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BASIC INCOME TAX
SYLLABUS
Professor Schaffer Fall, 2004
Books for Basic
Income Tax:
The casebook is Andrews, Basic Federal Income Taxation, 5th edition (Aspen).
The volume of selected sections of the Internal Revenue Code and Regulations we use is CCH’s Federal Income Tax, Code and Regulations, Selected Sections (2004-2005 ed.). If you want a used copy, you can also buy an earlier one without missing anything. A textbook: Chirelstein’s Federal Income Taxation: A Law Student’s Guide to the Leading Cases and Concepts (Foundation Press). Again, you don’t have to have the most recent edition.
Call
the bookstore (617/373-2286) or Gnomon Copy (617/536-4600) to determine if the
course materials are available in advance.
When this syllabus says a document is in the “course materials”, that means it is on the “Blackboard” website. Go to your “my.neu” account, and you should see a list of the courses for which you have registered. Click on this one, and it will take you to the Blackboard website for this course. Then click on “course documents.”
The assignment for the first
day of class is Part II, A, 1&2.
Assignment: the introduction to the case book (Chapter One), especially parts B through E. We won't discuss it in class but it has a lot of information in it and an introduction to commonly used words and phrases peculiar to tax law (Part E). It's a good place to go back to during the course, when you feel that you don't understand how all of the little pieces fit together. Chirelstein has a similar introduction to his book, for the same purpose, written with his usual verve.
a. Code sec. 61(a), Treasury Regulations secs. 1.61(a), 1.61-2(d)(1) & (d)(2).
b. Old Colony Trust Co. v. Comm., p.33, discussed at Chirelstein, para. 3.01(b). We will discuss in class the questions on pp. 35-37 of the casebook.
c. Benaglia, p. 37, discussed at Chirelstein, pp. 35-37.
d. Turner, p. 41, including questions after the case.
e. Memorandum, “Marginal Rates” available in Cargill, Room 51. The casebook also has an explanation of marginal rates at p. 27, as does Chirelstein at pp. 3-5. Take your pick.
a. Old Colony Trust Co. is the law, but where did it come from? Is it the common law? Did the court refer to words in a statute? Which words in which statute?
b. A side issue is found in question 1, pp. 33-34. Present sec. 61(a) is interpreted as having the same meaning as the statute in Old Colony, although its words are different. Why? Here we encounter for the first time an important feature of federal statute law. In interpreting a statute, courts give great weight to the legislative history, especially the reports of the congressional committees, which wrote the statute and recommended its adoption to the full Congress.
c. Read the two directors' resolutions adopted by the Company, one in 1916 and one in 1918. Part of your job as a lawyer is to explain to clients what contracts mean. These resolutions are like clauses in employment contracts, which fix an employee's compensation. How would you explain to the Company's directors (or Mr. Wood) what their 1918 resolution did?
(1). In trying to understand what the 1918 resolution did, and what the alternatives were, you need to understand the concepts of "effective rates" and "marginal rates." These are central concepts you must master in order to go further in this course. Now is the time for you to read the memorandum on the subject in our course materials.
(2). Please be prepared to answer the following questions: Which kind of rate did the 1918 resolution in Old Colony use to compute the federal income tax on Mr. Wood's salary (which the employer had to pay?) (This is really the same as question 4, p. 35 of the casebook.) Suppose for the sake of arithmetic simplicity that the tax rates are the ones set out in the distributed memo on "Marginal Rates.” Mr. Wood's salary is $10,000 and his income from unrelated sources is also $10,000. The tax on his total income of $20,000 is $3,000. What part of that $3,000 is the tax on his salary of $10,000? What are the possible answers to this question? Which answer did the 1918 resolution choose? Did the 1918 resolution use a marginal or an effective rate?
It's easier to
follow Benaglia if you know how it differs from the general rule (as the
judges and counsel undoubtedly did.) See
Treas. Reg. sec. 1.61-1(a), 1.61-2(d)(1)
and 2(i). Look also at sec. 83(a) of the
Code and figure out the answer to this:
A client pays her lawyer for legal services by transferring to the
lawyer property worth $1,000. There are
no restrictions on transferability or possibilities of forfeiture. How is the lawyer taxed under sec.
83(a)? When? By the way, if the receipt of property were
not taxed to the lawyer when the receipt took place, does that mean it would
never be taxed? See Chirelstein
para. 1.01.
a. None of the opinions in Benaglia mention sec. 119 of the Code. Why might that be? The citation to Benaglia says "acquiesced in" and then cites "C.B.,” which is not a kind of radio, but the Cumulative Bulletin, a publication of the Internal Revenue Service. What might "acquiesced in" mean in this citation?
b. We will discuss in class the questions on p. 41 and questions 1-5 on pp. 43-44.
