I.

Introduction
A. Orientation
1. The tax practitioners tools
a) Legislative materials
(i) The Codethe Internal Revenue Code of 1986 (first codified in 1939)
(a) The Code is the law
(i) Everything else is merely an aid to determine what the Code means
(b) The taxing power of the federal gov is vested in Congress under 16th Amend
b) Administrative materials
(i) Regs
(a) Sec. of Treasury has authority to prescribe all needful rules and regs for enforcement of Code
(b) Judiciary says whether regs promulgated by executive conform to enacted by legislature
(c) Congress sometimes carves out areas where Treasury can make, not merely interpret, the rules
(ii) Rulings
(a) Do not have the force and effect of regs; reflect current policies of the Service
(b) Private Letter RulingsMay not be relied upon as authority by anyone other than taxpayer to
whom ruling was issued and not officially published (Serve a useful function as planning tools)
(c) Published Revenue RulingsRulings that involve important substantive tax questions and
issues of widespread interest; precedential value that apply to everyone
(iii) Acquiescences
(a) Do not affect taxpayer who has just won case but Service is saying either we will or we will not
continue to contest point as it arises in other cases
c) Judicial materials
(i) All tax issues are settled in federal court
(a) except state tax issues, which are settled in state court
(ii) If Commissioner of IRS asserts a deficiency in income tax, taxpayer has 2 choices:
(a) payment under protestpay tax deficiency, file an administrative claim for refund and, upon its
denial or prolonged administrative inaction, file suit for a refund in either (forum shopping)
(i) U.S. Court of Federal Claims hears tax, patent, admiralty
(a) No jury; 16 judges
(b) judges are more specialized than district court, not as specialized as tax court judges
(c) appeal to The Federal Circuit Court of Appeals only hears tax, patent, admiralty
appeals
(ii) U.S. District Court (where taxpayer resides)

(a) Jury trial available

(b) judges dont know as much about tax law. If facts are on your side but not the law,
file here (more cases decided against gov)
(c) appeal is to Circuit Court of Appeals where taxpayer resides (i.e. 8 th Cir)
(b) refuse to pay tax and file lawsuit for a re-determination of the deficiency
(i) action filed in U.S. Tax Court (established as Art. I court)
(a) no jury trials
(b) 19 judges in D.C. (although they do travel) that understand tax law really well.
(i)
If facts are on your side but not the law, Tax Court is not the place to be
(ii) appeal is to the Circuit Court of Appeals where taxpayer resides
2. tax policy considerations
a) federal income tax is not a neutral, revenue raising device; every tax has regulatory effect on what people do
(i) to impose a tax on a transaction discourages activity
(ii) to relieve from tax a transaction otherwise subject to exaction encourages activity
b) possible alternatives to the current federal income tax include:
(i) flat taxtax w/ a broad base (few or no deductions) on which tax is imposed at a single low rate
(ii) modified flat taxtax on a tax base containing more deductions but imposed at modestly graduated
low rates
(iii) consumption taxpersonal tax at graduated rates on consumption, or consumed income, levied by
exempting all savings from tax, allowing a deduction for repayment of debt, and taxing all borrowing and
withdrawals from savings
(iv) general sales taxeither a familiar retail sales tax or a value-added tax
3. the road ahead
a) gather all items of income and assign them to proper taxpayer (GI for the year)
(i) various deductions are allowed to reach the net figure (taxable income)
b) In determining taxable income for the year, 3 additional questions must be considered w/ respect to each
item of income or deduction
(i) For what taxable year is an item income or deductible?
(ii) What is the character (capital gain or loss, or ordinary income or loss) of various items?
(iii) Is gain or loss immediately to be recognized?
c) Tax creditssubtracted from amount of tax otherwise actually to be paid; reduces tax dollar for dollar

B. Hypotheticals Introduction to Tax

1. GI may include:
a) cash, wages, earnings
b) lottery, prices, awards net worth has gone up ( 74; w/ 3 exceptions)

c) very expensive car given as a gift maybe. Increases net worth but, . . .
(i) gifts are excluded from income
(a) gift = Detached and disinterested generosity
(ii) but maybe its bribes/kickbacks which are included in income
(iii) Engagement ring: a gift? Detached and disinterested generosity? May constitute GI b/c if break up
w/ person, expected to give back?
d) Employer gives you a $500 bonus?
(i) anything given from employer to employee cannot be given in the nature of a gift
(a) rather, given in nature of compensation (services rendered) and therefore, GI
e) employer gives you a $500 watch?
(i) Still income even if in nature of property rather than cash
(ii) The problem w/ property rather than cash:
(a) Determining the value
(b) How do you pay taxes for it?
(i) We may have to sell watch in order to pay the tax on the watch
f) Paint house but dont get paid. Bring lawsuit of 1k
(i) Action based on services performed and is considered income
g) 10k student loan
(i) NOT income Borrowed $ doesnt increase net worth.
(a) There is a corresponding obligation to pay it back so you have an equal net worth
h) What if dont have to pay back loan?
(i) Its income discharge of indebtedness is income to receiver
(a) Exception to discharge of indebtedness if it is a gift
(ii) Loans not income. Discharges are income
i) 5k personal injury judgment
(i) medical aside, judgment is increase in net worth, but . . .
(ii) physical personal injuries are not income.
(iii) Punitives ARE income
(a) Puts you above where you were before.
j) Sexist bastard sue for slander and get 5k
(i) BUT 97, change code to say damages for personal injury that are non-physical ARE taxable.

(a) Huge issue b/c Congress is implying that these are not real damages
(b) Discrimination awards are income and so are taxable (sex, religious, etc)

II. Identification of Income Subject to Taxation

A. GI: The Scope of Section 61
INCLUSION
1. Introduction to Income (and taxes) {Code 61}
a) Federal income tax is imposed annually on a net figure known as taxable income
GI ( 61)
- Above the line deductions ( 62)
AGI ( 62)
- Below the line deductions ( 161-222) itemized deductions
**not everyone takes. In lieu some people take standard deduction ( 63) (usually people
who dont own homes yet)
- PE/s ( 151-152)
Taxable income ( 63)
x Rates ( 1)
Tentative tax liability
- Tax credits ( 21-53)
TAX DUE!
(i) **were there to be flat tax, the only thing that would change would be below the line deductions.
Instead would just have one option the standard deduction
b) Code 61GI = all income from whatever source derived
(i) A broad definition and interpreted as broadly as possible
(a) GI applies to everything unless you can point to an exception
(i) INCLUDES:
(a) Tips, wages, salaries, fees, commissions on insurance premiums, rents, interests on
an estate, bonuses (including X-mas), severance pay, jury fees, pensions, retirement pay
(b) Treasure Trove [Cesarini]
(c) Discharge of indebtedness [Old Colony Trust]
(d) If services are paid for in property fmv of property is income
(e) If services are paid for in exchange for other services fmv of property received
Employee gifts (not fringe benefits)
(f) Prizes and awards (w/ exceptions)
(g) Gain from dealings in property
(h) Compensation for non-physical damages

(i) Punitives
(j) Alimony and separate maintenance
(k) Illegal gains
(ii) EXCLUDES:
(a) Gifts/inheritance
(b) College loans
(c) Gross income for physical damages (maybe emotional)
(d) Property settlement in divorce and child support
c) Why do we care:
(i) Time value of money Invest money you have now to get return in future
(a) Take deduction as early as possible
(b) Include item in GI as ate as possible
2. Equivocal Receipt of Financial Benefit { 61; Reg 1.61-1, -2(a)(1), -2(d)(1), -14(a)}
a) Cesarini P found money in side pianoincome
(i) P Claim: a) not GI, b) even if it is income, it was due in 57 and SOL has run, and c) even if 64 is the
correct year, should have been classified as capital gains
(ii) The Results: ( 61 and Reg. 1.61-14(a)). The finder of treasuretrove is in receipt of taxable income
to extent of its value in US currency, for taxable year in which it is reduced to undisputed possession.
(a) treasure trove found in piano was GI
(i) some countries dont tax found money/items; US does
(b) for the year it was reduced to undisputed possession
(i) P must actually find the money to have superior title over all but the true owner
(ii) for undisputed possession, we look to state law
(iii) year reduced to undisputed possession is important due to SOL
(a) SOL is 3 years from when tax return is due
(i)
Cesarini wants income for 57 b/c SOL would be up
(ii)
Usually want year to be later instead of earlier b/c of time value of $
(c) taxed as ordinary income (not capital gains)
b) Old Colony Trust Co. Co. paid income tax of Prez of Co.income
(i) Cmmr. Claim: income taxes paid by Co. for Prez were additional income to Prez.
(ii) Prez Claim: if income, snowballing effect that could go on for affinity
(a) Way to get around circular result:

(i) Co. makes grossed up payments Co. grosses up income so after taxes, Prez would be
able to pay additional taxes and be left over w/ amount of salary
(iii) The Results: Payment by employer of income taxes assessed against employee constituted additional
taxable income (consideration of services rendered)
(a) discharge by a third person of an obligation to him is equivalent to receipt by the person taxed
(iv) Anytime someone pays a liability for you, there are tax consequences
(a) Employer pays other liabilities (property, phone bill) GI
(b) Mom pays phone bill, tax consequences. However, could be a gift
c) Glenshaw Class Co. taxpayer excluded punitves from incomeincome
(i) Income includes any increase in net worth or undeniable accession to wealth over which
taxpayer has complete dominion
(a) Loans and security deposits are NOT considered income
(i) Complete dominionIndianapolis Power and Light
(a) Facts: customers put down security deposit when electricity turned on; if nonpayment, security deposit is applied (occurs 95%)
(b) Court holds: dont have complete dominion until actually apply security deposit;
rather, deposit is a loan to the company
(b) Unlawful, as well as lawful gains, are considered income
(ii) Taxpayer couldnt rely upon Highland Farms b/c Cmmr hadnt acquiesced
(iii) The Results: punitive damages are taxable GI
(a) Mere fact that payments were extracted from wrongdoers as punishment for unlawful conduct
cannot detract from their character as taxable income to recipients
(iv) Reg. 1.61-14(a) why didnt anyone point to this? hadnt been written yet.
d) Problems (p. 65): Gains are taxed when realized. A realization event is a change in nature of relationship w/
property. (*Any way of disposing of property: stolen, given as a gift, sold, found) Realized gains must be
recognized in the year they are realized UNLESS there is a non-recognition provision. Recognizing a gain
means including the amount in GI.
(i) Cesarinis discover that piano was worth 500k
(a) It is accession to wealth; however, there is no realization event and therefore, taxpayers dont
have complete dominion yet. There is no recognition at this time
(i) Not income until they have realization event
(b) realizationchanging nature of relationship w/ property
(i) sale, exchange, casualty (not gift, inheritance, transfer pursuant to divorce)
(ii) NOT appreciation!
(a) some countries tax appreciation; US doesnt tax appreciation b/c:
(i)
hard to value property each year
(ii)
where are you going to get $ to pay tax? (sell piano to pay tax?
doesnt make sense b/c could be a good investment)
(iii)
Congress tries to match imposition of tax w/ receipt of $ to pay tax
(iv)
If tax appreciation, corollary must also be true if item depreciates,
gov would have to pay $ back pain in the ass
(c) recognitioninclude on income tax return

(i) Realized gains must be recognized in year they were realized

(a) UNLESS there is some non-recognition provision
(i)
ex: involuntary conversionhouse destroyed by fire and owner
receives insurance proceeds. Cong. could tax on gain b/c there has been a
realization (nature of property has changed). But Congress says would be unfair
to tax at this time instead, if owner takes the insurance proceeds and rolls them
over to buy a new house, realization doesnt have to be recognized.
(d) When Cesarinis found money in piano taxable right away
(i) When Cesarinis find out piano is worth more not taxable until realization event
(ii) Employee agrees to stay w/ Co. A in exchange for 40k salary, 2% of companys stock, which is worth
20k, and by buying Employees spouse a new car worth 15k. How much income does Employee realize
from these transactions?75k
(a) 40k salaryaccession of wealth; increases net worth; clearly income
(b) 20k stockalso increases employees net worth
(i) problem: no cash to pay tax, unless he sells the stock.
(a) General principletry to match imposition of tax w/ cash available to pay tax
(b) Exception to the general principlewe tax the stock anyway
(i)
Otherwise, too much game play (pay me in stock instead of money
and that way I wont be taxed)
(c) 15k for car
(i) if car had been given to employee, an easy case. GI.
(ii) car given to spouse, is also taxable to employee.
(a) First question, who is taxed on the car?
(i)
Employee, not spouse is taxed, even though spouse gets car. Employee
is performing the services and receiving the compensation
(ii)
Assignment of incomeincome must be taxed to him who earns it
(b) For tax purposes, we see this problem as employee receiving compensation.
Employee then gives the car as a gift to the spouse
(iii) Reg. 1-61-2(d) FMV of car and stock are included in employees income
(iii) Insurance Adjuster refers clients to an auto repair firm that gives Adjuster a kickback of 10% of
billings on all referrals
(a) adjuster has GI compensation income; accession to wealth over which taxpayer has complete
dominion
(b) even if kickback is illegal, also income
(i) Reg. 1.61-14(a)Illegal income is still income
(ii) Not self-incrimination b/c this is only for tax purposes! Fact that agencies share
information and you may be incriminating yourself doesnt seem to matter
(iv) Owner agrees to rent Tenant her lake house for the summer for 4k
(a) Rent is income to lessor! ( 62)
(i) NOT income when improvements are made or upon termination of lease ( 109)
(ii) lessor acquires no basis in improvements
(iii) business tenant can deduct rent

(b) how much income does O realize if she agrees to charge only 1k if T makes 3k worth of
improvements to the house?
(i) O still has an income worth 4k and will be taxed on this amount
(c) What if T does all the labor himself and incurs a total cost of only $500?
(i) Same result to O fmv of property received, so 4k
(a) if not in nature of rent, no gain no income. Will be income when sell property
(v) frequent flyer miles law has changed
(a) Frequent flyer miles are NOT taxable, even if get from employer who paid for ticket for
business purposes. However, if get for incentive then taxable. New exception, new case.
3. Income Without Receipt of Cash or Property; Compensation for Services { 61; Reg 1.61-2(a)(1), -2(d)(1)}
a) Cash is cash; property is FMV; what about services?
(i) Services are also incomefmv of property/service received. Rev. Ruling 79-24; 1.61-2(d)
(a) Services includes receipt by taxpayer of free use of property
b) barter clubs taxable
(i) A is getting paid for drafting wills by getting Bs plumbing services
(a) FMV of services received is income to A
(b) Rev. Ruling 83-163 constitutes income in year you received services
(i) Ex: if A drafts wills in 2001 and gets house painted in 2002, taxed on FMV of service
received in 2002
(a) Caution: not always an equal exchange of services
c) reciprocal back scratching income, but not taxable
(i) technically, this is income an informal barter club
(a) But, an informal situation is hard to monitor so Congress/Service hasnt tried to tax
d) Helvering v. Independent Life Ins. Co imputed income
(i) Imputed income taxable?
(a) Theory: if A lives in house, could have not lived in house and rented it out instead
(b) S.Ct. has said it is unconstitutional to tax imputed income
(i) Most lower courts today agree that taxing imputed income is not unconstitutional.
(a) Congress has just chosen not to tax this
(c) However, we cant assume that all imputed income is not taxable
(i) self-help (draft own will) not taxable
(ii) Imputed interest income IS taxable
(a) Mom gives kid an interest free loan

(i)
Mom must include interest would have earned had she loaned $ to
someone else (interest rate is low)
(ii)
Could characterize interest as a gift; however, if interest is over a
certain amount, no longer a gift
(ii) 2 types of imputed income that are NOT taxed:
(a) rental income of personal residence
(b) services one performs for self
e) Revenue Ruling 79-24
(i) Situation 1: lawyer and housepainter exchange services as members of a barter club
(a) FMV of services received by lawyer and housepainter are includible in their GIs
(ii) Situation 2: apt building owner received a work of art in return for rent-free use of apt
(a) FMV of work of art and FMV of apt are includible in GIs
(iii) Reg 1.61-2(d)(1)if services are paid for other than in money, FMV of property or services taken
in payment must be included in income
(a) If services were rendered at a stipulated price, such price will be presumed to be the fmv of the
compensation received in the absence of evidence to the contrary
f) Dean v. Commissioner (1951)
(i) Facts: taxpayer and wife were sole shareholders in a corporation. Wife owned real estate prior to the
marriage and after the marriage, transferred title to their corporation. Taxpayer and wife continued to live
there as their home.
(ii) fmv was to be included as GI
(a) It was taxpayers legal obligation to provide a family home and if he did it by occupancy of a
property which was held in the name of a corporation of which he was president, fmv of that
occupancy was income to him
(iii) This was no longer imputed income; this was corp. actually giving taxpayers something valuable so
they must include in income
g) Problems:
(i) Vegy grows vegetables in her garden. Does Vegy have GI when:
(a) She harvests her crop? not GI
(i) no realization event. Vegetables used to be in ground and now they are out of ground. But
taxpayer hasnt changed nature of item
(ii) we have reduced property to tangible form; but too early to tax on result of labor
(b) She and her family consume $100 worth of vegetables? not GI
(i) this is imputed self-help income and Congress has chosen not to tax this
(c) She gives to neighbor? depends
(i) Was it a gift?
(a) We are changing nature of relationship w/ property (realization)
(b) No longer considered imputed income when you go outside the family.
(c) Even though realization, and not imputed income, probably a gift
(ii) BUT, could have been an exchange of services

(a) if neighbor is providing you w/ something in return, this would be taxable

(d) She sells vegetables for $100? some is GI
(i) Sale = realization, which is income
(ii) FMV ($100) less $ spent on growing veggies
(iii) can she deduct cost of her labor?
(a) Yes. However, she will be taxed on her earnings from her salary
(e) She exchanges $100 worth of vegetables w/ Charlie for $100 worth of tuna which Charlie
caught? income is FMV
(i) why is this income to both of them
(a) As if selling, receiving cash, and then buying veggies.
(i)
Cross saleexchange of property for property

B. The Exclusion of Gifts and Inheritances

EXCLUDED

1. Rules of Inclusion and Exclusion { 102(a) and (b); Reg. 1.102-1(a), (b)}
a) Exclusion v. deduction:
(i) exclusionanything that is income is included in GI unless specific Code states otherwise
(ii) deductionan issue of possible deductibility is raised whenever taxpayer expends cash, or has
property that does not result in a gain
(a) nothing is deductible unless a Code provision states that a deduction is allowed
b) Checklist that may be helpful:
(i) GI includes the receipt of any financial benefit which is:
(a) Not a mere return of capital, and
(b) Not accompanied by a contemporaneously acknowledged obligation to repay, and
(i) Make sure its not really belated compensation
(c) Not excluded by a specific statutory provision
c) Irwinincome from property is including in GI; income as a gift is included in GI (essentially 102(a))
2. Gifts
a) The Income Tax Meaning of Gift { 102(a)}
(i) General Rule ( 102)GI doesnt include FMV of property by bequest, devise, inheritance, even
though it may increase donees wealth
(a) Bequestpersonal property passing by will
(b) Devisereal property passing by will
(c) Inheritanceproperty passing by intestate succession laws
(ii) Exception ( 102(b)): income derived from a gift is GI

10

(a) Value of stock is not income. Any dividends will be taxed; copyright royalties
(iii) Rationale: Gifts are not taxable income b/c will be taxed on gain when sell item
(a) Although there is no income tax consequences of a gift, there may be gift taxes
(iv) Duberstein gift = detached and disinterested generosity
(a) Facts:
(i) Case 1: Duberstein offered Berman good advice. Berman gave Duberstein a Cadillac.
(ii) Case 2: members of church give Stanton, a retiree, 20k they claim was a gift.
(b) Question: whether a specific transfer to a taxpayer in fact amounted to a gift to him
(c) S.Ct. refuses to define gift, but gives us definition anyway
(i) C/L gifta voluntary executed transfer of his property by one to another, w/o any
consideration or compensation therefore
(a) Mere absence of a legal or moral obligation to make such a payment does not
establish that it is a gift [Old Colony Trust]
(ii) Gift taxwhen something is transferred to someone else for less than FMV
(iii) giftsomething given out of detached and disinterested generosity, out of affection,
respect, admiration, charity or like impulses
(a) most critical consideration is transferors intention
(i)
if more than one motivation, we look at dominate one
b) Employee gifts { 102(c); 274(b); See 74(c); 132(e); 274(j); Proposed Reg. 1-102-1(f)
(i) General Rule ( 102(c)(1))Any amount transferred by or for an employer to, or for the benefit of,
an employee, is GI
(a) No legislative history so sometimes no clear cut answer
(i) broad cong. intent to deny gift classification to all transfers by employers to employees
(ii) for benefit of employeethis is the example of giving the car to ones spouse
(iii) employeecourts expand to mean former, retired employee
(b) A few limited exceptions:
(i) certain employee fringe benefitsReg. 132
(a) General Rulefringe benefits are income w/ some exceptions
(ii) modest achievement awardsReg. 74(c)
(iii) where employee can show transfer wasnot made in recognition of employees
employment
(iv) extraordinary transfers to the natural objects of an employers bounty if employee can
show that the transfer was not made in recognition of the employees employmentProp.
Reg. 1.102-1(f)(2)
(a) 2 requirements:
(i)
transfer made between related parties
(ii)
must be able to show transfer was on account of familial obligation and
not business standpoint (defined as certain family members)

11

(b) Proposed Regs

(i)
New ruleMust be finalized w/I 3 years of proposal or else Reg. fails
on its own terms
(ii)
Old rule (which this Prop. Reg. is under)proposal can be relied on to
same extent as final regulations
(ii) B/c employee gifts now are includible in GI under 102(c), they are not subject to 274(b)(1)
ceiling of $25 per donee per year of deductibility
(a) ceiling is applicable only to non-employee business gifts
(iii) General Ruleall amounts received must be included in GI UNLESS an exception applies
(a) ExceptionGifts are NOT included in GI
(i) Exceptionemployee gifts ARE included in GI
(a) Exceptionfringe benefits are NOT taxable
(iv) Problems (p. 82):
(a) Employer gives all her employees, except her son, a wine set, worth $120. She gives son a set
of wine, worth $500. Does son have GI?
(i) son has GIaccession to net worth [Glenshaw Glass]
(ii) Exceptions may apply (impossible to answer w/o more facts)
(a) Gift? Was it given w/detached and disinterested generosity?
(i)
$100 is GI, other $400 is a real gift from mother to son and therefore
excludable
(b) Proposed Reg. 1.102-1(f)(2)transfer from natural object of employers bounty
AND must be able to show transfer was on account of familial obligation and not
business standpoint.
(i)
None of it is GI.
(c) Maybe son was employee of the year or he was VP he got $500 TV b/c he had
higher status than other employees
(iii) if employer deducts as business expense, seems to be a clear statement of intention,
transfer b/c business relationship but not familial relationship
(a) courts look at this but isnt determinative
(b) Congregation gives Reverend 5k on her retirement. GI?
(i) Is it income under employee gift rules? Depends on structure of church
(a) Is congregation an actual employer? Maybe an independent contractor?
(i)
An issue of control
(b) Who pays for the salary?
(i)
Some denominations congregations contributions
(ii)
Some denominations organization that runs the church pays
(c) Webber v. CommissionerMethodist ministers have the requisite level of control
and they are employee of congregation; also an employee of the church. Both bodies
exercised enough control that ministers are employees
(i)
Other cases have different holdings
(d) Employee - Accession to wealth, doesnt fit into fringe benefits exception. Taxable.

12

(e) Not an employee doesnt automatically mean it is a gift

(i)
Given for past services, not out of detached and disinterested
generosity. Therefore, arguably, not a gift
(c) Retiree receives a 5k trip on his retirement. To pay for cost of trip, Employer contributed 2k,
and fellow employees of retiree contributed 3k. GI?
(i) case law allows us to split one transaction into taxable and non-taxable category
(a) 2k from employer is employee gift and so is taxable (perhaps a fringe benefit would
apply?)
(b) 3k from co-workers must look at each employees motive
(i)
likely a gift, BUT
(ii)
upon retirements, employee 1 is going to start new business and
employee 2 is hoping to work for him, so contributes 3k

C. Employee Benefits

EXCLUDED

1. Exclusions for Fringe Benefits { 132 (omit (j)(2) and (5)). See 61(a)(1); 79; 83; 112; 120; 125. Regs. 1.611(a), -21(a)(1) and (2), (b)(1) and (2)}
a) General RuleAnything employer give you is compensation for your services, and thus, taxable.
(i) In order to take compensation out of taxable income, statutory exception must apply
(a) fringe benefits ( 132)economic benefit, other than cash wages, given by employer to
employee, for the benefit of the employee thats in the nature of compensation
(i) General Rulefringe benefits are included in GI (even if employer deducts)
(a) UNLESS you can point to specific exclusion
(ii) Specific exclusions override 132
(a) If Code provides an exclusion of a type of fringe benefit, 132 is generally inapplicable to that
type of fringe benefit
b) Non-discrimination ruleBenefits are tax-free to highly compensated employees ONLY if benefits are also
provided on substantially the same terms to all employees ( 132(j)(1))
(i) Highly compensated employeeseither makes over 80k for the year before service is received
(preceding year) OR at any time during preceding or current year, held 5% of company
(i) 80k rule can be amended if everyone meets this, to a 80k + top 20%
(ii) > 5% of company stock
(ii) If found to be discriminatory
(a) highly compensated employees MUST include ALL amount in GI
(b) exclusion still applies to those employees (if any) who receive the benefit and who are not
members of the highly compensated group
c) 132 excludes fringes provided to employees (applies to no-additional cost; qualified employee)
(i) expanded definition of employeenot only persons currently employed but also . . .
(a) spouses and dependent children (those who can be claimed as a dependent on tax return)
(b) retired and disabled employees
(c) surviving spouses of employees or retired or disabled ex-employees
(d) for airlines only, parents

13

d) there are 8 categories of f.b. excluded under 132 (plus a few others in other sections):
(i) No-Additional-Cost Services ( 132(a)(1); 132(b))
(a) 3 requirements:
(i) Services are offered for sale to customers in the ordinary course of business (and this is the
service being offered)
(a) Quaker Oats cant get airline service (dont offer this service to public)
(b) United can get airline service
(ii) Employee is in the same line of business as service thats being offered
(a) steward for an airline owned by a company that also owns a cruise ship free
standby airline flights for employee, his spouse and his dependents are excludable but a
free cruise is not
(b) If 2 companies have a written reciprocal agreement that makes services of one
available to employees of other, employees of one company may exclude services
provided by other, if services in question are in employees line of business
(c) Conglomeratesif an employee was employed by a conglomerate in a position
related to both businesses, he would only qualify for exclusion in each line of business
he performed substantial services
(iii) Employer can not 1) incur any substantial additional cost OR 2) forgo revenue in
providing the service to the employee
(b) Other rules:
(i) ONLY applies to services; not goods
(a) Hotel room is a service
(ii) Services must be provided on a nondiscriminatory basis
(iii) Expanded definition of employee applies (132(h))
(iv) Service can be offered free of charge, at a reduced rate, or rebate
(c) Exception as to Reciprocity arrangements(132(i))
(i) Any service offered by employer to employee of another employer (Reg. 1.132-2(b)(2)).
(a) agreement is in writing
(b) in same line of business
(c) and neither incurs substantial cost or forgoes revenue
(ii) all other fringe benefits, we are ONLY talking about employer offering service
(ii) Qualified Employee Discounts (132(a)(2); 132(c))
(a) 2 requirements apply whether good OR service:
(i) Service or goods are offered for sale to customers in the ordinary course of business
(ii) Employee is in the same line of business as service/good thats being offered
(b) Other rules:
(i) Nondiscrimination rule applies (see notes)
(ii) Expanded definition of employee applies

14

(iii) May take the form of either price reduction or a rebate

(c) Ceiling on amount of exclusion:
(i) servicesmay not exceed 20% of price services are offered to customers
(a) 20% is qualified, not included in income
(b) rest is excess, so must be included in income
(c) ex. Legal services offered at $100. Give it to employees for $70. Only entitled to
$20 (20%). So, $10 must be reported as income
(d) includes hotels, airlines, purchases of insurance policies, does not include loans to
employees of financial institutions
(ii) goodsessentially the employers gross profit percentage on goods in the employees
line of business employers average mark up on goods sold
(a) the equation:
aggregate sales revenue for the year cost of goods sold
aggregate sales revenue
(b) based on sales of all property in employees line of business (not just the discounted
item), taking into account employers experience during a representative period
(i)
representative periodReg. 1-132.3(c)(1)(ii)year before year in
which discount is given
(ii)
if in 1st year of business, use either that year OR industry average
(c) Ex. 100k 70k, divided by 100k. average mark up on goods 30%
(i)
employee can only get 30% off; excess is income (1.132-3(e))
(d) Normal cost is $200. employee gets for $60. Discount of $140. Based on
equation, employee only gets to exclude 30% from income, excess must be included in
income
(e) doesnt include real property and personal property held for investment
(iii) if not sure if good or service, evaluate under both
(d) largely theoretical b/c
(i) employees dont know that they have to include it
(ii) employers dont provide employees w/ information
(iii) Working Condition Fringe ( 132(a)(3); 132(d))
(a) Services OR goods provided to an employee, cost of which, if employee had paid, would have
been deductible by employee as a business expense or by way of depreciation deductions
(b) Other rules:
(i) non-discrimination rules DO NOT apply
(a) you can pay for bar fees for just partners but not associates this is OK
(ii) expanded definition of employee DOES NOT apply
(c) there are limitations, but ignored for purposes of applying this definition for working condition
fringe
(i) only 50% of meals

