Rule: Gross income is defined as "any undeniable accessions to wealth, clearly realized, and over which the taxpayers have clear dominion."
(1) Facts: Glenshaw Glass Co. sued Hartford-Empire Co. for antitrust violation Settled for $324,000. Glenshaw didn't report this portion of the settlement as income for the tax year involved. Commissioner determined this was a deficiency and claimed that settlement minus legal fees should be taxed. Also joined with Commissioner v. Williams Goldman Theaters Inc. under which Goldman was entitled to treble damages worth $375,000, but only report $125,000 of recovery as gross income and claimed that $250,000 was punitive damages and not taxable.
(2) Issue/Holding: Whether antitrust damages and punitive damages constitute taxable income under §22(a) of the IRC? - Yes, antitrust damages and punitive damages are taxable income.
(a) Overrules previous definition of income that was given in Eisenhower v. Macomber (Income = gain derived from capital, from labor, or from both combined." Rule: Recovery of loss of capital from bad tax advice is not income. Shows that there is a correspondence in how payment in treated and how recovery payment is taxed. When payment is deductible, then recovery of payment is also taxable. When payment is not deductible, then recovery of payment is not taxable. This is because if initial payment was deductible, it was taken into account when you computed taxable income, so you need to include the recovery in income. On the other hand, when payment was not taken into account when you computed taxable income, you don't need to include the recovery in income.
Facts: Commissioner found that Clark overpaid his taxes in 1932 because of his lawyer's error. In 1934, his lawyer reimburses him roughly $20,0000.
Issue/Holding: Whether the $20,000 that Clark received was income? - No, it is not income because the payment was not derived from "capital, from labor, or from both combined," but is more akin to recovery of capital. Rule: Something is a gift if it is the result of the "detached and disinterested generosity" of the donor, and not "out of affection, respect, admiration, charity, or like impulses. As determined in Old Colony Trust C. v. Commissioner, "the mere absence of a legal or moral obligation to make such a payment does not establish that it is a gift. If the payment proceeds prim-airily from the constraining force of a moral or legal duty, or from the incentive of anticipated benefit of an economic nature, then it is not a gift."
Facts: Court combined two cases - Commissioner v. Duberstein and Stanton v. United States
(a) Commissioner v. Duberstein:
(i) Duberstein and Brennan do business together - have longstanding relationship/friendship. Duberstein sometimes gave Brennan names of other potential customers. One of the recommendations was so successful that Brennan gave Duberstein a Cadillac, despite there being no obligation to compensate Duberstein for referrals. Brennan deducted the expense of the Cadillac but Duberstein did not report it on his taxes, claiming it was a gift. Commissioner later asserted a deficiency against Duberstein for the amount of the Cadillac.
(b) Stanton v. United States:
(i) Taxpayer Stanton had been employed by Trinity Church in New York City for ten years. When he resigned, the church gave him $20,000 as a severance payment.
Issue/Holding - Justice Brennan: Are the Cadillac and the $20,000 payment gifts and therefore, non-taxable? - The Cadillac in Duberstein is not a gift because it was in exchange for services (overturns Appellate Court). The $20,000 payment in Stanton needs to be remanded to determine it was gift.
(a) What facts make something look more like compensation than a gift:
(i) If giver deducts the value of the good as a business expense makes it look like compensation because we don't allow givers to deduct gifts.
1. But what the giver does is not necessarily decisive, especially if he has been known to attempt to game the tax system.
(b) Note, although the recipients belief about whether it was a gift or not is not determinative because it is based on the donor's intent, the belief can be important against civil and criminal penalties.
(i) Recipient could also disclose the fact that he is assuming that this is a gift on his return. This will drop the level of confidence that is needed from should opinion to something lower, but this also draws the IRS' attention to the transaction. Rule: Whether something is a gift or not turns on the donor's state of mind. However, whether recipients are guilty of tax evasion depends on their beliefs about donor's intent, not what the donor's intent actually was.
Rule: A person is entitled to classify cash and property received from a lover as gifts, so long as their relationship consists of something more than specific payments for specific sessions of sex.
Facts: Kritzik gave Conley and Harris each over $0.5 million. Thinking it classified as gifts, they did not report it on their income and were charged with willfully evading their income tax obligation.