In valuing the tickets that Turner won, the court mentions that they were not transferable, that there would be selling costs, etc. Then it also says that Turner was not the sort of person who would have bought the tickets for their list price anyway. Are these two different approaches to valuing the tickets?
Assignment:
Code, sec. 106
Private Letter Ruling No. 9603011 (in the course materials).
1. In Benaglia, Congress had not spoken, at least explicitly. Now consider an employee whose employer pays for part or all of her health insurance. Absent specific statute law, would that be income to her? How do you know? Now look at sec. 106(a) of the Code. As to life insurance, sec. 79(a) and as to child care, sec. 129. There is also a provision allowing employees to escape tax on amounts which their employers contribute to their pension funds until those amounts are distributed to the employees, a very valuable privilege, as we will see. (Sec. 402(a)).
2. Some people have no health insurance where they work. They have to buy it out of their own pocket, and usually get no deduction for that expense. Does that make sec. 106 seem less fair?
Suppose Jones makes much more money than Smith does. His marginal rate is thirty-one percent. Smith has so little income that he pays no income tax. How much tax does each save by the exclusion from the definition of gross income of $1,000 of health insurance premium paid by their employer for each of them? (This question is of great general importance: the answer is the same for all of the deductions and exclusions from income we study in this course.)
In this problem, we looked first at the taxation of people with the same incomes, and then compared the taxation of people with very different incomes. The first is called the test of "horizontal equity" and the second the test of "vertical equity".
3. For a more recent attempt to use the Code (1996) to help taxpayers pay for medical expenses, see Code §220
4. (a) Sarah and Anne live together. Sarah works for the Town of Pleasantville, which pays for her health insurance. The Town adopts the policy of providing health insurance for “domestic partners” of its employees, and Anne qualifies as a “domestic partner.” According to Private Letter Ruling No. 9603011 in the course materials, does §106(a) protect both Sarah and Anne from taxation? (Put aside §§104 and 105 until later).
(b) The Town of Pleasantville is in the State of Knowles. Suppose the state legislature adopts a law that permits Sarah and Anne to marry. If they take advantage of this law, Sarah and Anne will be considered married for all purposes of state law. Will they be “spouses” under Code §152?
Edward H. Clark, p. 78
Raytheon Production Corp., p. 81
Glenshaw Glass Co., p. 85
Code secs. 61(a)(3), 1001(a) and (b), 1011 and 1012
Treas. Reg. Sec. 1.61-6
Chirelstein, pp.8-11, para 2.01, 2.04(b).
We will spend most of our time in class on the notes in the casebook, at pp. 88-89. In working out problem 1, it may help to think about an employee who is paid at the end of each month. Her salary is $1,000 per month. One payday, her employer fails to pay her. She retains counsel, sues, and eventually recovers $1,000 in damages. Should she be taxed on the $1,000 (less, of course, her expenses of litigation)? If you were a lawyer for the Internal Revenue Service, how would you explain to a court why the $1,000 is taxable?
Raytheon holds, among other things, that the damages for an "involuntary conversion" of property are to be treated as if they were sales proceeds. We will discuss in class just what Code section says that the taxpayer in the example about Blackacre on p. 87 of the casebook would have had income if it had sold Blackacre. How much would the income be? See sec. 61(a)(3), 1001(a)&(b), 1011, & 1012.
1. There is an outline of the whole statutory scheme for taxing gain on the sale of property at Treas. Reg. sec. 1.61-6. You can use this regulation as a flow chart for many of the problems in this course. For the moment, only subsection (a) of the regulation is in point.
2. You will find it helpful in working on problem 6 in the casebook to start with the rule used in a case both more simple and more common. Suppose the taxpayer buys property for a lump sum (say $10,000) and later sells part of it (say, one-quarter by area) for, say, $5,000. See Treas. Reg. sec. 1.61- 6(a). Problems 7(a) and (b) can be thought of as cases in which the usual rule of Treas. Reg. sec. 1.61-6(a) is impractical to apply and another must be found. Can you see why it would be impractical to apply Treas. Reg. sec. 1.61-6(a) in problems 7(a)&(b)? Or would it?
3. Many students find Chirelstein, para. 2.01 useful at this point.
4. In Raytheon, on pp. 84, the court discusses the Strother and Farmer & Merchants Bank cases. Are these cases analytically the same as problems 6(a)&(b) on p. 89? See if you can explain how they are similar. The discussion in Raytheon of Strother and Farmer & Merchants Bank gives a hint of how problems 6(a)&(b) would be resolved by a court.
Burnet v. Sanford & Brooks Co., p. 89
Chirelstein, para. 10.01
We will discuss Notes 1-5, pp. 93-94 in class.
