received under the plan under § 104(a)(3)), unhampered by the
7.5% floor otherwise applicable under § 213 to other individuals who must purchase health
insurance in the individual market because they are either (1) employees (rather than selfemployed individuals) whose employers do not offer health insurance or (2) unemployed.
The exclusion for employer-provided health coverage is an historical accident dating to WWII.
The Stabilization Act of 1942 imposed strict wage and price controls to tamp down rampant
inflation as employers competed for suddenly scarce workers while many men were fighting
overseas. Remember Rosie the Riveter? The Act made “raises difficult during a time of acute labor

39

Section 106 permits exclusion of employer-paid coverage under a health insurance plan, whether self-funded by the
employer or purchased from a third-party insurance carrier, for the employee taxpayer, his or her spouse, and
dependents. Section 105(b) permits the same taxpayers to exclude the benefits received (including reimbursement
from an employer of costs incurred) for medical care described in § 213.
40
Because the health costs are treated as business expenses under § 162, the self-employed can take these deductions
above the line in reaching AGI under § 62(a)(1).

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Chapter 17

Homes, Health, Charity, etc.

Chapter 17

shortages.” 41 But the Act did not limit employer competition over insurance and pension benefits.
Health insurance was relatively inexpensive in this era of low-tech health care (penicillin was just
recently discovered in 1928), so more employers began to offer group coverage for employees as
a way to attract them away from other employers (though some employers had offered such group
coverage even before 1939). “’It was just a way to allow employers to evade the wage and price
controls of World War II,’ MIT health economist Jonathan Gruber told NPR…. ‘And it’s sort of
grown exponentially since, and there really isn’t a single healthcare expert who would design a
system from scratch which would include this feature.’” 42
Without precise statutory authority, the IRS (critically) ruled that this insurance coverage would
be excludable from Gross Income, notwithstanding the predecessor to § 61(a)(1). In addition, the
National Labor Relations Board ruled in 1948 that fringe benefits could be the subject of collective
bargaining, which furthered the growth of employer-provided health insurance as part of union
collective bargaining agreements. In 1953, “the IRS issued a revenue ruling that effectively
reversed its previous stance, declaring employer contributions to employee health insurance plans
to be taxable income for the employee.” 43 Congress reacted in 1954 by adding §§ 105(b) and 106,
effectively codifying the earlier IRS ruling. And we were off to the races!
Fully three-fifths of the population under age 65 benefit from the exclusions under §§ 105(b)
and 106. 44 Group insurance (which typically has lower rates than insurance purchased on the
individual market) need not be confined to groups defined by employment; geographic or other
groups could work just as well. But the current statutory scheme encourages employers to provide
group health insurance instead of paying the equivalent cash wages to their employees and allowing
them to purchase group health insurance directly (because the employees would then be saddled with
the 7.5% f
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