15

(ii) all are subject to 2% floor

(d) Ex: use of a company car for business purposes; employers subscription to business periodical
for employee; a bodyguard provided to an employee for security reasons; on-the-job training
provided by an employer; annual bar dues (bar classes are income b/c not part of business yet)
(e) 1 category that doesnt fit in definition but still part of this category:
(i) 132(j)(3)use of demo cars by full time auto sales persons is a working condition fringe
if there are substantial restrictions on personal use
(iv) De Minimis Fringes ( 132(a)(4); 132(e))
(a) fringe so small that accounting for it would be impracticable or unreasonable
(i) look at how often it is offered by employer to employees occasional
(ii) if employer accounts for it (employer deducts for it; charges to clients), determinative?
(a) No a factor to look at, though
(b) Other rules:
(i) Non-discrimination rules DO NOT apply
(a) EXCEPT to the eating facility 132(e)!!!
(ii) Expanded definition of employee DOES NOT apply
(c) Ex: typing of personal letters by company secretary; occasional personal use of company
copying machine; occasional cocktail parties or picnics for employees; occasional supper money or
taxi fare advanced b/c of overtime work; coffee and doughnuts furnished to employees; occasional
theater or sporting event tickets; low value holiday gifts; modest retirement gift (i.e., a gold watch)
(d) eating facilities provision
(i) on or near employers business premises
(ii) revenue generated from operation, on average, covers their operating costs
(iii) non-discrimination rules apply
(v) Qualified Transportation Fringe ( 132(a)(5); 132(f))
(a) 3 types: (all caps are indexed for inflation)
(i) employer provided parking (includes commuter lot), up to $175 a month
(ii) employer provided van pools, up to $100 a month
(a) seating capacity is at least 6 adults (not including driver)
(b) 80% of mileage is used for commuting and adult seating capacity is used
(iii) employer provided mass transit passes (token, fare card, voucher), up to $100 a month
(a) even if they provide you w/ a portion of cost
(b) Other rules:
(i) Cash rebates are ok
(ii) Non-discrimination rules DO NOT apply
(iii) Expanded definition of employee does not apply

16

(c) Employers may offer an employee a choice between

(i) cash option (which if chosen IS included in GI) OR
(ii) one or more of qualified transportation benefits (which is NOT included in income)
(d) *If fringe is w/I definition of a qualified transportation fringe (before consideration of max
dollar limitation), it may not also qualify as a working condition fringe or a de minimis fringe
(vi) Qualified Moving Expenses Reimbursement ( 132(a)(6))
(vii) Qualified Retirement Planning Services ( 132(a)(7)) (a new one)
(a) Employee may exclude from GI value of any retirement planning advice or information
provided to them or spouse by employer maintaining a qualified employer plan
(i) Service may include pension or profit sharing planning
(ii) Non-discrimination rules apply
(iii) Expanded definition of employee does not apply f
(viii) On-Premises Athletic Facilities ( 132(j)(4))
(a) 3 requirements: (1.132 1(e))
(i) on employers business premises
(ii) facility must be operated by employer (although can hire a manager to operate)
(iii) substantially all use of facility has to be by employee, spouse, children
(a) if somebody else uses, not excludable from employees income
(b) doesnt say dependent children could make this argument
(b) Other rules:
(i) non-discrimination rules DO NOT apply
(a) HOWEVER, employer cannot deduct cost as a business expense UNLESS it
doesnt discriminate
(i)
as a practical matter, no employer is going to build athletic facilities on
premises and not be able to deduct those costs as a business expense, so nondiscrimination rules are going to apply
(ii) sorta expanded definition of employee
(c) includes gym, pool, golf course, tennis court
(ix) Statutory exclusion of other fringe benefits
(a) an ad hoc provision prevails over the general rules of 132
(i) if another Code provides an exclusion for a type of benefit, 132 is generally
inapplicable to that type of benefit
(b) other excluding fringe benefits from GI include:
(i) 79group life insurance; up to 50k of coverage can be excludable
(a) premiums of over 50k are included in income
(i)
exam tip: if 75k, only premiums over 50k must be included in income

17

(b) non-discrimination rules apply

(ii) 120excludes value of group legal services
(iii) 129 dependent care assistance; up to 5k a year OR earned income, if less than 5k
(a) must be in writing
(b) nondiscrimination rules apply
(c) doesnt say child care; parents care assistance may be applicable
(iv) 137excludes employer payments of qualified adoption expenses under an adoption
assistance program
(v) 112excludes compensation received by military personnel for service in a combat
zone
(vi) 134excludes some additional military benefits
(vii) 125Cafeteria plansallows employees to choose fringe benefits they would like to
have from a number of available fringe benefits (health, life, pension, etc.)
(a) excludable from income, even if you have choice of picking cash instead
(i)
if pick cash option, taxable
(ii)
if pick benefits, those amounts are excludable from income
(b) non-discrimination rules apply
(c) planning opportunity: pick non-taxable
2. Fringe Benefit Problems (p. 101):
a) Employee of national hotel chain stays in one of chains hotels in another town rent-free; hotel has several
empty rooms
(i) excluded as no-additional-cost service. 132(a)(1); 132(b)
(a) Must not be discriminatory
(i) If not a highly compensated employee, move on to requirements
(ii) If a highly compensated employee, dont go any further. Its income
(b) 3 requirements are met:
(i) service offered to public (hotels are service)
(ii) same line of business
(iii) no substantial additional expense or foregone revenue b/c rooms are still available
(a) some additional expenses maid service, utilities but these are not substantial
b) same as a, except desk clerk bounces a paying guest so employee can stay rent-free
(i) Not excluded from GI under no-additional-cost service. Reg. 1-132-2(a)(2).
(a) even though 2 requirements are met, 3rd requirement of forgone revenue is not met
(ii) employee could use Qualified Employee Discount

18

(a) offered to public, same line of business

(b) no requirement of incurring revenue/forgone additional cost
(c) could use but only excludes 20% (a service)
c) same as a, except employee pays bill and receives a cash rebate from chain
(i) Rebates still qualify for exclusion. 1.132-2(a)(3).
d) Same as a, except employees spouse and dependent children traveling w/o employee use room
(i) Excludable b/c expanded definition of employee applies. 132(h).
e) Same as a, except employee stays in hotel of a rival chain under a written reciprocal agreement under which
employees pay 50% of normal rent
(i) 132(i) allows for written reciprocal agreement so long as:
(a) in writing
(b) same line as business (hotel)
(c) neither of employers forgo revenue or incur substantial additional cost
(ii) 50% reduction is still ok
f) same as a, except employee is an officer in hotel chain and rent-free use is provided only to officers of the
chain and all other employees pay 60% of normal rent
(i) non-discrimination rules apply to no-additional-cost service
(a) officers are highly compensated employees (those who make over 80k)
(b) but we dont know that this employee is highly compensated just b/c non-discrimination rule,
doesnt mean employee automatically gets nothing
(i) if highly-compensated employee must include ALL of the amount in his income (1.1328(a)(2))
(a) if it discriminates, highly compensated employees dont get a thing
(ii) if not highly-compensated gets to exclude entire amount if all other requirements met
g) hotel chain is owned by a conglomerate which also owns a shipping line. Facts are same as in a, except that
Employee works for the shipping line
(i) No-additional-cost service?
(a) No - not same line of business as service hes getting
(ii) Qualified Employee Discount?
(a) No not same line of service
(iii) Working condition fringe?
(a) No hes on vacation
(iv) De deminis?
(a) may be able to argue cheap hotel room, but probably not
(v) appears that this must be included in income Fmv of his stay in the hotel

19

(a) FMVrate that room is being sold to other customers at that time; standard rate
h) Same as g except that employee is comptroller of conglomerate
(i) theoretically, he works for both lines, so long as he provides substantial services
i) employee sells insurance and employer Insurance Company allow employee 20% off 1k cost of policy
(i) qualified employee discount.
(ii) Service or good? Insurance policies are a service (legislative history says so)
(iii) requirements all met
(a) doesnt exceed 20% of what its offered to public for
(b) employee is in same line of business (sells insurance)
(i) exam tip: dont just say yes. Apply facts to law: he sells insurance, therefore, hes in the
same line of business
(c) employer has to offer these services to customers he does
(d) employer hasnt incurred substantial cost
(e) cant be discriminatory
(i) not enough facts here
j) employee is a salesman in a home electronics appliance store. Prior year store had 1m in sales and a 600k
cost of goods sold. Employee buys a 2k video cassette recorder from employer for 1k
(i) qualified employee discount.
(ii) Service or goods? goods
(iii) meets requirements
(iv) gross profit percentages
aggregate sales revenue (1m) cost of goods sold (600k) = 400k
over aggregate (1m)
= 40%
(v) allowed a 40% discount ($800 off); B/c got 1k off, $200 must be included in income. Other $800 is
excludable from income
(a) purpose of exclusion: employer paid $1200 for item. were ok if employee gets what employer
paid for it
(i) if employee buys for 1k we are dipping into employers pocket this is income
k) employee attends a business convention in another town. Employer picks up employees costs
(i) working condition fringe 132(a)(3). Costs employee paid would be allowed under t/b deduction
(a) attending a convention is deduction as business expense, subject to certain conditions
(i) if held outside of North America must show at least as reasonable to hold outside of North
America as it is inside (same rule applies on a local level)
(b) non-discrimination rules do NOT apply
(c) reason for exclusion: if employee had to include amount in GI, would also be included in
deductions, and this would have been a wash

20

l) employer has a bar and provides employees w/ happy hour cocktails at end of each week
(i) de minimis fringe 1.132-6(e)
(ii) occasional cocktail party ok; is this occasional enough? Must go to case law to find out
m) employer gives employee a case of scotch each Christmas
(i) holiday gifts w/ low market value are excludable Reg. 1.132-6(e)(1)
(ii) maybe excludable do research to find out
(iii) if employer distributed scotch? perhaps a more reasonable gift
n) employee is an officer of corp which pays employees parking fees at a lot one block from corporate
headquarters. Non-officers pay their own parking fees.
(i) qualified transportation fringe. discrimination rule doesnt apply.
(ii) could be higher than $175, in which case this would be limit of exclusion
o) employer provides employee w/ $110 worth of vouchers each month for commuting on a public mass transit
system
(i) qualified transportation fringe.
(ii) Cap of $100 a month; $10 a month has to be included in income
p) Employer puts in a gym at business facilities for use of employees and their families
(i) athletic facility 132(j)
(ii) as long as meets all requirements
(iii) whole discriminatory issue

D. Awards

INCLUDED

1. Prizes { 74; See 102(c), 132(a)(4), (e), 274(j); Reg 1.74-1, Proposed Red 1.74-1(b)}
a) Examples:
(i) Prizes 74, includes receipts for winning companys sales or other contest, Nobel Peace Prize,
Pulitzer Prize, contest to guess most jelly beans in a jar
(a) I.e. Price is Right win a car and a trip; no cash at all. Still have to pay taxes on them
(ii) Awards 117, includes scholarships and fellowships
b) General RulePrizes and awards are GI UNLESS statutory exception applies ( 74(a))
(i) If prize or award is made in goods/services, fmv of prize or award is amount included in GI
(ii) Anything in this Code supercedes 102 (gift exclusion)
(iii) 3 Exceptions to prizes being included in income:
(a) qualified scholarships
(i) 4 requirements (see scholarships and fellowships)
(ii) write essay and you win scholarship amount is excluded

21

(b) meritorious achievement award 74(b)excluded if meets 5 requirements:

(i) Award must be for religious, charitable, scientific, educational, artistic, literary, or civic
achievement
(a) Nobel Prize, Pulitzer Prize
(ii) Recipient must be selected w/ no action on her part
(a) Cant apply for it; cant enter contest or render services
(b) If preliminary selected, can fill out biographical/interview this is considered no
action on your part
(iii) Recipient cant be required to perform substantial additional services to get award
(a) Show up at award ceremony, but thats about it
(iv) Award must be paid directly to charitable organization ( 170(c)(1)) or gov entity
selected by recipient w/I 45 days(this is new)
(a) Thus, only way winner can escape an inclusion in GI is never to receive the award
(b) prior to 1987, got to receive $ and exclude all of it from income
(v) value doesnt exceed 50% AGI
(c) modest employee achievement award 74(c)
(i) Review
(a) 102(c) does not include gifts from an employer to an employee w/I 102(a) gift
exclusion rule, thus requiring inclusion of such gifts in an employees GI
(i)
however, gift from an employer to an employee such as a retirement
gift after a long period of service may escape GI inclusion by qualifying as a
132(a)(4) de minimis fringe benefit
(ii) One of few areas where exclusion is tied to deduction
(a) Misconception: if employer takes deduction, employee cant exclude
(i)
These are separate issues
(b) Here, dont operate independently, however
(iii) 4 requirements:
(a) must be an item of tangible personal property (no cash or cash equivalent)
(b) must be given for either length of service OR safety achievement
(i)
made more money for company doesnt qualify
(ii)
length of service awardrequirements: 1) employee must have been
in employers service for 5 years or more AND 2) employee must not have
received a length of service award for current or any of prior 4 years
(iii)
safety awardrequirements: 1) must be made to someone other than a
manager, administrator, clerical employee or other professional employee AND
2) only if 10% or less of an employers qualified employees receive such awards
during the year so that it is discriminating and not just a part of the general pay
scale AND 3) must be in form of tangible personal property (no cash)
(c) must be awarded as part of a meaningful presentation
(d) must be given under circumstances making it unlikely that it is disguised
compensation
(i)
given from employer to employee it is compensation.
(ii)
This is virtually ignored as a requirement

22

(iv) Caps on amount that can be excluded by recipient /deductible by employer

(a) Qualifiedpaid as part of established written plan which is non-discriminatory
(i)
$1600 per year, per employee
(b) Non-Qualifiednot in writing; can be discriminatory
(i)
$400 per year, per employee
c) Allen J. McDonnell
(i) Facts: home office salesmen and their spouses were selected from hat to accompanying sales contest
winners on their vacation to Hawaii. Trip was a business assignment, albeit an informal one, and they
were instructed not to go off alone
(ii) Court held expenses of trip are not includable in GI
(a) Mere fact petitioners were selected by a random drawing does not make trip a taxable prize or
award under 74
(b) Trip was not a vacation for petitioners
(c) Whether petitioners enjoyed the trip is immaterial
(d) Noteworthy that petitioners didnt go swimming or shopping, something Hawaii is known for
d) Problems:
(i) Each year national sportswriters get together and select single most outstanding amateur athlete in
country and award that person a check for 5k. Picabo, a talented skier, has been selected for this years
award. Award is given w/ stipulation that winner deliver a 15 minute acceptance speech at an awards
banquet. Picabo, essentially delivering an acceptable rejection acceptance speech, designates the
National Ski Patrol Organization, a charity under 170, to receive 5k award. Sportswriters send check to
Ski Patrol Organization. Will Picabo be able to exclude the 5k from her GI?
(a) meritorious achievement award
(i) must fall in one of categories 7 categories
(a) artistic n (artists in sense of artists, not athletes, says case law)
(b) civil achievement maybe (Defined as positive action that is exemplary, unselfish,
and broadly advantageous to community; professional athletes do NOT fall here even
though held up as role-models (b/c they are getting monetary award))
(i)
here, amateur athlete. Could argue civil achievement
(ii) we assume falls w/I 1 of categories; must be selected w/o any action on her part
(a) didnt nominate self, so ok
(iii) no additional service
(a) Can make you show up to get award
(b) 15 minute speech not clear
(i)
what is really talking about is 100 hrs of community service
(iv) must be given to charitable organization. Here, it is
(b) meets 4 requirements so excludable
(ii) Gusher Oil desires to make its employees feel more appreciated. To implement this desire, Gusher
creates an awards program whereby employees are given awards for achieving certain lengths of service.
(a) Cliff has been working for Gusher for 12 years. Announcing Cliffs retirement at the Oil
Barons Ball, Gusher Oil gives him a $300 gift certification
(i) modest employee achievement award

23

(a) length of service award

(b) meets cap for either qualified or non-qualified
(c) doesnt meet the not cash or cash equivalent
(i)
Under Regs gift certification and checks are cash b/c representatives of
cash. 1.274-8(c)(2)
(d) Is NOT excluded under 74(c)
(ii) Still excludable as fringe benefit, however
(a) 132 provides that if there is a specific code section that would exclude the amount,
and dont meet those requirements, cant fall back on 132 to exclude the amount
132(l)
(i)
EXCEPT for de minimis fringe benefits
(b) Cliff (who is continuing to work for Gusher) receives a gold watch worth $300 for his 12 years
of service, presented at the Oil Barons Ball
(i) excluded under 74(c)
(a) no indication that he has received award in last 5 years
(b) not cash or cash equivalent
(ii) *probably wouldnt be a de minimis fringe b/c not a retirement gift
(c) same as b except that Cliff has worked for Gusher for only 4 years
(i) under modest achievement award, must have at least 5 years of service; he doesnt so
doesnt qualify
(ii) likely includable in income unless can be excluded as de minimis fringe
2. Scholarships and Fellowships { 117; 127(a), (b)(1), (c)(1); Prop Reg. 1.117-6(b), (c)(1)-(4), (d)(1)-(3)}
a) 3 educational benefits can be excluded: (*others include tax credits and deductions, not covered here)
(i) qualified scholarships and fellowships - 117(a)
(a) 4 requirements:
(i) must be a degree candidate (undergrad or grad; preparing to go get a degree 1.117.3(e))
(a) really only non-degrees that dont qualify
(ii) must be attending an educational institution:
(a) regular faculty and curriculum; body of students enrolled; educational activities
regularly carried out
(b) **trade school would qualify (although would have problems w/ candidate for a
degree), internet courses also qualify
(iii) money must be spent on qualified tuition or related expenses
(a) tuition, fees, books, supplies, equipment required for courses
(i)
NOT room and board
(b) UMC we dont charge tuition; instead, we charge fees (??)
(c) Military uniforms?

24

(i)
Argument that not the types of supplies/equipment Service had in mind
(iv) Cant be disguised compensation for past, present or future services
(a) Most cases have held that if scholarship comes from employer, its compensation
for past, present, future services
(b) Examples:
(i)
Payment for teaching, research or other services by student required as
a condition of receiving money
(ii)
Educational grants by employer to current or former employee
(doesnt matter if there is no contractual obligation to render future services if
clear expectation employment will continue)
(b) Athletic scholarships:
(i) If expects, but doesnt require student to participate
(ii) If doesnt require any activity in place of participation
(iii) Scholarship wont be cancelled if student doesnt participate
(c) no limit on amount of scholarship, no limit on time (8 year student covered)
(d) non-discrimination rules dont apply
(ii) qualified tuition reduction 117(d)
(a) tuition break, either in form of reduced tuition or free tuition, that is given to you from
employer (you work for school)
(b) 4 criteria:
(i) attend and are employed by a educational institution
(a) doesnt have to be YOUR educational institution can be at any other 117(d)(2)
(ii) must be for undergrad work only
(a) 1 exception: employees of educational institutions taking graduate-level classes
can use qualified tuition reduction if graduate student is either a TA or RA
(iii) money must be spent on qualified tuition only
(a) No room and board
(iv) Cant be disguised compensation
(a) Unlike qualified scholarship (where everyone is disguised)
(b) Are you getting paid the fair and going rate?
(i)
If not, disguised compensation and must be included in income
(c) Other rules
(i) Cant discrimination in favor of highly compensated employees
(ii) Expanded definition of employee applies
(a) What if spouse is taking undergrad and employee is TA?
(i)
graduate exception applies only when employee is TA taking courses

25

(iii) no cap
(iii) educational assistance program 127
(a) permits employee to exclude up to $5,250 per year for amounts paid by employer for
educational assistance
(b) 5 criteria:
(i) must be in writing
(ii) cant exceed $5,250
(iii) costs must go towards tuition, books, supplies and an employer provided educational
course
(a) NOT room and board
(b) no assistance for courses involving sports, games or hobbies
(iv) graduate/undergraduate
(a) dont have to be a degree candidate
(b) dont have to be job-related courses
(c) individual doesnt have to attend an educational institution (i.e. trade school)
(v) employer cant have offered employee option of choosing education or cash
(a) its ok if its compensation (coming from employer)
(c) Other rules
(i) cannot be discriminatory in favor of highly compensated employees
(ii) expanded definition of employee does NOT apply
(d) **this is really a fringe benefit
(iv) Problems (p. 115):
(a) Student working toward an A.B. degree is awarded a scholarship of 6k for full tuition and for
room and board during the academic year. Tuition, including the cost of books, is 3k, and room and
board costs 3k. As a scholarship recipient, student is required to do about 300 hours of research for
professor. Nonscholarship students, if hired, receive 10k.
(i) Tax consequences to student: qualified scholarship (117(a))
(a) candidate for degree b/c candidate for AB
(b) educational institution unclear, but probably
(c) scholarship goes towards tuition, fees, books, supplies part does
(d) Therefore, 3k (tuition and books) qualifies for exclusion
(i)
BUT, cant be compensation for past, present, future
(ii)
Here, it is. Getting compensation for work/research that is valuable ot
other people so must be included in income
(e) Other 3k doesnt qualify b/c room and board must include in income.
(f) 127 or 117(d)?

26

(i)
not 127 b/c same requirements of tuition, etc.
(ii)
not 117(d) b/c same requirements of tuition, etc.
(g) creative arguments that it might be less than 6k.
(i)
Yes. 3k has to be included as room and board, but thats the 3k I earned
from my income
(ii) Tax consequences to student if all students are required to do 300 hours of research for
faculty?
(a) too bad; if FMV of that research, it must be included in income, even if everyone is
required to do it 1.117-6(d). same result as in (a). OR
(b) since all students have to do it w/ or w/o compensation this isnt compensation for
service rendered. May be excluded
(iii) result if student is not required to do any research but receives 6k as an athletic
scholarship?
(a) Rev. Ruling 77-263 athletic scholarship requirements:
(i)
university expects but does not require student to participate in sport
(ii)
requires no particular activity in lieu of participation in sport
(iii)
cannot terminate scholarship if student cannot participate due to injury
or b/c of students unilateral decision not to participate (really means does not)
(b) 3k for room and board must still be included in taxable income
(c) entire 6k may be included, we cant tell from this problem set
(iv) tax consequences to student if student receives only a tuition scholarship worth $2,500
(no books) b/c students spouse is an employee at a neighboring educational institution and
tuition scholarship is part of a nondiscriminatory plan between several institutions applicable
to all employees of such institutions?
(a) Not 117(a) b/c looks like in nature of compensation
(b) Not 127 b/c use of expanded definition of employee
(c) 117(d)qualified tuition reduction may work
(i)
is an educational institution
(ii)
- but not one employee works for. Thats ok 117(d)(2)
(iii)
tuition only
(iv)
cant be disguised compensation
(v)
- compare what other employees are receiving must be getting the
going rate
(vi)
can only be to undergrad except if TA/RA
(vii)
non-discriminatory cant be discriminatory in favor of highly
compensated employees
(b) Secretary, in large tax law firm, receives a 10k stipend from her firm to assist her while on a
leave of absence to obtain a college degree. Stipend is part of firm plan under which all recipients
are required to return to the firm following their educational leave
(i) Tax consequences to secretary? 127educational assistance program
(a) why not the other ones its from employer; problem b/c compensation
(b) tuition reduction an additional problem
(i)
educational institution must be employer - here, its not

27

(c) 127 requirements

(i)
cap of $5,250, rest must be included in income
(ii)
can be grad/undergrad this appears to be undergrad
(iii)
can only be used for tuition, fees, books, supplies, equipment (we dont
known what expenses are going for)
(iv)
non-discrimination rules apply
(v)
must be in writing
(d) $4,750 is income
(ii) tax consequences to secretary if she is not required to return to firm after completing her
degree?
(a) still qualify under 127, irrespective if she has to go back to work or not
(iii) tax consequences to secretary if she is not an employee, but instead receives stipend as a
prize in an essay contest?
(a) qualified scholarship requirements
(i)
candidate for degree
(ii)
assume at educational institution
(iii)
must be used for tuition
(iv)
clearly not in nature of compensation
(b) **pointsomething thats a qualified scholarship and a prize?
(i)
Qualified scholarships take precedents over prize/award that would
otherwise be included in income; 117 takes priority over 74.

E. Gain from Dealings in Property INCLUDED

1. Factors in the determination of gain { 1001(a), (b) first sentence, (c); 1011(a); 1012; Reg 1.1001-1(a)}
a) 61gains from sale or disposition of property is GI (not basis b/c basis is merely a return of capital)
(i) how do we determine gain on the disposition of property: 1001(a)Ar ab = gain
(a) gain/loss need be figured only if there is a realization event
(i) appreciation in value of property is taxed when gain is realized. Realization event triggers
a gain/loss. Gain must be recognized unless non-recognition provision
(ii) most realization events involve receipt of money, property and services received, and debt
taken over by transferee
(b) Aramount of money received + fmv of property ( 1001(b))
b) basisreturn of capital. Answers the question: How much have I got in it? EXCLUDED from income
(i) Summary of Basis:
(a) Cost Basis (1012)
(i) Cash basisamount of cash paid for property
(ii) Tax Cost Basis amount included in income as a result of receipt of property increases

28

(iii) Property for property exchangefmv of property received [Philly]

(a) Cost of purchasing property (attorney frees, broker fees, etc.) are added to basis
(iv) Compensationfmv at time reported
(v) Purchased subject to liabilitycash paid + amount of loan [Crane: assumptionyou will
eventually pay off those loans and have amount sunk into property]
(vi) that propertys basis (i.e. receive property as compensation; exchange of Bronco/accord)
(b) Gift Basis (1015)
(i) General Ruletransferred basis
(ii) Exceptions: Property has a built in loss at the time of the gift (transferred basis > fmv) +
(a) sold above fmv = transferred basis
(b) sold below fmv = fmv at time of gift
(c) sold between fmv and donors basis, no gain/no loss
(iii) Part sale/part gift (Reg. 1.1015-4)
(a) Donees basis = greater of: amount donee paid OR donors ab at time of gift; + gift
tax
(b) Donor must claim Ar ab
(i)
Doesnt realize loss if Ar is less than ab
(c) No part sale/part gift between spouses
(c) Basis at death (1014)
(i) Before 2010 ( 1014)fmv at death; stepped-up basis
(a) Exception: if decedent receives property as a gift, w/1 year of death, and that
property transfers back to donor at death or to donors spouse at time of death, basis is
transferred basis
(ii) After 2010 ( 1022)fmv of lesser of: ab OR fmv at time of death; + 1.3m (spouse 1st
4.3 is never taxed) (but increase in basis cant bring any property to have a basis over fmv)
(a) Exception:
(i)
If transferred w/I 3 years of death, not eligible for basis increase
(ii)
Exception: if gift was from a spouse
(d) Basis between spouses ( 1041)ALWAYS transferred basis, even if sale w/ full consideration
(ii) asis v. value:
(a) If property acquired is securities that increases in value to 15k, basis is still only 10k
(iii) ab = original basis amount of depreciation allowed + cost of improvements
(a) cost basis 1012
(i) cost of property; what you paid for it.
(a) i.e., $50 commission for $500 stock. Basis = $550.

29

(ii) All fees are costs of purchasing property and get added to basis
(b) Tax cost basisyou didnt pay anything for it but you included it in income
(i) Car dealer, instead of receiving money, saves hours worked to buy a 35k car
(a) Must include 35k in income (wages in form of property)
(ii) Sells car for 25k. 25k 35k = 10k loss
(iii) If car worth 35k but really only earned 30k, and he has to pay 5k additional.
(a) Ab = 5k cost basis +30k tax cost basis
(b) Reg. 1.61-2(d)(2)(i) if property is transferred from employer to employee or
independent contractor, as compensation for services, for an amount less than its fmv,
then regardless of whether transfer is in form of a sale or exchange, difference between
amount paid for property and amount of its fmv at time of transfer is compensation and
shall be included in GI of employee or independent contract
(c) Basis in exchange of properties
(i) Property for property exchange; barter exchange (different than barter club situation)
(ii) Q: what is basis of property received in such exchange
(a) Philly case
(iv) Lessee improvements to rental property
(a) Any lessee improvement to rental property are NOT included in income UNLESS they are in
the nature of rent ( 109)
(i) Reasons for 109:
(a) Valuing improvements is a problem
(b) You dont have the cash from the improvements at the time you receive them
(b) 1019 matches payment of tax w/ when taxpayer gets money to pay tax by not allowing an
increase in basis, thus increasing taxpayers Ar on sale or other disposition of the property
2. determination of basis
a) Cost as basis { 109; 1011(a); 1012; 1016(a)(1); 1019; Reg. 1.61-2(d)(2)(i); 1.1012-1(a)}
(i) Philadelphia Park Amusement Co. v. US (1954)
(a) Cost basis of property received in a property for property exchange is fmv of property
received in exchange (NOT fmv of property given)
(b) X has bronco he wants to get rid of (fmv = 10k). Y exchanges her accord (fmv = 11k).
(i) What is the realized gain of X?
(a) X has a sale or disposition of bronco, which triggers gain/loss
(b) Ar-ab = realized gain; Ar = 11k (accord); ab = 10k (bronco) = 1k realized gain
which is taxable b/c no non-recognition provision
(i)
Xs cost basis now is fmv of what he received 10k tax cost basis
(what he paid for it) + 1k cost basis (what he included in income) = 11k (fmv of
Ys basis)
(ii) What about Y?
(a) Sale or disposition of accord. Triggers gain or loss
(b) Ar = 10k (bronco); ab = 11k (accord). 1k realized loss.