Issue/Holding: Was the money Kritzik gave to Conley and Harris income to Conley and Harris or a gift? If it was income, did they act in knowing disregard of their duty to pay taxes? With regards to Conley, the court ruled that there was insufficient evidence and therefore, should be reversed. With regards to Harris, they held that there was not enough evidence to prove criminal liability, but are enough to prove civil liability.
Hayashi: This is an outrageous case - absurd that what position you take depends on someone else's intent. This is a reasonable "should level case" that they shouldn't pay taxes because it is normally a quid pro quo - Kritzik didn't pay gift taxes, so reasonable that his mistresses shouldn't have to pay taxes. Rule: Recipients of gifts are required to pay tax on all capital gains appreciation, whether it occurred during the time of their ownership or not.
Facts: A purchased 100 shares of stock for $1,000, which he held until 1923 when fair market price was $2,000. A then gave them to B who sold them during 1923 for $5,000. claims that Revenue Act of 1921, B must pay income tax upon $4,000 as realized profits (sale price - purchase price). B argues that she only has to pay gains of $3,000, the amount it appreciated during her ownership
Issue/Holding - Justice McReynolds: Is the recipient of the stocks responsible for all of the appreciation, or only the appreciation which occurred during her ownership? The recipient of stocks is responsible for all of appreciation, both that which occurred during his ownership and that which occurred during the donor's relationship.
(a) If B had won, this would allow people to give appreciated stock to another individual who would then sell it and then realize a smaller gain. This would prevent built in gain from being taxed, through mechanisms such as swapping appreciated property as gifts to eliminate all capital gains. Although this arguably would not be a gift because not "detached generosity" of donor, IRS could not police it - would be administrable. Rule: If there is an arm's length transaction, one does not need to value the "fairness" of consideration. Rather, the agreement should be considered a purchase and an individual's basis is the fair market value of the items transferred at date of purchase.
(1) Facts: S.S. Kresge transferred 700 shares of the S.S. Kresge Company to Farid-Es-Sultaneh (plaintiff) in anticipation of their marriage. The shares of stock, each with a fair market value of $315, were intended as financial protection for Farid-Es-Sultaneh in the event that Kresge should pass away before their marriage took place. The stock was exchanged for Farid Es-Sultaneh's promise to marry S.S. Kresge and her forgoing her inchoate marital rights. 1938, Farid-Es-Sultaneh sold 12,000 shares of the stock for $230,802.36. It was calculated that if Farid-Es-Sultaneh purchased the stock, her adjusted basis would be $10.66 2/3 per share, based on the fair market value of the shares at the time she received them. On the other hand, if the shares were a gift to Farid-Es-Sultaneh rather than a purchase, she assumed Kresge's adjusted basis of $0.159091 per share
Issue/Holding: How should we evaluate how much taxes she should pay on the gain? - Because the transfer was not a gift, but a purchase of marriage rights via an arm's length, plaintiff's basis is the fair market value at the time of purchase.
(a) Under §1012(a), her basis in the property is her cost. The cost of receiving the stock was the value of her promise to marry + the forfeiting of her inchoate marriage rights. Like in Davis, we assume that because the parties are dealing at arm's length, her cost is equal to the value of the stocks. Therefore, her basis in the stock is the value of the shares at prenup.
(b) Note, §1012(a) would not change this result because the transaction occurred prior to marriage. Rule: Federal income tax uses annual, as opposed to transactional, accounting. A federal taxpayer's taxable income is assessed annually, even when it is derived from a multiyear transaction from which the taxpayer ultimately makes no profit.
Rule: If you make an initial payment and it was initially deductible, then when you subsequently recover the payment, it is includable in your taxable income. If you make an initial payment and it was not deductible, then when you subsequently recover the payment, it is not includable in your taxable income.
Importance: Sanford and Books not decided on matching grounds and instead, decided based on practical necessity of closing a business' books once a year to determine annual income and tax liability. Thus, shows that annual accounting takes priority over matching.
Facts: From 1913-1915, respondent has a contract with the US to dredge the Delaware River. In 1915, the work under the contract was abandoned. Respondent had incurred $176,272 of expenses, which it recovered via lawsuit in 1920 (plus interest).
Issue/Holding - Justice Stone: Should the $176,272 of the recovery be treated as income or a recovery of capital? - The $176,272 should be treated as income because the US utilized an annual accounting system, not a transactional system. Annual accounting is the reasonable and predictable choice for raising revenue.
