Professional Documents
Culture Documents
I. Introduction to Taxation
a. Overview and History
i. Revenue Sources for Federal Government
1. 49% - Individual income tax
2. 10% - Corporate Income Tax
3. 37% - Social Security/Medicare tax
4. 3% - excise taxes
5. 1% - Estate, Gift, etc.
ii. State tax difference is that 19% of state tax revenue is from Sales Tax
g. Lottery aside
i. It has a payout of 53%
ii. Poor people spend 4 to 5 times as much as a percentage of income as rich on
lottery
1. Economists say that poor sees it as money making opportunity; rich sees
it as entertainment
iii. Used for college scholarships
1. But goes to wealthy students a lot more than poor students
iv. States with lottery havent increased money on education, it just allowed money
to go elsewhere and let lottery pay for education
vi. The 10.4Trillion shortfall that Bush says is done by calculating the Present Value
of expected shortfall FOREVER.
1. For example if the expected shortfall is 100Billion a year, its the Present
Value of that forever.
vii. Private Accounts
1. Theyd be pretty much the same as 401(k)s
2. Bushs proposal is that they can put 20% of what you put into social
security into a private account.
3. Example
a. No private: $4000 into SS
b. W/Private: $3200 into SS; $800 into account
c. So the SS Trust will have less in now
4. So government would need to borrow about $1T-$2T to pay off current
beneficiaries
5. But later there will be less guaranteed benefits because of the private
accounts, so it will get more even out in the end.
j. Imputed Income
i. The untaxed economic benefit from the use of ones own property and ones
own services
ii. Rental vale of condo is not taxed
iii. Policy: Fundamentally unfair people are in the same circumstance, but people
who own a house, doesnt pay tax on their living situation, but people who rent
and invest difference pay taxes on that
iv. But Tax advantages of any investment will be built into the price of the
investment
v. Policy: Taxes encourage people to do things themselves that wouldnt be the
most efficient way to do it
1. If would be better to work rather than clean, maybe wont if have to pay
taxes on income of work and not on cleaning your own house.
2. Higher tax rates are more likely to discourage the work behavior of
secondary earner women than any men or single women
3. The more younger children the more value you can produce at home
cost a lot to replace your effort
4. Alternatives around policy implications
a. Allow to file as two singles
i. But it would be a tax increase for single men and married
men
b. Use to be a law that allowed lower earner to reduce income by
10%
c. Also to have more deductions for people who work like more
child care deductions
k. Who should buy a home and who should rent?
i. High bracket itemizers should buy
ii. Low bracket should not buy
iii. Prices of homes have the tax advantage accounted for so you need to itemize
in order to take advantage of it and get your moneys worth
iv. Effects on the $1.1M deduction of interest
1. Price Effect Homes more than $1.1M would drop in price because
there are no tax advantages above the price
l. Externalities
i. When private costs or benefits to producers or purchasers of a good or service
differs from the total social cost or benefits entailed in its production or
consumption
ii. Traffic Example How do you reduce traffic through taxes
1. Tax Gas Europe way
2. Tax Cars but number of cars isnt the problem, its the amount that they
are driven thats the problem
3. Tax actual miles
4. Charge for going into city center
a. Dramatically reduced traffic in London
5. Future use GPS system to determine where they are going and tax
them accordingly
iii. Optimum Social Policy
1. Tax everything its externalities
2. Then do things that help out distributional effects in it
a. Help poor with extra money
3. Then this will help some poor people (who already take public
transportation) and hurt others (those who have to drive during peak
hours)
iv. Positive Externality
1. Guy paints his house, it benefits his neighbors
v. Negative externality
1. Guy makes his house look crappy, it harms value of neighbors house
vi. Taxing Externalities Congestion Tax
1. If you give everyone a check and then tax driving during rush hour then
everyones better off
2. Those who dont drive
a. Keep the money
3. Those who do drive
a. Less congestion on the road
m. Haig-Simons Income
i. Haig-Simons Income = Consumption + Change in Wealth
1. Y = C + deltaW
ii. Should be taxed on what was consumed plus how much wealthier you are
during the hear
iii. Change in wealth includes appreciation of assets
iv. This isnt the law but it accurately reflects what every person earned
o. Transfers at Death
i. 102 Bequests are tax-free to beneficiary
ii. 1014 Basis of property acquired by reason of death is the FMV at the time of
death (or optionally, 6 months after death)
iii. Planning: Sell losing stock before you die, keep gaining stock until after you die
because bases are adjusted
iv. Planning: Sell equal amount of winners and losers of stock during a year to pay
not cap gain taxes on it
1. Then keep all the winners until you die so the basis will change
2. Youll never pay tax on the gains of yoru stics
v. Policy: Because people shiled income from capital like this Acutal tax rate on
return of capital is about 5%
1. Middle class doesnt pay much tax from capital because most is in home
mortgage deduction and 401K
2. Rich do the above
3. Poor dont get these benefits
vi. If Estate tax is repealed
1. Would still have the readjustment of basis up to $1.3M
2. But if its more than $1.3M, then would have to
a. Figure out the carryover basis by
i. Determining price of home, and capital improvements
b. Now it would just be the FMV at death
s. Recovery of Capital
i. Components of it
1. Adjusted Basis What you pay for it
2. Amount Realized What you get for it
3. Gain Realized What your taxed on
a. Amount Realized Adjusted Basis
ii. NO LOSSES ARE RECONGIZED ON PERSONAL NON-INVESTMENT
PROPERTY
iii. Depreciation
1. Used on assets that will likely decline in value over a predicted use of
life
2. Tax code divides assets into certain types and decides how many years
property of that class is going to last
a. Most things are given a 5 year useful life
iv. Types of Depreciation
1. Straight-line
a. Deduct and equal amount of the cost during each year of its
useful life
b. i.e. for $10K printing press w/ 5 year life it would be deduction
of $2K for each of the 5 years
c. Some property can only be depreciated this way like value of
buildings
2. Amortization Describes depreciateion of intangible assets like patents
and trademarks
a. Usually straight-line over assets usual life
3. There are others, but wont need to know them for the class like
accelerated depreciation more in the beginning
v. Adjusting Basis
1. Decreases assets basis by the amount of depreciation or amortization
a. Even if you forget to take the deduction for business expense
purposes, your basis still adjusts
2. Adjusted Basis = Purchase price Depreciation
a. i.e. Bought for $30K, last 10 years; 3 years later adjusted basis is
$21K
b. If you sell that fro $35K in year 3, gain will be $14K (35-21)
3. Basic Principle: Tax the difference between the amount received and the
adjusted basis
4. Depreciation Recapture Rule: Any depreciation you took, if you make
income on it later, must be taxed at the income rate.