30

(c) When property is exchanged for property in a taxable exchange taxpayer is taxed on
(i) the difference between the ab of the property given in exchange and fmv of the property
received in exchange
(a) Basis of property received = ab of property given + any gain/loss recognized
(ii) If FMV of property received is unascertainable, reasonable to assume that value was
equal to property given
(ii) Problems (p. 121): Sale of disposition which triggers realized gain. RG = Ar ab. Must be
recognized unless there is a non-recognition provision
(a) Owner purchases some land for 10k and later sells it for 16k. Amount of owners gain on sale.
(i) Owner has a sale or disposition of property triggering gain/loss
(ii) Calculation of gain: Ar ab = realized gain
(a) Ar = 16k (what he got); ab = 10k; 16k-10k = 6k realized gain which must be
recognized in that year unless can point to some non-recognition provision/exception
(b) difference in result a if owner purchased land by paying 1k for an option to purchase land for an
additional 9k and subsequently exercised the option.
(i) Owner has a sale or disposition of property triggering . . .
(ii) Calculation of gain
(a) Ar = 16k (what he got); ab = 10k (comprised of what he paid: 1k cost of option and
9k purchase); 16k-10k = 6k realized and recognized gain
(c) Result in b if rather than ever actually acquiring the land owner sold the option to investor for
1500.
(i) Owner has a sale or disposition or property triggering . . .
(ii) Calculation of gain
(a) Ar = 1500 (what he got); ab = 1k; 1500-1k = 500 realized gain
(b) Issue: the option is an interest in property
(d) Difference in a if owner purchased land by making 2k cash payment from owners funds and an
8k payment by borrowing 8k from bank in a recourse mortgage (on which owner is personally
liable). Would it make any difference if mortgage was a nonrecourse liability (on which only land
was security for obligation)?
(i) Ar = 16k; ab = 10k (cash of 2k, borrow 8k and put into property); 6k realized gain
(a) issue: whether liability goes into basis
(b) Cranes underlying assumption: when you borrow $ and sink it into property,
you immediately get to put borrowing amount in basis, on assumption that
eventually you will pay off the liability
(i)
recourse or non-recourse liability goes into borrowers basis
(e) Result in a if owner purchased land for 10k, spent 2k in clearing land prior to its sale, and sold it
for 18k.
(i) Ar = 18k; ab = 12k (10k he paid for land + 2k in improvement); 6k realized gain
(a) Improvements increases basis.
(f) Difference in e if O had previously rented land to lessee for 5 years for 1k per year cash rental
and permitted lessee to expend 2k clearing property? Assume that, although O properly reported
cash rental payments as GI, 2k expenditures were properly excluded under 109
(i) Ar = 18k; basis = 8k (10k 2k)
(ii) exceptions for improvements:
(a) lessee makes improvements and rent is NOT reduced lessor does not have to
include improvements in GI ( 109)

31

(b) Reasons:
(i)
Try to match imposition of tax to pay for tax
(ii)
We dont really know value of improvements until sell property
(c) Lessee improvements and rent reduced MUST still be included in income! (but
can increase basis???)
(iii) Taxpayer doesnt have to include cost of lessees improvements to property
(a) Rent doesnt increase basis UNLESS taxpayer takes money and invests it into
property
(iv) 1019companion to 109. If O does not include improvements in income b/c not in
nature of rent, O does not increase his basis as a result of those improvements
(a) if does include lessee improvements exclude amount from basis
(v) 109good for taxpayers b/c keeps GI down. Will have to include value of improvements
sometime. Defer including amount in income until sale of property
(vi) 1019bad for taxpayers. Realized gain would be higher. Doesnt allow taxpayer to
increase basis.
(vii) interest does not go into basis b/c cost of borrowing $, not a cost of purchasing property
(g) difference in result in a if when land had a value of 10k, O, a real estate salesperson, received it
from employer as a bonus for putting together a major real estate development, and owners income
tax was increased 3k by reason of receipt of land?
(i) Ar = 16k; ab = 10k; realized gain = 6k
(ii) why does he get to include 10k in basis when he never paid anything?
(a) Its like you got 10k in cash, then turned around and bought property for 10k.
(i)
not how much you pay in tax; its how much you include in income
(ii)
not 3k that gives us tax cost; but amount he includes in income = 10k
(iii) 3k. not a cost of purchasing property a cost of living in US
(a) justification: protective arm of US government surrounding us wherever we may
roam
(iv) is there a difference in treatment between different types of income tax?
(a) federal and state dont go in basis
(b) transferred, sales tax do go into basis!
(i)
Property tax doesnt affect basis
(h) Difference if owner is a salesperson in art gallery and O purchases 10k painting from art gallery,
but is required to pay only 9k for it (instead of 10k b/c owner is allowed a 10% employee discount
which is excluded from GI under 132(a)(2)), and owner later sells painting for 16k?
(i) Ar = 16k; ab = 10k (9k paid + 1k discount)
(ii) discount is not in code.
(a) But discount is supposed to be excluded from income you never pay taxes on it
(i)
courts have said, we should increase basis by 1k discount excluded
from income, b/c otherwise, person ends up paying tax on 1k.
(iii) how do we know excluded or deferred?
(a) research

32

(i)
deferral, there will be a corresponding provision on what to do w/ basis
(ii)
exclusion, increase basis. Otherwise becomes deferral basis and not
exclusion
b) Property Acquired by Gift { 1015(a); 1015(d)(1)(A), (4) and (6); Reg. 1.1015-1(a)}
(i) General Rulewhen receive a gift, you dont have to include it in income (102)
(a) donor of gift has no income tax consequences (this isnt anywhere in code!)
(b) donee is taxed on transferred basis from donor
(i) Inter vivos generally, donors basis ( 1015)
(ii) Testamentary generally, value at donors death ( 1014)
(iii) EXCEPTION: if 1) a built in loss in gift at time of transfer and 2) donee sells it
below that fmv, then donees basis is the fmv at the time of the gift
(c) Receiving a gift = no income tax consequences
(i) Donor paid 20k; property goes up to 50k. Donor gives property to donee.
(a) Donees ab = 20k. At time of transfer, property has built in gain of 30k; not taxed
until sold
(ii) 1015provision that helps donee find out information from another taxpayer. Treasury property will
help you. If cant, will infer basis of fmv at time given as a gift.
(iii) Non-recognition provisionsold, triggering a realized gain. Dont have to recognize gain until
donee later sells property
(a) policy for transferred basis otherwise Congress would never get money
(i) this is a deferral instead of exclusion
(iv) 1 exception to transferred basis rule on gifts:
(a) applies when 2 requirements are met:
(i) property has a built in loss at time of the gift
(a) basis is higher than fmv
(ii) donee sells the property for less than fmv at time of gift
(b) if both requirements are met, donees basis is fmv (at time of gift), NOT TRANSFERRED
BASIS.
(i) Reason for rule: Congress wont permit transfer of losses between taxpayers
(a) EXCEPTION: Can transfer loss between spouses
(v) Taft v. Bowers
(a) Ar donors basis = gain taxable to donee
(vi) Farid-Es-Sultaneh v. Commissionerdefinition for income and gift taxes may differ
(a) Pre-nup where P got shares of stock for release of right to dower upon divorce
(b) Q: was transfer from him to her a gift (transferred basis (which would be low)), or an exchange
of property for property (basis would be fmv on date of transfer (taxable gain))
(i) she wanted property for property exchange b/c SOL would have run to tax gain, shed get
fmv basis, so stepped-up basis w/o having to pay taxes on gain

33

(ii) Wasnt spousal transfer b/c not married yet 1041 doesnt apply to pre-nups
(c) Court holds She gets basis equal to fmv at time of she received the stock
(vii) Problem (p. 128): The basis of property acquired by gift is transferred basis at the time of the gift
unless there is a loss. With a loss, if property sold < fmv, basis = fmv. If property sold > fmv, basis =
transferred basis. There was a sale or disposition triggering a realized gain. Ar ab = RG
(a) Donor gave donee property under circumstances that required no payment of gift tax. What
gain or loss to donee on subsequent sale of property if property had cost donor 20k, had a 30k fmv
at time of gift, and donee sold it for:
(i) 35k
(a) Ar = 35k (what he sold it for); ab = 20k (transferred basis); realized gain = 15k
which must be recognized unless non-recognition provision. There isnt one here
(ii) 15k
(a) Ar = 15k (what he sold it for); ab = 20k (no built in loss at time of gift. Therefore,
exception doesnt apply); realized loss = 5k
(b) Although realized gains must be recognized unless non-recognition provision, not
so for losses may or may not be able to be recognized.
(c) Only 3 types of losses that CAN be recognized 165(c):
(i)
trade/business losses
(ii)
investment losses (stock losses are deductible)
(iii)
casualty losses (theft, storm, fire, shipwreck)
(d) sale of car, property, etc dont recognize those losses.
(iii) 25k
(a) Ar = 25k; ab = 20k; realized gain of 5k which must be recognized
(i)
If built in gain or no gain or loss at time of the sale or disposition,
always use transferred basis!!
(b) What if property had cost donor 30k, had 20k fmv at time of gift, and donee sold it for:
(i) 35k
(a) Ar = 35k; ab = 30k b/c 35k > 20k. Therefore, basis = transferred basis; realized
gain of 5k
(i)
even though built in loss, donee didnt sell it for less than fmv
(ii) 15k
(a) Ar = 15k; ab = 20k b/c 15k < 20k. Therefore, basis = fmv; realized loss of 5k
(b) Donee sells property below fmv at time of the gift, and property was transferred at a
loss. Therefore, exception applies.
(i)
any loss suffered by donee after transfer can be recognized by donee
(assuming a recognized loss)
(iii) 24k
(a) Ar = 24k; ab = ?; realized gain = 0
(b) First, exception to general rule apply here?
(i)
property transferred has a built in loss at time of gift.
(ii)
But donee does NOT sell property for less than fmv

34

(iii)
Therefore, loss basis doesnt apply.
(c) But if we use gain basis, donee would have 6k loss. Cant transfer 1.10151(a)Ex.when a built in loss at time of gift, if donee sells above fmv, we use ab; if sell
below fmv at time of gift, donee uses fmv; if sells anywhere in between (only if built in
loss) no gain or loss
(i)
Reason: 30k is supposed to be used to determine gain. If we use it, it
will provide a loss; 20k supposed to be used to determine loss. If we use it, it
will provide a gain
(ii)
There are 2 basis one for determining loss; one for determining gain
(iii)
no gain, no loss built in loss and donee sells in between basis and fmv
(d) B/c selling price < transferred basis and > fmv, there is no gain/loss on sale
(c) Part sale/Part gift problem: Father had some land that he had purchased for 120k but which had
increased in value to 180k. He transferred it to daughter for 120k in cash in a transaction properly
identified as in part a gift and in part a sale. What gain to father and what basis to daughter under
Reg. 1.1001-1(e) and 1.1015-4?
(i) These Regs are law, but are not in Code, only in Regs
(ii) Part sale/part gift
(a) donors gain is Ar - ab (Reg. 1.1001-1(e))
(b) donees basis is greater of: (Reg. 1.1015-4)
(i)
amount donee paid for property
(ii)
donors ab + gift tax paid
(iii) Property cost 120k; fmv is now 180k; 60k gain someone is going to pay tax on this
gain (either donor or donee)
(a) Sale/gift, usually split between donor and donee (however, not in this case)
(iv) fathers gain is 0
(a) donors gain = Ar ab = 120k-120k = 0
(b) what if father had sold to daughter for 100k?
(i)
Ar ab= 100k 120k = 20k loss
(ii)
BUT Reg. 1.1001-1(e), realized loss cannot be recognized by donor in
part sale, part gift
(v) daughters basis
(a) Amount she paid and fathers ab for property at time of the transfer are both 120k
(b) So donees basis is 120k.
(c) Different example - donor sold for 140k.
(i)
Amount paid by donee = 140k; donors ab = 120k. Use greater number
of 140k for basis. 180k - 140k = 40k recognized gain.
(vi) Note: this reg goes on to say greater of the two options, in either case, increased by gift
tax paid
(a) Part sale/gift, donees basis is effected by this and also gift tax
(d) Suppose transaction were viewed as a sale of 2/3rds of the land for full consideration and an
outright gift of other 1/3. How would this affect fathers gain and daughters basis? Is it a more
realistic view than that of Regs?
(i) not the law for this sort of situation (father/daughter); this is the law w/ respect to charity
(ii) treat this as sale of 2/3 and gift of 1/3 [father sold land for 120k; worth 180k each parcel
is worth 60k]

35

(iii) fathers tax consequences

(a) Ar = 120k (what he sold it for); ab = 80k (120 divided by1/3rds; ab for each basis is
40k. for 2 of the parcels, 80k). 1011(b)ar/fmv * total ab for property = ab in sale
portion [120/180 * 120 = 80k].
(b) fathers gain 40krealized and recognized gain if sold to charity
(i)
in (a), father didnt recognize any gain.
(ii)
Sale/gift Generally puts more gain on donor than on donee
(iii)
----Charities are tax exempt
(iv)
----Manipulates system by taking part of gain out of tax system
(v)
----Timing tax donor now, donee is taxed later. Donee is tax exempt
and probably wont get taxed later.
(c) What about gift portion? (1/3)
(i)
If a true gift, no income tax consequences
(iv) Donees basis
(a) 2 separate basis
(i)
basis in sale portion 120k. (cost basis what she paid for it) 1012.
(ii)
Basis in gift portion 40k. (basis in gift, generally transferred basis
from donor in gift portion)
(iii)
Total basis 120+40 = 160
c) Property Acquired Between Spouses or Incident to Divorce { 1041; Reg. 1.1041-1T(a) and (d)}
(i) 1041almost complete tax neutrality to transfers of property between 2 groups of people: 1)
spouses (people who are married under the law) and 2) former spouses if transfer is incident to divorce
(a) General Ruletransferee spouse or former spouse ALWAYS takes a transferred basis in
property received
(i) No gain/loss is recognized
(a) gift basis rule can NOT transfer loss, only fmv
(b) spouses rule CAN transfer a loss
(ii) provides that transferor has no recognized gain/loss
(a) this is the second non-recognition provision
(b) policy justification: spouses are looked at as 1 economic unit
(ii) Problem (p. 131): Andre purchased some land 10 years ago for 4k cash. Property appreciated to 7k
at which time Andre sold it to his wife Steffi for 7k cash, its fmv
(a) Tax consequences to Andre?
(i) there was a realization event sale or disposition triggering realized gain.
(ii) Ar = 7k (what he sold it for); ab = 4k (what he put into it); Realized gain = 3k
(iii) None of gain needs to be recognized ( 1041) no tax consequences to Andre.
(b) Steffis basis in property?

36

(i) Transferred basis under 1041 = 4k

(c) Gain to Steffi if she immediately resells the property?
(i) Realization event
(ii) Ar = 7k; ab = 4; gain = 3k.
(iii) no non-recognition provision, so must be recognized
(d) what results in (a) (c) if property had declined in value to 3k and Andre sold it to Steffi for 3k
(i) Andre: Ar = 3k; ab = 4k; realized loss of 1k
(a) Non-recognition provision applies b/c transfer between spouses.
(i)
Loss can only be recognized if it fits into 165 categories. Land is
usually an investment. But here, doesnt matter b/c transfer between spouses
(ii) Steffis basis: transferred basis of 4k
(iii) Steffi resells property:
(a) realized gain is recognized unless non-recognition provision
(b) recognized loss is recognized only if: t/b, investment or casualty
(i)
land is often an investment so loss must be recognized
(e) what results to Andre and Steffi if Steffi transfers other property w/ a basis of 5k and value of 7k
(rather than cash) to Andre in return for his property?
(i) assume that Andres land is really Wimbledon; Steffi has cottage
(ii) tax consequences:
(a) sale or disposition realization event
(b) Andres Ar = 7k (fmv of what he got cottage worth 7k); ab = 4k (basis of what he
gave up); realized gain of 3k but not recognized b/c it is a transfer between spouses.
1041 applies. No tax consequences to Andre
(c) Steffis Ar = 7k (fmv of what she got); ab = 5k; realized gain = 2k not recognized
b/c it is a transfer between spouses
(d) subsequent sale of cottage:
(i)
Andre sells cottage: Ar = 7k (fmv); ab = 5k (transferred basis); realized
gain of 2k must be recognized between no non-recognition provision applies.
He has 2k realized and recognized gain.
(ii)
Steffi sells Wimbledon: Ar = 7k (fmv); ab = 4k; realized gain of 3k
must be recognized
d) Property Acquired from a Decedent { 1014(a), (b)(1) and (6), (e); Reg. 1.1014-3(a); 20.2031-1(b)}
(i) Property acquired by devise (real property through a will), bequest (personal property through will);
inheritance (property acquired through intestate succession)
(ii) General Ruleproperty acquired from decedent generally receives ab of its fmv on date of death (
1014(a))
(a) effect give property that appreciated during the decedents ownership a stepped-up basis w/
no income tax cost to anyone. this is generally what occurs
(i) step-down basis results w/o deductible loss if property declined in value during
decedents ownership
(b) means that, although appreciated property is fully subjected to estate tax, appreciation itself
entirely escapes income tax one of last great tax shelters
(i) thus, elderly people w/ substantially appreciated property often choose not to sell such
property in order to avoid income taxation and are said to be locked-in to their positions

37

(c) 1 of last great tax sheltersstepped-up basis: appreciation during decedents lifetime will
NEVER be taxed
(i) Ex: X buys for 10k; at death fmv = 40k. 30k gain is never accounted for
(a) encourages individuals to retain appreciated property until their death and sell
before death any property that has declined in value
(iii) exception 1014(e)transferred basis applies when 2 criteria are met:
(a) if property is transferred as gift to decedent w/I one year of death AND
(b) it goes back to donor or donors spouse upon death through will
(i) Loopholes doesnt say cant be transferred back to kids. If goes to kids a stepped up
basis. so far been upheld
(iv) BUT in 2010 - - - Estate tax passed in 2001repealed in 2010, will come back in 2011
(a) In order to pay for repeal, Congress will repeal 1014, effective same time as estate tax is
repealed. 1014 will also come back in 2011. (However, many believe this will be permanent)
(b) 1022 tells us 1014 will be repealed. In 2010,
(i) property acquired by decedent receives a basis equal to lesser of fmv of property at
death OR decedents ab [Modified carryover basis rule]
(a) preserves built in gain. Heirs will have to pay taxes on gain, just like it were a gift
(b) 2010 built in loss sell property and take loss, rather than transfer to heirs and
give them the loss
(ii) there are some adjustments:
(a) 1022(b) heirs can increase transferred basis by up to $1.3 million
(i)
Caveat cant increase basis higher than _____
(ii)
Only affect decedents who have more than 1.3 million in built in gain.
(b) 1022(c) spouse can increase transferred basis for an additional $3 million
(i)
so spouse gets $4.3 million of gain that does not get taxed OR 1.3m to
others, 3m to spouse. 4.3 in basis increase.
(iii) Exception: If property was received by decedent by gift w/I 3 years of death, that
property is not eligible for basis increase, unless gift was from spouse.
(v) Problem (p. 133):
(a) In the current year, Giver holds 2 blocks of identical stock, both worth 1m. Giver purchased
first block years ago for 50k and second block more recently for 950k. Giver plans to make an
inter vivos gift of 1 block and retain the 2nd until death. Which block of stock should Giver transfer
inter vivos why?
(i) Give gift of stock w/ highest basis b/c even though giver doesnt care (doesnt have to pay
income tax irrespective of block) wants to put lowest tax consequences (lowest built in gain)
on donee
(a) basis w/ 950k will cost donee less
(ii) Generally, dont want to keep for estate property w/ built in loss (stepped down basis);
dont want to give away property w/ built in loss (transferred basis); you should sell it and
take the loss
3. The Ar { 1001(b); Reg. 1.1001-1(a), - 2(a), (b), (c) Ex (1) and (2)}
a) Summary of Ar
(i) Amount of cash you receive (on sale or disposition b/c it is triggering event)
(a) Selling expenses reduce Ar (deduct)
(ii) Property for property exchangesfmv of property received

38

(iii) Service for property [Intl Freighting]

(iv) Relief from liability [Crane] interest doesnt affect basis
(v) Gift Tax
b) International Freighting Corporation, Inc. v. Commissioner
(i) services received are included in ar!
(ii) Ar = fmv of services received
(a) How do we know value of services received?
(i) If cant value, assumed equal to property given up
(b) delivery of the shares was not a gift b/c it was compensation for services actually rendered
(iii) if you pay off a liability w/ appreciated property then built in gain is triggered
(a) similarity pay liability w/ depreciated property, you trigger built in loss a realization event
c) Crane v. Commissioner
(i) Liabilities relieved or taken subject to by buyer go into sellers Ar
(ii) S.Ct. held
(a) First step, determine basis of property
(i) propertyland and building themselves, or owners legal rights in them, undiminished by
mortgage
(a) property does not mean the same thing as equity
(b) Second step, ascertain what adjustments are required under 113(b)
(c) Third step, look at the Ar on the sale of the bequeathed property
(i) 111(b) ARthe sum of any money received + fmv of the property
(d) Assumption: as big as holding borrowed $ goes into basis on assumption that you will
eventually pay it off and have it sunk into property
(i) For example, you buy a house 20k down, 80k borrowed. Sell for 105k?
(a) Ar = 105k; ab = 100k (Buyer assumes liability once liability is put into ab, you
must put it in Ar); realized gain of 5k
(iii) depreciation writing off cost of property over time
(a) only w/ t/b or investment
(b) we can depreciate our basis putting liabilities in basis gives us more depreciation
(iv) 2 different kinds:
(a) liability taken subject tonon-recourse liability, lender can only take property back
(b) liabilities that are assumedrecourse liability; can take everything if you default
d) Commissioner v. Tufts

39

(i) When fmv of property is LESS than unpaid amount of loan, all liability goes into AR
(a) When a taxpayer receives a loan, he incurs an obligation to repay loan in future
(i) B/c of obligation, loan proceeds arent income to taxpayer. When he fulfills obligation,
repayment of loan likewise has no effect on tax liability
(b) When a taxpayer sells or disposes of property encumbered by a nonrecourse obligation, he is
required to include among the assets realized the outstanding amount of the obligation
(i) Fmv is irrelevant to this calculation
(ii) Ar = entire liability (even if it exceeds fmv), NOT fmv of property
(a) If we allowed Ar = fmv, buyer would get a loss; buyer didnt suffer loss bank did
e) Gift tax as Ar
(i) Net giftdonor transfers property to donee on condition that donee pay gift tax arising from transfer
(ii) Example:
(a) Donor transfers property worth 150k to donee in a net gift transfer. Flat 50% gift tax rate.
(i) Donor ends up w/ 100k gift and donee pays a 50k gift tax
(iii) Diedrich v. Commissionerdonees payment of the donors gift tax liability is an Ar to donor
(resulting in part sale/part gift)
(a) if payment of gift tax is Ar, realm of part sale/part gift
(i) To tell if something is part sale/gift:
(a) transfer is for less than full consideration AND
(b) transfer would otherwise qualify as a giftpart sale/part gift
(iv) transfer basis is donors ab directly before gift increased by tax paid on portion of gift that has
appreciated
transfer basis + net appreciation [fmv ab] x gift tax paid
fmv
f) Problems (p. 153):
(i) Mortgagor purchases a parcel of land from Seller for 100k. Mortgagor borrows 80k from bank and
pays that amount and an additional 20k for cash to seller giving bank a nonrecourse mortgage on land.
Land is security for mortgage which bears an adequate interest rate.
(a) What is Mortgagors cost basis in the land?
(i) Crane. 20k (cash) + 80k (liability basis on assumption he will sink that $ into land) = 100k
(b) 2 years later when land has appreciated in value to 300k and Mortgagor has paid only interest
on 80k mortgage, Mortgagor takes out a second nonrecourse mortgage of 100k from bank again
using land as security. Does Mortgagor have income when she borrows the 100k?
(i) No increase in her net worth, so no income when she takes out 2 nd mortgage
(ii) No gain b/c GI doesnt include money received from loan
(c) What is Mortgagors basis in land if 100k of mortgage proceeds are used to improve the land?
(i) Improvements do increase basis b/c once pay off liability, $ is sunk into property. 1016.
(ii) 200k

40

(d) What is Mortgagors basis in land if 100k of mortgage proceeds are used to purchase stocks and
bonds worth 100k?
(i) liability does not increase basis in land b/c once you have paid off liability, even though
land is collateral for mortgage, wont have 100k money sunk into land, will have liability
sunk into stock.
(ii) twist on Crane. Land still has basis of 100k liability doesnt have basis, wont have $
sunk into land but rather into stock
(e) What result under facts of d, if when principal amount of 2 mortgages is still 180k and land is
still worth 300k, Mortgagor sells property subject to both mortgages to Purchaser for 120k of cash?
What is Purchasers cost basis in land?
(i) Ar = 300k (fmv of what you receive)
(a) Cash + liabilities (assumed by purchaser. Crane.) So,
(b) $120 cash + 80k (1st loan) + 100k (stocks and bonds)
(i)
even though 100k of liabilities, went into basis of stocks and bonds,
purchaser is taking over stocks and bonds when liability is paid off, will go into
property
(ii) Mortgagers gain
(a) Ar = 300k; ab = 100k; 200k realized and recognized gain (no non-recognition
provision (only gift and transfers between spouses))
(iii) Think of liabilities as cash goes into basis
(f) What result under fact of d, if instead Mortgagor gives land subject to mortgages and still worth
200k to her son? What is sons basis in land?
(i) Transaction is part sale/part giftReg. 1.1001-1(e)
(ii) mortgagors gain
(a) Ar = 180k (what he got; relief from liabilities); ab = 100k; 80k realized gain.
(i)
If a gift, it does not need to be recognized b/c non-recognition provision
(ii)
BUT if part sale/gift, non-recognition provision doesnt apply and 80k
must be recognized
(iii) Sons basis
(a) part sale/giftReg. 1.1015-4: greater of amount paid by donee OR transferors ab
(i)
Donee paid nothing, but he assumed 180k liability so 180k.
(ii)
Donees transferred basis 100k
(iii)
So we use 180k (greater of the 2)
(iv)
Sons basis = 180k + gift taxes paid
(b) Property is worth 300k; donees basis is 180k; 120k gain is built into property
(g) What results under facts of f, if Mortgagor gives land to her Spouse rather than to her Son?
What is Spouses basis in the land? What is Spouses basis in land after Spouse pays off 180k of
mortgages?
(i) Mortgagors Ar = 180k (liabilities) + 120k (fmv of property) = 300k; ab = 100k; realized
gain is 200k
(a) no recognition of gain b/c transfer between spouses. Cant have part sale/gift
between spouses (1 economic unit)
(ii) Spouse always takes transferred basis = 100k
(iii) what is spouses basis in land after Spouse pays off 180k of mortgages?
(a) doesnt have any affect on basis of property b/c already got effect on basis when
took out $

41

(iv) what if she sells for fmv (300k)?

(a) Ar = 300k; ab = 100k; 200k of realized and recognized gain
(h) What results to Mortgagor under facts of d if land declines in value from 300k to 180k and
Mortgagor transfers land by means of a quitclaim deed to Bank?
(i) Ar = 180k (bank took on liabilitiesCrane); ab = 100k; realized gain of 80k
(i) What results to Mortgagor under facts of h if land declines in value from 300k to 170k at time of
quitclaim deed?
(i) Ar = 180k (liabilities are still relieved); ab = 100k = 80k
(a) Tuffs!!!!when liabilities exceed fmv of property and non-recourse liability
(ii) Investor purchased 3 acres of land, each acre worth 10k for 30k. Investor sold 1 of acres in year one
for 14k and a second in year 2 for 16k. Total Ar by Investor was 30k which is not in excess of her total
purchase price. Does investor have any gain or loss on the sales?
(a) Reg. 1.61-6(a)
(i) not Ar of 30k and ab of 30k; instead, we have purchase of 3 lots and sale of 2 lots (applies
irrespective of value of each lot)
(ii) each plot has basis of 10k
(a) plot 1: Ar = 14k; ab = 10k; 4k realized and recognized gain
(b) plot 2: Ar = 16k; ab = 10; 6k realized and recognized gain
(iii) assumption on anything first in, first out.
(iv) We dont get to add basis together; must add up among plots purchased
(iii) Gainer acquired an apartment in a condominium complex by inter vivos gift from Relative. Both
used it only as a residence. It had been purchased by Relative for 20k cash and was given to Gainer when
it was worth 30k. Relative paid a 6k gift tax on transfer. Gainer later sells apartment to Shelterer.
(a) What gain or loss to Gainer on his sale to Shelterer for 32k?
(i) Ar = 32k; ab = gift so transferred basis of 20k + _________
(ii) whole issue: what is ab?
(a) normally, just 20k
(b) but now we are introducing gift tax. When gift tax is paid by donee, there is an
adjustment to basis on gift tax. 1015(d)(1)transferred basis (or fmv if loss) + gift tax
paid (of 6k) BUT
(c) 1015(d)(6)special rule. In case of any gift, increase in basis shall be never more
than 6k
(i)
gift tax increase = amount of gift tax paid * net appreciation in gift
[fmv ab] (over) fmv of gift6k * (30k 20k) = 60k/30k = 2k!
(ii)
ab = 20k + 2k = 22k; gain of 10k.
(iii) Reason for this rule: giving income tax break to extent that income tax and gift tax are
imposed on same amount. 1015(d)(6) limits
(iv) This rule applies when straight gift; donee pays gift tax; and part sale/part gift
(b) What is Shelterers basis in apartment?
(i) Shelterers basis = 32k (cost basis)

F. Damages and Related Receipts EXCLUDED

1. Introduction

42

a) Amounts received as damages or reimbursements for damages are governed in part by 104-106
(i) 3 different types EXCLUDED ( 104):
(a) workers comp plan
(b) personal injury awards
(c) payments out of accident and health insurance plans
(ii) Caveat for all: excluded only if NOT deducted as medical expenses in prior year
(a) Cant deduct and then exclude under 104
(b) If didnt take medical expense deduction, can exclude this from income.
(c) Reason for rule: we dont want double dipping.
(i) Same yearexclude, dont deduct
(ii) Different yearsdeduct, dont exclude
(iii) Medical expenses: only deductible each year to extent they exceed 7.5% of AGI
2. Damages in General
a) Raytheon Production Corporation v. Commissioner
(i) Recoveries which represent a reimbursement for lost profits ARE income
(i) Reason: profits would have been taxable income, recoveries are merely their substitutes
(ii) test: In lieu of what were the damages awarded?
(a) determining factor is nature of basic claim from which compromised amount was realized
(i) where suit is NOT to recover lost profits but is for injury to good will, recovery represents
a return of capital and, w/ certain limitations is NOT taxable
b) Problems:
(i) P brought suit and unless otherwise indicated successfully recovered. What are tax consequences?
(a) Ps suit was based on a recovery of 8k loan made to debtor. P recovered 8.5k cash, 8k for loan
plus $500 of interest
(i) 8k for loan is NOT taxablerecovery of capital; not increasing net worth already paid
taxes on it. Principle is not taxable a return of investment
(ii) $500 for interest IS taxable. An accession to wealth and therefore is taxable.
(b) what result to debtor under facts of a if instead debtor transferred some land worth 8.5k w/ basis
of 2k to P to satisfy obligation?
(i) Repay loan, generally no tax consequences
(ii) D had a sale or disposition (debtor disposed of land to pay debt), triggering realized gain
(a) Ar = fmv of what he received (property for property exchange paid off loan w/
property) = 8.5k; ab = 2k; 6.5k realized and recognized gain.
(i)
Intl Freightwhen pay off a liability with appreciated property, it will
trigger built in gain
(iii) What is Ps basis in land?