Note, this case predated IRC §172 and that is why they could not carry the loss forward. Also, if this occurred now, we would apply IRC §111(a) and it would not be deductible. Rule: "Income may be defined as gain derived from capital, from labor, or both combined." Including the profit gained from the sale/conversion of capital assets.
Rule: Under the 16th Amendment, a stock dividend paid as additional shares of stock is not taxable income.
Note, the current law is still that Pro-rata stock dividends are generally NOT taxed. However, the constitutional view in this case is widely disparaged - Congress can adopt any not entirely unreasonably definition of income. Furthermore, this is the only time SCOTUS has ever struck down a tax based on their interpretation of income as provided in the 16th Amendment.
Note, this also is the case that analogizes capital gain and income to fruit and tree "the fundamental relation of "capital" to "income" has been much discussed by economists, the former being likened to the tree or the land, the latter to the fruit of the crop."
Facts: Mrs. Macomber owned 2,200 shares of common stock of Standard Oil Company with par value of $100. The company then declared a 50% stock dividend, and Mrs. Macomber received 1,100 new shares - thus, she has no change in wealth, because she got dividends, but her total ownership in the company decreased.
Issue/Holding: Is Mrs. Macomber subject to tax? - No, stock dividends are not taxable.
(1) Government argued that 1) receipt of stock dividend increased Mrs. Macomber's wealth (this is clearly wrong), 2) receipt of stock dividend realized her prior increase in wealth, and 3) her prior increase in wealth could constitutionally be taxed at any time.
(2) Court rejected this argument.
(a) First, defined income within the meaning of the 16th Amendment as: "Income may be defined as gain derived from capital, from labor, or from both combined" including the profit gained through a sale or conversion of capital assets (Doyle cases) (pg. 234).
(b) A stock dividend is a postpone of realization in that the company's accumulated profits are being capitalized, not distributed to stockholders or retained as surplus available for distribution in money or in kind.
(c) "The essential and controlling fact is that the stockholder has received nothing out of the company's assets for his separate use and benefit; on the contrary, every dollar of his original investment, together with whatever accretions and accumulations have resulted from employment of his money and that of other stockholders in the business of the company."
(d) Stock dividend takes nothing from corporation and adds nothing to shareholder
"Nothing could more clearly show that to tax a stock dividend is to tax a capital increase, and not income" than the fact that stock would require conversion in order to pay the tax **This is no longer good law - has been replaced by IRC §109!!***
Facts: Bruun leasing land to Helvering, who tears down old building and builds new building. Lease is later abandoned and property reverts to Bruun. During the term of the tenancy, the tenant had increased the value of the land. Value of new building - value of old building = $51,000
Issue/Holding: When the property reverts to Bruun in 1933, does he have income? Yes, there was income. Therefore, Bruun must realize a gain of $51,000 (value of new building - value of old building).
(1) Bruun argued that the definition of gross income in §61 is not broad enough the gain in question. Emphasized that the gain be "separate from the capital and separately disposable." Court rejects this argument and limits Eisenhower v. Macomber exclusively to the taxability of stock dividends, not taxation of real property.
iii) Rule: It is not necessary for recognition of taxable gain that one be able to sever the improvement begetting the gain from the original capital. This is walking Eisenhower v. Macomber back.
Rule: Realization need not be in the form of cash derived from the sale of an asset. Gain may occur as a result of exchange of property, payment of taxpayer's indebtedness, relief from a liability, or other profit realized from the completion of a transaction.
Note, this has not stayed the current law because:
(1) This was abandoned during the Great Depression because the value of the property < the amount he was paying in rent. We do not want to chill people from making the economically sound choice.
(2) If the value of the land had fallen and the lease was reverted, he could not realize the loss, so there is unfairness here.
(3) Under current law:
(a) Note, that although the net income is the same under Bruun and IRC §109 & §1019, §109 & §1019 is better because it defers recognition. Rule: Using property as collateral and borrowing in excess of one's basis is not a realization requirement.
Importance: Borrowing on a non-recourse basis is a way for taxpayers to rid themselves of risk of their property depreciating, but not trigger the tax consequences of disposing of the property.