Treas. Regs 1.451(a) and 1.446(c)(i) and (ii)
Note 4, p. 93, discusses a subject of great practical importance. After reading that note and Treas. Reg. secs. 1.451-1(a) and 1.446(c)(i)&(ii), work out the following problem. A firm of architects designs a building and supervises its construction in the years 2000 and 2001. The firm pays salaries to its employees who work on the project, buys supplies, pays rent, etc. The total expenses allocable to the project are $50,000, $25,000 paid in 2000 and $25,000 paid in 2001. The firm finishes half the job in 2000 and this entitles it to be paid $30,000 under its contract with the client. It finishes the rest of the job in 2001 and is entitles to be paid another $30,000 then. The client pays in 2002.
1. Under the cash method of accounting, in what year is the fee includible in the firm's income?
2. How about under the accrual method?
3. The firm's expenses are probably deductible in 1997and 1998 under either method (a good review of the cash and accrual methods is to figure out why this is so). Which method of reporting the income would give a more accurate presentation of the firm's financial condition to a potential creditor or to a person interested in becoming a partner? Do you see why accountants sneer at the cash method and why its use may amount to fraud in the law of torts and in federal securities law?
4. Professional firms love the cash method of accounting because they can deduct the expenses of generating income in an earlier than they include the income itself.
Assignment: Code secs. 172 and 186.
The net operating loss deduction is Congress' way of undoing the unfairness of the result in Sanford & Brooks.
1. How would Sanford & Brooks come out under Code secs.172(a)&(b)(1)?
2. One calculates one's net operating loss by going to Code secs. 172(c)&(d). Try applying them to Sanford & Brooks.
3. Sec. 172 is a statute of general application. Relief for cases like Sanford & Brooks is now available under sec. 186, IRC. If Sanford & Brooks occurred today, which section, 172 or 186, would apply? What was the point of having two relief statutes? Keep in mind that for many years net operating losses could be carried forward for only five years.
Assignment:
Dobson, p. 94; Chirelstein, para. 10.03
Code secs 111, 166 and 186.
Treas. Reg. 1.166-1(e)
Notes, pp. 102-104.
We will discuss questions 2, 3 and 4 in class.
Casebook, p. 104.
Assignment:
Code sec. 104 (a)(2).
Problem, Casebook, p 105
Casebook, Part C, pp. 105-110
Let’s go back to Private Letter Ruling 9603011 in our course materials and the problem about Sarah and Anne on p. 4 of this syllabus. Anne breaks her ankle playing basketball and has to go to a hospital emergency room. Sarah’s health insurance (provided by her employer) pays the bill. Is either Anne or Sarah taxed on this payment?
Assignment:
Code secs. 213, 262, 106(a)
Ochs, p. 112
Policy Analysis, p. 119-120. You can pursue this interesting subject further at Chap 7, B and C of the casebook (optional).
Assignment:
Code secs. 72(a), (b), &(c)
Treas. Regs. Secs. 1.72-1 through1.72-6, 1.72-9
Casebook, Chapter 3,F,1
Chirelstein, para. 2.02
"How to Make an Annuity" (in your course materials).
We will do problem 3, casebook, p. 122. We will ask how each of these annuities would be taxed under the pre-1987 law and under present law. When Andrews refers you to Reg. sec. 1.72-9, you should take the hint. What is the difference between table I and Table V (newly added) in that regulation? We will use Table V.
Problem 5 brings us into the world of employee pensions, in practice the most important kind of annuity. Sec. 72(f)(2) is an optional brain-twister; do it if you like that sort of thing.
Chirelstein argues that the "correct" method of taxing annuities would be to treat early payments as mainly interest, and the later ones as mainly returns of capital (pp. 36-37). This is not universally accepted. A good reply is in Kahn, Accelerated Depreciation - Tax Expenditure or Proper Allowance for Measuring Net Income? 78 Mich. L. Rev. 1, 19-26 (1979), which also contains a fine primer on taxation of annuities, p. 19-26.
Code sec. 101(a)
Casebook, pp. 126-129 (omit problems p.129-30).
Chirelstein, para. 2.03.
1. Assignment:
Code, sec. 102
Irwin v. Gavit, p. 143
Chirelstein, para. 4.02.
Notes 1-5, p. 145-46 of the casebook.
We will discuss questions 1 and 5 in class.
2. In answering question 5, think about a person who is receiving an annuity payment. That person gets to exclude a part of each payment as a return of basis. Why does the Code say that a person who has inherited an income interest in property may not do the same? (As for the amount of the basis of property received as a gift or bequest, see Code secs. 1014 and 1015, and stay tuned for Part B of this Chapter of the casebook.)
3. Chirelstein's discussion of Gavit relies heavily on the idea that a payment to be made in the future has a calculable present value. So will our class discussion. This idea is explained in the Appendix to the Chirelstein book, and also in the essay "Present Value of a Future Payment", in your course materials.