43

(a) P has basis of 8.5k in land

(i)
Cost basis: when exchange property for property (loan for land) basis
of property received is its fmvPhilly. 8k (cost basis from original loan) AND
(ii)
Tax cost basis: $500 (amount included in income, so increases basis)
(c) Ps suit was based on a breach of a business K and P recovered 8k for lost profits and also
recovered 16k of punitive damages.
(i) 24k taxable income b/c this is a K claim and not a tort claim
(a) b/c K, nothing excludes these amounts from income
(b) 8k damage recovery must be included
(c) 16k punitivies must be included under Glenshaw Glass
(d) lost profits included in GI (b/c not based on personal injury)
3. Damages and Other Recoveries for Personal Injuries { 104(a); 105 (a)-(c) and (e); 106(a); Reg. 1.104-1(a), (c),
(d); 1.105-1(a); 1.106-1} GI does NOT include:
a) recoveries of damages for personal injuries or sicknesses104(a)(2)
(i) prior to 1997, excluded any amounts recovered for personal injuries or sickness
(a) excluded recoveries for physical and nonphysical personal injuries (defamation, 1 st Amend
rights, discrimination, alienation of affection)
(ii) limitations after 1997:
(a) limited to damages received from tort-like personal injury claims
(b) further tightened the reins by formulating a 2-prong test which a taxpayer had to satisfy to
qualify for 104(a)(2) exclusion:
(i) underlying action must be based upon tort or tort-type right
(a) doesnt matter if file lawsuit or not; doesnt matter if judgment or settlement
(ii) only PHYSICAL personal injury awards are excluded from GI
(a) damages from non-physical MUST be included in income (race, gender)
(b) policy justification:
(i)
Suffered enough theory
(ii)
Really havent had increase in net worth
(iii) General RuleAll punitives MUST be included in GI. [Glenshaw Glass]
(a) EXCEPTION: punitive damages in a wrongful death action where state law provides that
only punitive damages can be awarded in such an action
(iv) recoveries for emotional distress depend on nature of underlying action
(a) incurred on account of physical injury excludable
(b) emotional distress itself is not a physical injury, despite manifestation of physical symptoms
included in GI, except to extent that damages are received for amounts paid for medical care which
is attributable to emotional distress
(v) Issue:
(a) Injured in car accident, sue, 100k judgment, 30k to attorney all excluded

44

(b) discrimination, sue, 100k judgment, 30k to attorney

(i) 70k MUST be included in income (non-physical injury)
(ii) 30k in attorneys fees? perfect circuit split
b) payments made under workers comp104(a)(1)
(i) 3 types:
(a) injured in work place, you get to recover medical expenses in full exclude b/c any amounts
under workers comp is excludable
(b) wages for time couldnt work lost wages
(i) problem from policy standpoint this is a substitute for something that would have been
taxable
(a) HUGE benefit for workers comp payments
(ii) cap on amount you can recover, but ALL excluded from income
(c) lump sum payment for loss of use
(ii) also excludes benefits paid to an employees survivors if worker is killed on the job
(iii) Pretty much all you get is excluded
(a) However, doesnt include retirement benefits!
(iv) to be excluded under 104(a)(1) amount in question MUST be paid for death or injury that is jobrelated, not merely under entitled workers compensation law
(a) nonoccupational benefits, such as amounts paid for disability during employment but not caused
by injury or sickness related to employment, are not covered by 104(a)(1)
c) payments under accident and health insurance plans for personal injuries or sickness104(a)(3)
(i) difference between 104(a)(3) and 105(a):
(a) 104(a)(3)applies when taxpayer has paid premiums
(i) ALL payments received under such plans are excluded from income
(a) Doesnt matter if they exceed your actual medical expenses get to exclude all
(b) No limit on amount that can be excluded, even if receive more than expenses
(c) Doesnt have to be a commercial insurance plan
(ii) Main justification: paying for insurance plan w/ after tax $$
(b) 105applies when employer has paid premiums
(i) value of employer-provided health and accident insurance is excludable under 106
(ii) General ruleall amounts received are includable in income
(a) Exceptions that follow have pretty much assumed rule:
(i)
Payment are to reimburse taxpayer for actual medical expenses of
taxpayer, spouse, dependent
(ii)
Payments are paid by employer directly to hospital

45

(iii)
Payments are paid for loss of use of body part of taxpayer, spouse, dep,
so long as amount paid is computed w/o regard for time taxpayer was gone from
work
(iv)
**Workers Comp payments (104) preempts 105
(v)
**non-occupational injuries that produce financial compensation
outside 104 are excludable under 105
d) 105(b)EXCEPTION to 105
(i) any amounts paid for actual medical expenses ARE excluded (you, spouse, dependents)
(a) doesnt matter if insurance co. or employer gives $ to you or they pay hospital directly
(b) no plan is going to pay you more than amount of bills
(c) still subject to caveat of medical deductions (if deduct, cant use exclusion)
(d) wage continuation payments ARE taxable
(ii) note: this is the amount of medical care actually paid for which measures the exclusion, in contrast to
the possibility under 104(a)(3) that amounts received under a health or accident policy, which measure
the exclusions, may exceed medical expenses incurred
e) 105(c)EXCEPTION to 105
(i) payments under accident and health insurance plans for permanent bodily injury ARE excluded
(a) only limitations: cant be based on amount of time missed from work
(ii) if an employee receives payments through health or accident insurance provided by an employer w/o
tax cost to employee for loss of a member or function of the body or for disfigurement of employee or
employees spouse or dependent, and if amount is computed only w/ regard to nature of injury and not to
period employee is absent from work, amount is excluded from GI
(iii) employee will receive payment for casualties of this type under workers comp and can exclude
receipts under 104(a)(1).
(a) When this is so, section 104(a)(1) preempts 105(c)
(i) Little difference b/c amounts that are of type received under workers comp acts but are
outside of 104 b/c they exceed what is provided for are permitted to be excluded under 105(c)
(a) However, nonoccupational injuries and disfigurement and also injuries and
disfigurement of an employees spouse and dependents may produce financial
compensation outside 104 which is excluded from GI by 105(c)
(iv) 104 and 105(b) are restricted by an except clause:
(a) except in case of amounts attributable to (and not in excess of deductions allowed under 213
(relating to medical, etc., expenses) for any prior taxable year
(b) effect of exception: include in GI any amount, otherwise excluded, which constitutes
reimbursement of a medical expense that served as the basis of a 213 deduction in a prior year
(c) objective: dovetail exclusionary rule w/ medical expense deduction
f) 104(a)(4) and 104(a)(5)
(i) 104(a)(4)excludes disability pensions of members of armed forces and certain other gov units
(ii) 104(a)(5)excludes disability income attributable to injuries incurred as a result of a terrorist or
military activity
(a) Congress passed several different laws excluding income after 9/11
(i) this one didnt apply b/c very few disabled most were killed
g) Over-compensation69-154
(i) General RuleEmployer plan is GI UNNLESS for actual expenses.
(a) However, if taxpayer is over-compensated b/c he has both employer and employee plans,
employer pays for amount of actual adamage that are in proportion to total recovery award

46

(i) Ex: $900 expenses$800 employer$400 eployee

(a) 8/12 by employer; 2/3 of $800 = $600 excludable by employee, $200 includable by
employee
(ii) Ex: 4k expenses; 2k employer, 3k employee
(a) 2/5 employer = 1600 excludable, 400 includable; 3k employee all excludable
h) Problems (p. 193):
(i) P brought suit and successfully recovered in following situations. Tax consequences to P?
(a) P, a professional gymnast, lost use of her leg after a psychotic fan assaulted her w/ tire iron. P
was awarded damages of 100k
(i) All 100k is excluded from income 104(a)(2)
(a) Policy justification: already suffered enough; put in position would have been in;
no accession to wealth
(b) 50k of recovery in a is specifically allocated as compensation for scheduled performances P
failed to make as a result of injured leg.
(i) Generally, compensation for lost wages are GI. But if damages are b/c of personal injury,
all damages (except punitives) are excludable. All 100k is still excludable
(c) Jury also awards P 200k in punitive damages
(i) Punitives all must be included in GI 104(a)(2). Glenshaw Glass
(d) Jury also awards P damages of 200k to compensate for Ps suicidal tendencies resulting from
loss of use of her leg.
(i) Underlying action test: Excluded b/c emotional distress was a result of physical injury
(e) P in a separate suit recovered 10k of damages from a fan who mercilessly taunted P about her
unnaturally high, squeaky voice, causing P extreme anxiety and stress.
(i) 10k must be included in GI; no exclusion for emotional distress arising out of nonphysical injuries
(f) P recovered 200k in a suit of sexual harassment against her former coach
(i) 200k must be included in GI; no exclusion for non-physical injuries
(g) P dies as a result of leg injury, and Ps parents recover 1m of punitive damages awarded in a
wrongful death action under long-standing state .
(i) 1m excluded b/c there is an exception for punitive damages awarded in a wrongful death
action under state law if punitive damages are only wrongful death recovery 104(c)
(ii) Injured and spouse were injured in a car accident. Total medical expenses incurred = 2.5k
(a) In year of accident they properly deducted 1.5k of expenses on their joint income tax return and
filed suit against Wrongdoer. In succeeding year they settled their claim against Wrongdoer for
2.5k. What tax consequences on receipt of 2.5k settlement?
(i) Generally, damages from personal injury are excluded. But double dipping rule applies
here
(a) 1.5k is income b/c already took deduction - 213
(b) 1k is excludable b/c 104(a)(2) a physical personal injury
(b) In succeeding year spouse was ill but, they carried medical insurance and additionally spouse
had insurance benefits under a policy provided by employer. Spouses medical expenses totaled 4k
and they received 3k of benefits under their policy and 2k of benefits under employers policy. To
what extent are benefits included in their GI?
(i) 3k excluded - 104(a)(3)
(ii) general rule under 105(a) amts from employer included
(a) exception 105(b) says if for actual medical expenses the amounts are excludable

47

(iii) 104 all amounts excluded from income

(a) Reg 69-154 this tells how much of employers payment is excluded.
(b) Have to take proportion of amount
(c) In order to determine how much of the employers payment is for medical expenses,
we prorate expenses among amount received.
(i)
ER/total x medical expenses
(ii)
2k/5k x 4k. can exclude 1600 from income.
(iii)
The other 400 must be included under 105(a) deemed to be not for
actual medical expenses.
(c) Under facts of (b), may injured and spouse deduct medical expenses? 213(a)
(i) No. they have excluded them so they cannot deduct. No double dipping

G. Separation and Divorce

General Rule: You cannot deduct personal expenses for self, spouse, dependents 262
o Exceptions:

Divorce

Permanent separation

Temporary separation
o Payments that are not deductible; not included in income:

Alimony

Property settlements

Child support
1. Alimony and Separate Maintenance Payments
DEDUCTIBLE to the extent included
a) Direct Payments { 71 (omit (c)(2) and (3)); 215(a) and (b); 7701(a)(17); Reg. 1.71-1T(a) and (b) (omit Q
6, 7, 11, and 12}
(i) General Rulepayments that qualify as alimony or separate maintenance are GI to payee spouse
under 71(a) and deductible by payor spouse under 215(a) (above the line)
(a) deductibility by payor is dependent upon includability of payment in GI of payee
(i) reciprocal principle is exception rather than rule
(ii) bargaining matter in negotiations for any settlement
(b) Above the line deduction (do not have to itemize to be able to take deduction)
(ii) 7 Requirements for Taxable and Deductible Alimony (go through all of them; 1 b/c ___):
(a) Payment must be in cash/check/money order, not property, not promissory note
(i) Cant be credit card third party debt covered by 1.71-1T(b) Q1A5
(b) Payment must be received by, or on behalf of, a divorce or separation instrument

48

(i) Allows payor to pay cash to 3rd party (i.e. rent, mortgage)
(a) Exception: if mortgage payment and you own it, not on behalf of spouse
(ii) Applies in only one of 4 differing situations:
(a) Divorced
(b) Legally separated by decree
(c) Married but payments are directed by a written separation agreement
(d) Married but payments are directed under a support decree
(c) Divorce or separation instrument can NOT designate payment as a non-alimony payment
(i) Label of non-alimony yields tax relief to recipient (no GI under 71(a)) and an increased
tax burden for payor (no deduction under 215(a))
(d) spouses can NOT be living in same household when payments are being made if
permanently separated or divorced
(i) exception: if temporary situation, may still live in same household.
(a) Policy: Encourage reconciliation
(e) There is NO obligation for payor spouse to make any payment after death of recipient
spouse
(i) Payments required to be made after death of payee spouse are not for support and are not
permitted to qualify as alimony or separate maintenance payments
(a) payments have flavor of property settlement, or child support
(ii) 2 ways to meet:
(a) state it in divorce decree (better to put it in b/c state law may change)
(b) state law that so provides, thats good enough
(f) Payment is not for child support
(i) even if something is designated as alimony, it might be disguised child support
(g) If spouses are still married, they cant file a joint tax return 71(e)
(iii) Most alimony and separate maintenance payments qualify for tax allocation but property settlements,
whether in cash or other property, do not
(iv) Problems (p. 203):
(a) Determine if following payments are accorded alimony or separate maintenance status and
therefore are includible in recipients GI under 71(a) and deductible by payor under 215(a). Unless
otherwise stated, Andy and Fergie are divorced and payments are called for by divorce decree.
(i) Divorce decree directs Andy to make payments of 10k per year to Fergie for her life or
until she remarries. Andy makes 10k cash payment to Fergie in current year.
(a) Meets all requirements of alimony and so includible by F; deductible by A
(ii) Same as a except that Andy, finding himself short on cash during the year, transfers his
10k promissory note to Fergie.
(a) Not alimony b/c doesnt fit cash requirement. F cant include; A cant deduct
(iii) Same as b except that instead of transferring his promissory note to Fergie, Andy
transfers a piece of art work, having a fmv of 10k
(a) Same result as b (most likely this is a property settlement)

49

(iv) Same as a except that in addition decree provides that payments are nondeductible by
Andy and are excludible from Fergies GI.
(a) Specifies that its not alimony, so its not alimony.
(v) Would it make any difference in d if you learned that Andy anticipated that he would have
little or no taxable income in immediate future, making 215 deduction practically worthless
to him, and as a consequence of this agreed to nondeductibility provision in order to enable
Fergie to avoid imposition of federal income taxes on payments?
(a) doesnt make any difference if reason they designate as non-alimony is to avoid tax
consequences (no element of intent in )
(b) doesnt matter if And had 0 income and deduction is meaningless (Fergie must still
include amount in income)
(vi) What result in a if divorce decree directs Andy to pay 10k cash each year to Fergie for a
period of 10 years?
(a) not alimony b/c he has to continue payments for 10 years whether she dies or not
(i)
if she doesnt die w/I 10 years, still not alimony
(ii)
**can determine if alimony at the outset. If doesnt meet requirement
that ends when she dies, and no state law to contrary, not alimony (may be
property settlement, but not alimony)
(vii) Same as f except that under local law Andy is not required to make any post-death
payments
(a) State law overrides divorce decree
(b) This is probably alimony if it meets all the requirements
(viii) Same as a except divorce decree directs Andy to pay 10k cash each year to Fergie for a
period of 10 years or her life, whichever ends sooner. Additionally, decree requires Andy to
pay 15k cash each year to Fergie or her estate for 10 years. Andy makes 25k cash payment to
Fergie in year.
(a) 10k is alimony; 15k is not
(i)
10k meets requirements and is in nature of alimony
(ii)
15k is for after her life so doesnt meet requirements
(iii)
contrast w/ can it be alimony if she doesnt die v. here, 10k cant go on
so we can split a payment into part alimony, part non-alimony 1.71-1T(b)Q14Ex1
(ix) Same as a except that at time of payment, Andy and Fergie are living in same house
(a) not alimony b/c living together, and not a temporary situation
(b) Not included in income to Fergie/ not deductable by Andy
(x) Same as i except that Andy and Fergie are not divorced or legally separated and payments
are made pursuant to a written separation agreement instead of a divorce decree
(a) Includable by Fergie/ deductible by Andy
(i)
This is ok living in same household only applies if permanently
separated or divorce. So long as not filing joint tax return, this is alimony-isk
2. Property Settlements { 1041; 1015(e); Reg. 1.1041-1T(b)} tax neutrality (not deductible/not includable)
a) Payments not meeting 71/215 requirements are simply a form of property settlement or child support
resulting in tax neutrality
(i) Must be:
(a) Payment made between spouses
(b) Payment made incident to divorce
(ii) Property settlements can take the form of:
(a) Cash, property, relinquishment of marital rights, assumption of liability in excess of basis,
discharge of indebtedness

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b) 1041 nonrecognition rule applies (Reason: inappropriate to tax transfers between spouses)
(i) transfer of property to a spouse incident to a divorce will be treated in same manner as a gift
(a) gain or loss will not be recognized to transferor, and transferee will receive property at
transferors basis
(b) transfer is treated incident to a divorce if:
(i) transfer occurs w/I one year after marriage ends (divorce decree/separate maintenance
decree is finalized)
(a) automatically deemed a property settlement; irrebutable presumption; deemed
incident to divorce and tax neutral event
(b) after 1 year must show it relates to cessation of marriage in order to take
advantage of nonrecognition provision
(ii) OR is related to the divorce
(a) Rebuttable presumption that transfer of property is related to cessation of the
marriage if (Reg. 1.1041-1T(b)(2)q7):
(i)
transfer is pursuant to a divorce or separation instrument, as defined in
71(b)(2), AND
(ii)
transfer occurs not more than 6 years after date on which marriage
ceases
(iii)
**Rebut presumption if paying for debt w/ appreciated property
(b) If transfer occurs outside 6 years, rebuttable presumption does not relate to
cessation of marriage (not governed by 1041)
(i)
Can be rebutted if they can show that transfer was made to effect a
division of property owned by former spouses at time of cessation of marriage
(c) presumptions may be rebutted if:
(i)
transfer was not made w/I one and six year periods b/c of factors which
hampered an earlier transfer of property AND
(ii)
transfer is effected promptly after impediment to transfer is removed
c) problems (p. 212): Transfer made w/I 1 year of divorceproperty settlementnon-taxable. Sale or
disposition triggering a realized gain. Ar ab = Realized gain. Doesnt have to be recognized b/c 1041
(i) Michael and Lisa Maries divorce decree becomes final on Jan 1 of year one.
(a) Pursuant to their divorce decree, Michael transfers to Lisa Marie in March of year one a parcel
of unimproved land he purchased 10 years ago. Land has a basis of 100k and fmv of 500k. Lisa
Marie sells land in April of year one for 600k
(i) M has sold or otherwise disposed, triggering a realized gain. Ar = 500k; ab = 100k;
realized gain = 400k. Not recognized b/c 1041 which applies b/c transfer between former
spouses incident to divorce (irrebutably presumed to be a transfer between spouses)
(ii) Lisa has Ar = 600k; ab 100k; realized is 500k; all must be recognized b/c no nonrecognition provision
(b) Same as a except that land is transferred to satisfy a debt that Michael owes Lisa Marie. Land
has a basis of 500k and fmv of 400k at time of transfer. Lisa Marie sells land for 350k.
(i) land transferred to satisfy debt (property for property exchange). 1041 applies within
one year after marriage ends even if the reason was for debt. If not within one year relates
to cessation of marriage either within 6 years and in decree or the parties can prove it was
to affect property division. Michael has Ar = 400k (fmv); ab = 500k; has realized loss of
100k. loss is not recognized b/c 1041
(ii) LM has Ar = 350k; ab = 500k (transferred basis); realized loss of 150k that can probably
be recognized b/c investment property and therefore fits under 165
(c) What result if pursuant to divorce decree, Michael transfers land in a to Lisa Marie in March of
year four.
(i) 1041 neutral consequences b/c w/I 4 years of finalization of divorce, presumption in favor
of being pursuant to cessation of divorce b/c w/I 6 years
(d) Same as c except that transfer is required by a written instrument incident to divorce decree
(i) still qualify. 1.1041-1T(b) Q7. answer is same as a. non-recognition. Transferred basis
to Lisa Marie
(e) Same as c except transfer is made in March of year seven

51

(i) B/c greater than 6 years, 1041 doesnt appear to apply.

(a) If 1041 doesnt apply, Ar = 500; ab = 100; realized gain is 400; all of it must be
recognized. A taxable event to Micahel. Int.l Freight triggers built in gain. If
liability, same result. Lisa Marie has a cost basis of 500k
(ii) any way this could be governed by 1041?
(a) Can rebut 6 years presumption
(i)
Transfer was contemplated by divorce decree
(ii)
Could show reason for delay.
(b) If they can do either of these things, answer same as a.
3. Child Support { 71(b)(1)(D); (c); Reg. 1.71-1T(c)}
a) General Rulechild support payments are excluded from income
(i) Payor can deduct to extent taxable to recipient
(ii) Spouses cannot live in same household when payment is made
b) In most cases, divorce/separation sets amount for child support
(i) tax neutral (not deductable by payor, not includable by payee)
(ii) must look behind labels may not be what it appears to be
c) Child support if:
(i) Designated fixed as child support
(ii) Payment is reduced on a contingency relating to child
(iii) Payment is reduced at time associated w/ contingency (Reg. 1.71-1T(c)Q18)
(a) 1 minor child: date of reduction is w/I 6 months of either side of childs 18 th/21st birthday or age
of majority under state lawdeemed fixed for child support and wont be treated as alimony
(b) 2 > minors: reduced on 2 > dates that are w/I 1 year on either side of a specific birthday
between 18-24
d) Problems (p. 214):
(i) Sean and Madonna enter into a written support agreement which is incorporated into their divorce
decree at time of their divorce. They have one child who is in Madonnas custody.
(a) Agreement requires Sean to pay Madonna 10k per year and it provides that 4k of 10k is for
support of their child
(i) 4k is clearly fixed for child support and cant be alimony. Is therefore not included in
income/deductible
(ii) not enough facts to determine if 6k is alimony or property settlement
(b) agreement requires Sean to pay Madonna 10k per year, but when child reaches 21, dies, or
marries prior to reaching 21, amount is to be reduced to 6k per year
(i) b/c 4k will cease when 1 of contingencies occurs, it is fixed for child support
(c) agreement requires Sean to pay Madonna 10k per year but that payments will be reduced to 8k
per year on Jan 1, 2008, and to 6k per year on Jan 1, 2012. Sean and Madonna have 2 children:
Daughter (born June 17, 1990), and son (born March 5, 1993)
(i) 4k is currently child support b/c reduced at a time that can clearly be associated w/
contingency related to children (second one)
(a) reduction is w/I 6 mos of 18th b-day; son turns 18 on March 5, 2011. reduction is
w/I 1 year; payments ARE reduced w/I . . (second provision applies); therefore, both
reductions qualify as fixed for child support; not deductible by Sean, not included by
Madonna

52

(i)
if second doesnt apply, 1st may still apply
(d) what result in a if Sean pays Madonna only 5k of 10k obligation in current year
(i) under 71(c)(3) only 1k would be treated as alimony if dont make full payment, goes
to child support (no tax benefit). Only remaining amount goes to alimony

H. Other Exclusions from GI

1. Gain from the Sale of a Principal Residence { 121 (omit (d)(4) and (5), (e)); Reg 1.121-1(a), (b)(1), (2) and (4)
Ex 1, (c)(1), (d), -2(a)(1) thru (4) Ex 2, -3(g)(1) thru (2) Ex 1, -3T(b), (c)(1) thru (4) Ex 1, (d)(1) thru (3) Ex 1, (e)(1)
and (2), (f)}
a) Before 97, law in this area was a mess
(i) Rollover of gain when sold old had to buy new that was at least as much as old and had to roll prices
(a) basis of replacement residence was reduced by amount of any gain not recognized on sale of old
residence by reason of this gain rollover rule
(ii) One-time exclusion may exclude from GI up to $125k of gain from sale or exchange of a principal
residence
b) Now - 121
(i) no blanket rule that taxes gain on sale of principle residence
(a) for most residences, gain will be untaxed.
(ii) General RuleTaxpayer generally is able to exclude up to 250k of gain realized on sale or
exchange of a principal residence (500k for mfj)
(a) 121(a) requirements
(i) residence must be principle residence (where you spend a majority of your time; although
a good faith test)
(a) residence defined broadly: condos, yacht, stock in co-op, includes all land
surrounding house, so long as land isnt used for production of income
(i)
if lease land or part of land to another, that part cant qualify for
exclusion under 121.
(ii) must have used it as principle residence 2 of 5 years preceding sale
(a) principle residence determined on year by year basis (7 mos = 1 year)
(iii) have to have owned it for 2 of 5 years before sale
(a) could rent for 3 years and then buy and move out would have lived in principle
residence and would have owned it - ok
(iii) 3 limits on 121:
(a) Max amount you can exclude is 250k121(b)(1)
(i) goes up to 500k for married taxpayers filing a joint return
(a) but both must meet the use requirement (both dont have to own)
(i)
if dont meet use reqt entitled as if spouses hadnt been married
(b) dont have to meet use requirements for 2 years at same time
(c) neither has used exclusion w/I last 2 years
(b) Can only be used once every 2 years121(b)(3)
(i) caveat 121(c) STILL TAKE A PARTIAL EXCLUSION, EVEN IF SELL HOUSE
BEFORE 2 YEARS IS UP if 1of 3 reasons is satisfied:

53

(a) move is for job related reasons, health reasons, or other unforeseen
circumstances
(i)
can be for taxpayer, spouse, co-owner of residence
(ii)
unforeseen circumstances involuntary conversion; private letter ruling
hostility of neighbors
(ii) partial exclusion:
(a) exclusion is limited proportionately to shorter of:
time since 121(a) applied to previous sale Or time house was used as pr x exclusion amount
2 years
(iii) can make election not to use 121 on first sale, and then use it on second sale 121(f)
(c) Depreciation gain cant be excluded from GI to extent it is attributable to depreciation
(i) Deprecation is a deduction of basis for business/rental property
(a) X bought land for 100k9k depreciationCB = 91kX sells property for 121k
91k = 30k. however, 9k cannot be excluded
(iv) Special Rule when property owned by spouse or former spouse:
(a) Where former spouse is transferred property under 1041, period such transferee owns property
shall include period transferor owned property
(b) Treated as using property as principal residence during any period of ownership while such
individuals spouse/former spouse is granted use
(v) Special rule also applies if a taxpayer satisfies ownership and use requirements for 1 year in 5 year
period prior to sale and then becomes physically or mentally incapable of self-care and moves to a care
facility
(a) Taxpayer is treated as using principal residence during time actually spent in facility
c) Problems (p. 226):
(i) Determine amount of gain that Taxpayers (mfj) must include in GI in following situations:
(a) Taxpayers sold their principal residence for 600k. They had purchased residence several years
ago for 200k and lived in it over those years.
(i) Sale/disposition; Ar = 600k; ab = 200k (no reason to believe their basis has gone up for
improvement); 400k realized gain; not recognized b/c up to 500k mfj under 121.
(a) 121 applies b/c
(i)
used as a principle residence
(ii)
we dont know how long ago they purchased residence. Several
must make sure this is at least 2.
(iii)
lived in it during that time (so long as both meet use).
(iv)
Married filing jointly so have up to 500k; only used 400k
(b) Taxpayer in a purchased another principal residence for 600k and sold it 2 years later for $1m
(i) Ar = 1million; ab = 600k; 400k realized gain; meet use and ownership requirements here
too (2 years later)
(ii) post 97, can use exclusion over and over (so long as have at least 2 years between sales)
(c) What result in b if second sale occurred 1 years later?
(i) not excluded b/c they only lived their for 1 years and exclusion used more than once
every 2 years. None of exceptions apply (health, job, etc).