Facts: In 1931, Mrs. Woodsam borrows $400,000 on nonrecourse basis against a property with basis of $296,000. In 1934, she contributes property to a corporation in exchange for the issuance of new stock. Contribution of property to corporation is non-recognition event and corporation inherits her stock. In 1943, the corporation sells her property. The corporation argues that in 1931, when Mrs. Woodsam took out her $400,000 loan, it should have caused her to realize a $104,000 gain ($400,000-$296,000). This would have caused her basis to step up to $400,000 before she contributed the stock to the corporation.
Issue/Holding - Circuit Judge Chase: Whether the basis for determining gain or loss upon the sale or other disposition of property is increased when subsequent to acquisition or property, owner receives a loan in an amount greater than his adjusted basis which is secured by a mortgage on the property upon which he is not personally liable? - No, borrowing in excess of the value of the property does not constitute disposition of a property, and therefore, her borrowing did not change the basis for the consumption of gain or loss. **This is no longer good law!!**
Facts: Mrs. Logan owned 1,000 shares of stock of Andrews & Hitchcock Mining. Her basis in the shares were $180,000. Andrews owned a right to a part of the ore mined from an iron ore deposit. In 1916, Youngstown bought all the shares of Andrews & Hitchcock - including those owned by Mrs. Logan. In consideration for the purchase, Youngstown made a cash payment to shareholders and agreed to make additional future payments based on amount of ore it was able to mined, However, there was uncertainty about what the level of future payments would be because the contingent future payments were dependent on the future profitability of the mine.
Issue/Holding - Justice McReynolds: In an open transaction, are receipts from a sale or bequest taxable as income before capital is fully recovered? No, gain/loss upon a sale is determined by subtracting from the gross proceeds the amount of capital invested.
(a) Commissioner's Theory: Advocates for the closed transaction approach - require taxpayer to recover the present value of all future payments as income today.
(i) Government estimated that she would receive $9,000/year, which would total $225,000. PV of those payments is $100,000.
1. Amount Realized today = $120,00 in cash + $100,000 future payments = $220,000
2. Adjusted Basis = $180,000
3. Gain = $40,000
(ii) Advantages of this Approach:
1. If one can accurately measure the present value of future payments, then this is the best reflection of income
(iii) Disadvantages of this Approach:
1. Need a tremendous amount of information in order to be able to calculate this approach
(b) Logan's Theory: Advocates for the basis first approach - where only after one recovers all of their basis do they start to accumulate gain.
(i) Logan argued that the value of future payments is too uncertain to be included in today's income. Rather, argued that she should be allowed to recover the entire basis before reporting any gain. Thus, $120,000 should be treated as a recovery of her basis with a remaining basis of $60,000. As payments start to come in, those payments should also be a recovery of basis. The first year in which it becomes clear that assuming her consideration of stock is more than basis would be year 7 (assuming that all payments are 9,000) because this is the first time that the amount of money she has received > $60,000 basis.
(ii) Advantages of this Approach:
1. Simple
(iii) Disadvantages of this Approach:
1. Loss of revenue for treasury
(3) Rule: In an open transaction, receipts from a sale or bequest are not taxable as income until capital is fully recovered.
(a) Note, this rule is no longer good law; however, it is helpful to use this case to think about the spectrum of possible recovery-of-basis rules Rule: Cash basis taxpayer cannot be deemed to have realized income at the time that a promise to pay in the future is made.
Facts: Minor is a physician in Snohomish County, Washington. Minor entered into an agreement with Snohomish Physicians under which he agreed to render medical services to subscribers of Snohomish Physicians' prepaid medical plan in exchange for fees to be paid by Snohomish physicians according to its fee schedule. Minor also entered into a supplemental agreement where a designated percentage of his fees would go into a deferred compensation fund. On his federal income tax for 1970, 1971, and 1973, Minor included only 10% of the fees in his gross income because the remaining 90% went into the supplemental plan. IRS argued that although the constructive income does not apply, Minor should have recognized income through the economic benefit doctrine. Minor argues that he had no right to compel Snohomish Physicians to execute the trust agreement, to even to cause it to be created, implemented, or continued. Furthermore, he has no current vested interest - no right, title, or interest in the trust/agreement/any asset held by trust
Issue/Holding: Is a taxpayer entitled to defer his tax obligations by participating in deferred compensation plans? - Yes, deferred compensation plan is unsecured from Snohomish Physicians' creditors and therefore incapable of valuation and not property under §83.