5. Special Rule: The first $100K of equipment usually appreciable, can be
deducted immediately as a part of Cost of Goods Sold
t. Partial Sales
i. Sale of partial lands are Basis of All parcels * (Value of Sold/Value of All
parcels)
1. 6 acres bought at $6K. Sold 3, then basis is $3K but only fi theyre
similarly valued acres
ii. If they are different then the basis depends on what acres are sold
1. If the valuable ones are sold, then the basis is based on them
iii. Inaja Land v. Commissioner
1. Should money received from sale of damaged property be recovery of
capital or gain?
2. In this case, LA pollutes their river and have to pay $50K to release
liability for pollution
a. Legal fees are $1K, so gain of $49K
3. Basis was $61K
4. Said it was tax free
5. Based on two factors
a. Basis allocation in the case would be difficult
i. But today wouldve had experts maybe deciding what
cost of polluted land was when it was bought
b. Sale was involuntary
iv. Sale of oil rights
1. Should recover a percentage from the basis each year
a. Like depreciation
u. Life Insurance
i. Two Types
1. Whole Life
2. Term Life
ii. Whole Life
1. Has two elements
a. Term Insurance Element
b. Savings Element
2. Tax Treatment
a. Taxed like a 401(k) the buildup of interest is not taxed until
withdrawn
b. And only taxed on the gain
c. And if withdrawn as death benefit its never taxed
3. What you can do with savings portion of it
a. Use for retirement
b. Use to buy more death benefits
4. Not a great deal because the companies take huge cuts
iii. Term Life
1. Provides the purchasers heirs with cash death benefit in the event of
the purchasers death
2. Tax Treatment
a. Amount received as a death benefit generally are excluded form
taxation under 101
b. Life Insurance premiums generally are not deductible
c. Why is it done this way why not deduct premiums and tax
benefits?
i. Too complex
ii. It seems unseemly to tax when relative dies
1. People buy life insurance because death causes
financial loss so shouldnt tax them on it
2. Also the one time payment will be taxed high, but
there wont be any income later so its not really a
fair tax
d. Employer provided life insurance
i. First $50,000 of benefit is tax-free to employee
1. But non-discrimination rules must apply
ii. If more, employee would be taxed on it
3. Fairness
a. Its actuarial fir when the premiums coming in would equal
benefits going out
b. In real world, not the case because companies have to cover
expenses and profits
iv. Policy Free market doesnt work for insurance
1. Bad insurance companies dont work under the free market because
really dont know if its a good insurance until you really need it
2. But you can evaluate term life better because all that it is what you pay
in and what youll get out
3. Whole life is harder to figure out
a. Because it promises you money for retirement
4. If you do get a fair return on whole life, there are a number of tax
benefits
v. Annuities
i. Contractual right to receive payments for a fixed item or for the life or lives of
some person or persons
ii. 72 - The purchaser of an annuity is not taxed until payment is received. Each
payment consists partly of return of capital and partly of income earned. The
portion taxes is calculated as:
1. Exclusion Ration - A percentage of each annuity payment is excluded
from taxpayers gross income. The rest is taxed
2. Once the total excluded payments equals the taxpayers investment in the
annuity, all additional payments are included in income
3. If taxpayer dies before recovered all of investment, shes granted a
deduction for the amount of unrecovered investment
iii. Exclusion Ration
1. Investment in annuity/total expected payments
2. ex: Purchases annuity at age 70 for $100K. Pays her $10K/year for life.
Expected to live 15 more years. So expected payments are $150K
a. Exclusion Ration is: 100K/150K = 2/3
b. So 2/3 of each payment is not taxed and 1/3 is
c. If she dies in year 10 50K has not been deducted so estate can
deduct 50K as unrecovered investment
iv. Tax advantages of annuities Deferral
1. No tax is paid unless payments are made, even though the investment is
increasing in value each year
2. Taxable gain on the annuity is assigned equally to each payment received
even though the actual gain is hither in early years and lower in later
years
v. Planning Buy Annuities or not?