54

(ii) All 400k must be included. Tell clients to wait and must be bona fide residence
(d) What result in b if Taxpayers had sold their first residence and were granted non-recognition
under former 1034 (rollover provision) and, as a result, their basis in second residence was 200k
(i) Ar = 1million; 200k = ab; 800k realized gain. Allowed 500k b/c married filing jointly.
Must include rest in GI.
(a) lots of taxpayers will have low basis (b/c kept rolling over basis from small house
(20k) and keep getting bigger house.) B/c of old rules too bad if under old rules.
(e) What result in a if residence was Taxpayers summer home which they used 3 months of year?
(i) dont necessarily know that this was principle residence (where you spend most time, not
where you spend everywhere else 3 mos in summer home, 9 mos in apartment apartment
still principle residence) Place you live in most.
(a) if not principle Ar = 600k; ab = 200k; realized gain is 400k must be recognized
b/c no non-recognition provision
(f) What result if Taxpayer who met ownership and use requirements is a single taxpayer who sold
a principal residence for 400k and it had an ab of 190k after taxpayer validly took 10k of post-1997
depreciation deductions on residence which served as an office in taxpayers home?
(i) Ar = 400k; ab = 190k (reflects depreciation taken); realized gain is 210k; 10k of gain must
be recognized b/c to extent 97 depreciation; other 200k excluded b/c meet ownership and
use requirements
(ii) Cant deduct and exclude for same property (double dipping)
(ii) Single taxpayer purchased a principal residence for 500k and after using it for one year, single sold
residence for 600k b/c singles employer transferred single to a new job location.
(a) How much gain must single include in GI?
(i) Sale or disposition; Ar = 600k; ab = 500k; 100k realized gain. Do fraction under 121(c)
b/c moved for job reasons: * 250k (otherwise allowable exclusion) = 125k is the amount
of exclusion allowed can exclude all of it b/c amount of gain is less than 250k
(a) Doesnt have to be a mandatory move just for job purposes
(b) What result in a if single sold residence for 700k?
(i) Ar = 700k; ab = 500k; 200k realized gain.
(iii) Taxpayer has owned and lived in taxpayers principal residence for 10 years, last year w/ taxpayers
spouse after they married. Spouses decide to sell residence which has a 100k basis for 500k
(a) If spouses file a joint return do they have any GI?
(i) Ar = 500k; ab = 100k; realized gain of 400k; married couple filing jointly; H meets
ownership and use; spouse doesnt meet use requirement (she doesnt get any of exclusion).
Can only exclude his portion; 250k excluded; other 150k cant be excluded b/c she doesnt
meet use requirement
(a) Note: spouses will meet ownership reqt by marrying someone who has it; not so
w/ use reqt
(b) What result if spouses had lived together for 2 years in taxpayers residence prior to their
marriage and sold residence after one year of marriage for 500k?
(i) H meets ownership; b/c file jointly can exclude up to 500k; can exclude all b/c only gain
of 400k.
(ii) only 1 of them needs to meet ownership requirement
(c) What result in a after one year of marriage taxpayer pursuant to their divorce decree deeded
one-half of residence to spouse and spouse lived in residence while taxpayer moved out and, one
year later, they sold residence for 500k?
(i) 2 transactions here
(a) transfer of pursuant to divorce decree
(i)
Ar = of fmv = 250k; ab = basis = 50k; realized gain of 200k. no
recognition b/c pursuant to divorce decree (assume happens w/I 1 year) 1041
applies requiring tax payer not to have to recognize any gain.
(ii)
Spouses basis is also 50k (transferred basis in she gets)
(b) now sell the whole thing. Ar = 250k; ab = 50k; each have 200k realized gain. How
much can each of them exclude from income under 121?
(i)
taxpayer can exclude all. Limit is 250k. he excludes all b/c meets all
requirements

55

(ii)
spouse121(d)(3)(a) has owned property all 10 years (she meets
ownership requirement his ownership is transferred to her); meets use
requirement (she lived there dont have to resort to other provisions to meet use
requirement). She can exclude up to 250k, so she can exclude it all
(iii)
had they stayed married, she would not have needed to meet ownership
requirement. We dont want to punish her for getting a divorce
(d) What result in a if after one year of marriage taxpayer pursuant to their divorce decree deeded
of residence to spouse and taxpayer continued to occupy residence while spouse moved out, and,
one year later, they sold residence for 500k
(i) still have transfer. That has same consequences
(ii) each have 200k realized gain. None is recognized
(a) taxpayerowned for 2 years, hadnt used exclusion in previous 2 years, used up
until time of sale. Spouse doesnt have last year of use, taxpayer has the use. No
problem excluding all of his gain
(b) spousetreated as having used property during period of ownership
(i)
only owned it for 1 year (when he transferred pursuant to divorce) shes
deemed as having owned it.
(ii)
121(d)(3)(a) deemed to have owned for entire period taxpayer owned
(iii)
use 1 year actual use (they lived there 1 year while married) no use
thereafter. She must get deemed use. 121(d)(3)(b). she only gets time actually
used it (dont need ) + period that he uses it after the divorce (this is the deemed
year).
(iv)
--Reason: she could have been the one to have the house. She
shouldnt be penalized for not having use. Provisions are supposed to not
penalize people for tax reasons if they get a divorce
2. Exclusions and Other Tax Benefits Related to the Costs of Higher Education { 25A; 135; 529; 530; 72(e)(2)(B);
(8)(B), (9); 108(f); 117; 127; 132(c)(3); 221; 222}
a) 1990 flurry related to tax benefits for higher ed.
(i) 5 different benefits:
(a) 2 are tax credits (Hope Scholarship; LLC)
(b) 1 is deduction deduction for higher ed expenses
(c) 2 are exclusions for income Educational Savings Bonds and Coverdell
(ii) student loan interest is also deductible (*covered later)
(iii) 529 qualified tuition program (the MOST in MO) mostly state so we wont cover
b) difference between deduction and credit
(i) deductiondirectly reduce income and then you apply your tax rate
(ii) creditdirect reduction in tax liability; therefore, credits are more valuable than deductions.
(iii) ex: 1000k GI; 400k deduction v. 400k credit; 50% tax rate
(a) deductions reduce income: 1000k 400k = 600k; tax at 50% rate. After deductions and tax
rate, we pay 300k. we end up w/ 700k in pocket
(b) credits dont effect GI. 1000k at 50% = 500k. 400k credit; 100k tax liability. After tax, we
have 900k in pocket.
(i) Credit offsets dollar for dollar. Its worth 100% of credit amount
(a) Deductions are only worth amount of deduction x tax rate.
c) Exclusions weve already covered
(i) Exclusions for scholarships ( 117)
(ii) Exclusions for employer educational assistance programs ( 127)

56

(iii) Exclusions for student loan forgiveness ( 108(f))

d) Other possibilities
(i) Some educational expenses are deductible under 162
(a) To the extent an employer funds such costs, such funding is a working condition fringe benefit
excluded by 132(a)(3)
(ii) Other forms of tax benefits provided for higher education
(a) 221 allows an interest deduction for some interest payments on qualified education loans
(b) 222 allows a deduction for qualified tuition and related expenses
e) The Hope Scholarship Credit ( 25A)
(i) Max Credit: Per student credit of 1500
(a) 100% of 1st 1k of qualified tuition and related fees and 50% of 2nd 1k of such expenses
(b) After 2001, each of 1k of qualifying expenses are adjusted for inflation in $100 multiples
(c) Credit is elective
(ii) Eligibility:
(a) Credit is available for expenses paid after Dec. 31, 1997 for education furnished after that date
(b) Allowed for a taxpayers payment of qualified tuition and related fees at an eligible institution
of higher education for a student who is taxpayer or taxpayers spouse or dependent
(i) Qualified tuition and related expensestuition and academic fees
(a) NOT room and board, books, and non-academic fees, such as student activity,
athletic or insurance fees
(b) NOT student and sports activities which are unrelated to academic instruction, or
for courses related to sports or hobbies, unless such courses are part of students degree
program
(ii) Eligible institution of higher educationincludes certain vocational schools (it is an
educational institution eligible to participate in US Department of Education student aid
programs)
(a) Broader definition doesnt have to be 4 year degree institution
(iii) Costs actually paid by dependent are deemed to be paid by taxpayer (but dependent
cannot claim credit themselves)
(a) I.e. dependent pays 3k, parents pay 3k; parents can claim 6k
(b) 2002 private letter ruling may change this: if parent can take dependency exception
but doesnt, then dependent can take Hope Scholarship. PLR 200236001
(i)
private letter cant be used or cited as precedent; but gives us guidance
as to what service is thinking.
(c) Although applied to Hope, is probably equally applicable to LLC
(d) Child still cant get dependency exemption
(c) Student must carry at least of normal academic load of a full time student
(i) This is not the case w/ LLC
(iii) Limitations:
(a) Credit allowed ONLY for 1st 2 years of students postsecondary education

57

(i) But a year is defined as a calendar year really, Hope only entitled to 1 years
(a) But, provision that says can prepay for 1 semester out
(i)
Possible to take 1st semester of credit in 2002 and pay for spring of
2003 in 2002 (1 full year in 2002), 2003 (1st semester sophomore years), etc.
you end up getting 2 full years. must pay spring semester in Dec, though
(b) Student cannot have been convicted of a federal or state drug felony in year in which credit is
being taken
(i) Also not the case w/ LLC
(c) Nonrefundable credits; they cannot generate a tax refund
(i) However, amount of credit reduces tax liability and that can increase size of a refundable
credit
(d) Any tuition or related fee that is funded w/ an amount that is excluded from GI (i.e., tax-free
scholarships and fellowships, payments from an employers educational assistance plan, or other
tax-free educational benefits) does not qualify for 15A credit
(i) Not available if amounts paid are deductible as t/b expenses under 162
(ii) No credit available in year in which distribution from IRA is excluded from income
(iii) However, tuition and related fees that are funded by gifts or inheritances that are
excluded from GI under 102(a) DO qualify for credit
(e) W/ respect to any year, only one of credits is allowed w/ respect to any student
(i) LLC may not be elected for a student in a year if Hope is allowed for year
(f) Married taxpayers filing separate returns are not entitled to credits
(i) prevents you from playing games
(iv) Phase-Outs:
(a) Credits begin to be phased out when
(i) MAGI > 40k for a single taxpayer; completely phased out when MAGI reaches 50k
(ii) MAGI > 80k for mfj; completely phased out when MAGI reaches 100k
(b) How do we calculate?
(i) $1500 x (MAGI 40k for single (80k mfj) / 10k (20k mfj) = disallowed credit
(a) 1500 x (45k 40k = 5k) /10k = 750k disallowed credit/amount of credit that is
phased out
f) Lifetime Learning Credit ( 25A)
(i) Max Credit: Beginning in 2003, max credit available is 2k per year per taxpayer (i.e., LLC limit is 2k
per year, no matter how many students you are paying for)
(a) Per taxpayer credit of 20% of 1st 10k of qualified tuition and related expenses in years
subsequent to 2002 (max credit of 2k) for any year of a students post secondary education
(i) Need at least 10k expenses to get LLC
(a) Hope only needs 2k worth of qualified expenses
(ii) Qualified expenses must exceed $7500 in order to be worth more than Hope
(b) If you are married filing jointly, you are considered 1 taxpayer
(c) Allowed for ANY year of students post-secondary school

58

(i) No limit on number of years that LLC is available for a qualifying student
(d) Credit is elective
(ii) Eligibility:
(a) Credit is available for expenses paid after June 30, 1998 for education furnished after that date
(b) Allowed for a taxpayers payment of qualified tuition and related fees at an eligible institution
of higher education for a student who is taxpayer or taxpayers spouse or dependent
(i) Qualified tuition and related expensestuition and academic fees
(a) NOT room and board, books, and non-academic fees, such as student activity,
athletic or insurance fees
(b) NOT student and sports activities which are unrelated to academic instruction, or
for courses related to sports or hobbies, unless such courses are part of students degree
program
(ii) Eligible institution of higher educationincludes certain vocational schools (it is an
educational institution eligible to participate in US Department of Education student aid
programs)
(a) Broader definition doesnt have to be 4 year degree institution
(iii) Costs actually paid by dependent are deemed to be paid by taxpayer (but dependent
cannot claim credit themselves)
(a) I.e. dependent pays 3k, parents pay 3k; parents can claim 6k
(b) 2002 private letter ruling may change this: if parent can take dependency exception
but doesnt, then dependent can take Hope Scholarship. PLR 200236001
(c) Although applied to Hope, is probably equally applicable to LLC
(c) Student is not required to carry any specific academic load
(i) For example, student enrolled in a single course to improve job skills can qualify
(ii) Not the case w/ Hope
(iii) Limitations:
(a) Nonrefundable credits; they cannot generate a tax refund
(i) However, amount of credit reduces tax liability and that can increase size of a refundable
credit
(b) Any tuition or related fee that is funded w/ an amount that is excluded from GI (i.e., tax-free
scholarships and fellowships, payments from an employers educational assistance plan, or other
tax-free educational benefits) does not qualify for 15A credit
(i) Not available if amounts paid are deductible as t/b expenses under 162
(ii) No credit available in year in which distribution from IRA is excluded from income
(iii) However, tuition and related fees that are funded by gifts or inheritances that are
excluded from GI under 102(a) DO qualify for credit
(c) W/ respect to any year, only one of credits is allowed w/ respect to any student
(i) LLC may not be elected for a student in a year if Hope is allowed for year
(d) Married taxpayers filing separate returns are not entitled to credits
(iv) Phase-Outs:
(a) Credits begin to be phased out when
(i) MAGI > 40k for a single taxpayer; completely phased out when MAGI reaches 50k

59

(ii) MAGI > 80k for mfj; completely phased out when MAGI reaches 100k
(b) How do we calculate?
(i) 2k x (MAGI 40k for single (80k mfj) / 10k (20k mfj) = disallowed credit
(a) 2k x (45k 40k = 5k) /10k = disallowed credit
g) Educational Savings Bonds ( 135)
(i) Savings bonds, generally
(a) invest $ by loaning $ to gov. gov pays you interest. Big benefit dont have to pay tax on
interest each year as it accrues. Rather can defer tax on interest until cash in bonds
(i) if you use them for education, never have to pay tax on interest!
(ii) Exclusion:
(a) 135(a)allows an exclusion from GI on gain on redemption of qualified US savings bonds
(b) bond is qualified if:
(i) Series EE US Savings Bonds
(ii) it was purchased at a discount after 1989
(iii) the purchaser had attained age 24 before date of bonds issuance
(iv) bonds must be in name of taxpayer claiming exclusion
(a) exclusion is not available to a parent if bonds are purchased by parent but put in
name of a child or are purchased by a child
(iii) Qualification:
(a) exclusion only applies to qualified higher education expenses
(i) includes tuition and fees at an eligible educational institution for taxpayer and taxpayers
spouse and dependents during year of bond redemption
(a)
(iv) 3 limitations to exclusion:
(a) qualified expenses are reduced by tax-free scholarships, fellowships, employer-funded
educational assistance, other tuition reductions, AND any expenses to extent that they were used in
computing 25A Credits and any expenses taken into account in determining exclusion for
distributions from a Qualified Tuition Program or an Educational Savings Account (but not gifts or
inheritances)
(b) married filing separately no exclusion
(c) if bond redemption proceeds (principal and interest) in a year > qualified higher education
expenses for year, only a portion of gain is excluded from GI
(i) equal to qualified educational expenses over redemption proceeds
(a) qualified educational expenses over redemption proceeds * taxable interest =
allowable deduction
(ii) Ex: Steve redeems his Series EE US Savings Bond in 1997 for 30k, of which 10k is gain
(interest) and 20k is principal. His qualified educational expenses for year are 24k (less than
redemption proceeds). Therefore, he can only exclude from GI 8k of his 10k gain (24k/30k
or 80%)
(iii) Lesson dont cash in any more than qualified educational expenses for year
(v) Phase-Out:
(a) Begin to be phase-out when MAGI > 40k for single; completely phased out at 55k

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(b) Begin to be phased-out when MAGI > 60k for single; completely phased out at 90k
(c) To calculate:
(i) otherwise allowable exclusion (interest not principle) x modified AGI 40k (60k mfj) /
15k (30k mfj) = amount of exclusion that is disallowed
(ii) Ex: interest is 9k; make 50k
(a) 9x50-40 = 10/15 = 6k amount to f excluded disallowed
(b) completely phased out at 55k; 90k for mfj
(d) no exclusion is available for married taxpayers filing separate returns
(e) expenses used to qualify for Hope or LLC cannot be used as qualified educational expenses
under 135
(i) doesnt mean that you cant use savings bonds. You can just cant double dip on same
exceptions
h) Qualified Tuition Programs ( 529) we dont cover at all
i) Coverdell Educational Savings Accounts/ Educational IRAs ( 530)
(i) Available beginning in 1998
(ii) Trust created in US exclusively for purpose of paying qualified educational expenses of a designated
beneficiary (proceeds tax exempt)
(iii) Max: $500 per year, per beneficiary; after 2002, 2k per year, per beneficiary
(iv) Qualifications:
(a) Nondeductible contributions must be made in cash, and in case of an individual contributor,
they may not exceed 2k per year per beneficiary
(b) If proceeds distributed from IRA are used for qualified higher education expenses, then those
proceeds (including earnings on IRA) are exempt from tax. Proceeds may also be used for
elementary and secondary education beginning in 2002
(i) Higher educational expensestuition, books, fees, supplies, equipment, and room and
board
(c) Taxpayer purchasing IRAs must designate beneficiary under age of 18 at time IRAs are
purchased
(d) Income inclusion and penalty are avoided if excess amount is rolled-over to an Educational
Savings Account benefiting a different beneficiary if 1) new beneficiary is under 30, 2) a relative it
the original beneficiary, and 3) rollover occurs w/I 60 days of distribution
(i) 2k limit doesnt apply to rollovers **lots of game play here.
(a) currently can designate one beneficiary, and all the time know that you are going
to rollover
(v) Limitations:
(a) Must already have kid when take out IRA and must designate that person as beneficiary
(b) No deduction is allowed for amount contributed to IRA in year of contribution
(c) expenses used to qualify for Hope or LLC cannot be used as qualified educational expenses
under 530
(d) no contribution may be made in a year to extent that anyone makes a contribution to 529
Qualified Tuition Plan for beneficiary of plan
(e) Distributions are excluded from GI to extent that they do not exceed qualified education
expenses incurred by beneficiary in year distribution is made
(f) If there is an excess distribution to beneficiary, it is taxed using 72 rules AND it is subject to a
10% penalty
(i) dont want to cash these in unless using for education!!!

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(vi) Phase-Outs:
(a) Begins to be phased-out when MAGI > 95k for single; completely phased-out at 110k
(b) Begins to be phased-out when MAGI > 190k for mfj; completely phased-out at 220k
(c) phase out is much higher!
(d) How to calculate: otherwise allowable exclusion (IRA earnings) x MAGI 95k (190k mfj) /
15k (30k mfj) = amount of exclusion disallowed
(vii) Benefits:
(a) doesnt have to be just for you, spouse, or dependents
(i) grandparents can do for grandchildren; niece/nephews
(b) expenses are broader than any other category
(i) use tuition for LLC; use savings bond for rest of tuition; IRA for room and board
(c) higher phase-outs
j) Deductions for Higher Education Expenses ( 222)
(i) Deduction is available for expenses paid during only from 2002 2005
(ii) Max Deduction: 3k per year per taxpayer in 2002 and 2003, and increased to 4k per year per taxpayer
for 2004 and 2005
(iii) Eligibility:
(a) Deduct costs of graduate education
(b) Qualifying tuition and related expensestuition and academic fee ONLY
(i) Doesnt include room and board, books, and non-academic fees, such as student activity,
athletic or insurance
(c) Above the line deduction
(iv) Limitation:
(a) Married taxpayers filing separate returns are not entitled to deduction
(b) Deduction cannot be used for same student for whom LLC or Hope is taken during year
(c) Expenses paid for by educational savings bonds or educational IRAs under 135 or 530 cannot
be used as qualified educational expenses for purposes of deductibility under 222
(d) Expenses paid for by tax-free scholarships and fellowships, payments from an employers
educational assistance plan, or other tax-free educational benefits cannot qualify for deduction
(i) But expenses paid out of a tax-free gift or inheritance do qualify for deduction
(e) Taxpayer cant claim if a dependent
(v) Phase Outs:
(a) NOT phased out. Taken out completely for MAGI > 65 for individuals; 130 mfj (2002-2003)
(i) 2004-2005 80k for individuals; 160k for mfj
k) Credits are better than deductions!

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(i) Exclusions are generally worth same as deduction. However we prefer exclusions
(ii) Credits are better Hope and LLC
(iii) Exclusions Savings Bonds and IRAs
(iv) Deduction
l) Only 2 that cant use in same year are
(i) Hope and LLT for same student in same year
(a) but can use either of these w/ Educational IRA and Savings bonds
(b) Could use all 3 together
m) 2 educational tax benefits in which room and board are considered as qualifying expenses:
(i) Educational IRA
(ii) Deductibility of student loan interest
n) Problems (p. 235): Max cap which is comprised of ___. W/ LLC, mfj considered 1 economic unit = 1
taxpayer. Expenses paid w/ non-taxable funds are not qualified expenses. Gift doesnt reduce qualified
expenses.
(i) Law Student and Spouse are self-supporting and Spouse works while student attends law school.
Consider amount of any 25A credit they may elect in following circumstances assuming they file a joint
return:
(a) Student pays 10k in tuition for current year. Spouse works and spouses have a MAGI of 30k for
year
(i) Cant take Hope b/c not in first 2 years of undergrad
(ii) Can take 2k LLC (20% x 10k) this is non refundable
(b) Same as a except tuition is paid from a student loan
(i) Same answer as (a). Student loans are same as cash b/c obligation to pay back (a liability)
(a) But doesnt decrease qualified expenses
(c) Same as a except that student is granted 7k scholarship excluded by 117 that reduces tuition to
3k
(i) Hope isnt going to apply.
(ii) LLC 7k scholarship is going to reduce student expenses to 3k
(iii) Only have 3k of qualifying expenses. 20% x 3k = $600
(iv) if qualified for both, would want Hope
(d) Same as a except that students parents pay 8k of tuition and student pays 2k, although student
is not a dependent of parents
(i) Cant take Hope b/c not first 2 years of undergrad
(ii) LLC 10k of qualifying expenses.
(a) Parents cant take. Only person that can take is student. Student has 10k of
qualifying expenses b/c student paid 2k and parents paid 8k as a tax free gift to student
(i)
Same result in (a)
(b) had parents qualified they, too, would have had 10k qualifying expenses

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(c) 25A(g)(2)(c)
(e) Same as a except that spouses have a MAGI of 100k for year
(i) LLC is completely phased out by 100k. they arent entitled to any credit
(a) 2k is max for year. We take 2k and multiply by MAGI (100k) 80k (mfj) divide by
20k = 1. 2k x 1 = 2k. this represents amount disallowed. All is eliminated and cant
take any at all.
(i)
Had they made 92k: 92-80/20 = 12/20 x 2k = $200. can only take
$800 credit
(f) Same as a except that spouse is also in college. Spouse is in third year of college and pays 5k in
tuition
(i) Hope doesnt qualify. Results are same as in (a).
(g) same as a except that after law student graduates, spouse, who has not previously attended
college, quits work and enters a vocational school as defined in 25A(f)(2). Spouse pays 10k in
tuition and lawyer earns 75k
(i) Eligible for Hope b/c in first year of vocational school. Max of 1500 Hope (100% of 1 st
1000, 50% of next 1000 = 1500).
(ii) LLC worth more b/c spouse paid 10k in qualified educational expenses. 2k w/ LLC
(just this year got raised to 2k)
(a) But same person cant have Hope and LLC in same year
(i)
LLC is worth more than Hope (new this year!)
(ii)
possible to take other 8k w/ IRAs so long as not for same expenses
(h) what result in a if before credits, spouses had 3k of tax liability and 3k of withholding from
wages which qualifies for a potentially refundable credit under 31?
(i) talking about 2 possible credits: 3k (31 credit withholding); 2k ( 25a)
(a) credits are applied before tax liability
(b) withholdings after tax liability
(ii) how do these credits work together?
(a) tax liability is 3k; subtract LLC of 2k = 1k of tax liability; 3k of withholdings (or
refundable tax credit/ earned income credit) so receive 2k
(b) subtract non-refundable = tax liability; then subtract refundable; then get refund
amount
(i)
Code allows us to do this way the pro-taxpayer position
(c) if done the other way around, wouldnt get any refund back b/c cant take LLC on 0.

III. The Characterization of Income and Deductions (its either ordinary or capital)
A. Introduction
1. In order to receive capital gain/loss treatment, the following requirements must be met ( 1222):
a) A sale or exchange
(i) No trigger until get rid of property
b) Of a capital asset
c) A determination of how long taxpayer has held capital asset
(i) LTheld for more than 1 year (there are currently 3 categories: 28%, 25%, 15%)

64

(ii) STif 1 year or less (taxed same as ordinary income)

(iii) gains Long > short (b/c taxed at preferential rate)
(iv) losses short term gains > long (b/c taxed at higher rate)
2. tax rates
a) tax rates have changed dramatically 4% in last year
(i) these rates had already been established, they were just expedited to 2002
b) 2003 tax rates: 10%; 15%; 25%; 28%; 33%; 35%
c) doesnt mean that all income is taxed at __%
(i) they are progressive 1(i)(2)
(a) part of income is taxed at 10%, next 15%, etc.
(b) effective tax rate of 25% means that next dollar of income is going to be taxed at that rate.
(i) Unless that $ puts you into next bracket

B. *The Mechanics of Capital Gains { 1(c) and (h) (omit (h)(2), (5)(B), (6), (8), (9),
(10), (11)); 1222. see 1(a)-(e); 1201(a); 1202 (a)-(e); 1221(a)(1)-(4)}
1. Advantages:
a) LTCG taxed at preferential ratesyou want to hold gains for longer than 1 year
(i) Want to sell losses before 1 year so that they are STCL (offset highest gains first)
b) LTCG and STCG are used to offset capital losses
2. Policy justification at why we tax long term capital gains at lower rates:
a) Bunchinggain accrued over several years but is bunched into 1 year and taxed (upon realization)
(i) W/o tax breaks, taxpayer may be forced into higher tax bracket
(ii) Ex: buy a piece of artwork for 1k. goes up to 2k 5k 10k. sell at 100k. 99k gain.
b) Inflationhold asset year after year. 3rd house goes up a little each year due to inflation.
c) **Lock-in effectwe know that you dont get taxed on gains until sell/exchange. What if dont sell, even if
it would be wise economically to do so. Investment is not put to best use. Sell, move on but then have to pay
tax.
(i) give people some incentive to sell when time to sell.
(ii) problem: I dont need the $ investment isnt doing well. If die, heirs get stepped up basis (unless
2010 transferred basis) and no one ever has to be taxed . . .
(iii) reason we want you to hold assets a long time, b/c Congress feels that holding long term is going to
be best for the economy. Encourage people to invest on long term.
3. Different tax rates
a) 28%collectiblesart work, antiques, gems, coins, stamps and alcoholic beverages
(i) Also applies to 1202 stock small business stock (not going to cover here)
(ii) What happens if in lower tax bracket than 28%?

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(a) says if you are in tax bracket below 25%, then collectibles are taxed at 15%.
(i) Doesnt make since for 25% bracket people to be in 28% bracket (its higher). Doesnt
make since if in 10% bracket to be put in 15% (its higher)
(a) Guess at 25% if in 25%; at 10% if in 10%.
b) 25%unrecaptured 1250 gain to extent that such gain makes up net capital gain
(i) gain on sale of depreciable real property (investment and business property), but only up to
depreciation taken.
(a) there will never be losses in this category (only for gains)
(ii) what happens if in lower tax bracket than 25%?
(a) 15% rate for persons below 25%
(b) same problem as above, except problem only for 10% people.
c) 15%gain on most long term capital assets included in net capital gain (other than gains from
collectibles, unrecaptured 1250 gain, and 1202 gain)
(i) gain on stocks, bonds, investment land, boat/car, business not attributable to depreciation and other
types of capital assets which are statutorily labeled adjusted net capital gain
(ii) applies only to assets sold on or after May 6, 2003 (before, category was at 20%)
(iii) if at bracket below 15%, taxed at 5% (before it was 10%)
4. Dividends
a) 2003 tax act
(i) tax most dividends as long term capital gains
(ii) taxed at 15% or 5% if in lower tax bracket
(iii) huge benefit although, a big revenue loser.
b) although taxed as long term capital gains for tax purposes
(i) not treated as such for offsetting capital losses
c) rate reduction only good until 2008, and then phased out.
d) do have to pay taxes on reinvested dividends
(i) but get to increase your basis (need to keep track of own)
5. Examples:
a) Trump sells a few small assets:
(i) first calculate gains and losses from each asset; put in separate categories; then net:
28%
200k gems
(550k) Picasso

25% (never losses here)

300k trump tower

15%
250k - stock
(100k)

Short Term
(20k)

(ii) step 1 net w/I each rate category

(a) if net losses w/I any category, they wipe out net gains that would otherwise be taxed at highest
rates
28%
(350k)

25%
300k

15%
150k

Short Term
(20k)

(iii) step 2 net long term losses w/ long term gains

(a) losses offset highest tax gains first (pro-taxpayer) [wipe out 25% before 15%] {found in Rev.
Ruling 97-59; codified in 1(h)}
(i) (350k) at 28% and 300k at 25% = (50k) at 28%
(ii) (50k) at 28% and 150k at 15% = 100k at 15%
(iv) step 3 net long term against short term
(a) 100k at 15% netted w/ (20k) ST = 80k net 15% capital gain
(b) net capital gain1222(11)net long term capital gain net short term capital loss
(i) 1222 doesnt tell us how to net thats in 1(h)
(c) lets say that 20k was loss in 15% and short term was 100k
(i) end up w/ 80k short term gain which is taxed at ordinary rates.
b) Dont net gains when you have gains on both sides
(i) 100k LTCG and 20K STCG
(a) leave it here!
c) if we have losses in more than 1 category:
(i) step 1: net w/I each rate category
28%
(350k)

25% (never losses here)

400k

66

15%
(20k)

Short Term
(20k)

(ii) step 2: net long term losses w/ long term gains

(a) offset against highest tax gain first
(i) 2 losses which do we use first
(a) doesnt matter b/c after this year, if any loss left over, loss gets carried over to future
as 28% loss.

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(b) (350k) and 400k = 50k at 25%. 50k and (20k) = 30k at 25%28%
(iii) Step 3: net long term against short term
(a) 30k at 28% and (20k) ST = 10k NLTCG (NLTCG NSTCL)
6. Problems (p. 689):
a) T, a single taxpayer, has a salary of 50k in current year. T also has following transactions all involving sale
of capital assets: 1) gain of 15k on a collectible held for 2 years; 2) gain of 20k on stock held for 15 months.
(i) Determine amount of Ts net capital gain
(a) 15k collectible; 20k stock = 35k NLTCG (didnt have any STCG)
(ii) at what rate will components of Ts net capital gain be taxed?
(a) How do we know they arent in lower tax bracket?
(i) Would be 15% or 5% (50k for single taxpayer is going to put you in above 15% bracket;
were ok here)
(b) What year did they sell it in?
(i) Last year would need to ask if May 6 or after
(a) Before May 6 at 20%
(b) After May 6 at 15%
(c) 15k at 28%; 20k at 15%
b) taxpayer, who is the highest federal tax bracket in current year, has 5k gain from a collectible and 5k gain
from stock, both held long-term.
(i) What is taxpayers net capital gain and how is it taxed if taxpayer also has 5k loss from a collectible
held long-term?
(a) Net w/I categories
(i) 5k gain from 28% bracket is offset by 5k loss from 28% = 0; 15% category 5k gain and
no loss. Taxed at 15% rate
(ii) What results in (a) if instead taxpayers 5k loss is from stock held long-term?
(a) Net capital gain = 5k; 5k taxed at 28%
(iii) What results in (a) if instead taxpayers 5k loss is from stock held for 9 months rather than from
collectibles?
(a) 28% 5k gain; 20% 5k gain; STCL 5k; NLTCG = 5k
(b) What is it taxed at?
(i) Short term gains/losses offset highest tax bracket first.
(a) So, it offsets 28% gain; the service allows loss in one category to offset gain in
highest taxed category first. 1(h)(5)
(c) Recap: w/I, long against long, long and short highest % goes first
(iv) What is taxpayers net capital gain and how is it taxed if taxpayer has 5k gain from a collectible, 5k
unrecaptured 1250 gain, 5k gain from stock, and 10k loss from stock, all held long-term?
(a) First step: net w/I categories
(i) 5k collectible at 28%; 5k 1250 at 25%; 5k gain offsets 10k loss at 15% = 5k loss

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(b) net against highest tax bracket which is 28%

(i) So 5k at 25%.