(a) Court holds that Minor wins because beneficiary of trust was Snohomish, not Minor. Because assets were subject to Snohomish's creditors, that is sufficient to defeat the economic benefit doctrine.
(b) An important difference between this and Amend v. Commissioner (Tax Court, 1950, pg. 287), was that Amend was an arm's length transaction, but this is not (Minor is an employee and shareholder). Furthermore, the stakes are higher here because it is 90% of Minor's compensation until he retires vs. a one-year deferral. Rule: A corporation that buys back a bond at less than its issuing price realizes taxable income because it is effectively a discharge of indebtedness.
Note, in this case, Justice Holmes required assets to be freed in order to result in taxable gain, but that has ever been replicated.
Facts: In July 1923, Kirby Lumber Company (Kirby Lumber) (plaintiff) issued bonds in the amount of $12,126,800. Later that year, Kirby Lumber bought some of its bonds back for less than their original value. Ultimately, Kirby Lumber saved $137,521.30. The lower court found this amount to be taxable income.
Issue/Holding - Justice Holmes: Does a corporation that buys back a bond at less than its issuing prices realize taxable income? Yes, a corporation that buys back its bond at less than its issuing price is essentially discharging a portion of its indebtedness; therefore, the difference between the issuing price and the purchase price is taxable income to the corporation because it is an accession to income.
(i) How are they buying back the bonds at a discounted rate?
1. The value of the bonds is the present value of all future payments. When Kirby Lumber issues bonds, they pay $1 million and have to pay 5% rate of interest, but now they look riskier so if they were to do this now, they would have to pay 10% interest. Therefore, bond only having 5% interest rate would sell at a discount because when interest rates increase, the price of outstanding bonds fall. Rule: The discharge of indebtedness resulting form a settlement fixing the amount of a disputed debt is not taxable as income.
Facts: Zarin was an avid gambler. Resorts in Atlantic City granted Zarin a line of Credit, under which, Zarin could write a check called a marker and in return, Zarin would receive chips which could then be used to gamble at the casino's tables. New Jersey Division of Gambling Enforcement made it illegal to make further extensions of credit to Zarin, but Resorts continued to do so. In April, 1980, Zarin owed Resorts $3,435,000. Resorts filed a New Jersey state court action to collect the $3,435,000. The parties settled for $500,000.
Issue/Holding: Does Zarin have income from discharge of indebtedness? No, there is no discharge of indebtedness because the gambling debt is best characterized as disputed debt/contested liability.
(a) Commissioner argued that Zarin had $3.4 million in debt and settled for $0.5 million, so he had $2.9 millions of consumption.
(b) Zarin argued that he browed $500,000 and paid $500,000, so he has no change in wealth.
(c) Court's Reasoning:
(i) Is this indebtedness within §108? No, the two prongs of §108(d)(1) are not satisfied:
1. Prong 1: Indebtedness for which taxpayer is liable
a. This fails because New Jersey state law makes debt unenforceable
2. Prong 2: Indebtedness subject to which taxpayer holds property
(d) Note, this is a bit of an "awkward fit" of contested liability - contested liability better applies to case when two parties disagree about what the amount of the loan was later and then agree on an amount. Here, parties agree that he got $3.4 million and only paid back $500,000, so not a natural fit.
(e) If you were Zarin's lawyer, would have been more effective to argue that this fell into exception under §108(e)(5). **Note, this is no longer good law!!**
Facts: In 1932, Crane inherited land in building worth $255,000. Property was encumbered by a nonrecourse mortgage also equal to $255,000. Between 1932-1938, Mrs. Crane claims depreciation deductions of $25,000. In 1938, she transfers property, still subject to mortgage, for $2,500 in cash + purchaser assumed debt on property.
Issue/Holding: What is Mrs. Crane's gain or loss from the disposition of this property? Mrs. Crane realized a gain of $27,500.
(i) Government's position was that her amount realized was $2,500 in cash + relief from $255,000 debt. Therefore, her amount realized was $257,500. Government argued that she was right to deduct the depreciation deductions. When she inherited property, her basis was $255,000. After taking those $25,000 in depreciation deduction, her basis was $230,000. Thus, her gain is her amount realized - her adjusted basis, so she realized gain of gain of $27,500 ($257,000-$230,000).