Assignment: Code secs. 1001(b), 1015
Andrews, p. 151-52
Taft v. Bowers, p. 152
Chirelstein, para. 4.01
Problems on p. 154 of the casebook, to be discussed in class
If you could read and understand the Code, secs. 102, 1001(b), 1014, 1015 you wouldn't have to read anything else. Mere mortals will need the cases, text, etc., because they illustrate and explain the Code and regulations. For the problems on p. 154, look at the first sentence of Code sec. 1015(a)- all of it.
Code secs. 1014, 166
Treas. Reg. 1.166-1(e)
Casebook, pp. 154-156.
Problems, pp. 156, omit probs. 3 and 5.
Just what does "basis" mean? In problem 4 on p. 156, you need to know the lawyer's "basis" in the "account receivable" (money owed by a client.) What should that basis be? Suppose the amount owed was $1,000, and the lawyer sold the right to receive that amount to a bank for $950. How should the lawyer be taxed on the $950? What basis under secs. 1001, 1011 and 1012 would give the result you think appropriate? You can get the same answer as to the lawyer's basis by returning to the question of how much the lawyer should be allowed to deduct if the lawyer had held on to the account receivable, and the client had never paid. See Code secs. 166(a)(1) &(b) and Reg. 1.166- 1(e). What "basis" to the lawyer for the receivable under Code secs. 1001, 1011 and 1012 do sec. 166 and its regulation imply?
What if the lawyer in either case was an accrual method taxpayer who took the $1,000 into gross income upon sending the client a bill for that amount? What should be the tax on a sale to the bank? What should be the deduction upon the client's failure to pay? What "basis" do your answers now imply?
This brings us back to the deeper question of how lawyers and judges interpret statutes. The basis of the account receivable is defined in Code sec. 1011, which refers in turn to sec. 1012. Sec. 1012 speaks of "cost". Do your answers to the previous problem really have anything to do with the lawyer's cost?
The word "cost" in sec. 1012, apparently simple and unambiguous, can become difficult to interpret and apply. The courts and Revenue Service must choose between the simple, everyday meaning of the word, which will in some cases give results that Congress could hardly have intended, and a new meaning, purely technical and unique to tax law, having no relation to the word's meaning in ordinary parlance, but which gives just and consistent results. Indeed the word "cost" in sec. 1012 seems sometimes to be given, for tax law only, the meaning "whatever basis will give a just result or a result consistent with the Code's policies." Perhaps the word should be spelled "coste" to remind us that it sometimes stands for concepts special to income taxation and not for "cost" at all.
Farid-es-Sultaneh, p. 157.
Chirelstein, para. 5.04.
Code secs. 1001(a) and 1041 (the latter added in 1984.)
Notes, Casebook, pp. 161-64.
Casebook, pp. 253-55
a. Let’s follow up the question at the end of Andrews' note 3. If Farid takes as her basis the value of the shares when transferred to her, what does that suggest about Kresge's income tax on the transfer? If he is not taxed on "gain" is there appreciation, which escapes tax forever?
b. Lets go back to the client in part III,A,3 who pays her lawyer with property worth $1,000. If she paid $300 for the property, her gain is $700, realized and recognized. The same would be true if she paid any other debt in this way. Why are secs. 1001(a) & (c) so interpreted? This is a rule of very wide application and importance because it applies to so many transactions.
c. In the marital context, the same rule was applied to someone in Kresge's position or to one who transferred property upon divorce in return for the release of marital rights. The case was Davis, casebook, chap. 5,D,2. In most divorce cases the only asset the husband owned was the family home, or his half of the family home, and there were strong reasons why the wife should get this asset. Yet divorce seemed to many a bad time to impose tax on the increase in value in the family home since it was purchased. Other reasons to change the law can be found in the legislative history of Section 1041 on p. 253 of our casebook.
d. In the context of marriage, Code sec. 1041, enacted in 1984, undoes Davis and Farid. How would the transfer from Kresge to Farid be treated today? Suppose, for example, Mary sells property with a basis to her of $300 to her husband for $1,000? Or suppose she has borrowed $1,000 from her husband and pays her debt of $1,000 by transferring to him property worth $1,000? Make sure you understand how secs. 1041(a) & (b) work here. Maybe more important, keep in mind that they are an exception to the general rule. These would be taxable sales if between persons not married, with gain or loss realized and recognized under secs. 1001(a)&(c).
e. The enactment of sec. 1041 has led to an odd usage of words among lawyers. It is common to refer to the general principle that paying one's legal obligation with appreciated property leads to realization and recognition of that appreciation as the principle of the Davis case. But the facts of the Davis case itself would today lead to the opposite result. The reason for this odd state of affairs is that Davis decided both a general principle and applied it to a husband's transfer of property in a divorce settlement in return for his wife's surrendering her rights to alimony, downer, etc. In enacting sec. 1041, Congress has left the general principle undisturbed, but said that it is not to be applied in the context of marriage.
f. Here's a puzzler. If Kresge transferred shares to Farid today on exactly the same terms as he did in the Farid case, would sec. 1041 apply to the transfer?