C. The Mechanics of Capital Losses { 1211(b); 1212(b)(1), (2)(A)(i); 1222(10); See

165(c) and (f); 1211(a); 1221(a)(1)-(4); 1222}
1. Generally, capital losses are not deductible. Capital losses can be used to offset capital gains +a 3k ordinary
income
2. FIRST STEP: when netting, make sure that loss is otherwise deductible!!!!!!!!!!!!!!!!!!!!!
a) Capital losses must be deductible (165) to have any tax consequences
b) losses are only deductible if t/b, investment, or casualty ( 165(c))
(i) loss on sale of car is not an investment
(ii) loss on boat, drugs, rec home personal losses are NOT deductible
3. Step two: determine how and to what extent deduction may be utilized
4. Capital losses can only offset capital gains plus up to 3k ordinary income
a) Any capital loss balance remaining is carried forward indefinitely, retaining its original character as either
long-term or short-term capital loss
(i) But unused capital losses die w/ taxpayer ( 1211)
(a) Cant deduct anymore
b) Penalty against being married only 3k for married people (per taxpayer, and considered as 1 taxpayer)
(i) For married filing separately, capital losses can only offset capital gains plus up to $1500
5. policy justifications for limiting deductibility of capital losses:
a) bunchingonly recognize losses when you sell item. Loss that has accrued over a number of years all gets
bunched into year you sell. W/o some limitations, could drop you into lower tax brackets
(i) realization concept
b) parallelismgive you a break and tax gains at 15%. Why should losses be put against ordinary income
which is taxed at 35%.
(i) Limit deductibility so that taxpayer cant get rate benefit.
(ii) So gov cant get whipsawed.
(iii) If capital losses could offset ordinary income, capital losses would be more valuable
c) cherry picking
(i) otherwise, people will cherry pick loss, take loss and wont sell gain b/c can
(ii) will be forced to sell gain property and not be able to cherry pick losses
(a) assumes that you have gains.
(b) Penalizes those who may only have a stock or two.
6. 1212(b) Carryover
a) capital losses not utilized in year incurred are carried over into subsequent taxable years and treated as LTCL
or STCL, depending upon their original character

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(i) if sum allowed under 1211(b) does not exceed 3k of excess losses over gains, there is no net capital
loss, no carryover, and no need or permission to use 1212(b)
b) amount and character of any carryovers
(i) when working w/ , one must make 1212(b)(2) computation first, before computing carryover losses
under 1212(b)(1)
(a) 1212(b) tells us amount of carryover will be amount of net short-term and net long-term capital
losses reduced by 3k amount that wiped out ordinary income
(ii) character remains same in year to which it is carried
(a) 1(h) long term carryovers first offset highest gains. So, all carry over as 28% losses
c) in subsequent year
(i) first use gains and losses from current year and net
(ii) then use carryovers and net.
d) Examples:
(i) LTG = $400; LTL = $2,400; STG = $400; STL = 2k.
(a) Net long against long; net short against short
(i) NLTL = (2k); NSTL = ($1,600)
(b) B/c have net loss on both sides, cant net long against short
(c) Only allowed to deduct 3k from ordinary income 1211(b).
(i) As a result, T has a net capital loss, 1212(b) applies, T is deemed to have a constructive
3k short-term gain under 1212(b)(2)(A)(i)
(a) LTG = $400; LTL = $2,400; STG = $3,400; STL = 2k.
(i)
NLTL = (2k); NSTG = $1,400
(d) Now, net long against short
(i) $600 NLTL1212(b)
(ii) 30k of ordinary income (so above 15% taxpayer)
28%
10k
(22k)

25%
8k

15%
5k
(4k)

ST
2k
(4k)

(a) first step: net gains against losses w/i

28%
(12k)

25%
8k

15%
1k

ST
(2k)

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(b) step 2: net long against long (offsetting gains w/ losses)

(i) LTCL = 3k; STCL = 2k = 5k loss
(c) Step 3: cant net short against long b/c both are losses
(d) Step 4: determine what carryover is going to be (must go through process b/c carryover retains
character.)
(e) This is how the carryover works:
(i) Re-net by adding in constructive short term capital gain.
(a) A made up concept. Really the same as ordinary income
(ii) Constructive short term capital gain is the lowest of:
(a) 3k
(b) taxable income w/o regard to capital gains and losses (allowed to offset 3k of
ordinary income ONLY if you have 3k. if dont make 3k in ordinary income, must use
this number)
(c) NSTCL + NLTCL (anytime you use this number, result will be 0 carryover)
(f) Here, lowest of 10k, 3k, 5k. lowest is 3k.
(g) Add to ST side 3k of constructive short term gain = 1k
(i) Now we have gain on one side and loss on other side. Net.
(a) 2k LTCL carryover
(h) to determine taxable income
(i) income from sources other than gains/losses and subtract off amount used as constructive
capital gain
(a) 30k 3k = 27k taxable income
(iii) Same as (b), but now, only have 2k ordinary income
(a) Netting process still have 3k of LTCL and 2k of STCL
(b) Amount of constructive gain is the only thing that is going to change.
(i) Now the lowest of the three numbers is 2k. our constructive gain
(ii) ST is now 0; nothing to offset 3k loss on LT.
(a) So now 3k LTCL carryover.
(c) Taxable income is now 2k 2k = 0 no taxable income.
(i) Should always be the answer if we use this number.
(iv) Same as (b), but now, have LTCL of 19k in 28%
(a) First step: Net w/I each(9k) at 28%; 8k at 25%; 1k at 15%; and (2k) in ST
(b) Step two: Net long against long(9k) wiped out w/ 8k gain. 1k loss and 1k gain = 0

71

(i) but still have 2k loss on ST side.

(c) Must determine carryover by going to constructive
(i) LT = 0; ST = 2k loss.
(ii) Add in short term constructive: 3k, 30k, 2k
(d) 2k gain and 2k loss = 0
(i) only enough to wipe off losses. We dont have any carryover
(e) taxable income = 30k 2k = 28k taxable income
(v) Same as (b), but now have 5k gain and 7k loss in 15%
(a) First step: net w/I(12k) at 28%; 8k at 25%; (2k) at 15%; (2k) in ST
(b) Step 2: net long against long (which one do we use? doesnt matter)
(i) (12k) offsets 8k gain = (4k)
(ii) Cant continue to net in long
(iii) We combine long term capital losses = 6k; ST = 2k loss (doesnt say this but we do it
anyway)
(c) Constructive STCG: 3k, 30k (taxable income), 8k (6+2)
(d) Lowest is 3k.
(i) Now have 1k gain on ST side.
(e) Net long term w/ short term gain = 6k loss + 1k gain = 5k LTCL carryover.
(i) Doesnt matter if LT left over is 28% or 15% b/c as LTCL, it offsets 28% gains first. In
other words, its carried over as 28% loss. (pro-taxpayer)
(a) Only extra step if have losses in more than one category is combine them.
(b) If short term is big enough, could have carryovers on both sides
(f) Taxable income = 27k
e) problem (p. 694):
(i) Here are 2 questions on capital losses incurred in current year. Figure for taxable income given in
column A reflects a single taxpayers taxable income for each of 2 years w/o regard to his capital gains
and losses. Note that in computing GI (as adjusted) on return no gains will be included, since capital
losses exceed capital gains and 1211(b) excess amount will be a reduction
Taxable income
a) 10k
b) 10k

LTCG
2k
2k

LTCL
6k
10k

STCG
$2,600
2k

STCL
1k
4k

(a) For each year separately, w/o regard to computations for other years, determine amount of
taxpayers capital loss that is allowed as a deduction from ordinary income under 1211(b)(1) or
(2) and amount and character of his capital loss carryover, if any, under 1212(b)
(i) Determine what types of gains/losses we have

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(ii) Are the losses deductible at all? (NEVER MAKE THIS ASSUMPTION. MUST ASK
THIS QUESTION BEFORE GETTING TO NETTING PROCESS)
(iii) First step: net w/I each bracket (we dont have anything to do here)
(iv) Step two: net longs against longs; shorts against shorts NLTL = 4k; NSTG = $1,600
(v) Step three: net long against short b/c still have gain on one side and loss can be used to
offset. $2,400 NLTL
(vi) Step four: add constructive short tem capital gain. Lowest of: 10k (taxable income), 3k
( prescribed amount), or 2400 (NLTCL + NSTCL)
(a) lowest is 2400.
(b) add constructive gain in to constructive STCG. NSTG ($1,600) + constructive gain
(2400) = 4k net STCG
(vii) Step five: offset losses with gains (4k LTCL and 4k STCG). No loss carryover.
(viii) Taxable income = 10k 2400 = 7600
(b) Year 2:
(i) Are these losses deductible? (assume deductible, but must ask)
(ii) First step: net w/I (dont have to do this in this problem)
(iii) Step two: net between longs/shorts. NLTCL = 8k; NSTCL = 2k (must do addition on
final)
(iv) Step three: net longs against shorts
(a) Losses on both sides so cannot do this step.
(b) Reason: what we are doing when we net is offsetting gains w/ losses.
(v) Step four: Determine constructive gain. Least of 10k, 3k, 10k (NLTCL + NSTCL)
(a) Lower is 3k so add 3k to STCL = 1k
(vi) Step five: Net between long and short (b/c now we have gain and loss) = 7k LTCL
carryover
(a) Carryover is at 28% for next year. Will first offset 28% gains.
(b) When loss is carried over, first net that years loss, then add in carryovers
(vii) Taxable income = 10k 3k = 7k net ST = 1k

D. The Meaning of Capital Asset

1. The Statutory Definition { 1221(a)(1)-(4); See 1221(a)(5)-(8), (b)}
a) In order to have a capital gain/loss, there must be a sale of exchange of a capital asset.
b) capital asset ( 1221)everything is a capital asset EXCEPT for 8 categories of non-capital assets
(i) must go through 8 categories of non, and if doesnt fit into any, its a capital asset.
c) 8 categories of non-capital assets (i.e. ordinary income; property which is at heart of taxpayers incomegenerating activities):
(i) certain property used in taxpayers t/b that is either a) depreciable personal property or b) real
property1221(2)
(a) t/bactivity that is regular and continuous enough to rise to level of t/b

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(b) depreciable personal propertyproperty that is subject to wear or tear or obsolescence

(i) computers, office supplies; stock is not subject to wear/tear, so not depreciable
(c) real propertyland, buildings, other fixtures (things that are permanently attached)
(d) quasi-capital asset under 1231
(i) deprciable personal property or real property used in the taxpayers t/b and held
for more than 1 year
(ii) best of all worlds w/ quasi-capital assets
(a) if sold at a gain, gain is capital. B/c must be more than 1 year, its LTCG (Taxed at
preferential rates)
(b) If sell at a loss, its ordinary loss (Can offset any type of income, w/o limitation);
deductible b/c business loss
(iii) Policy justification:
(a) Want to encourage t/b to invest in long term assets
(ii) copyrights, literary, musical, and artistic compositions, or letters or memorandums1221(3)
(a) non-capital asset status only applies to:
(i) person who created it
(ii) for letters/memos, for person whom they were written for
(iii) anyone who receives property w/ transferred basis (by gift)
(a) if bought its a capital asset for purchaser but not seller
(b) policy: just b/c what artist does, shouldnt make it any less than ordinary income thats how
she makes her living
(iii) accounts and notes receivable1221(4)
(a) until collect asset, you have a valuable asset
(i) accounts receivable generally for services
(ii) notes receivable generally for goods
(b) people were saying I have a sale or exchange, account receivable is capital asset. So
Congress made these non-capital assets
(c) requirements:
(i) acquired in ordinary course of business
(ii) for services rendered or property sold
(iii) during time between billing and being paid
(iv) publications of US gov
(a) Even though sale/exchange, its ordinary income
(b) different reason for this: deals w/ charitable organizations
(i) people were getting these free from gov, donating them free to library and took deduction
of fmv of book as charitable contribution, even though werent paying for book

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(ii) prevents people for taking charitable contributions to stuff they got free
(c) if donate non-capital asset to charity cant take fmv; must take basis, which is 0.
(d) Only excluded as a capital asset if receive publication free of charge
(i) If goes up in value, would be a capital asset
(v) Inventory includes stock and trade, and property held for sale to customers in ordinary course of
taxpayers t/b
(a) Stock and trade the final product you sell to customers; raw materials
(b) must rise to level of t/b
(i) problem: people hold property for more than 1 purpose
(ii) primarily principally or of first importance
(a) courts have also held that while it matters why you bought property initially, reason
you hold property can change over time
(c) 4 requirements that must be met in order for property not to be considered inventory, and thus
held as a capital assets (not held primarily for sale = capital asset status; primarily for sale =
inventory, thus non-capital/ordinary income) 1237
(i) taxpayer can never have held this land primarily for sale to customers
(ii) taxpayer cant hold any other real property primarily for sale to customers
(iii) no substantial improvements can be made to the property by taxpayer or related parties
(iv) taxpayer has to hold property 5 years before sale (unless it was inherited)
(d) planning opportunity:
(i) If theres going to be a loss, argue primarily for sale/inventory/ordinary income loss can
be offset
(ii) If theres going to be a gain, argue not held primarily for sale/capital asset/preferential tax
rates
(e) Exceptions:
(i) If sell more than 5 lots on a tract of land (contiguous parcel of land), then year in which 6 th
sale occurs falls w/I this exception.
(ii) Exception says gain from any sale in that year (that 6 th sale and beyond) will be ordinary
income up to 5% of selling price
(iii) Ex: 1, 2, 3, in 2001 and 4, 5, and 6, in 2002 5% rule applies to 4, 5, and 6
(a) Ar = 100k; ab = 60k; realized gain of 40k.
(b) 35k LTCG; 5k of ordinary income
(f) So, if you meet the requirements of 1237, deemed not to be in business well give you capital
gains.
(i) But once you get to 6th sale, were going to give a little bit of ordinary income
(g) Exception to exception:
(i) All expenses of selling property are deducted from 5% selling price is ordinary income
(a) 100k 2k = 98k; Ar = 40k; ab = 58k
(b) first calculate Ar, reduce Ar by selling expenses

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(c) multiply selling price by 5%

(d) reduce amount by selling expenses
(vi) commodities derivative financial instruments (wont cover)
(vii) hedging transactions (wont cover)
(viii) supplies 1221(a)(8)
(a) assets used in t/b w/ useful life of less than 1 year (i.e. paper products)
d) analysis:
(i) Say gain is 50k [must be recognized b/c no non-recognition provision]
(ii) whats the character of gain?
(iii) in order to have capital gain, must meet 2 requirements:
(a) is it a capital asset? This is inferred from
(i) its not __, _,
(ii) stock can be inventory if in business of buying/selling stock
(iii) and therefore it is a capital asset. when sell stock, it is a capital gain asset
(b) is it a sale/exchange?
e) Mauldin v. Commissioner (1952)No fixed formula for determining whether property sold by taxpayer was
held by him primarily for sale to customers in ordinary course of his t/b; must look at various factors
f) Malat v. Riddell (1966)Primarily = of first importance = principally

E. The Sale or Exchange Requirement and Statutorily Created Gain and Loss
Consequences {{ 165(g), 166(d), 1222, 1241, 1271; See 1235, 1253}
1. There must be a sale or exchange of a capital asset
2. look at what youre getting in exchange for giving up something that can be used again
3. General Rule
a) to trigger gain/loss, must have a realization event
(i) in order to have capital asset must have sale/exchange
(ii) almost everything is a sale or exchange.
(iii) When is disposition not a sale or exchange?
(a) A gift is not an exchange didnt get anything for it
(b) Spousal transfer is not an exchange
(c) An involuntary conversion house destroyed by fire is not an exchange
b) Court has held
(i) Foreclosure sale is a sale or exchange; even though involuntary b/c have gotten out of mortgage

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(ii) Condemnation is a sale or exchange

(iii) Abandonment or involuntarily deed back to lender is a sale or exchange
c) if transaction does not involve a capital asset, OR if it does not constitute a sale or exchange, it will give rise
to ordinary income or to an ordinary deduction
4. exceptions: Deemed sale or exchange, thus converting what would otherwise be ordinary into capital:
a) worthless stock or securities (and bonds) 165: if stock or security becomes worthless in taxable year,
deemed to be a sale or exchange on the last day of the taxable year it becomes worthless
(i) always going to have a loss in this scenario a bad thing b/c wed rather have ordinary loss than
capital loss.
(a) good thing if gain taxed at preferential rates
(ii) reason: we dont want to encourage people to wait until they are worthless and then reap the tax
benefits; want to put worthless stock and securities on equal footing as a sale or exchange at $1 and take
huge loss.
(iii) 1 problem w/ provision it is supposed to equate sale just before worthlessness w/ worthlessness;
this can have the effect of converting what would be short term loss w/ what is a long-term loss
(a) ex: buy stock on May 1, 2002. bankruptcy on Feb. 1, 2003.
(i) Deemed sale/exchange on Feb. 1, 2003 this is deemed a short term loss. But deemed
worthless on last day of year Dec. 31, 2003, converting short term into long term capital
loss
(a) This is anti-taxpayer b/c will have a loss you want to offset ST loss first b/c ST
losses first offset ST gains that are taxed at higher rates. Also violates policy provision
was designed to equate in first place. But this is the law.
b) Nonbusiness bad debts deemed sale or exchange of debt 166
(i) (a) if a business debt (lender is in business of loaning $) then debt, when it becomes worthless is an
ordinary loss
(ii) (d) non-business. If you own $, and not considered a business debt, deemed to be a STCL in year it
becomes worthless (when established that taxpayer cant pay)
(a) taxpayer is entitled to a deduction, but it is STCL
(b) Anti-taxpayer provision b/c will have a loss otherwise, this would be an ordinary loss
c) Cancellation of a lease, deemed s/e 1241
(i) pro-taxpayer provision b/c will have a gain converting what would otherwise be ordinary income
into capital gains
(ii) when a lessee relinquishes a lease in exchange for a payment by lessor, character of gain is not
affected by fact that lease is extinguished so that lessee has made no exchange
(a) such receipts are considered as amounts received in exchange for the lease
d) debt instrument cancelled by either payment or settlement, deemed sale/exchange 1271
(i) generally, when debt is cancelled, lender doesnt have a sale or exchange, b/c not giving debtor
anything debtor can use again.
(ii) Pro-taxpayer b/c normally buy debt for less than face value

F. The Holding Period { 1223(1), (2), (11); See 1014(a), 1015(a), 1041(b)(2), 1222,
1233, 1259}
1. Rules for calculating holding period:
a) holding period beings to run on the day following date of acquisition of asset involvedRev. Ruling 66-7
(i) dont count day property is purchased but do count day it is sold
(a) Feb. 2 Feb. 2 this is 1 yearshort term
(b) Feb. 2 Feb. 3 this is 1 year and 1 daylong term

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b) Holding period is governed by trade dates (i.e. day you call broker)Rev. Ruling 66-97
(i) Rules are uniform = trade dates are used for everything
(a) Amount of purchase/sale price
(b) Date of purchase/sale price
(c) Holding period for stock
(ii) Settlement dates are irrelevant for capital gains/loss
2. What does this mean? LTCL and STCL!!!!!!!!!!!!!!!!
a) You want to hold on to gains for more than 1 yearLTCG taxed at preferential rates
(i) STCG taxed at ordinary rate so we like them less
b) Want to sell losses before 1 year so that they are STCL
(i) We like STCL > LTCL, b/c STCL first wipe out STCG (which is taxed at ordinary rates)
3. Special Rules that might alter holding period
a) property received through inheritance
(i) if receive assets w/ stepped up basis at death ( 1014) automatically given LTCG/LTCL1223(11)
(a) doesnt matter how long heir, decedent held estate
(b) policy rationale: want to wind up estate so we give long term
(c) bad if asset goes down b/c have LTCL
(i) but great if assets goes up (most do) LTCG
(d) ONLY applies when asset receives a stepped up basis at death
(i) 2010 transferred basis doesnt receive automatic long-term holding period.
b) Property received w/ transferred basis, get to add on to your holding period transferors holding
period1223(2)
(i) tacted holding period
(ii) 1015 gift transferred basis 1223 tacted holding period.
(a) Transferred basis also under 1041 (former spouses)
(b) Also under 1022 (2010 transferred basis)
c) First-in, first-out basisReg. 1.1223-1(i)
(i) If taxpayer does not specify which stock they are selling, first in, first out.
(a) If identify block to be sold use holding period of that stock
4. Problems (p. 717):
a) Taxpayer, a cash method, calendar year taxpayer, engaged in following transactions in shares of stock.
Consider amount and character of Ts gain or loss in each transaction:

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(i) T bought 100 shares of stock on Jan. 15 of year one at a cost of $50 per share. T sold them on Jan. 16
of year two at $60 per share.
(a) Sale or exchange so there was a realization event. We use Ar ab = realized gain. Ar = 6k; ab
= 5k; realized gain is 1k. (state where these numbers came from) Must be recognized b/c no nonrecognition provision.
(b) Gain is capital gain b/c 1) capital asset b/c doesnt fall w/I exclusions unless a dealer and falls
w/I inventory (or something like this), 2) sale or exchange b/c there was a sale, 3) LTCG b/c
holding period is a year and a day b/c we start counting on day after we purchase (Jan. 16 of year
1), end up counting on day of sale (Jan. 16). We have come to Jan. 16 twice.
(i) When counting same day twice you are in year 2
(ii) T bought 100 shares of stock on Feb. 28 of year one at a cost of $50 per share. T sold them on Feb.
29 of year two, a leap year, for $60 per share.
(a) Same as above . . . Ar = 6k; ab = 5k; gain is 1k. Must be recognized b/c no non-recognition
provision.
(b) Gain is capital gain b/c 1) capital asset . . ., 2) sale or exchange . . . , 3) STCG b/c leap year
fucks it up
(i) start counting day after purchase (March 1 of year 1); end up counting on Feb. 29 of year
2. have not counted any day twice. Therefore, short term its only 1 year.
(a) short term is still capital gain, but taxed at ordinary rate can offset capital losses
(iii) T bought 100 shares at $50 per share on Feb. 10 of year one and another 100 shares at $50 per share
on March 10 of year one. T sold 100 of shares on Feb. 15 of year two for $60 per share.
(a) Blah, blah, blah. Gain is 1k.
(b) Gain is capital gain b/c 1) capital asset blah, 2) sale or exchange blah, 3) LTCG b/c since he
cant identify which one he sold, first-in, first-out concept applies
(i) We start counting on Feb. 11 of year 1. We go to Feb. 15 of year 2. Therefore, held for
over 1 year
(ii) If taxpayer had identified that wanted to sell second block it would be short term
(iv) T told Ts broker to purchase 100 shares of stock on Dec. 29 of year one at a time when its price was
$50 per share. Stock was delivered to T on Jan. 3 of year two when it was selling for $52 per share. T
told Ts broker to sell stock on Dec. 30 of year two when it sold for $60 per share, and it was delivered to
buyer on Jan. 4 of year three when it was selling for $63 per share
(a) Must use trade dates of Dec. 29 so ab = 5k; and Dec. 30 so Ar = 6k; 1k Ar, must be recognized
b/c no non-recognition provision (only gifts and transfer between spouses).
(b) Capital gain b/c 1) capital asset, 2) sale or exchange, 3) LTCG b/c held for 1 year and 1 day
(i) Actual purchase date is day after we purchase it; we counted same day twice = LTCG
(v) Same as (d) except that value of stock on Dec. 30 of year 2 was $45 per share and on Jan. 4 of year
three was $48 per share.
(a) Still must use trade dates (Dec. 30). Ar = $4,500; ab = 5k; $500 loss that must be recognized.
(i) Is loss deductible? This is established under 165 t/b, investment, or casualty. This is an
investment, so capital loss. LTCL of $500
(b) Character same holding period as before. Capital loss b/c sale or exchange of a capital asset.
(i) Sale or exchange b/d sold it. (people never get this point on final!)
(ii) Capital asset b/c not a non-capital asset (non-capital assets are . . . )
(iii) Deductible loss b/c investment
(iv) Can only offset capital gains up to 3k ordinary income
(vi) Ts father bought 100 shares of stock on Jan. 10 of year one at $30 per share. On March 10 of year
one when they were worth $40 per share he gave them to T who sold them on Jan. 15 of year two for $60
per share.
(a) Ar = 6k; ab = 3k father bought shares at 3k and under gift basis receive transferred basis (
1015. Exception: if property has built in loss at time of gift and donee sells it for a loss (below
fmv), then donee takes fmv of gift). Here, it is a transferred basis b/c built in gain and exception
wont apply
**exception will be on final
(b) 3k realized gain.
(c) Capital gain b/c 1) capital asset, 2) sale or exchange, 3) LTCG b/c held for over 1 year

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(i) 1223 when you have a transferred basis, get to tack on donors holding period. Holding
period for this stock is Jan. 11, and runs to Jan. 15 of year 2
(a) T got stock in March if not for tacked on holding period, would have been STCG
(ii) Son got transferred basis in whole or in part - so it is applicable in part sale, part gift!
(vii) Ts father purchased 1000 shares of stock for $10 per share several years ago. The stock was worth
$50 per share on March 1 of year one, the date of Fathers death. The stock was distributed to T by the
executor on Jan. 15 of year two and T sold it for $60 per share on Jan. 15 of year two.
(a) When someone dies, (unless year 2010, in which 1022 and get transferred basis 10k), 1014
applies and they get stepped up basis at death = fmv at time of death.
(i) Ar = 60k; ab = fmv at time of fathers death = 50k; gain of 10k
(b) holding period received through inheritance so automatically get long term holding period
(this is not a tacked period) [we want to encourage quick winding of estates]
(c) capital gain b/c not a non-capital asset and there was a sale or exchange. = LTCG
(d) However, in year 2010 ab = 10k instead of 50k
(i) 1223(11) wont apply b/c basis is not determined under 1014 , wouldnt get automatic
holding period
(ii) However, we do have transferred basis
(a) So heir would get tacked basis
(viii) Same as (g) except that T was executor of Ts fathers estate and as such T sold stock on Jan. 15 of
year two for $60 per share to pay estates administration expenses.
(a) Ab is still 50k; realized gain is 10k b/c estate also gets stepped up basis at death (1014(b))
(b) 1223(11) gives holding period both to heirs and executor or administrator of estate
(i) Estate also gets long term holding period (to encourage quick winding up of estate)
(c) Result is same in H as it was in G

G. Up until now what is GI; what is the character of that income

1. if there were to be a flat tax semester thus far would not change
2. 1 thing that would change concept of deductions
a) but not all deductions
(i) business deductions would still be the same
(a) 162(m)no deduction allowed for salaries exceeding $1m per year
(i) loopholes: base salary; doesnt include other bonuses and benefits

IV. Deductions in Computing Taxable Income

A. Perspective
1. GI above the line deduction = AGI PEs (greater of itemized deduction (below the line deductions) or standard
deduction = taxable income x tax rates = tentative tax liability credits = actual tax liability ($ paid to gov)
2. 3 categories of deductions:
a) above the line
b) below the line

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c) PEs

B. Business Deductions
1. Introduction { 1; 63}
a) Taxpayer has no constitutional right to a deduction; taxpayer must find a statutory provision that specifically
allows deduction claimed
b) 63taxable income is GI minus deductions provided in
2. The Anatomy of the Business Deduction Workhorse: 162
a) General Ruletaxpayer gets a current deduction (this year) for all ordinary and necessary expenses paid or
incurred in the current taxable year in carrying on a t/b 162
b) Ordinary and Necessary {162(a); Reg. 1.162-1(a)}
(i) ordinary1 that is common in taxpayers community or usual in that business Would person in
community normally pay that expense?
(a) Ordinary does not mean recurring; could have ordinary that only comes up once in someones
lifetime (i.e. defending sexual harassment suit)
(b) Welch v. Helvering
(i) Pays corporations debts out of own pocket. It is not ordinary to pay anothers debts w/ no
legal obligation to do so. Therefore, not deductible
(a) Didnt lose expenditures completely. Was allowed to add expenses to basis of
business (so when sold, would have less of a gain)
(c) Problem w/ this area: decided on case-by-case basis. Can find cases going the other way
(i) Jankinspaid investors b/c felt bad. Ct allowed him to deduct
(ii) Distinction: Jankins already had business reputation. Was paying to maintain reputation
(iii) Build (not ordinary and necessary) v. maintain (ordinary and necessary)
(ii) necessaryif appropriate and helpful in developing and maintaining taxpayers business
(a) only time when held not to be necessary:
(i) lavish or extravagant for the circumstances
(ii) if reimbursed or compensated for it
c) Expenses { 162(a), 263(a); Reg. 1.162-4; 1.263(a)-2; Proposed Reg. 1.263(a)-4(a) through (c)(1); (d)(1);
(e)(1)(i), (2), (3)(i)}
(i) this is the sticky area: is it an expense (deductible) or a capital expenditure (not deductible, but gets
added to basis) (wont be clear on exam)
(a) test: what was its original life
(i) if doesnt extend expense
(ii) if extends life capital expenditure
(ii) expenses = currently deductibleamount spent for maintaining or repairing property; doesnt
materially add to value; doesnt prolong original life (decreases ordinary income)
(a) Ex: Fix leaking roof, faulty wiring, re-wallpapering
(iii) Capital expenditure = added to owners basis (not deductible until realization event)adds value to
property; prolongs its original useful life; permanent improvements; adapts property to new and different
life263(a)
(a) Ex: Re-gut inside of building, add hot tub, trees and bushes (not yearly flowers), add new roof

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(i) Some you just have to research, wont be clear-cut

(iv) Benefit is either lowers taxable income or adds to basis when selling property. But it matters
(a) Time value of money. Would rather take deduction now rather than later
(i) repair is currently deductible against ordinary income
(a) prefer to reduce ordinary income (b/c taxed at higher rate) then capital.
(b) Generally, prefer expenses rather than capital expenditure
(i) Businesses prefer expenses over expenditures b/c value of money
(ii) Individuals would prefer capital
(a) personal expenses are not deductible (i.e., paint bedroom, cant deduct; add hot tub,
increases basis higher basis lowers the gain) 262
(b) Funnel personal expenses through business so can deduct instead of lose (although
this is illegal)
(v) Midland Empire Packing Co. v. Commissioner (1950)
(a) Repair v. replace
(i) repairto restore to a sound state or to mend
(a) merely keeps property in an operating condition over its probable useful life for
uses for which it was acquired
(ii) replacement, alterations, improvementssubstitution
(a) prolong life of property, increase its value, or make it adaptable to a different use
(b) earthquake shoring up is an improvement costs must be capitalized
(b) Court held
(i) Lining basement walls and floor was essentially a repair and it is deductible as an ordinary
and necessary business expense
d) Carrying On Business { 162(a); 195; 262; Reg. 1.195-1(a)}
(i) Morton Frank v. Commissioner (1953)
(a) travel expenses and legal fees spent in searching for a newspaper business w/ a view to
purchasing cannot be deducted under 162(a)
(i) not engaged in any t/b at time expenses were incurred, merely preparatory
(b) Should not be read so broadly as to suggest all costs incurred in seeking employment can never
give rise to 162 deduction
(i) 162 deductions include:
(a) Frank was in t/b and was seeking to expand that t/b or some branch of it
(b) Frank wanted to switch in another job in same field
(i)
Doesnt matter if successful or not
(c) Frank had proceeded into transactional stage
(ii) Start-up Expensespaid or incurred before t/b begins

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(a) 162start-ups NOT deductible [Frank]