(ii) Crane's position is that her amount realized on the sale of property is $25,000 in cash that she received and that's it. She excludes the amount of the mortgage assumed by the person she sold her property to. Furthermore, Crane claims that her basis in the property is $0 because the property she inherits she argue is the equity in the property (FMV of Property - Debts Encumbering Property = $255,000 - $255,000). Therefore, her gain is $25,000 ($25,000-$0).
1. Note that reporting her base as 0 is totally inconsistent with her having taken depreciation deductions for the prior 6 years because depreciation deductions are allowing you to recover your basis in the property. However, these tax years are closed by statute of limitations
(iii) Note, the difference between the commissioner's theory of gain and Crane's theory of gain is the amount of depreciation deduction that she took ($27,500-$2,500=$25,000).
Court's Holding - Government's theory is correct, she inherited a gain of $27,500.
1. This theory comports better with: 1) language of the code, 2) implicit principles of depreciation, and 3) sound administrative practice.
2. The amount realized includes the mortgage because it was a burdened to the extent of property's value:
a. Footnote 37 in the original opinion: "Obviously, if the value of the property is less than the amount of the mortgage, a mortgagor who is not personally liable cannot realize a benefit equal to the mortgage. Consequently, a different problem might be encountered where a mortgagor abandoned the property or transferred it subject to the mortgage without receiving boot. That is not this case." This footnote suggests that the amount realized may only be debt to the extent of property's value.
(c) Rule: Amount realized on property is not limited to equity in property (value in excess of the mortgage). Rather, the amount realized is equal to amount of mortgage + boot (including debt liabilities assumed by buyer). However, if the value of the property is less than the amount of mortgage, then the amount realized may only be debt to the extent of the property's value.
Note, this is no longer available for a number of reasons including statutory changes, anti-abuse rules, and Tufts. But example illustrates some hallmarks of tax shelters. Hallmarks of tax shelter are not in itself illegal but often are reasons to make you warry.
a. Use of non-recourse debt
b. Circular cash flows - money is going around in circle without making anyone better off
c. Taxpayers who are subject to different types of tax regimes
i. Ex. Bisma is fully taxable entity and Jacob is taxable exempt entity
d. Most important is extreme difference between economic reality and tax base Rule: The amount realized in the disposition of property subject to a non-recourse mortgage includes the entire amount of the mortgage, regardless of whether the mortgage exceeds the fair market value of the property.
Importance: Amends the doctrinal rule iterated under Crane and allows for the full amount of the nonrecourse debt to be included in amount realized, even if it is greater than the value of the property.
Facts: General partnership put up $45,000 of their own money and borrowed $1,850,000 in a non-recourse loan to make a total real estate investment of $1,895,000. In the first two years of ownership, they claimed deductions for ordinary losses and depreciation of $440,000. This reduced their adjusted basis to $1,455,000 ($1,895,000-$440,000). Likely use depreciation deductions to offset other ordinary income. Then they abandoned the property. Amount of loan outstanding was still $1,895,000 and the property had a FMV of $1,400,000.
(i) Under Crane, taxpayers take the position that their amount realized is the amount of non-recourse loan, only to extent to value of property. So, adjusted basis is $2,455,000, and amount realized is $1,400,000, giving them loss of $55,000.
(ii) Commissioner took the position that on the disposition of the property wasn't fair market value but full cost of property of $1,895,000 and their adjusted basis is $1,455,000, so they have a gain of $395,000.
Issue/Holding - Justice Blackmun: When nonrecourse loan is in excess of the property's fair market value, what is the amount realized on the disposition of property? The amount realized includes the full amount of the nonrecourse loan, not just the amount equal to the FMV of the property. Rule: Community property and income, however derived, may be divided equally between spouses for federal income tax purposes.
Importance: This case created an advantage for community property state married couples because they were allowed to report ½ earnings of earner to a non-earning spouse. This created pressure on common-law property states to switch to community property. Therefore, in 1948, Congress adopted joint filing, which gives all couples the same benefit.
Facts: Seaborns are husband and wife who live in Washington (community property states). They filed separate tax returns each reporting ½ of the community property. Commissioner takes the position that all income has to be reported by the husband.
Issue/Holding - Justice Roberts: Can a married couple in a community property state file separate tax returns, each for ½ of the community property? Y es, married couples in a community property state can file separate tax returns and community property and income, however derived, may be divided equally between spouses for federal income purposes.
i) Here by law, the earnings are never the property of husband, but that of the community." Rule: Tax liability for income from property attaches to/ follows ownership.