Assignment: Cottage Savings Assn. p. 255.
Suppose Mr. Smith buys property for $100, and it rises in value to $500. Of course if he sold it for $500, he would have gain of $400, computed under sec. 1001(a).
Now suppose that Mr. Smith does not sell the property. Under our present system, he is not taxed on the increase in value. (For example, sec. 1001(a) speaks of an “amount realized” and a “sale or other disposition”.) Most economists, on the other hand, think of unrealized appreciation as income, since it increases the net worth of the owner.
Much of our tax law is shaped by this “requirement of a realization”, as we call it. For example, we have studied how damages for injury to property (the Raytheon case) are taxed as if the property had been sold for the amount received as damages. But there would be no taxation if the property’s increase in value above basis had been taxed when it occurred, without a realization. Indeed, even the simple case of a sale of property for cash would be different: the property’s appreciation would already have been taxed.
The Supreme Court held, more than seventy years ago, that Congress lacked power to tax increase in value of property while it occurred, before it was realized, on the ground that unrealized appreciation is not “income” within the meaning of the Sixteenth Amendment of the Constitution. (That is the amendment that authorized income taxation.) This is the only time the Court has held a provision of the income tax invalid unconstitutional.
What does the Court say in Cottage Farm Savings is the reason for the requirement of a realization. Does it sound like a reason that rises to a constitutional level?
We will now study some of the effects of the requirement of a realization. The first is deferral of tax.
1. Assignment: Casebook, chap. 5,B
2. We have a memo in the course materials that may help at this point. "The Present Value of a Future Payment" is about the concept of the value of deferring taxes, also discussed in the casebook. You may confine yourself to part I and II of the memo for the moment.
The whole Chirelstein book is rightly oriented around this subject: a good place to start is para. 1.01.
Assignment:
Casebook, Chap 5H
Chirelstein, Note: Income Tax, Consumption Tax, Flat Tax, p. 386
Code sec. 1031 and regulations thereto
Alderson, p. 267
We will discuss questions 1, 2, 5 and 6, pp. 272-79 in class.
Assignment:
Code sec. 1033
Casebook, pp. 278, part (a), (to be discussed in class.)
Assignment:
Casebook, pp. 278-80, part (b)
Questions, p.280, to be discussed in class.
For many years section 1034 allowed homeowners to defer the gain on the sale of their homes if they reinvested the proceeds in another home. In 1997, this was changed to an outright exemption. Look at Code section 121: does anyone now pay tax on gain on the sale of their home?
Despite the repeal of §1034, tax lawyers will need to understand it for many years. Why?
Code secs. 1(h), 1221 and 1222.
Casebook, Chap. 5,F.
Chirelstein, para. 16.01-.02. Para. 16.03 is optional and will not be discussed in class.
During most of the years we have had an income tax capital gain was taxed a much lower rate than ordinary income. In 1986, Congress abandoned this scheme, providing the same rate for both. Starting in 1991, preferential rates for capital gain have been gradually restored in a highly complicated way. The new tax increases the preference. It’s all at §1(h) of the Code: can you decypher it?
The definitions of capital gain and loss, long-term and short-term, found in sec 1222, all make the “sale or exchange” of a “capital asset” a necessary condition. The definition of “capital asset” is in sec. 1221.
There is a memorandum, “Illustrative Examples of Capital and Ordinary Assets”, in your course materials, and Chirelstein’s secs. 16 and 17 covers much of the same ground, if you would like to pursue the question.
A car dealer sells a Toyota to a customer. Is the dealer’s gain capital gain? See sec. 1221(1). Why do you suppose those who wrote sec 1221 inserted subsection (1)?
We will discuss this controversial issue in class. The possible justifications for preferential treatment set out on p. 284 of the casebook are critiqued for some reason on pp. 1043-46. The critique is a good one, even if the casebook’s organization is odd.
Assignment:
Code secs. 1211, 1221(2), 1231.
Casebook, Chap 13,D
Chirelstein, sec. 18.02
Sec. 1221 (2) of the Code seems to make the property it describes simply not a capital asset. Actually, sec. 1231 gives that property even better status than that of a capital asset. It would have been better drafting to include a cross-reference to Code sec. 1231 in sec. 1221(2). So there are three, not two categories: capital assets, ordinary (also called non-capital) assets, and sec. 1231 assets (sometimes called quasi capital assets).