(b) Exception: 195 start-ups may be treated as deferred expenses/amortized over not loess than
60 months (starting when t/b commences)
(i) 195 amortization of start-up expenses is permitted if:
(a) in t/b
(b) Otherwise deductible expenses (if in nature of capital expenditures rather than
expenses, must add to basis)
(c) Ordinary and necessary (not lavish or unreasonable)
(d) Over a period of NOT less than 60 months, beginning in month that active t/b
begins
(ii) Lose if never start t/b
(iii) Taxpayer must be self-employed (this is proved only in legislative history; been upheld)
(iv) Elective: must check to get it
(v) If t/b fails before 60 months, may deduct rest of expenses at end of year
(vi) Must be of type that would be allowable as a deduction if paid or incurred by an existing
t/b. Amounts incurred w/ respect to:
(a) Investigating creation or acquisition of an active t/b
(b) Creating an active t/b
(c) Activities engaged in for profit before day on which active t/b begins, in
anticipation of such activity becoming an active t/b (e.g., costs for advertising, training
employees, lining up distributors or potential customers and fees for professional
services in setting up books)
(d) amounts deductible under 163 (interest), 164 (taxes), and 174 (research expenses)
do NOT constitute start-up expenditures. As such, these expenses need not be
amortized but instead may be deducted currently to extent allowable under respective
s
(iii) Employees seeking employment
(a) 195 doesnt apply
(b) 162 does apply IF already in same line of business, regardless of success
(i) employees seeking 1sts time employment or new t/b cant take deduct b/c not carrying on
t/b
(ii) Rev. Ruling 75-120deductions are not allowed under 162 for expenses incurred by
individuals who have been unemployed for such a period of time that there is a substantial
lack of continuity between their past employments and their endeavors to find new
employments, but length of time necessary to establish this substantial lack of continuity
remains uncertain
(c) Hundley Exception:
(i) If expense not owed until start business, carrying on t/b at this time and deductible
e) Problems (p. 344):
(i) Determine the deductibility under 162 and 195 of expenses incurred in following situations
(a) Tycoon, a doctor, unexpectedly inherited a sizeable amount of money from an eccentric
millionaire. Tycoon decided to invest a part of her fortune in development of industrial properties
and she incurred expenses in making a preliminary investigation.
(i) We would prefer 162. its a better deal b/c you can deduct them immediately
(ii) Preliminary investigation expenses are not deductible under 162. B/c Tycoon was a
doctor previous to inheriting her wad, she was NOT in t/b of developing industrial properties.
(a) But, expenses can be amortized under 195 if:
(i)
In t/b

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(ii)
Otherwise deductible expenses (if in nature of capital expenditures
rather than expenses, must add to basis)
(iii)
Ordinary and necessary (not lavish or unreasonable)
(iv)
Period of NOT less than 60 months, beginning in month that active t/b
begins
(b) Same as (a) except Tycoon, rather than having been a doctor, was a successful developer of
residential and shopping center properties
(i) As long as ordinary and necessary and are expenses, currently deductible under 162 b/c
already in business of development
(ii) But how broadly do we look at?
(a) residential and shopping center properties = industrial properties?
(b) Math teacherprinciple same
(c) dentistorthodontist same
(d) General practitionertax different
(e) tax in NYtax in CA - different
(f) Generally, those which you need a new license will be treated as different t/b
(i)
But cant assume this
(ii)
Law in ILlaw in MO not under 162 or 195, may lose them
completely; No S.Ct. case and people probably deduct them all the time
(iii) If not deductible, expenses can be amortized under 195 if:
(a) Ordinary and necessary
(b) A period of NOT less than 60 months, beginning in moth that active t/b begins
(c) Facts same as (b) except that Tycoon, desiring to diversify her investments, incurs expenses in
investigating possibility of purchasing a professional sports team
(i) B/c Tycoon is in business of residential property development, he is NOT engaged in t/b of
sport teams so not deductible not 162
(a) Expense can be amortized under 195 if:
(i)
He actually does purchase
(ii)
Rises to level of t/b
(iii)
Ordinary and necessary
(iv)
Period of NOT less than 60 months
(b) If Tycoon never even enters the business, not even amortizable under 195
(d) Same as (c) except Tycoon purchases a sports team. However, after 2 years Tycoons fortunes
turn sour and she sells team at a loss. What happens to deferred investigation expenses?
(i) Different line of business so not deductible
(ii) Amortized if blah, blah, blah
(a) 195(b)(2) if you start and then close before 60 months, you are entitled to take
remaining expenses in last year, so long as they can otherwise be deductible under 165
(i)
which they are b/c t/b; for investment; for casualty losses

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(iii) ++can accelerate deferment

(iv) planning?
(a) Half ass business, then get accelerated deferment
(i)
Service will say you never really start up
(b) Encourages you to start business and see if you can do it
(v) If never started business, 195 doesnt even apply
(ii) law students spouse completed secretarial school just prior to student entering law school. Consider
whether spouses employment agency fees are deductible in following circumstances:
(a) agency is unsuccessful in finding spouse a job
(i) not deductible
(ii) Not carrying on t/b prior to fee, therefore, can NOT deduct fees under 162
(iii) cant use 195 either b/c shes not self-employed
(b) agency is successful in finding spouse a job
(i) same as (a)
(c) same as (b) except that agencys fee was contingent upon its securing employment for spouse
and payments will not become due until spouse has begun working
(i) not carrying on t/b prior to fee, but deductible under Hundley exception b/c fee was NOT
charged until employment began, expense was not incurred until she was in the business.
Therefore, deductible under 162.
(d) same as (a) and (b) except that spouse previously worked as a secretary in Old Town and seeks
employment in New Town where student attends law school
(i) was in same line of business in both towns deductible under 162 (dont need new
license)
(a) doesnt matter if successful or not
(b) if had been unemployed for a year (homemaker), wouldnt be in same line as
secretary and wouldnt be deductible under 162 unless she continued to look for work
entire time she was unemployed
(e) same as (d) except that agency is successful in finding spouse a job in New Town as a bank
teller
(i) new t/b, not deductible
(ii) depends on manifested intent of agency.
(a) If trying to find work in same line of business and business hires her at different
job, deductible under 162
(i)
rev. ruling 75-120if looking for job in t/b and find a job in different
t/b, expenses are deductible
(b) If trying to find any job not same t/b and therefore, not deductible
(f) if an independent contractor, considered self-employed and can get 195
(i) can employer treat you as independent contractor even if not really one?
(a) cant get around these rules be careful about classifying anyone as independent
contractor
3. Specific Business Deduction
a) Travel Away From Home { 162(a)(2), 162(a) second to last sentence; 274(n)(1); See 162(h); 274(c), (h)
and (m)(1) and (3); Reg. 1.162-2(omit 2(c))}

85

(i) General Ruleif traveling away from home in pursuit of t/b, can deduct reasonable and necessary
expenses
(ii) Flowers test travel expenses are deductible only if expenses are:
(a) reasonable and necessary traveling expense
(i) standard is no different than ordinary and necessary standard; cant be lavish or
extraordinary; must be helpful for business
(b) incurred while away from home
(i) US v. Correllfor a period requiring sleep or rest (or overnight)
(ii) Reason for rule: put traveling salesman on same footing as professor
(c) incurred in pursuit of business (business exigency requirement)
(i) there must be a direct connection between expenditure and carrying on of t/b of taxpayer
or of his employer. Moreover, such an expenditure must be necessary or appropriate to
development and pursuit of t/b
(iii) Can deduct
(a) airfare, mileage to and from airport (or cab ride), baggage cost
(b) if drive rather than fly (mileage this year is 37.5 cents per mile for business travel)
(i) moving expenses are deductible at 14 cents per mile
(c) hotel costs
(d) meals, tips, and entertainment (subject to reasonableness requirement)
(i) capped at 50% of actual cost. 274(m)
(e) dry cleaning expenses
(iv) Andrews v. Commissioner (1991)uses principle place business
(a) Purpose of 162(a)(2)mitigate burden upon a taxpayer who, b/c of exigencies of his t/b, must
maintain 2 places of abode and thereby incur additional living expenses
(b) General ruletaxpayers home for purposes of 162(a) is area or vicinity of his principal place
of business
(c) Cannot have 2 tax homes under 162(a)(2)
(i) Living expenses duplicated as a result of business necessity are deductible
(a) those duplicated as a result of personal choice are not
(b) Reasoning: Taxpayer cannot be expected to relocate her primary residence to a
place of temporary employment
(ii) Must look at length of time spent engaged in business at each location
(a) Where ever most time is spent, that is taxpayers tax home allowance of
deductions for duplicate living expenses incurred at other minor post of duty
(v) Must be away from home? But where is ones tax home?
(a) principle place of residence v. principle place of business
(i) Serviceprinciple place of business is tax home
(ii) Most courtsprinciple place of residence is your tax home

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(a) I.e. Congressman in KC who spends 10 months in JC

(i)
Residence KC
(ii)
Business JC
(b) When are you away from home?
(i)
Would rather JC b/c then can take deductions for 10 months
(b) Rev. Ruling 63-82 and Andrews: General Rulewhere most time is spent is determinative
(i) Exception: if you are an employee at both places (v. independent contractor), then money
earned is determinative (Rev. Ruling 54-147)
(c) Some people dont have a tax home (home travels w/ person)
(i) So, dont always get travel away from home expenses
(vi) Meals: Rev. Proc. 2003-80allows you to take a per diem w/o having to prove actual expenses
(a) How much is per diem
(i) High cost location - $46 dollars per day
(ii) Low cost location - $36 dollars per day
(b) For each trip you can choose either per diem or save all receipts
(i) Can do it one way on one trip and other way on different trip
(c) Can only deduct 50% of per diem really only get $23 that is deductible
(vii) Rev. Ruling 99-7
(a) 162(a)allows a deduction for all ordinary and necessary expenses paid or incurred during
taxable year in carrying on any t/b
(b) 262no deductions are allowed for personal, living, or family expenses
(i) General Rulecost of commuting between taxpayers residence and taxpayers place of
business or employment generally are nondeductible personal expenses
(a) Exception: costs of going between 1 business location and another business location
generally ARE deductible under 162(a) ~ general business expense
(ii) General RuleDaily transportation expenses are NOT deductible when paid or incurred
by taxpayer in going between taxpayers residence and a temp work site inside that metro
area b/c that area is considered taxpayers regular place of business
(a) Exception: daily transportation expenses ARE deductible business expenses when
paid or incurred in going between taxpayers residence and a temp work site outside
that metro area
(iii) General RuleIf taxpayer has 1 or more regular work locations away from taxpayers
residence, taxpayer may deduct daily transportation expenses incurred in going between
taxpayers residence and a temp work location in same t/b, regardless of distance
(iv) General RuleIf a taxpayers residence is taxpayers principal place of business w/I
meaning of 280A(c)(1)(A), taxpayer may deduct daily transportation expenses incurred in
going between residence and another work location in same t/b, regardless of whether other
work location is regular or temp and regardless of distance
(c) Temp work locationany location at which taxpayer performs services on an irregular or short
term (days or weeks) basis
(d) residencetaxpayers principal place of business w/I 280A(c)(1)(A) is not necessarily
determinative of whether residence is taxpayers tax home for other purposes, including travelaway-from-home deduction under 162(a)(2)
(viii) Temporary v. indefinite employment
(a) if have principle place of business and you travel to another location in pursuit of t/b, can deduct
ALL expenses while temp away from home
(b) when does temporary employment become indefinite or permanent employment?

87

(i) 162(a)
(a) 1 year or less temp away from home so expenses are deductible
(b) more than 1 year indefinite and not deductible
(ii) Rev. ruling 93-86 intended to clarify temporary
(a) Taxpayers supposed to be away from home 9 mos. Actually there 11.
(i)
All 11 are deductible; intended to be temp, it was temp
(b) Taxpayers supposed to be away from home 15 mos. Actually there 11.
(i)
None of expenses are deductible; intended to be indefinite even
though turned out to be temp
(c) Taxpayers supposed to be away from home 9 mos. At end of 7 mos., asked if she
could stay another 8 mos.
(i)
Up until 7 mos intent was temporary; therefore, first 7 mos are
deductible.
(ii)
At month 7 you learn indefinite all rest is not deductible
(d) planning opportunities!!
(i)
decide in mos. 12 that are going to stay another year, everything up to
month 12 is deductible.
(ix) Commuting Expenses
(a) generally not deductible considered to be a personal expenses
(b) issue: what about when away from home? split of authority
(i) Servicewouldnt be deductible if at home, so shouldnt be deductible away from home
(a) But meals are clearly deductible
(ii) Most courtscommuting expenses while away from home ARE deductible
(a) This is so, even if away from home for 6 months.
(iii) Still an open issue, though, b/c service still fights
(c) Rev. ruling 99-7generally not deductible
(i) But if commuting from home to temp work site outside metro area, deductible, even if not
staying over night.
(ii) This is where Service has eased its commuting rules
(iii) Commuting from 1 work place to another work place is also deductible
(a) However, this is a general business deduction, not travel away from home deduction
(x) Combined business and personal travel
(a) the only issue is: are your expense going to and from deductible?
(i) Work days are clearly deductible
(ii) Non-work days meals, lodging, commuting expenses are clearly NOT deductible

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(b) 274(c) if its a combined business and pleasure trip, question is whether trip is primarily
business in nature.
(i) If yes, all of transportation expenses are deductible
(ii) If no, trip is primarily personal, none of transportation expenses are deductible.
(iii) Primarilynumber of days
(a) I.e. leave on Monday. Work all day. Tuesday work all day. Wed work till 6pm.
Thurs and Fri play. Transportation expenses are all deductible
(i)
If work ends at 3 on Wed. probably still primarily business
(ii)
If work 1 hour on Wed. probably primarily personal
(iii)
For most part whether bulk of day is spent on business
(iv)
All this changes when we talk about intl travel
(xi) Problems on (p. 377):
(a) Commuter owns a home in Suburb of City and drives to work in City each day. He eats lunch
in various restaurants in city
(i) May commuter deduct his costs of transportation and/or meals?
(a) Cost of commuting not deductible.
(b) Cost of meals not deductible b/c commuter is not away from home for a period
requiring sleep or rest (Currel Rule)
(ii) Same as (a), but commuter is an attorney and often must travel between his office and the
city court house to file papers, try cases, etc. May commuter deduct all or any of his costs of
transportation and meals?
(a) Commuting expenses expenses from home to office are NOT deductible
(b) Transportation expenses expenses from business to somewhere other than home
ARE deductible b/c traveling from business location to business location to business
location are ordinary and necessary business expenses
(i)
Doesnt matter if travel is for same t/b or 2 different jobs.
(ii)
Can either deduct actual expenses or 37 cents a mile
(c) Cost of meals NOT deductible b/c he is not away from home for a period
requiring sleep or rest (Currel Rule)
(iii) Commuter resides and works in city, but occasionally must fly to other city on business
for his employer. He eats lunch in other city and returns home in late afternoon or early
evening. May he deduct all or a part of his costs?
(a) Cost of transportation deductible b/c traveling from business location to business
location are ordinary and necessary business expenses
(i)
Not deductible under travel away from home exception, but deductible
under ordinary and necessary business expenses
(b) Cost of meals NOT deductible b/c not away from home for a period requiring
sleep or rest
(b) Taxpayer lives w/ her husband and children in City and works there.
(i) If her employer sends her to Metro on business for 2 days and 1 night each week and if
Taxpayer is not reimbursed for her expenses, what may she deduct?
(a) Where is tax payers tax home?
(i)
Service says principle place of business. City
(ii)
Most courts say principle place of residence. City
(b) Tax home is clearly City and therefore, she is away from home while in Metro. She
can deduct expenses while in Metro:

89

(i)
all transportation expenses to and from Metro
(ii)
50% of meals and entertainment while in Metro
(iii)
lodging while in Metro
(iv)
Split of authority on whether she can deduct commuting expenses
while in Metro
(ii) Same as (a), except that she works 3 days and spends 2 nights each week in Metro and
maintains an apartment there.
(a) Tax home?
(i)
Court view Principle place of residence is city she spends more
nights a week there
(ii)
Service view principle place of business is now probably Metro b/c
she spends 3 days a week in Metro
(b) Either way, when she is away from home it is b/c exigency of business, and
therefore deductible.
(i)
If metro city taxes are in deductible
(ii)
---Service will not let her deduct mortgage for 1k home. They will ask
what is reasonable? $800 is probably reasonable b/c if she stayed at a hotel, it
would cost $800. However, maybe its cheaper to get an apt instead of a hotel.
(iii)
If city metro taxes are deductible
(iii) Taxpayer and husband own a home in City and husband works there. Taxpayer works in
Metro, maintaining an apartment there, and travels to City each weekend to visit her husband
and family. What may she deduct?
(a) She can deduct nothing
(b) Tax home is in Metro (whether principle place is business/residence)
(c) When she is in City she is away from home
(i)
BUT she is NOT away from home due to exigencies of business
(Flowers requirement); she is away from home for personal reasons. Her family
could be w/ her in Metro.
(ii)
Cant have 2 tax homes.
(c) Burly is a professional football player for City Stompers. He and his wife own a home in Metro
where they reside during 7-month off season.
(i) If Burlys only source of income is his salary from Stompers, may Burly deduct any of his
City living expenses which he incurs during football season?
(a) None are deductible.
(b) if principle place of residence, tax home is in Metro. When he is in city, hes away
from home. But not b/c of exigencies of business. not deductible
(c) if principle place of business, tax home is in City. When he is in city, hes not away
from home. not deductible
(d) Need jobs in both places for expenses to be deductible
(ii) Would there be any difference in (a) if during 7-month off season Burly worked as an
insurance salesman in Metro?
(a) Now his expenses are deductible in either city or metro, depending on where tax
home is
(i)
If residence Metro expenses in City are deductible
(ii)
If business depends on more time spent v. money earned
(b) Money v. time spent?
(i)
If employee in both locations, we use money earned

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(ii)
If not an employee at both locations (I.K.), use time spent
(iii)
---as a football player, he is probably an employee (control)
(iv)
---as insurance salesman probably independent contractor
(c) He spends more time in Metro
(d) under either definition of tax home he is away from home while in city and his
expenses there are deductible
(e) nothing to suggest that you need to work a certain number of months, make a
certain amount of money
(i)
a planning opportunity: get a job where you live, then expenses away
from home are deductible
(d) Temp works for Employer in City where Temp and his family live.
(i) Employer has trouble in Branch City office in another state. She asks Temp to supervise
the Branch City office for 9 months. Temps family stays in City and he rents an apt in
Branch City. Are Temps expenses in Branch City deductible?
(a) Temps expenses are deductible in branch city if she is away temporarily
(i)
less than 1 year (both expected and actual)
(ii)
in pursuit of t/b
(b) All deductible in branch city getting there, where she stays (usually 2 bedroom
apt), commuting expenses, 50% of meals (actual receipts are per diem) of entire time in
branch city
(i)
May also have trips back to city that he may be able to deduct
(ii) What result in (a) if time period is expected to be 9 months, but after 8 months it is
extended to 15 months?
(a) Allowed to deduct for shorter period of time of 1 year OR when trip becomes
definite
(b) At 8 months, know that no longer going to be temporary; instead time is now
indefinite. Therefore, deductible up to 8 months.
(iii) What result in (a) if Temporary and his family had lived in a furnished apartment in City
and he and family gave apartment up and moved to Branch City where they lived in a
furnished apartment for 9 months?
(a) Issue is duplication of expenses.
(i)
Maj dont require duplication so long as meet away from home
requirement; would allow taxpayer to take deduction (need temp situation for this
example. Otherwise, would not be away from home)
(ii)
Min says must be able to show duplicative expenses. Reason why we
give you a deduction is b/c you have duplication of expenses. B/c expenses are
not duplicated, not deductible
(e) Traveler flies from her personal and tax home in NY to a business meeting in FL on Monday.
Meeting ends late Wednesday and she flies home on Friday afternoon after 2 days in the sunshine.
(i) To what extent are Travelers transportation, meals, and lodging deductible?
(a) Majority of trip must be business in nature, and it is. Therefore,
(i)
Entire airfare and expenses to and from airport are deductible under
Reg. 1.162-2(b)(2) more than 50% needs to be business
(ii)
Meals (50% cap either of actual meal or per diem) and lodging for
Monday and Tuesday are deductible
(iii)
Wednesdays breakfast and lunch would be deductible maybe dinner
depending on time she gets back turns on whether she had flown home right
after meeting, and would have gotten meal, then deductible
(iv)
Wednesday night lodging? If could have gotten a flight out in
afternoon/evening and gotten home at a reasonable hour not deductible.
Service takes a reasonableness approach
(v)
Tips, baggage, 1 call a day are deductible
(vi)
Rest of trip is non-deductible b/c for personal reasons

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(ii) May traveler deduct any of her spouses expenses if he joins her on the trip.
(a) Used to be if spouse was there for a bona fide business trip
(b) Now - must meet all 3 requirements under 274(m)(3):
(i)
Spouse/dependent is a bona fide employee of taxpayer who is trying to
deduct expenses (this category knocks most people out)
(ii)
Travel is for bona fide business purpose (ironing someones shirt is not
bona fide anymore)
(iii)
Expenses otherwise deductible
(iii) What result in (a) if Traveler stays in Florida until Sunday afternoon?
(a) If personal days exceed business days, trip is personal in nature and NONE of
airfare is deductible
(b) Can deduct 100% of lodging for Monday and Tuesday
(iv) What result in (a) if traveler takes a cruise ship leaving Florida on Wednesday night and
arriving in NY on Friday
(a) Generally, so long as trip is primarily business, all travel is deductible
(b) However, 274(m)(1) imposes cap on transportation by waterway.
(i)
Doesnt say none are deductible
(ii)
Cap = 2x daily per diem for travel w/I US for gov employees x # of
days in transit. This includes lodging AND meals. Fed per diem = (150) x 2 =
300; meals subject to 50%
(iii)
Here 2 days of transit. $130 x 2 days x 2 = $520 for expenses that are
deductible; anything over is not allowed
(c) 274(c)
(i)
limitations do NOT apply to this problem b/c one of the exceptions for
travel outside US is if you travel for less than a week, go back to general rules
(v) What result in (a) if Travelers trip is to Mexico City rather than FL?
(a) what is the limitation of 274(c) travel outside US, generally?
(i)
Still must meet regs requirement that trip be primarily business to be
able to deduct any travel [normally, so long as have more business than personal,
travel IN US is deductible]
(ii)
If it is primarily business, then rather than getting all of the travel, we
only get a PRORATED portion for travel outside of US:
# of business days
total # of travel days
[The cost of transportation x (bus days/total days) = deductible
expenses] denies deduction for % of personal transportation if
outside of US
(iii)
Exception (c)(2)(A) if total trip is a week or less ALL is deductible
still must be primarily business, but then can deduct everything
(iv)
Exception if business travel is > 75% of total travel, then entire trip is
deductible (lodging and meals for personal days are still not deductible)
(b) So only business portion is deductible
(vi) What result in (e) if Traveler went to Mexico City on Thursday, Friday, Monday, and
Tuesday, and returned to NY on succeeding Friday night?
(a) Do we have primarily business travel?
(i)
Looks like 4/9 days, BUT

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(ii)
If you are out of the country and have business on either side of
weekend, then weekend counts as business days. Reg. 1.274-4(d)(2)(v).
(iii)
B/c business on Friday and Monday, weekend days are business days
(iv)
This ONLY applies to travel OUTSIDE of U.S. (although, many courts
have used same determination for travel inside US)
(v)
AND Friday is also a business day b/c its a transportation day (only
question would be if could have gotten home same day, in which case Friday
wouldnt be a business day b/c could have gotten home after meeting on
Tuesday)
(vi)
7/9 are business days; primarily a business trip b/c >50%
(b) Because we are there for business more than personal, something is deductible (if
more personal than business, nothing)
(i)
Total transportation would be deductible if Friday is a business day. If
Friday is a personal day 6 nights business
(ii)
Prorated amount of transportation (2/3 of the cost of transportation)
(vii) What result in (e) if Travelers trip to Mexico City is to attend a business convention?
(a) Must be primarily business in nature to have any transportation deductible
(i)
Here, it is primarily business
(b) 274(c) applies trip is less than a week so all transportation is deductible
(c) 274(h) attendance at conventions
(i)
limitations on conventions outside the North American area
(ii)
disallows expenses if travel outside of North America UNLESS you
can prove that its just as reasonable to have meeting outside of North America
than it is inside North America
(iii)
conventions for investment are almost always disallowed
(iv)
convention on cruise ships are disallowed
(d) Rev. Ruling 2003-109 North America = ALL 50 states and D.C., US possessions
and territories, Canada, Mexico, beneficiary countries (Barbados, Dominica Republic,
Cuba, Honduras, Jamaica, etc.), compact of free association jurisdictions
(i)
Broader definition for North America than you think

C. Deductions Not Limited to Business or Profit-Seeking Activities

1. Introduction
a) General Rule personal interest is NOT deductible ( 262); business and investment interests ARE
deductible
(i) business interest deductible under 162
(a) borrow money from bank to build factory
(i) in connection w/ t/b
(ii) ordinary and necessary
(ii) Investment interest deductible under 212 (not responsible for investment interest on exam)
2. Interest { 163(a), (h); 280A(d)(1); See 163(d) and (f); 221; 263A; 265(a)(2) through (4); 266}DEDUCTIBLE
a) Rev. Ruling 69-188 (1969)
(i) interestamount one has contracted to pay for use of borrowed money, and as compensation paid for
use or forbearance of money

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(a) doesnt include payment for specific services which lender performs in connection w/
borrowers account. Interest would NOT include:
(i) separate charges made for investigating prospective borrower and his security
(ii) closing costs of loan and papers drawn in connection therewith
(iii) fees paid to a third party for servicing and collecting that particular loan
b) J. Simpson Dean v. Commissioner (1961)interest free loans result in no interest deduction for borrower;
interest-free loans result in no taxable gain to borrower
c) The Disallowance of Interest
(i) General Ruleinterest received is taxable as ordinary income ( 61); cant take deduction for most
personal interest (borrow money to buy drugs) 163(h)
(ii) 2 exceptions (deductible even though they are personal expenses):
(a) qualified residence interest163(h)(3). Must meet 2 requirements:
(i) debt must be secured by qualified residence
(a) qualified residenceneed not be principal residence of taxpayer, but qualifying
indebtedness is limited to a max of 2 residences and, if there are 2, one must be
taxpayers principle place residence
(b) residence = mobile homes and live-in boats
(i)
first principle residence (weve already defined this) place you live
most number of days in a year
(ii)
second any other home that you own, generally, so long as dont rent
it out, doesnt matter how many days out of the year you use
(iii)
--but if you DO rent out second residence, must use it for more than 14
days or 10% of rental use, whichever is greater
(iv)
------EX: rental use is 10 mos. 30 days would be 10% - must use as a
residence for more than 30 days. B/c you stayed there for 60 days it qualifies
as qualified residence
(v)
Could only have 1 place [principle place is an apartment home in
Aspen and home in FL can only use one of houses]
(ii) debt must be either acquisition indebtedness or home equity indebtedness
(a) acquisition indebtednessdebt 1) secured by a qualified residence, which is 2)
incurred by taxpayer in purchasing, constructing, or substantially improving a qualified
residence; also includes debt incurred as a result of refinancing AI and any subsequent
refinancing of such indebtedness [technically, this doesnt fit (not a p/c/si). However,
163(h) treats it as AI up to loan being financed; however, amount of refinancing debt
that can subsequently qualify as AI can never exceed outstanding principal of debt
which is being refinanced; 3) total amount a taxpayer may treat as AI may not exceed
$1million.
(i)
Grandfather rules: for loans taken out before 1987. So long as interest
was deductible under old rules, entire loan is considered AI under new rules
(same for refinancing)
(b) home equity indebtedness any debt (other than AI), 1) secured by a qualified
residence, 2) to extent equity does not exceed fmv of residence minus outstanding AI
incurred by taxpayer w/ respect to such property (Equity = fmv AI); 3) thus capped at
amount of equity a taxpayer has in his home; 4) also capped at 100k; 5) can use $ for
hei for anything EXCEPT bonds (benefit cc debt, car loan. Consolidate loan and turn
non-deductible to deductible, but only if you itemize)
(c) Ex: fmv = 1.1million. AI capped at 1 million. So equity in house = 1k for hei
purposes
(d) if borrow 1.1 million to buy 1.1 million home, can deduct 1k as hei, so actually
have cap of 1.1 million
(iii) if dollar limitations on AI or HEI are exceeded, then excess indebtedness is treated no
differently from other personal loans, and any interest paid on such excess is personal interest
that is non-deductible
(b) interest on qualified education loans 221
(i) qualified education loansloan incurred by taxpayer solely to pay for qualified higher
education expenses of a student
(a) qualified educational expensestuition, books, fees, and room and board
(ii) must be at least time student
(iii) can be for self, spouse, dependent
(iv) up to $2500 a year

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(v) qualified are reduced by tax-free . .