1. Buy them
a. Allows you to guarantee payment stream that would last as long
as you live
i. Wont have any left over or wont run out
b. Important tax advantages discussed above
2. Dont buy them
a. Insurance companies will try and cheat you but shop around to
avoid it
b. Annuity pays you for the rest of your life so real healthy old
folks buy them
i. Its adverse selection insurance companies cant use
normal life expectancy charts so they move the average,
since only customers are in healthy category
w. Gambling
i. Winnings are fully taxable
ii. Losses can be deducted against winnings during the same taxable year
1. But those losses are deductible only as itemized miscellaneous
deductions
2. Thus, one is required to report winnings even if one is a net loser for the
year
iii. Gambling expenses, such as travel expenses to tournaments are only deductible
for professional gamblers
iv. Comps are treated as gambling winnings
v. Reporting Requirements W2-G
1. Payer must issue a W2-G if winnings are
a. $600 or
b. 300 times the amount wagered
c. This applies to winning events such as dog racing, horse racing
and state lotteries
i. Also Casino games like Let it Ride
2. For Bingo, Slots, or Video Poker must be issued for a win in excess of
$1,200
3. For Keno have net proceeds greater than $1,500
4. Table Games Winnings are not reported
vi. Planning
1. In theory youre supposed to keep track of your sessions and report
winnings as income and losses in miscellaneous deduction
a. Good policy would just to combine the income and losses
2. Deductions do NOT affect the Alternative Minimum Tax
3. Miscellaneous deduction subject to a 2% floor
4. As a professional
a. Need to show you have an intent to make money
b. IRS wont believe you if you dont have not winnings or only
play on the weekends
c. The more fun something is, them more burden of proof is that
youre a professions
z. Forgiveness of Indebtedness
i. Loan Proceeds are not income and loan payments are not deductible
1. Applies to both:
a. Recourse loans: Borrower is personally liable
b. Nonrecourse loans: Borrower is not personally liable
i. CA law makes original loan for home purchases to be
non-recourse
ii. Can only take the house, not any other assets
iii. But refinancing are recourse can take other assets
2. Haig-Simons consistent because increase in consumption is offset by
lowering of wealth
3. Consumption Tax treatment would be tax principal when received and
deductible when paid
ii. Discharge of indebtedness
1. Individuals are taxed on the discharge of indebtedness
2. United States v. Kirby Lumber
a. Issues 1M in bonds repurchases them later for $862K
b. The $148K difference is considered taxable income
iii. Transfer of Property Subject to Debt
1. Amounts borrowed are included in basis and may produce depreciation
deductions
2. If property subject to a liability is transferred to another, the discharge of
debt is treated as part of purchase price
3. Ex: Alan borrows $500K interest only loan to buy property; depreciates
at 20K/year (business property cant depreciate personal property)
a. If in year 8 he abandons property, still oweing $500 but already
depreciated 160K then theres adjusted basis of $340K; and
gain of 160K
4. Planning Current law encourages more sales of new homes
a. Because you can exclude first $250K gain on sale of residence,
the more homes you sell in period then the more non-taxed gain
youll have
i. But there are restrictions to how often you can do seen
later
b. Two examples
i. Over 10 years, bough house at 500K, sold at 1.5M taxed
on 500K if married; 750K if single
ii. Over 10 years, bought house at 500K, sold at 1M, bought
another at 1M sold at 1.5M taxed on 0 if married; 500K
if single
5. Commissioner v. Tufts
a. The assumption of a non-recourse mortgage constitutes a taxable
gain to the mortgagor eve if the mortgage exceeds the fair market
value of the property
d. Constructive Receipt
i. If taxpayer has an unrestricted right to income she is taxed on the income even if
they have not physically received it.
1. Exception to the cash based taxpayer not taxed until paid
2. Accrual is taxed on income when it is earned, even if not collected
a. Its more accurate way to determine how a business is doing
ii. Amend v. Commissioner
1. Under contract that was signed, taxpayer did not have right to money
until 1945 so should be taxed in 1945
a. No evidence of tax avoidance purpose
2. The farmer consistently delayed receipt of payments this way throughout
his career
a. If he hadnt, IRS couldve applied 446(b)
i. Allows IRS to impose a method of accounting if the
taxpayers method does not clearly reflect income
iii. If you receive a check and not cash it until the next year you are taxed in the
year you receive it
iv. Notes on Constructive Receipts of Wages
1. Payment to employees are not deductible by the employer until the
payments are taxable to the employees. This is true even if employee is
cash basis and corporation is accrual basis 404(a)(5)
a. Ex: Year 1 Work Done; Year 2 Paid
i. For financial accounting business expense deduction
taken in year 1
ii. But this rule overrides this, they cant take deduction until
employee takes income; so since employee is cash basis
wont take it until year 2, so employer cant take it until
year 2
iii. Planning They need 2 separate bucks accrual basis
one, and one for taxes that considers these payments in
different years
2. Policy: If employee and employer in same tax bracket, total tax received
will be the same regardless; but if employer is tax-exempt (like a charity)
then timing affects the total tax burden
3. Amend under current law:
a. Installment sale rules would apply. Thus Amend would report
income in 1945 when he received the payment
b. If Amend opted out of installment treatment, he would be taxed in
1944 under treasury regulation which treats receipt of an
installment obligation as the receipt of property in an amount
equal to the FMV of the obligation
v. Ex: Offered signing bonus of $1M at end of 5 years
1. Team bought $600K annuity for in players name, worth $1M in 5 years
a. Taxed on amount of annuity in Year 1; and then again in year 5
on the gain
2. Team contributes $600K to trust fbo player, that pays $1M in 5 years
a. Same as #1
3. Trust fbo Corporation and then $1M paid to player in year 5
a. Taxed on $1M in Year 5
b. But if team goes belly up, creditors get the trust
4. Contract for it, owner signs as a guarantor
a. Taxed in Year 5
b. Protected unless company and owner go bankrupt
5. Corporation sets up 401(k) for him?
a. Cant do that because cant collect 401(k) until retire
b. And there are contribution limits on it
c. And wont meet non-discrimination rules
vi. Commissioner v. Olmstead
1. Facts
a. Olmstead had right to commissions based on prior sales for
Peoples Life Insurance
b. At Peoples request, he exchanged his right to future commissions
for fixed payment annuity of $500/month for 15 years
c. He couldve taken cash, but preferred an annuity
i. If that happened, he wouldve been taxed when he
actually received the payments cash basis
2. IRS claimed that he traded property right for annuity so should be taxed
on Gain Realized
a. Which was 68,000, because adjusted basis of commission rights
is 0 because he was entitled to them because of labor
3. Court holds: Not taxed on value of annuity
a. Was a cancellation of old payment structure and a replacement
with a new payment structure rather than a taxable exchange of
property under 1001
4. Policy doesnt make sense to tax it
a. Doesnt have the money to pay the taxes
b. Theres no abuse going on hes worse off now
c. The obligation is still coming from the corporation, theyre still
promising to pay Olmstead
d. If we did tax him and knew it, then he wouldnt have accepted
the deal, which would discourage corporation to restructure its
commission annuity policy because it would be inefficient
5. Treat this like a novation ripping up the old contract and making a new
one
a. So shouldnt be taxed on it.