Assignment:
Code secs. 61(a)(12), & 108; Treas. Reg. 1.61-12
Casebook - introduction to Chap. 6, p 291
Kirby Lumber Co., p. 291
Chirelstein, para. 3.02
Zarin, p. 296
Discussion:
The Kirby Lumber Co. case has about it a whiff of prosperity. Here is a company that can pay off a huge debt in cash and make a profit doing it. You might think that is a headache for the rich only, rather like the high cost of repairing a Rolls-Royce. But one reason for creditors to forgive an indebtedness is that the debtor is broke. If a debtor owes a total of $35,000 and has assets of only $4,500, her creditors might just as well accept, say, $3,500 in discharge of her debts. They can't get much more from further litigation, litigation is expensive and each creditor knows that if it doesn't settle now, some other creditor may get all the assets or the debtor may spend them. And if the debtor goes through bankruptcy proceedings, the creditors are given no choice: the bankruptcy court grants a "discharge" of the debts whether the creditors consent or not. So "income from discharge of indebtedness" is a law for the poor as well as the rich, not to mention middle-class people who have lost their jobs or are hooked on credit cards.
Here are two problems we will discuss in class:
(a) Lets start with nuts and bolts. If Betty Smith who owes $35,000, has $4,500 in assets and settles her debts for $3,500, is she really supposed to pay tax on $31,500 ($35,000 debt less $3,500 payment) out of her remaining $1,000? See Code sec. 108 (a)(1)(B), (a)(3), and (d)(3). If not, how much income does she have from this transaction?
A crucial question (and a standard one in tax law): if sec. 108 gives Betty relief, is it forgiveness or deferral? See Code sec. 108(b)(1) and (b)(2).
(b) Just who has "discharge of indebtedness" income within the meaning of Code sec. 61(a)(12)? The East Coast Brick Co. borrows $1,000,000 and invests it in a new factory in California. The California venture is a bust, and the company loses $800,000 on it. Of the $800,000 loss, $400,000 is expenses in excess of operating revenue from the California factory, and $400,000 more is from selling for only $600,000 the factory bought for $1,000,000. The Brick Co. is now in bad financial shape. The creditor who lent it $1,000,000 accepts $200,000 in full payment, and is glad to get it. Does the Company really have income under Kirby Lumber and Code Sec. 61(a)(12)? It has just lost its corporate button-down collar shirt in this transaction: how can anyone say it had income? That is what the Bowers v. Kerbaugh Empire case is about, discussed in Kirby Lumber.
Assignment
Code: sec. 1341.
North American Oil Consolidated v. Burnet, p. 307
United States v. Lewis, p. 309
Chirelstein, para. 10.02.
We will discuss Notes 1, 2 and 4, pp. 311-12, including Code sec. 1341 as it applies to these cases.
Assignment:
American Automobile Asso., p. 323
Rev. Proc. 71-21, p. 334.
Chirelstein, para. 12.02.
. Notes 1-6, pp. 330-34 .
Assignment:
Code Secs. 61, 62, 63, 151.
Casebook, pp. Chap 8 Parts A-E.
Chirelstein, Introduction, and paras. 7.05-7.07.
After applying §1 to taxable income we have an amount of tax, but tax credits reduce it. The most important is probably the child tax credit in Code §24.
This is by far the most important provision on interest since it affects so many people.
Code Secs. 163 (a) and (h).
Please read: Casebook, pp. 456-58,(The article by White is optional. It seems to be considered a classic by people who can understand it.)
Chirelstein, Sec. 7.04
Look at the definitions of “qualified residence interest” and “acquisition indebtedness” in Code Secs. 163(h)(3)(A) and (B).
1. Suppose I buy a house in which I will live. The price is $300,000, and I have $100,000 which I can use for a down payment. I pay the entire $100,000 of my cash for the house, borrowing $200,000 for the purchase, and giving a mortgage on the house for the $200,000. I buy a big boat, too, borrowing the full price of $50,000. Can I deduct the interest I pay on the loan that I use to buy the boat ?
2. Same deal, but instead of using my cash of $100,000 and borrowing $200,000, I pay $50,000 in cash and borrow $250,000, giving a mortgage on the house to secure that loan. With the $50,000 in cash that is left I buy the boat. Can I deduct interest payments on the entire $250,000 borrowed?
3. Now assume I have owned the house for 10 years, and never bought a boat. The mortgage principle is down to $100,000 and the house is worth $350,000. I borrow $50,000 against the house, giving my bank a second mortgage, and use the just- borrowed $50,000 to buy a boat. Can I deduct the interest on the second mortgage? See Code Sec. 163(h)(3)(A)(ii) and 163(h)(3)(C).
4. When interest on a certain kind of debt is treated favorably or unfavorably, it becomes necessary to decide to what the debt should be allocated. For example, the three questions above raise the issue of whether a loan is for the purpose of acquiring a house or a boat. In §163(h), how does one tell?
Casebook, Chap. 9, C
Chirelstein, para. 1.03.
As you can see, middle class people have their tax breaks, too. Can you think of a reason (or reasons) why home ownership should be so favored in our tax law? (And keep in mind that new Code section 121 means that some or all of the gain on sale of a house usually escapes tax, too.)
Problems 4(b) and (c), p. 445, and problems 2(a) and (b), p. 462.