(vi) can deduct student loan interest for so long as paying interest on qualified loans
(a) phase outs are low:
(i)
single 50k of AGI; completely phased out at 65k
(ii)
mfj 100k of AGI, completely phased out at 130k
(vii) its an above the line deduction (can take deduction even if dont itemize)
(iii) Pointscosts bank charges to take out loan
(a) 1% of loan amount, not purchase price of house
(i) ex: borrow 100k for house. Point is 1k
(b) point is really prepaid interest
(i) Caveat: some places, call it a point, but really it is cost of doing paper work for home
(a) If points are being used for processing of home or other closing costs, those do not
fall in definition of points we are talking about here
(c) interest is deductible. The question is can you deduct over life of loan or up-front?
(i) 461(g)(2)special rule whereby points can be deducted currently (they are also an
itemized deduction must itemize or cant take). 3 requirements:
(a) points are for purchase or substantial improvement of a principle residence
(i)
not a qualified residence, only a principle residence
(ii)
construction of principal residence we dont know
(iii)
----based on - no
(iv)
----on other hand this section was written before other one
(b) payment of points has to be an established practice in your area
(c) amount of points is reasonable in your area
(d) what happens if refinance and pay points on refinancing?
(i) Are points deducted currently?
(a) Generally, no. they must be amortized over life of loan.
(b) There is an outlier exception (in the 8th Cir. all perceive this case to be dead
wrong; service has not acquiesced). Huntsman v. Cmr, 905 F.2d 1182 (8th Cir.
1990)When you refinance a loan on principle residence, points are deductible
currently if all 3 requirements are met:
(i)
Established practice in area
(ii)
Must be reasonable
(iii)
Other one, 8th doesnt worry about (purchase/substantially improve)
(c) some commentators say only applicable to very limited number of cases
(i)
took out 5 yr balloon loan and then refinanced balloon w/ fixed rate

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d) Problems:
(i) Taxpayers purchase a home in current year which they use as their principal residence. Unless
otherwise stated, they obtain a loan secured by residence and use proceeds to acquire residence. What
portion of the interest paid on such loan may Taxpayers deduct in following situations?
(a) Purchase price and fmv of home is 350k. taxpayers obtain a mortgage for 250k of purchase
price
(i) All 250k is deductible as AI
(a) Y qualified residence b/c principle residence
(b) Y made in acquisition of home loan was used to acquire a qualified residence
(c) Y less than 1 million so ALL is deductible
(ii) **most cases are going to be this easy
(a) when add second homes, a little more complicated
(b) Facts are same as in (a) except that in 2 years Taxpayers have reduced outstanding principal
balance of mortgage to 200k and fmv of residence has increased to 400k. In the later year,
Taxpayers take out a second mortgage for 100k secured by their residence to add a fourth bedroom
and a den to the residence
(i) Can deduct all either through HEI or AI
(a) First loan all 250k is AI
(b) Second loan also AI;
(i)
Secured by qualified residence
(ii)
Used to purchase, construct or SUB IMPROVE qualified residence
(iii)
Less than 1 million, so all deductible
(c) Second loan could also be HEI
(i)
Capped at 100k, can be used for anything
(ii)
But should use AI so can use HEI later
(iii)
Difference in interest rates when being sunk into house, more
collateral to go after
(c) Facts same as in (b) except Taxpayers use proceeds of 100k mortgage to buy Ferrari
(i) Still being collateralized by principal residence, so facts same as (b)
(a) but second loan HAS to be HEI. Meets all the requirements:
(i)
Secured by qualified residence
(ii)
Not using it for only improper purpose (bonds)
(iii)
Doesnt go over equity of house (which is 200k)
(iv)
Doesnt go over 100k cap
(b) This means you have used up all of HEI
(i)
determination on whether interest is deductible is made on year by year
basis
(d) Facts are same as in (a). Ten years later, Taxpayers have paid off 200k of 250k mortgage and
residence is worth 500k. In later year, Taxpayers borrow 200k on residence, 50k of which is used
to pay off remaining balance of original mortgage and remainder is used to pay personal debts

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(i) 50k is deductible AI

(a) replaces AI, so is treated as such. When you refinance, refinance proceeds up to old
AI are treated as AI (even though technically not used to purch/constr/subst improve
residence)
(ii) 100k is deductible as HEI
(a) even though used for personal stuff, HEI only requires that loan be secured by
qualified residence
(i)
here it is
(ii)
capped at 100k or equity in house (fmv AI = 450k) so plenty of
equity, but capped at 100k
(iii)
not used to buy bonds
(b) so out of 200k new loan, interest of 150k (50k AI, 100k HEI) is deductible; interest
on other 50k is not deductible. What that means is that of interest is deductible and
of interest is not deductible
(e) facts are same as in (a) but additionally, towards end of current year, Taxpayers financial
prospects improve dramatically and they purchase a luxury vacation residence in FL for its fmv of
$1,250,000. They finance 950k of purchase price w/ a note secured by a mortgage on FL house,
use house 45 days of year, and elect to treat residence as a qualified residence
(i) must first decide which loan we can deduct interest on and which we cant
(ii) First loan of 250K is AI (from above)
(iii) Second loan?
(a) we only have 750K left to meet 1 mill cap
(b) 750/950K FL loan is AI. Why does it qualify?
(i)
Secured by qual residence b/c you can include up to two residences as
qualified residences, doesnt have to be principle residence
(ii)
If dont rent it out, doesnt matter how much they use it
(iii)
--If rent it out, must use it for more than 32 days as residence (greater
of more than 14 days or 10% of rental use) which they do here 45 days
(iv)
Purch or acquiring residence
(c) What if 2nd residence has a higher interest rate?
(i)
Leg. history provides and court follow first in, first out basis. Dont
get to decide which residence you want to be AI
(iv) But another 100k can be HEI
(a) Still secured by qualified residence
(b) Capped at 100K or equity in house equity in house is (1,250,000 FMV 750 AI)
= 500K
(v) Of 950K loan, 850K of interest is deductible as qualified loan, the rest is not deductible.
(a) 85/95 of each payment of interest is deductible. The other 10/95 of each payment is
not deductible.
(b) What if the first mortgage is 3% and the second mortgage is 8%
(i)
We would prefer to treat all of the second mortgage of AI and less of
the cheaper mortgage as AI.
(ii)
BUT Congress says First In First Out
(f) Facts are same as in (a) except that year of acquisition of 350k residence subject to 250k
mortgage was 1985. in addition, instead of using all loan proceeds to purchase residence,
Taxpayers applied 200k toward its cost and used other 50k of proceeds to buy a sailboat. By
current year, Taxpayers have reduced outstanding principal of 1985 loan to 175k. in current year,
they refinance property (now worth 500k w/ a loan for 300k which is secured by residence. They
use 175k of proceeds from current year loan to pay off balance of 1985 loan and remaining 125k to
pay off their childrens educational loans
(i) Must be secured by qualified residence it is (principle residence)

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(ii) Must be either AI or HEI

(a) Under grandfather , if interest on debt was deductible under old law, entire old loan
is deductible as AI
(i)
Can refinance AI; refinanced loan will be treated as all AI
(ii)
So 175K of new loan is AI.
(b) 100K HEI
(i)
secured by qualified residence
(ii)
capped at lesser of 100K or equity in house (fmv - AI) [500k 175k =
325k]
(c) 275 qualified indebtedness of 300k indebtedness is deductible . 11/12 (or 275/300)
of interest paid each month is deductible as qualified indebtedness. Represents
qualified indebtedness over total indebtedness that is deductible
(i)
possible that others may be qualified educational interest
(iii) 2 benefits of grandfather :
(a) can be greater than 1million
(b) can be used for other things
(ii) Single taxpayer, T, who graduated from law school, pays 3k of interest in current year on qualified
educational loans.
(a) If T has 40k of MAGI in current year, what amount of interest can T deduct?
(i) T can deduct 2500 of 3000 of interest Code 221
(ii) Must be interest paid for qualified student loan but only $2,500 of interest. Rest is not
deductible
(iii) Note: it is an above-the-line deduction no need to itemize in order to take it
(b) Same as (a) except T has $57,500 of MAGI in current year.
(i) Above the phase-out but not totally (phase out is done at 65k or more (130k mfj))
(ii) MAGI (basically, same as AGI) 50k (100k mfj) put over 15k (30k mfj) x otherwise
deductible interest = amount of deduction phased out
(iii) 57,500 (MAGI) 50k = 7500/15k x 2500 = 1250 (amount not allowed to T)
(iv) Note: MAGI is actually AGI + any amount excluded from income if you worked over
seas and didnt have to pay tax on it (not covered in this class)
(v) So T can deduct 1250 of the interest the rest is just disallowed (cant carry it over to
future years or anything like that)
(c) Same as (a) except T is married and T and Spouse file a joint return and have 140k of MAGI in
current year
(i) This would be above the phase out so no interest is deductible. Why?
(a) 140K (MAGI) 100k = 40k/30k 4/3
(b) 4/3 x 2500 = more than 2500 so we are completely phased out.
(ii) As soon as that fraction hits 1, you are completely phased out. (130k or more)
(iii) On exam: if you say that the Code provides you are completely phased out at 130k, it
doesnt here. Need to work through the formula. Sometimes the Code does actually say
phased out at $xx,xxx and so can just state the phase out amt.

D. Deductions for Individuals Only

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1. The Concept of AGI { 62(a) and (c); 274(n)(1); See 86(a)-(c); Reg. 1.621T(b) and (d); 1.162-17(b) and (e)(3);
See 1.62-2}
a) GI above the line deduction = AGI ( 62)
b) 62above the line deductions:
(i) doesnt authorize any deduction; simply identifies deductions authorized elsewhere in
(a) NEVER say this is deductible under 62; its above the line under 62
(i) 63 deductions are below the line
(ii) benefits of above the line:
(a) dont have to itemize to take them
(i) get them in addition to standard deduction
(b) itemized deductions, some of them, are subject to limitations
(i) medical expenses only deduct if exceed 7.5%
(ii) others, can only deduct if exceed 2% of AGI floor
(c) lots of tax benefits are based on how much GI you have
(i) reduce before AGI (benefits, i.e. student loans, take longer to phase out)
(iii) examples: t/b deductions (but only if self-employed); reimbursed employee business expenses;
losses from sale or exchange of property; deductions attributable to rents and royalties; alimony;
moving expenses; student loan interest; higher education expenses
c) Problems:
(i) Assume following expenses are properly deductible. Does deduction fall under 62, or may it be
claimed only as a 63 deduction.
(a) Employee, a policeman, purchases a new uniform at his own expense
(i) Below the line deduction
(ii) One of biggest above the line deduction is t/b (62(a)(1)), but only if you are selfemployed (can not be an employee)
(a) Policeman is an employee so this section does not apply
(iii) This purchase is a miscellaneous itemized deduction and it will be subject to the 2%
floor (probably will never be able to deduct).
(a) The rule: deductible if cant be worn anywhere else (Ex: police uniforms, nurse
outfits)
(i)
if you can wear it somewhere else its not deductible at all.
(b) Employee salesman pays cost of entertaining purchasers in social circumstances that are
directly related to her t/b and is not reimbursed by Employer
(i) Below the line deduction
(ii) Qualifies as t/b, but b/c he is an employee, and therefore, cant be an above the line
deduction
(a) all employee expenses are subject to 2% floor
(b) can only deduct 50% anyway
(c) Same as b except that employer reimburses employee for exact cost incurred

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(i) How should employee treat expenses and reimbursement on her return? What result to
employer?
(a) So long as these would be deductible, employer does not have to deduct (not
included on W2)
(i)
This is legal b/c really it is a working condition fringe Reg. 1.16217(b)(1)
(b) 62(a)(2)(a) reimbursed expense of employee are above the line deductions
(c) Reg cited in problem:
(i)
When you get reimbursed by employer in exact amt, all you need to do
(if reimbursement is exactly the same as the amt) is note the reimbursement on
your return
(ii)
You dont include the reimbursement in GI and then take a deduction
above the line.
(iii)
Dont include it and dont deduct it. Just note it on return
(ii) What if the amount paid to employee as reimbursement exceeds her actual expenses?
(a) Report excess as income
(iii) What if actual expenses exceed her reimbursement?
(a) If expense exceeds reimbursement, deduction is below the line Reg. 1.162-17(b)
(3)
(iv) why do we need Reg and
(a) if reimbursed, not on W2 no deduction
(b) if in W2 income corresponding an above the line deduction
(d) Same as b except that employer, an individual, rather than employee, entertained the purchasers
(i) Above the line 62(a)(1)
(ii) Employer is limited to 50% of otherwise allowable under 264(n)
(iii) reason for rule: allow for different types of tax payers
(a) as a professor, no expenses
(b) if self-employed, certain expenses
(i)
earn and taxed on are 2 different numbers
(e) Employee, at his own expense, pays $500 tuition for a refresher course in Home Town to bring
himself up to date on current business techniques relating to his employment
(i) Deductible item expenses related to education (valid business expense)
(a) B/c an employee, its a below the line deduction 2% floor
(b) BUT if qualified educational expenses its above the line deduction (222)
(i)
Normally, educational expenses are allowed (deductible under 1.162-5)
but its an employee expense so theyre below the line.
(f) Employee makes payments for medical expenses and charitable contributions and for taxes on
her residence and interest on a note secured by a mortgage on the residence
(i) Because not expressly listed in 62, they are all below-the-line deductions.
(a) Medical ( 213), charitable contributions ( 170), taxes (both state income and
property taxes (not sales tax), interest ( 163), miscellaneous employee expenses

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(g) Same as f except that taxes and interest relate to a residence that employee rents to tenant
(i) So under 62(a)(4) interest in taxes theyd be above the line deduction
(ii) B/c deductions attributable to property held for the production of rents or royalities.
(iii) So, if I make my money through not being a prof but instead through being a landlord,
the expenses attributable to making that money are above the line b/c they bring me down to,
after those expenses, to after-expense profit just like my prof salary is my AGI.
(h) Employee has a loss on sale of some stock that he held for investment
(i) Above the line deduction
(ii) Still must be deductible loss under 165
(a) If loss on boat not deductible
(b) If loss on sale of stock deductible
(i) Employee deducts 1k of interest on student loans
(i) Above the line
(j) Employer, whose business is unincorporated, pays his state income taxes
(i) State income are considered not related to t/b
(a) Taxes for rental, business property are above the line
(ii) Example: prop taxes on factory are directly related to trade so above the line
(iii) But, income taxes that you pay are NOT directly related to business theyre related to
your earned money from working, but in essence not an ER trade deduction and therefore
above the line thats what the IRS has said.
(iv) Theyre a consequence of carrying on your t/b and therefore not above line.
(k) Employer pays accountant $400 to prepare his federal income tax return, $150 of which is
allocable to preparing schedule related to income from his sole proprietorship business
(i) Tax return prep fees are deductible under 212 b/c relates to production of income
(a) Generally, considered misc. business deduction subject to 2% floor
(i)
Unless they are business tax returns, which so long as self-employed
are above the line deductions
(ii) $150 is above the line b/c of 62(a)(1)
(iii) The rest is below the line
(iv) Visualize it like this: would you have had the expense but for having your own business?
Answer is no, so above the line.
(a) Would you have had accountant expenses for your personal tax return but for your
personal tax return? Yes.
(v) Rev 92-29 directly on point expenses for preparing tax return for your business is
above the line, the rest below the line
(l) Single pays ex-spouse $6k in alimony. Is this w/I common threat of 62 deductions?
(i) Above the line 62(a)(10). 215 gives the deduction
(m) Employee incurs properly deductible moving expenses
(i) To extent not reimbursed by employer, above the line (a)(15)

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(ii) If reimbursed by employer for moving expenses, its an excludable fringe benefit if it
meets certain requirements. ( 217)
(iii) If youre not reimbursed but you have to move for your job, its an above the line
deduction
(n) Employee is an elementary school teacher who buys $350 worth of classroom materials in 2003
(i) Above the line 62(a)(2)(d) (but only applied in 2002-2003) up to $250
(a) rest is below the line
(ii) Benefit given to teachers only for elementary and secondary teachers
2. Personal and Dependency Exemptions { 151(omit(d)(3)); 152. See 71(a), (c); 215; 6013(a), (d); 7703. Reg.
1.151-1(b) and (c)(2)}
DEDUCTION
a) GI above the line deduction = AGI PE
(i) Even though called an exemption, its a reduction
(ii) thought to be minimum amount you would need to live on that should be exempt from tax
(iii) indexed for inflation (for last 25 years, has gone up $50 a year)
(a) 2004 - $3100 per person, per year. automatic deduction
b) General ruleEvery taxpayer has at least 1 automatic deduction PE
(i) EXCEPTION: if another taxpayer CAN properly claim individual as a dependent, individual is denied
an exemption for himself. 151(d)(2)
(a) Irrelevant if taxpayer actually does claim as dependent
(i) Contrast w/ Hope (and maybe LLC) where if taxpayer doesnt take credit, dependent can
c) Spousal exemption 151(b)
(i) H and W filing together = 2 exemptions = $6200 in 2004
(ii) If file separately, each get own
(a) EXCEPTION: If dont file a joint return, spouse may claim an allowance for other spouse
ONLY if other 1) has no GI for year and 2) cant be claimed as dependent for any other taxpayer
(you get 2)
d) Dependent 152
(i) Authorizes no deduction; merely sets out precise rules for determining who is a dependent
(ii) Same amount as personal = $3100 in 2004
(iii) Can take dependent exemption if meet 3 requirements:
(a) GI test: generally, someone cant be claimed a dependent unless they have GI for year of less
then PE amount (2004 is $3100)
(i) 2 broad exceptions: (only apply to parents taking dependency for child)
(a) if under 19 for all year, GI test doesnt have to be met for parents
(b) if under 24 for entire year, and you are a full time student for at least 5 months,
dont have to meet GI test for parents to take you as exception
(ii) **if dont make GI amount (25 not full time student) you pass test
(a) 30 year old can still be claimed as dependent

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(b) support test: provide over of support for dependent over year 152(a)
(i) look at value of stuff you provide (roof over head, feed you) determine economic value
+ any cash they send you
(a) scholarships received dont count towards support
(i)
but student loans do count if taken out by dependent (10k loan taken
out by student v. 9k given by parents cant be claimed as dependent)
(ii) no exceptions to this rule for students in school
(iii) elapsed time doesnt measure support
(c) relationship test: 152(a)
(i) they are relatives (including adopted or foster children)
(a) 1 EXCEPTION - 152(a)(9)sponger exception
(i)
non-related individual who lives in taxpayers house as member of
household for entire year (still must meet GI and support test)
e) Special Rules
(i) Taxpayer cannot claim child as dependent, even though 3 requirements are met, if child is married and
filing a joint tax return
(a) W/ 1 exception: if married couple files tax return only to claim refund if taxes paid in (no tax
liability at all), Service has rules this is not the filing of joint tax return, so therefore, parent can
claim as dependentRev. Ruling 65-34
(i) Kid can take parent as dependent
(ii) Divorced or legally separated parents 152(e)
(a) General ruleif parents have custody for over year and provide over support, parent who
has legal custody longer gets deduction (if legal custody is not specified, physical custody will be
determinative)
(i) doesnt matter who pays the money
(ii) HOWEVER, they can enter into agreement that person who gets dependency exemption,
can waive to other person
(a) Must attach to filing
(iii) if dont have custody for over year or support other rules apply
f) Problems (p. 568):
(i) In following parts of question, state number of deductions for PEs available. Following facts may be
assumed unless otherwise indicated: T was married; Ts spouse had no GI during year and was not a
dependent of any other person; T files a separate return. Treat each part separately unless otherwise
indicated
(a) T married H on Dec. 31, and Hs only income for year was $50 of interest on tax exempt bonds
(i) T has 2 PEs
(a) She can take herself
(b) She can claim H as an exemption under 151(b)
(i)
Under 7703 marital status is made as of close of Ts taxable year, Dec.
31
(ii)
In addition, all requirements are met for T to claim H as an exemption:
(iii)
T and H dont file a joint return
(iv)
H had no GI for year (tax exempt bond income only)

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(v)
H was not a dependent of any other person
(b) Same as (a) except that on Dec. 31 H also received $100 as a wedding present from Uncle U
(i) Same answer b/c gifts do not constitute income under 102 of Code. Therefore, H still
doesnt have any GI and can be claimed as an exemption on Ts return
(c) Same as (a) except that $50 was a gain from sale of bonds in (a)
(i) even if you have an instrument that produces tax-exempt monies (tax-exempt bonds issued
by govt), when you sell those instruments at a gain, the gain is taxable
(ii) Now T can no longer claim H as an exemption, b/c H had GI for year, and therefore
doesnt meet 2nd requirement of 151(b)
(a) requirement for spouses is NO GI (not below exemption amount like dependants)
(d) Under facts of (c) may T claim a dependency exemption for H if a spousal exemption is
foreclosed?
(i) T meets the GI test b/c W makes less than the exemption amount (only 50 income),
presume T provides over support.
(ii) BUT, H is not a dependent of T for purposes of 151(c) b/c he does not meet relationship
requirement of 152(a) spouse is NOT listed
(a) Sponger category? NO. b/c expressly says who is not a spouse during the year
(e) Same as (c) except that T and H file a joint return
(i) 2 PEs are allowed on a joint return, one for each taxpayer. Reg. 1.151-1(b)
(ii) In each of following parts state whether T was entitled to a dependency exemption for particular
person involved. Assume following facts for each of these parts, unless otherwise indicated: taxable year
is 1989; T was married but filed a separate return; and T furnished over of support for particular person
involved. Also assume, unless otherwise indicated, that such person earned less than 2k GI during year,
and did not live w/ T. Treat each part separately unless otherwise indicated
(a) X was Ts wifes brother
(i) Yes. Under 152(a)(8), brother-in-law meets relationship test for being claimed as a
dependent. B/c support and GI tests are met, T can get a dependency exemption for X
(b) Same as (a) but assume further that:
(i) Ts wife died year before
(ii) T and W were divorced year before
(a) (1) Are you still a bro-in-law if wife isnt around anymore?
(i)
Reg 1.152-2(d) once a bro in law always a bro in law SO still meets
relationship test
(b) (2) Same answer dependency exemption allowed
(c) X was Ts wifes deceased sisters husband
(i) T does not get a dependency exemption here b/c X is not an anything-in-law to T.
Therefore, he fails to meet relationship test of 152(a)
(a) facts had us assume that she did not live with T (so we cant use sponger
relationship)
(d) Same as (c) except that X lived w/ T entire year
(i) Now T can claim a dependency exemption for X. X meets relationship test of 152(a)(9)
b/c he lives w/ T for entire year, and other 2 requirements are met (GI and support)
(ii) If T and X living together in violation of local law, the dependency exemption is
disallowed (152(d or b?)(5))
(a) Ex: Ordinance that no more than 4 unrelated people can live together
(e) X is Ts son who is 19 this year and who earned 2k from summer jobs during year but who is a
full-time college student, except in summer

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(i) Here, even though Xs GI is not less than 2k exemption amount (since its exactly 2k), T
still can take a dependency exemption for X
(a) The reason is that X is a full-time student under 24, and therefore doesnt have to
meet GI test in order for his parent to claim him as a deduction 151(c)(1)(B)(ii)
(ii) Xs income is not less than exemption amount (must be LESS THAN book is wrong)
exactly equal so X does not meet GI test
(f) X is Ts 18 year old daughter who had only $500 of GI during the year, but who married Y
during year w/ whom she files a joint return
(i) T cannot claim X as an exemption, even though she is under 19
(a) This is the married dependent exception, and it says that even though all of
requirements for being a dependent are met, T cant take X as a dependent if she files a
joint return w/ her husband
(g) Same as (f) but Y also had relatively little income from which tax was withheld and their return
was filed only for purposes of obtaining a refund
(i) Now T can take a dependency exemption for X
(a) Issue here is when taxpayers have filed a joint return
(i)
Even though they did here, if their purpose was merely to secure a
refund in a situation in which no return would normally be required to be filed,
deduction by T will be allowed
(ii)
This is basically an exception to exception married dependent rule, and
is supported by Rev. Rul 65-34
(h) X was Ts 18 year old son for whom T contributed 2k in support while X, who had no GI,
applied 3k out of gifts from Uncle U to his support
(i) T gets no exemption, b/c he did not supply over of Xs support
(a) Except w/ regard to scholarships, support money is counted regardless of source
(b) Therefore, Xs gift money that he uses to support himself counts, and he supplied
3/5 of his own support
(i) Same as (h) except that Xs only contribution to his own support was 3k scholarship enabling
him to attend Embraceable U.
(i) Under 152(d), support in form of a scholarship is disregarded in applying support test to a
parent or a stepparent. Therefore, T can claim X as an exemption, b/c he supplies 100% of
Xs support (disregarding the scholarship)
(iii) W, upon graduation from law school, decides to divorce H after 3 years of marriage. The divorce
becomes final in current year and W is awarded custody of their son H, Jr. Who is entitled to the
dependency deduction in the following circumstances?
(a) W furnishes 40% of Jr.s support and H furnishes 60%
(i) W is entitled to the dependency exemption b/c she is custodial parent. Actual support
percentages are irrelevant 152(e)(1)
(b) Same as (a) except that W waives claiming any dependency deduction
(i) Now H gets to claim H, Jr. as a dependent. 152(e)(2) provides that non-custodial parent
can take deduction if custodial parent signs a waiver and non-custodial parent attaches waiver
to his or her return
(c) Same as (a) except that Jr. lives w/ Grandpa for 9 months out of the year
(i) W is entitled to dependency exemption again as custodial parent under 152(e)(1)
(a) Custodial parent is defined as parent who has custody of child for greater portion of
calendar year
(b) Legal and not physical custody is determinative. Legal custody is determined by
most recent divorce, custody or separate maintenance decree (Reg. 1.152-4(b))
(c) Here, even though H, Jr. lives w/ Grandpa for 9 months, W was awarded custody,
and therefore is the custodial parent
(d) Instead of getting divorced, W moves out of the house into her own apartment on May 1 of
current year and continues to reside there throughout the year. Jr. lives w/ H and both W and H
equally provide for Jr.s support
(i) H would be entitled to deduction b/c he is the custodial parent
(a) A divorce decree isnt necessary if both spouses live apart at all times during the last
6 months of the calendar year (152(e)(1)(A)(iii)

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3. The Standard Deduction { 63; 67. See 68; 7703. Reg 1.67-1T(a)}
a) GI above the line deduction = AGI PEs either standard or itemized deduction
b) General RuleTaxpayer is going to take either standard or itemized deduction, whichever is greater
(i) 1 EXCEPTION: if spouses file separately and 1 itemizes, other has to itemize 63(c)(6)(A)
(a) reason: so 1 doesnt take standard and other takes itemized
c) Standard deduction 63
(i) Congress way of simplifying (dont have to prove you have deductions)
(ii) Standard deduction = basic standard deduction + additional standard deduction
(a) Basic standard deductions in 2004 (indexed for inflation):
(i) Single individuals$4850
(ii) Married individuals filing jointly and for surviving spouses$9700
(a) Until last year, married wasnt double single. Complaint of marriage tax penalty.
(b) Starting next year, this amount will go back down; Bush is pushing for permanency
(c) If dont have $9700 itemized, will want to take standard deduction
(b) additional standard deductions for elderly and blind taxpayers
(i) elderly person or blind who is married or a surviving spouse$950
(a) elderly = attained age 65 before close of his taxable year
(i)
Regfor purposes of additional standard, deemed to turn 65 day before
you do. (Ex: Jan. 1 turn 65 in 2003; deemed to turn 65 in 2002)
(b) if married and both are elderly and both are blind = 950 x 4
(ii) elderly person or blind who is unmarried$1200 ($2400 if both)
(a) it costs more to live if you are single
(c) 1 limitation to standard deduction ( 63(c)(5)):
(i) if can be claimed dependent of another taxpayer (151) then deduction is limited to greater
of:
(a) $800 (2004 its new!)
(b) earned income + $250
(i)
earned income - what you earn through services (i.e. paper route)
(ii)
unearned investments, interest, dividends, rents, royalties
(ii) but this standard deduction for children is limited
(a) capped at regular standard deduction amount
d) itemized deduction

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(i) amounts of all deductions (other than exemptions) that are left over after above the lines under 62
(ii) general categories:
(a) medical expenses (in excess of 7 % of AGI), taxes (includes state income, but not federal;
property (both real and personal); but not sales), interest (investment (we didnt talk about), student
loan interest, qualified residence interests), charitable contributions, misc itemized deductions
(i) Miscellaneous itemized deductionsdeductions other than those deductible under 62
(above the line), exemptions, and those specifically listed in 67(b)
(a) employee business expenses, investment expenses (pay tax return preparer, financial
planner)
(iii) 2 limitations:
(a) misc itemized deductions can only be deducted to extent they exceed 2% of AGI 67(a)
(i) Ex: 4500 of business; 100k AGI.
(a) Can only take deductions in excess of 2k so can only take $2500.
(b) Dont want to compare 4500 to standard deduction
(b) phased out for taxpayers w/ high AGI ( 68) (not responsible for this)
(i) phase out starts in 2005
(ii) for some taxpayers w/ high AGI, might get almost all phased out so will take standard
e) Problems (p. 579):
(i) Single Taxpayer in current year has 20k of AGI, a single PE, and following allowable itemized
deductions: 1k in interest, $500 in taxes, $1500 in unreimbursed employee travel expenses, $200 in tax
preparation fees, and $300 bar association dues. For simplicity, assume that there are no inflation
adjustments after 1988.
(a) What is taxpayers taxable income for current year?
(i) Must first get into business before can be deductible
(a) Expenses incurred to get into business are not deductible
(ii) GI above the line = AGI (20k) PE (Code is 2k; 2004 is 3100) standard or itemized
(a) Standard for single taxpayer Code is 3k
(b) Itemized 1k interest; $500 taxes; misc deduction = 1500, 200, 300 = 2k, but only
gets to take excess over 2% of AGI
(i)
2% of 20k = $400. Excess = 1600.
(ii)
Itemized = 1k + 500 + 1600 = 3100
(c) Itemized are bigger so will take 3100
(iii) SO, 20k (AGI) 2k (PE) 3100 (itemized) = $14,900
(b) What difference in result in (a) if Taxpayers 65th birthday is Jan 1 of succeeding year
(i) Under Reg. 1.151-1(c)(2), deemed to turn 65 on Dec. 31
(ii) Standard = standard (Code = 3k) + additional standard (Code = $750) = $3750
(iii) Itemized = 3100
(iv) Now, standard is bigger so will take 3700

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(v) SO, 20k (AGI) 2k (PE) 3500 (standard) = $14,250

(c) What difference in result under facts of (a) if Taxpayer is married couple filing a joint return?
(i) 2 PE (Code = 2k x 2 = 4k)
(ii) Itemized stays the same = 3100
(iii) Standard = 5k for married filing jointly ( 63(c))
(iv) Higher is standard of 5k
(v) SO, 20k (AGI) 4k (PE) 5k (standard) = 11k
(d) What difference in result under facts of (c) if Taxpayers deductible interest is 4k rather than 1k?
(i) Itemized = 4k + 500 + 1600 = 6100
(ii) Standard = 5k
(iii) Now will want to take itemized b/c 6100
(iv) SO, 20k (AGI) 4k (PE) 6100 (itemized) = $9900
(a) if PE and deductions (above and below) are more than income, could wipe out
(b) if can wipe out income dont have to file tax return
(i)
but should b/c if file SOL is 3 years; if never file SOL never starts to
run
(ii) T, who is single, a child of X and a full-time law student has gross investment income of 4k in current
year and no 62 or itemized deductions. For simplicity assume that there are no inflation adjustments
after 1988. X properly claims T as a dependent for year.
(a) What is Ts taxable income, if any, for current year?
(i) Greater of earned income + 250 or $800 (2004; different in Code 63(c)(5) - $500?)
(a) Investment income is unearned income so doesnt count.
(b) Greater is $500 this represents the standard deduction
(ii) 4k (AGI) no PE (b/c parents get it) 500 = 3500 taxable income
(b) what difference in result in (a) if instead T has 1k of earned income and 3k of investment
income?
(i) Greater of earned income + 250 or 800/500
(a) Earned income = 1k. + 250. Now this amount is higher. Standard = 1250
(ii) 4k (AGI) no PE 1250 = 2750 of taxable income
(c) what difference in result in (a) if instead T has 4k of earned income and no investment income?
(i) Earned income +250 = 4250
(a) This is higher than cap. Must take standard deduction = 3k in Code
(ii) 4k (AGI) 3k (standard deduction) = 1k of taxable income
(d) what result in (a)-(c) if X neglects to claim T as a dependent?
(i) Same result. Its not whether X DOES take as dependent, but rather, if X CAN take T as
dependent

Code

2004

Personal Exemption:
Standard Deduction:
- single
- mfj
- mfs

2k

$3100

3k
5k
2.5k

$4850
$9700

Standard Deduction:
- dependents

Greater of:
$500
earned income + $250

Greater of:
$800
earned income + $250

$600
$750

$950
$1200

Standard Deduction:
- 65 or blind
- single, not a surviving spouse

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