f. Stock Options
i. The money you pay for the option gives you the right to buy stock at a certain
price within a certain time frame
ii. Basis = Exercise Price + Price of Option
iii. Amount Realized Price of stock when you exercise the option
h. Theoretical Issues
i. Consumption Tax
j. Accounting Methods
i. Cash Method
1. Income is reported in the year it is received
2. Expenses are deducted in the year they are paid
3. Individuals who do not own their own businesses must use the cash
method
ii. Accrual Method
1. Income is reported in the year when all the events have occurred which
fix the right to receive such income and the amount can be determined
with reasonable accuracy
a. All Events Test
2. Expenses are deducted using the same test
3. Businesses that have inventories of unsold goods or material at the end
of the year must use the accrual method
a. The IRS requires all larger businesses to use accrual method
iii. 446
1. 446(a) Taxable income shall be computed under the method of
accounting the taxpayer regularly uses for financial reporting
2. 446(b) If the taxpayers accounting method does not clearly reflect
income, then the computation of taxable income shall be made under
such method as, in the opinion of the IRS, does clearly reflect income
3. 446(e) A taxpayer must obtain consent of IRS to change accounting
methods for tax purposes
iv. GAAP
1. Generally accepted accounting principals used in financial accounting
are usually used in tax accounting, but sometimes taxpayers are required
to apply different rules where GAAP leads to tax avoidance opportunities
2. Used especially when business does not accrue pre-paid income
v. Georgia School Book Depository
1. Collection is trivial to all events test especially when the debtor is
trustworthy and solvent
2. Facts
a. They were entitled to 8% commission after they distributed
books to schools
b. Depository never had title to the books
vi. Notes on Accrual of Pre-Paid Income
1. Dancing School Lessons Amount paid in advance for lessons are
accrued in year payment is made
2. Advance Baseball Ticket sales Amounts paid in advance for tickets are
accrued in the year the games are played
a. Here, we know when the games are going to be, in the dance
lessons we dont
3. Engineering Services - IRS cannot make you pay the first of either paid
or services performed
4. Appliance Service Contracts Amounts paid in advance for such
contracts are income in the year the service contract is sold, rather than
the year in which services are performed since it is unclear if or when it
will be performed
a. Extended warranties fall here
5. Magazine Subscriptions 455 income from prepaid magazine
subscriptions is accrued over the life of the subscription
6. Auto Club - 456 prepaid dues may be spread over the lifetime of
membership
7.
b. Casualty Losses
i. 165(c)(3) deduction for losses from fire, storm, shipwreck, or other
casualty, or from theft.
ii. Hypos you receive a $5000 payment
1. Its counterfeit
a. Never counted in income
2. Was robbed on way to bank
a. Casualty Loss
3. Bought a Vase with it and was immediately stolen
a. Casualty Loss for FMV
4. Vase stolen 2 years later
a. Casualty loss for Lesser of
i. FMV or
ii. Basis
b. Fair because you never pay tax on the gain
5. Vase destroyed when car is struck on way home
a. Casualty Loss
i. A violent, immediate way of loss is considered other
casualty
6. Vase is destroyed when cat knocks it over in unexpected fit
a. NOT Casualty Loss thats what cats do, its normal
7. Vase is Counterfeit
a. Casualty Loss probably counted as theft
8. Your own arson destroyed the vase
a. NOT Casualty Loss if its your own fault, you cant take
deduction if youre grossly negligent or reckless
i. Can deduct a normal car accident
iii. More Hypos
1. Termites NO, its not sudden
2. Lose a Ring NO, not casualty loss, its just misplaced
3. Earthquake YES
4. Ring flushed down toilet by someone else
a. Debatable it needs to be sudden to be deductable
5. Lowering value in housing because of OJ Case
a. Temporary lowing in value is not a casualty loss
iv. How to take the Casualty Loss Deductions
1. 10% AGI Floor for taxpayers
a. And subtract $100 for each event
2. Businesses can always deduct their losses in the amount of FMV or basis
v. Policy: Is this good?
1. Yes: Same ability to pay if you dont count the income that moneys
gone
2. No: Shouldve gotten insurance or protected it better
c. Medical Expenses
i. 213(a) - Medical expenses are deductible to the extent they exceed a 7.5%
AGI Floor
ii. Employer provided medical care is excluded from employees income without
any threshold
1. Self-employed individual can deduct 100% of premium paid for medical
expense
iii. Policy Arguments for medical care deduction
1. Same ability to pay because the difference is the medical care
a. It assures that they are taxed the same
iv. Policy Arguments against monitoring
1. Some medical expenses have elements of personal consumption they
are voluntary
2. The medical expense deduction disproportionately benefits the wealthy
3. Shouldve got insurance
4. Invite fraudulent claims
v. Who gets the deductions
1. People with high uninsured medical expenses
a. Insured people dont get it
2. People who itemize
3. They tend to be
a. Disabled people who arent covered
b. People in psychiatric care usually not insured and relatively
expensive
vi. Whats covered
1. 213(d)(1) medical care means amounts paid
a. for diagnosis, cure, mitigation, treatment, or prevention of
disease, or for the purpose of affecting any structure or function
of the body
i. This is where the bulk of litigation happens
b. for transportation primarily for and essential to medical care
c. for qualified long-term care service (nursing home)
d. for insurance covering medical service or long-term medical
care
2. 213(b) Only prescription drugs and insulin are deductible
a. Over-the-counter drugs are not covered
vii. Cases
1. Taylor v. Commish Doctors orders were not to mow lawn due to
allergies, so hired a gardener
a. NOT deductible
i. There was no showing that family member couldnt do it
ii. Also, no proof that he wouldve mowed the lawn had he
had no allergies
2. Hendersn v. Commish had to make van modifications for sons
wheelchair; wanted to deprecate the value of the van
a. Depreciation NOT deductible; only expenses paid are
b. Modifications of van was deductible in year they were paid
3. Ochs v. Commissioner - Doctor ordered for kids to go away while mother
dying from cancer; wanted to deduct cost of boarding school
a. NOT Deductible
b. The court said the expenses were needed due to loss of wifes
services, but if she had died they definitely wouldnt be
deductible
c. DISSENT: mitigation, treatment or prevention of desease is
allowed for a deduction. If wife had been sent to nursing home,
it wouldve been deductible
i. The suggested test is: Would taxpayer normally spend
money in this way regardless of the illness
d. The issue may be of causation
i. Did the illness cause them to send the kids to boarding
school
1. Was the boarding school needed because of the
kids or because of the illness?