Under Sec. 163(h), may interest paid on student loans be deducted? Why or why not? As part of a whole program of using tax credits and deductions to subsidize higher education, new Sec. 221, allows the deduction to some payors of a limited amount of student loan interest.
Code section 262 and its regulations.
Code Sec. 21
Smith p. 511
Casebook, Notes 1-8, pp. 513-15
Chirelstein, Sec. 6.01(a), insofar as it deals with the Smith case.
Up to now, we’ve studied deductions. Code §21 allows a “credit" against tax instead of a deduction. Be sure you understand the difference between a tax credit and a deduction. See p. 23 of the casebook and Chapter 8,G of our casebook..
Joe and Mary are married. Each earns $15,000 in 1999. In that year they pay Sam $2,000 to clean their house once a week. Their first child, Sally, is born in May of 2000. They pay Marcia $1,000 from September to December of 2000 in return for taking care of Sally while Mary is at work. In 2000, Mary earns $10,000 and Joe and Mary again pay Sam $2,000 for cleaning their house once a week. What credit against tax is allowed under Code Sec. 21(a) to Joe and Mary? See Code Secs. 21(b)(2)(A), (c) and (d). Does Joe's income in 2000 matter? Why?
Before 1976, there was a deduction for certain childcare expenses (old section 214, now repealed). See Casebook, Note 5, p 514. Who was helped by the shift to a credit? Who lost out? Can you make an argument that high bracket taxpayers have a special and greater need for a childcare deduction or credit?
Suppose Mary and her employer agree to reduce her salary for 1999 by $3,000. Her employer also agrees to reimburse Mary for her child care expenses up to $3,000. This reduces her taxable income by $3,000. See Code Secs. 129 and 125, and the explanation in Notes 7 and 8, pp. 514-15. This arrangement undoes Congress' strategy in Sec. 21 of targeting the child care credit to low income persons. It has exactly the same effect as making the cost of childcare deductible in full, up to $3,000 in Mary’s case.
Assignment:
Pevsner, p. 515.
The result reached in this particular case is not as important as the general rule it illustrates. Do you think that the costs of clothes worn at work should be made deductible?
Cases and notes to cases at Chap. 12,C of the casebook.
Code sections 263 and 263A, and the regulations to Sec. 263
Chirelstein, para. 6.02(a)&(b)
Don’t neglect the Notes beginning on p. 634, but omit Notes 7 and 10.
These cases have in common that in all of them courts are trying to define and explain just what expenditures are nondeductible because they are “capital expenditures”. According to these cases, how does one identify an expenditure, which has to be “capitalized”, rather than deducted?
Why are these expenditures not immediately deductible? Suppose that Mr. and Mrs. Jones have $200,000 in income this year, and they invest $20,000 of it in stock of General Motors. The expenditure is certainly an attempt to make a profit. If you think back to the beginning of this course, you’ll remember that they get a basis for the stock under Sec. 1012 of the Code. Why can’t they get a basis and also deduct the cost immediately? Or, if basis and immediate deduction are mutually exclusive, why can’t they waive the basis and just deduct the cost in the year they buy the stock? Does buying the stock reduce their net worth?
Suppose the Exxon Corporation made $200,000,000 in profit this year, but used every cent of it to build a new refinery. Should that expenditure reduce their taxable income to zero?
What are the stakes for these taxpayers, and for the ones in the cases in this chapter? Are they losing their deductions for their expenditures? Or are they suffering something rather milder? See Note 11, p. 638 of the casebook.
According to the Court, are wages paid to workers who construct a building for the Power Company currently deductible or do they have to be capitalized? What was the Company’s practice as to those wages, and what does the Court say about that practice?
Did either side contend that the price of the Company's trucks and cars was immediately deductible? If there was no dispute that these costs had to be capitalized, then what was the argument about?
Code Secs. 167, 168 and 197.
We’ve just seen that some business and investment expenditure can’t be deducted currently, but are instead “capitalized”. When an expense has to be capitalized, the next question is “can the taxpayer depreciate it?” If so, the taxpayer is allowed a deduction, but not all in the year of expenditure.
The basic idea of depreciation is that if a taxpayer spends money for business or investment purposes, and if that expenditure has to be capitalized, one way for the taxpayer to recover its basis (that is, deduct the expenditure) is to spread it over the life of the asset it has bought, deducting a part of the price each year.
Some business expenditures are not deductible currently, nor by depreciation. Instead the buyer of certain assets gets to use the cost basis of the assets only upon sale, where the basis is subtracted from amount realized in computing gain or loss. (Code Sec. 1001(a)). So these taxpayers are also allowed to subtract their expenditure from income: here too, the question is when.
Learning which expenditures can neither be deducted currently nor depreciated (or to say the same thing in different words, must be capitalized but may not be depreciated) is not hard, but the rules are sometimes arbitrary. Goodwill, for example, was not depreciable until 1994, when sec. 197 was enacted.