viii. Notes on Medical Expenses
1. Transportation costs for medical care - Deductible
2. Costs of birth control, legal abortions, and vasectomies - Deductible
3. Costs of psychiatric treatment - Deductible
a. But marriage counseling is not
4. Costs of fitness training and weight reduction are NOT deductible
a. Unless obese, because its recognized clinically as a disease
5. Trip on doctors orders, NOT deductible
6. Hotel costs for a person who was removed from hospital due ot
overcrowding Deductible
7. Impatient addiction treatment - Deductible
8. Cost of long term care for chronically ill including costs of
maintenance services Deductible
9. Cosmetic drugs NOT Deductible
10. Cost of Medical Insurance Deductible
11. Extra costs, and only the extra costs, of aids for the handicapped such as
car modifications are deductible
a. Braille book costs $15, regular book cost $5; deduct $10
12. If you make improvements to your home recommended by doctor
Deduct the amount the expense exceeds the additional value to your
home
13. Cosmetic Surgery NOT Deductible
a. Repair for defects of cosmetic surgery Deductible
d. Charitable Contributions
i. 170(a)(1) allows taxpayer to claim as an itemized deduction any charitable
contribution . . . payment of which is made within the taxable year.
ii. 170(c) A charitable contribution is defined as a contribution or gift to certain
enumerated eligible donees:
1. States, possessions, or political subdivisions of the US if the contribution
is made for exclusively public purposes
a. Like donations to public libraries, parks, etc.
2. Organizations that are organized and operated exclusively for religious,
charitable, scientific, literary or educational purposes or to foster national
or international amateur sports competition or for the prevention of
cruelty to children or animals
3. A post or organization of war veterans
4. Individual gifts to domestic fraternal society, but ONLY IF such
contribution is used exclusively for religious, charitable, etc. purposes
a. So have to give to the Rotary Charity Fund, not Rotary itself
5. Certain non-profit cemetery companies
iii. Eligible donees continued
1. Need to non-profit
2. Cannot attempt to influence legislation or intervene in political
campaigns
3. Valid Organizations examples
a. Olympics, Church of Scientology
4. Non-Valid Organizations
a. Governments of foreign countries, individuals, Political
Organizations
i. Political Organizations can have entities that are tax
deductible like education and litigation funds
iv. Limitations
1. Individuals can only deduct up to 50% of AGI
2. Corporations can only deduct up to 10% of AGI
3. If anything above the ceilings, you carry that forward for 5 years
v. Notes on Charitable Donations
1. Any non-reimbursable expense in connection with the charity is
deductible
a. i.e. Transportation costs to go work at a charitable event
2. Penalties for getting the value wrong
a. Have to pay the tax burden difference plus interest and maybe a
penalty below
b. Accuracy-related penalty if deficiency is at least $5000 and
i. If claim that value of property is two or more times the
actual value of the property.
1. Penalty of 20% the tax defiency that results from
overstatement
ii. If claim is 4X actual value
1. Penalty is 40% of deficiency
vi. Donations of Property
1. If a person donates appreciated long-term capital property (stocks,
valuable items) to a charitable institution, the taxpayer generally can
deduct the FMV of the property, not just the basis
2. Independent appraisals are required for gifts of property with value
greater than $500
3. Tangible Property
a. If gift is related to the purpose of charity receiving it FMV
deduction
b. Gift that would produce ordinary income, such as inventory
Basis deduction
4. Examples
a. Non-tangible Property stock
i. Basis $1000; FMV $5000; can deduct $5000
b. Tangible Property paining
i. Basis $1000; FMV $5000
1. If charity sells it - $1000
2. If charity USES it - $5000
5. Planning: You can probably always deduct at FMV more than you can
sell it for
vii. Private Foundations
1. 509 Trusts or corporations organized for charitable giving that
receives its principal support for one person or family
a. ex: Ford Foundation, Carnegie Foundation
2. They are criticized for maintaining the power of donors ideology
through grants and other self-serving behavior
a. But are subject to special regulations to ensure that they spend a
portion of them on charitable assets
viii. Private Benefit
1. Ottawa Silica Co. v. United States
a. Ottawa was a mining company that donated land for HS
i. Did it because a road would have to be built for HS and
they would directly benefit Ottowa because they intended
to use some of that land for housing development
b. Court says: Ottowa does not get a charitable deduction because
the company received a substantial benefit from the building of
the school access roads
c. Why didnt Ottawa just call it a business expense and deduct it?
i. They would have to capitalize it because giving this land
away increased the value of the rest of the land, so can
only writ it off when they sell the land
2. Examples of what and how much can be deducted
a. Donate $100 and receive 2 CDs
i. Part deduction - $100 FMV of CDs
b. Give $1M to Law School; In return you get a $5000 lunch in
your honor
i. Whole $1M
c. Donates $10K in return for right to purchase 2 season tickets for
$500 each
i. Even if you get tickets in return, you get to deduct 80% of
the cost
d. Make payment of $1000/year to rent pew at church
i. Fully Deductible - Special Rule Pew fees are not
considered substantial benefit
e. Donates $100K to LA Philharmonic and get a bunch of benefits,
like dinners and publish of names
i. Under tax code, Philharmonic has to report FMV of
package to IRS
ii. Deduct 100K FMV of package
ix. Discriminatory Charities Bob Jones v. US
1. BJU believed interracial marriage and dating is immoral
2. Contributions NOT deductible because the commitment to racial equality
is a fundamental societal goal and charitable donations should not be
permitted to institutions than undermine that goal
3. This rule HAS NOT BEEN EXTENDED AT ALL
a. Non deduction is limited to racial discrimination
x. Is the Charitable Deduction a Good Idea?
1. Yes
a. The deduction encourages donations to charity
b. The deduction promotes desirable social spending without the
interference of government
c. The deduction is needed for an appropriate measure of ability to
pay because donor cannot spend the money she has given away
d. The deduction places donors of money and donors of services on
an equal footing
2. No
a. The deduction often supports activities that a democratically
elected government would never fund directly
b. Activities enjoyed by the rich such as the opera and museum
often receive larger donations than organization to help the needy
c. The deduction is an upside down subsidy. A $100 contribution
reduces the tax burden of a top bracket taxpayer by at least $40
but doesnt reduce the tax burden of a non-itemizer at all
d. Gifts of property are plagued by fraudulent valuations
e. Donors really get benefits: prestige, invitations to meet stars, etc.
f. Fund raising is very expensive. Taxation is a much cheaper way
to raise money for public purposes
g. The deduction constitutes an indirect support of religion
e. Interest
i. 163 Business or investment interest generally is deductible
ii. Interest on personal loans generally is NOT deductible 163(h)
iii. Qualified residence interest is deductible 163(h)
iv. Two categories of qualified residence interest
1. Acquisition indebtedness
a. Debt thats:
i. Incurred to buy, build, or improve a qualified residence
and
ii. Secured by the residence
b. $1M limit on it can deduct the interest on up to $1M
i. So if you borrow $2M, you can deduct interest on $1M of
it
2. Home equity indebtedness
a. Debt that is secured by a qualified residence and is NOT
acquisition indebtedness
b. Its limited to the lesser of
i. $100,000 or
ii. The FMV of the home, less the taxpayers acquisition
indebtedness
v. Examples
1. Buys home for $2M; Mortgage of $1.5M
a. Use acquisition indebtedness for $1M
b. Use home equity indebtedness for $100K
c. Remaining $400K is taxable
2. Buys $500K home; $300K mortgage. One month later $150K mortgage
a. Use acquisition indebtedness for $300K mortgage
b. Home equity for $100K
c. But remaining $50K is not deductible
3. Moral of the story is For tax purposes, better to buy a home than to
refinance
vi. Qualified Residence: the taxpayers principal residence and one other residence
1. A dwelling that the taxpayer rents to other can be a qualified residence if,
during the year, the taxpayer uses the dwelling for the greater of
a. 10 days or
b. 10% of the number of days that it is rented
2. Interest payments would be allocated between the rental and personal use
vii. Refinancing of Acquisition Indebtedness
1. If acquisition indebtedness is refinanced, the new debt also is acquisition
indebtedness up to the amount refinanced
2. Ex: Home with FMV of $400K with AI mortgage of $150K; refinance
$300K; $150K of the new mortgage is AI
a. Other debt is: $100K of home equity; $50K, not deductible
viii. Taxation of Points
1. Points must be capitalized and deducted over the life of the term of the
loan
2. Exception: Points paid on debt secured by principal residence AND
incurred to purchase or improve the residence may be deducted in the
year paid
3. Planning should you get high points or high interest?
a. Better to take points on original loan then taking it on refi
b. On original loan can deduct
i. But refi you need to capitalize it
4. Non-tax planning
a. If your going to hold loan for long time Get points
i. Interest rate will be lower
ix. Policy Is it good?
1. Yes
a. Encourages home ownership
b. Prevents large losses for people who relied on the pre-1987
interest deductions
2. No
a. For the Rich
b. Why not have interest free loans for everything
c. Can deduct interest secured by homes (home equity
indebtedness) and buy something unrelated to home
d. Encourage individuals to overinvest in housing
x. Student Loans
1. 221 permits a deduction of the interest on qualified education loans
2. Qualifying education expenses include tuition, books, fees, supplies, and
equipment for students enrolled on at least a time basis
3. Deduction may be taken even if taxpayer does NOT itemize
4. Max deduction is $2,500
5. Deduction is available only for the first 60 months in which payment of
interest is required
6. Deduction is phased out for single taxpayers with income above $50K
and joint above $100K
g. Dependency Exemptions
i. $3100 for year 2004 Adjusted annually for inflation
ii. Dependent must
1. be related by blood, marriage, or adoption
2. get more than of support
3. have gross income less than exemption (does not apply if there
dependent is taxpayers child, is either under 19 or a student under 24
and, if married, does not file a joint return with his spouse)
iii. Only one parent gets exemption for one dependent
i. Miscellaneous Credits
i. Adoption Expenses
1. Up to $10K/child
2. Phased out to incomes over $150K
ii. Child Tax Credit
1. $1,000/child for 2004
2. Phased out for taxpayers with incomes of $110K (joint) or $75K (single)
j. Phaseouts
i. Are in personal exemptions, child tax credits, adoption expenses, student loan
expenses, EITC
ii. Biggest impact is the EITC phase out explained above
iii. Affect upper-middle class too ($75K - $400K) who are subject to many of them
iv. Policy: Whats wrong with them
1. Make returns incredibly complicated
2. Would probably be better to just raise the marginal tax rate 1% and
eliminate the deductions and credits anyway
b. Hobby losses
i. 183 For activities not engaged in for profit, there shall be allowed
1. The deductions which would be allowable whether or not activity for
profit (i.e. personal deductions) AND
2. The deductions permitted if the activity were engaged in for profit, but
only to the extent that the gross income from the activities exceeds the
deductions allowable under #1
a. These are subject to 2% floor
ii. How you figure it out
1. Start out with income from activity
2. Subtract deduction you can take such as personal deductions
3. Remaining is net profit
4. You can deduct the costs associated with the activity subject to the 2%
floor
iii. Why being a professional is better
1. Hobby only deduct losses to the extent that theres winnings and
subject to a 2% floor
2. Professional if losses, can deduct even if there was no winnings and
no floor
iv. 183(d) presumption
1. If activity has made a profit in 3 of past 5 years (or 2 of 7 if horse
breeding) it is presumed to be an activity engaged in for profit
2. Taxpayer can elect to wait for 5th year to determine if presumption is met,
but must waive the statute of limitations if he does so
v. Nine Factors to determine if its a profession or hobby
1. Whether the taxpayer carries on the business in businesslike manner and
keeps complete and accurate books and records
2. Degree taxpayer prepared for the activity either by study or consultation
with experts
3. Time and effort expended in carrying on a business
4. Likelihood that assets used in activity will grow in value
5. Success or failure of taxpayer in carrying on similar activities
6. History of income and losses with respect to activity
a. But start-up losses do not demonstrate lack of profit motive
7. Profits earned as compared with the taxpayers investment in and losses
from activity
8. Financial status of taxpayer
9. The degree the activity appears to be recreational or for personal
pleasure
a. The more fun the activity is, the more likely to be a hobby
vi. Collecting items such as art, stamps is generally considered a hobby
vii. Game show contestant Whitten v. Commish
1. Tried to deduct cost of attending Wheel of Fortune, including meals
transportation as wagering losses after wining $20K
2. Court held amateur gambles can only deduct amounts lost on bets, and
cannot deduct meals, transportation, etc.