What is difficult, then, about depreciation? It is that Congress and the Treasury have for many years used it as a way of encouraging investment, rather than measuring the true useful life of the taxpayer’s expenditure. Their underlying method is simple: they allow the business taxpayer who buys certain assets to take depreciation deductions earlier than if the straight-line method were used. Or they allow the taxpayer to deduct immediately what would ordinarily have to be deducted over several years (depreciated). Earlier deductions usually favor the taxpayer even though the total amount deducted over the years is never more than the taxpayer’s basis. You know why: the time value of money.
When we get to the statutes and administrative rules, life will be easier if you keep in mind that no one expects you to compute depreciation allowances under sec. 168. That is just an arithmetic exercise, and, in practice, accountants do that chore. If you ever want to calculate, say, double declining balance depreciation under sec.168, there is a Revenue Procedure (87-57) in the Appendix to our Code book which shows you how the numbers work for an investment of $100. (That table uses 150 per cent declining balance for “15-year” and “20-year” property because sec. 168(b)(2) says to do that.) By the way, you can also buy a hand-held calculator (or a program for your computer) that will do depreciation calculations for you, but there’s no reason to for this course.
Treas. Regs. 1.167(a)-(2), -(a)(3) (a)-(10)(a).
Casebook, p. 688.
Simon, p. 688
Chirelstein, para. 6.08(a) & (b).
Newark Morning Ledger, p. 703
Code Sec. 197.
Description of Code Sec. 197, Casebook, pp. 716-720.
Chirelstein, para. 6.10.
Jane bought a building and rented it to a tenant. She paid $100,000 for land and building together. The land without the building would be worth $20,000. Can she spread the $100,000 cost over the useful life of the building? See Code 167(g), Treas. Reg. 1.167(a)-2, 1.167(a)-5.
Jane asks if she can take a depreciation deduction on the house she just bought and moved into. See Code 167(a), 265(1), and Treas. Reg. 1.167(a)-2.
Suppose Jane's building is a two-family house, and she moves into the top floor, renting out the bottom floor. What part of her $100,000 can be spread over the useful life of the building?
Casebook, chap. 14 B
Chirelstein, para. 6.08 (c) & (d), 6.09(a)
How much of a depreciation deduction is allowed each year with respect to a particular asset? That might have been treated as a question of fact: what is the true decline in value of the asset each year? Instead, Congress (often at the President’s request) has been treated it as an opportunity to encourage business to purchase new machinery. If the depreciation deduction is made larger in earlier years, the effect is to decrease the true tax rate on the income produced by the purchased equipment. The point of this subchapter of our casebook is to show you how over the last forty years Congress and the Treasury have changed the purpose of the deduction from the measurement of cost to an incentive for investment. Notice that the very name of the present system (Section 168) is not "depreciation" but "accelerated cost recovery".
The assigned readings will give you an idea of the various techniques Congress and the Treasury have in the past used to move the law in this direction, and some of the consequences.
The present system of methods and rates of depreciation is found in Code Sec. 168. To see how it works, let’s take a business, which buys a machine. Suppose the Treasury's Asset Depreciation Range (ADR) guidelines give the useful life of the asset as 15 years. According to 168(a), we need the applicable depreciation method and the recovery period.
For the "method", we find that Section 168(b)(1) allows the very favorable 200 percent declining balance method. Two good descriptions of that method are at page 721 of our casebook and para. 6.08(d) of Chirelstein, who sometimes calls it "double declining balance."
For the "recovery period" we go to Sec. 168(e) and find that the property is "7-year property" because it is expected to last 15 years. (Is that clear?). Section 168(c) tells us that "7-year property" is, as you would expect, depreciated over 7 years but with the highly accelerated 200 percent declining balance method allowed by Sec. 168(b)).
The point of the exercise is that the true economic life of an asset has very little to do with its "tax life". When Congress decides that it wants to help an industry, it allows it to use some combination of a short useful life for its asset and a fast method of depreciation. If Congress decides that an industry isn't paying enough taxes, it lengthens the useful life for depreciation of assets in that industry, or specifies a slower method of depreciation, or both. In 1986, the real estate tax shelter was zapped in several ways. One of them is in 168(b)(3), another in 168(c)
. The latest example is found in Code §168k, added by the “Job Creation and Worker Assistance Act of 2002”, P. L. 107-147. Take a look at it. If a firm buys an asset for its business and pays $1,000, §168(k) gives it a deduction of $300 (30% of $1,000) in the first year of use. This reduces the basis to $700. Then the firm goes to §168(a) and starts depreciating the $700. If this were a five-year asset, the deduction under §168(a) for the first year would be 20% times 700 times 2 (the method is double declining balance), or $120 times 2, which is $240. The total deduction for the first year is the sum of the two deductions, or $540: more than half the purchase price!
Casebook