c. Home Office
i. Rules are complex but generally:
1. Deduction permitted if office is EXCLUSIVELY used on a regular basis
as a principal place of business
2. Deduction generally not permitted for employees, because it has to be
your principal place of business
a. Employees principal place of business is work
3. In Popov, the 9th circuit permitted a deduction of a portion of the living
room of a one bedroom apartment of a professional violinist who had no
other practice facility
a. Even though it probably wasnt used exclusively for practicing
it seems like it was a fair sense of justice in this case
e. Happiness Article
i. Easy utilitarian case for progressive taxation
1. Income has declining marginal utility so redistribution from rich to poor
increases total utility
2. The higher marginal tax rates required for redistribution produce an
efficiency or deadweight loss, primarily by reducing work effort
3. The welfare gains from redistribution must be weighed against the
efficiency costs of higher tax rates, but under plausible assumptions,
some level of redistribution is desirable
ii. Optimal level of redistribution requires estimating both the efficiency costs of
higher tax rates and welfare gains from redistribution
iii. Utility function is based on logarithm of income
1. Survey rather have $100K for sure than 50/50 of $50 or $200K
2. Suggest that people really care more about the first money than the new
money
iv. Happiness Surveys
1. Ask questions like on scale of 1 to 10 how happy are you
2. Problems with them
a. Misremembering pleasure and pain
b. Exaggerated impact of current moods
i. When its sunny, better answers
ii. When lab stinks, worse answers
c. Peoples last memory is really what they report of their happiness
3. Though the tests are noisy we are looking at happiness of groups, so
all the nose gets balanced out over time
4. These experiments do correlate with:
a. Reports of family and friends
b. Smiling during interviews
c. Attendance at work
d. Ability to recall positive events in life
e. Low Suicide rate
5. Conclusion: While not without problems, these subjective measures may
provide useful information about the causes and correlates of human
happiness
v. Cross-National Comparisons
1. Wealthier Nations show much greater happiness than poor nations
2. Among poor nations, additional income has significant impact on
happiness
a. Extra $1000 raises happiness by 1/10 a standard deviation
3. Among rich nations, additional income has a very small impact on
happiness
a. Extra $1000 raises happiness by 1/50 a standard deviation
4. Other factors
a. Former Soviet bloc nations are less happy then predicted by
income
b. Protestant nations are happier then predicted by income
c. Democracy, political stability and political liberty are correlated
with happiness, but these factors are so closely correlated with
income that it is difficult to determine their independent influence
on well-being.
5. In sum: Cross national comparisons are consistent with the traditional
notion of declining marginal utility of income additional income
increases the utility of the citizens of all nations, but has the greatest
effect where those citizens are poor
vi. Longitudinal Studies of National Well-Being
1. High rates of economic growth may only have a modest impact on the
long-term happiness of the citizens of developed nations
2. Long-term economic growth has a surprisingly small impact on well
being of nations
a. In US Real Income from 1972 to 1998 grew 58%, while no
increase in very happy
3. Rapid growth in France and Japan since WWII has produced little
increase in happiness in those countries
4. Little correlation between rate of economic growth and growth in
happiness
5. In Sum
a. Additional income has much greater impact on poor nations than
on rich
b. Long-term economic growth has a surprisingly small impact on
the well-being of nations once a reasonable level of economic
development has been obtained
vii. Happiness and the US Income Distribution
1. From poverty to middle-class
a. Moving from bottom decile to fifth decile in 1996 required an
additional $12,177 of income and produced a utility gain of 0.25
points
b. In this low income range, and additional $1,000 produced an
average increase in happiness of .0205 points
2. From middle-class to upper-class
a. Moving from the sixth decile to top decile in 1996 requied an
additional $44,170 and produced a utility gain of .07 points
b. In the high income range, an additional $1000 produced an
average increase in happiness of only .0016 points
3. Declining marginal utility of income
a. An extra $ of income over the high income range had less than
8% of the impact on happiness of an extra $ in low range
4. Dissatisfied Rich
a. Households in the top decile have seen a much greater than
average growth in income 33.4% as compared to an average
increase of 8.5% for the lower nine deciles
i. Yet these households reported no increase whatsoever in
happiness
viii. Happiness Paradox and Relativity Trap
1. Growth in Incentive over time has little impact on happiness
a. Substantial economic growth over the past several decades did
little to raise the happiness levels in developed nations
b. Although individuals with higher incomes are, on average,
happier than poorer individuals at any point in time, the average
happiness of a cohort remains relatively constant over their
lifetimes despite significant growth in income
2. Happiness Paradox
a. At any given time, people with more money tended to have
greater satisfaction with life than those with less, but increasing
the income of all people does not increase reported happiness
3. Relative Income and happiness
a. Happiness may depend more on an individuals relative income
than on the individuals absolute income
b. But leisure is less positional than income
4. Policy: Positional Goods and policy
a. The standard argument that taxation produces inefficiency by
reducing work effort may be only half true
i. Taxation will reduce work effort, but that reduction may
be efficient
b. The reason is: Earning additional income imposes a much larger
negative externality on other than does enjoying additional
leisure. To the extent that earning additional income produces a
negative externality, it may be efficient to tax that income
ix. Beyond Rivalry Adaptation & Aspiration
1. Misjudging the Value of Money
a. When individuals are asked what change would most improve the
quality of their lives, the most frequent response is more
money
b. The actual increase in happiness is modest
c. A study from Illinois lottery winners found that their happiness
was not significantly different from controls
i. Lottery winners reported significantly less pleasure than
nonlottery winners from ordinary experiences such as
talking to friends, eating breakfast, and laughing
2. Explaining the small increase in happiness
a. Adaptation Theory
i. More material goods provide additional pleasure at first,
but the impact is largely temporary
b. Aspiration Theory
i. Individuals aspiration levels rise as their income rise
ii. One study found that this preference shift destroys 60-
80% of welfare effect of an increase in income
x. Improving Long-term happiness
1. Positional goods
a. Income spent on such goods does nothing to improve welfare of
society
2. Non-postitional (relatively) correlates to happiness
a. Leisure activities, especially involving social interaction
b. Volunteer work
c. Stronger family/love relationships
d. Exercise and Good health
3. Why is the Misery Index Unemployment and Inflation if that has
nothing to do with happiness
4. Other potential nonpositional items are clean air, public safety, parks
xi. Happiness and Inequality
1. Inequality itself has a significant impact on happiness in Europe, but
little impact in the United States
a. In US, Rich leftists are the only ones who would like equality
more
i. Poor leftists and all righties dont care about equality
2. 70% of US feel that people are poor because of laziness; 70% of West
Germans feel its because of society
xii. Race and Redistribution
1. Black poverty rate is 3 times higher than White
2. Most Whites think Blacks would be as wealthy if they tried hard enough
3. Support for welfare in the US is higher among people who live near
welfare recipients of the same race, but lower among people who live
near welfare recipients of different races
4. More ethnically fragmented states spend a smaller portion of their budget
on social services
5. Policy: Why it may not be desirable to give weight to racial bias
a. Fairness considerations to disadvantaged groups
b. Policies based on stereotypes of Blacks may not be in long-run
self-interest of Whites
i. Spill-over effects of poverty such as high crime rate
ii. Also, people in favor if segregation in 1960s are now
saying they regret their former attitudes and are happier
with the current racial climate
xiii. Tax Policy and Happiness: Summary
1. The traditional notion of declining marginal utility throughout the
income distribution is still sound. However, the traditional shape of the
marginal utility curve may need some adjustment
2. The impact of additional income on different groups may be a difference
in kin rather than simply one of degree.
a. For poor individuals, where income is purchasing goods that
satisfy basic needs, most of the goods purchased will be
nonpositional
3. Purchases by the poor
a. Are likely to have a relatively low negative externality from
rivalry and may actually have a positive externality to the extent
that individuals have a distaste for inequality
b. Are likely to show little decline in value from adaptation
4. Revenue from increasing taxes on the rich to support a middle class tax
is likely to produce a far smaller improvement in well being than would
using that same revenue to fund basic services for the poor
5. Direct government expenditures on non-positional goods may increase
well-being more than reducing taxes, because private individuals are
likely to sue much of the additional income to purchase positional goods
f. Office Decoration
i. Have to show a good business purpose for purchase of decoration in order to
deduct it
ii. Hypos
1. Employee Buys painting and rug for office Henderson v. Commish
a. NOT Deductible no good business purpose
2. Self employed, buy a paining and rug for office
a. Deductible thinks its good for business defer to owner
3. Law firm buys decorations for lawyers office
a. Employer not taxed, its a business expense
b. Employee not taxed, working condition fringe
4. Law Prof buys painting and rug for office and donates it to the school
a. NO charitable deduction because receives substantial benefit
from it
iii. IRS defers to business to determine if its a business expense
1. If employee buys, theres a heavier burden of proof
j. Commuting
i. Cannot deduct commuting expenses
ii. Revenue ruling 94-17
1. Traveling to and from work generally is a non-deductible commuting
expense
a. If your company gives you a car, taxed on it if used to get to and
from work
2. Going from one business location to another is deductible
3. If taxpayer works at various different jobs then travel to each is non-
deductible
a. Maid travel costs from different houses are non deductible
b. Maid with a maid service first drive to HQ (thats not
deductible) but after HQ to homes, thats deductible
i. Even if you dont go to HQ first, its deductible
4. However, travel to a temporary job outside taxpayers metro area is
deductible
5. If a taxpayer has a regular job, travel to a temporary job within the
metropolitan area is deductible
6. If taxpayers residence is the taxpayers principle place of business, then
the taxpayer may deduct transportation expenses between residence and
other work locations in the same trade or business.
k. Clothing
i. Three requirements to deduct work clothing Pevner v. Commish
1. The type of clothing must be required as a condition of employment
2. The clothing must NOT be adaptable to general usage as ordinary
clothing
3. The clothing must NOT be worn outside of work
ii. Uniforms are always deductible
iii. Should Pevners clothes be deductible fancy clothes she wouldnt have bought
by her self; she doesnt wear them outside work
1. Yes
a. She has less real income than an employee who is required to
purchase expensive clothing.
b. She should get it for excess of YSL for ordinary clothing
2. No
a. It is hard determining who would use the clothes outside work
iv. Hypos
1. Can tennis pro deduct tennis clothing?
a. NO, its too popular; can wear it in ordinary life
2. Fire, police, military
a. Deductible
3. Custom suits like Century 21 blazers
a. Deductible cant really wear them out
4. Mr. Rogers and his sweaters
a. Close case could wear them out, but probably wouldnt
l. Expenses of Education
i. Education expenses are deductible only if the education:
1. Maintains skills or is required by an employer; AND
2. Does not provide training towards a new occupation
ii. Carroll v. Commissioner Philosophy education and police officers job is not
closely enough related to qualify for deduction
iii. Notes on Education
1. On the job training is deductible by employer and tax-free to employee
2. Expenses of acquiring an LLM in taxation are deductible for a practicing
attorney, but not for a student who attends directly after law school