Facts: Mr. Blair is the beneficiary of a trust. He has the right during his life to the income from this trust. He conveys to each of his three children the right to $9,000/year of that income for as long as he lives.
Issue/Holding - Justice Hughes: By transferring the right to receive income from the trust to his children is it sufficient to say that income is theirs (and taxable to them) and not his (and taxable to him)? Yes, the income is taxable to the children, not him.
(1) Blair is arguing that he transferred sufficient amount to his children that they became beneficiaries (and taxable) and not him
(2) Government is arguing that this is not a transfer of property, but a gift, because no attempt was made to assign equitable title, right, or interest in the estate itself
(3) Court's Decision: "We conclude that the assignments were valid, that the assignees thereby became the owners of the specified beneficial interest in the income, and that as to these interests they and not the petitioner were taxable for the tax years in question."
(a) If the benefits of the trust have been assigned, then so to have the liability
(b) Petitioner was owner of the property of the trust during his life, and this property, like any other, is alienable in the absence of a restriction on alienability. Rule: A gift of interest coupons detached from bonds amounts to realized income to donor.
Importance: The holding is still good law but the way to distinguish between Blair and Horst is a based on whether it is a temporal limitation relative to what you have. If it is temporarily limited relative to what you have, then it taxable. If it is not temporarily limited relative to what you have, then it is not taxable.
Facts: Father detached bond coupons shortly before they were due and delivered them to his son, who collected them at maturity. Commissioner argues that when the interest payments are due on the bonds, the issuer of the bonds gives the interest to the father, who then gifts it to his son. Therefore, the interest is taxable to the father. Alternatively, taxpayer argues that the son receives the interest; therefore, he the interest rate is taxable to him.
Issue/Holding: When father gives his son detached bond coupons and the son subsequently collects interest on them, who is the interest taxable to? - The interest is taxable to the father.
(1) Power to dispose of income is equivalent of ownership. Therefore, Horst realized the income when he gifted it to his son and saw son's needs and wants satisfied. Rule: For federal tax purposes, expenses intended to generate future income through acquisition of a specific asset must be capitalized.
Facts: Encyclopedia Britannia decided to publish Dictionary of Natural Sciences. Because Encyclopedia Britannia was short staffed, it hired David-Stewart Publishing Company to research, prepare, edit, arrange, and illustrate the manuscript for the book The deal specified that David-Stewart Publishing Company would turn over a complete manuscript, which Britannia would copyright, publish, and sell in exchange for the royalties that Encyclopedia Britannica expected to receive. Encyclopedia Britannia treated advances that it expected to receive as ordinary and necessary business expenses deductible in the years in which they were paid to David-Stewart, even though it had not yet received royalties. IRS disallowed deductions and assessed deficiencies.
Issue/Holding - Circuit Judge Posner: Whether the expenditures made by Encyclopedia Britannia were capital expenditures (deducted over useful life) or expenditures for services (deductible immediately)? The expenditures made by Encyclopedia Britannia were capital expenditures because they were used to produce or acquire a specific asset. Therefore, the cost must be capitalized and amortized against sales.
(1) Context is really important here because the opinion is grappling with how to treat this as a non-deductible expense in light of the fact that the expenses would have been deducted if they had been performed internally.
(a) The court argues that this is a specific product, not a service that you are acquiring
(b) The court justifies it by claiming that this was not an ordinary business practice for them because it normally produced in house, but this distinction is no longer important because it was eliminated by §263A in 1986
(2) Alternative Argument for Deduct them Currently:
(a) Should deduct them currently because paying them currently, so tracks ability to pay
(i) Counterargument: you are paying them to provide services that will generate future income
(b) Administrative costs in determining what portion of individuals' wages over time is spent on this specific project is too great and we want to track ability to pay
(i) Counterargument: Not a good argument because lawyers bill in 6 minutes - shows that it's possible to track time spent on specific problems. Even if you don't have this level of precision, you would expect competent management to have some idea/ system. Rule: Expenditures for ordinary and necessary business expenses may be deducted from gross income if incurred while carrying on a trade or business. For an expense to be ordinary, it does not mean that the expense is habitual. Rather, it means that it is what one would expect an individual in that industry to do. Note, this is an industry specific, not an individual specific test.
Hayashi: The decision itself is sound in so far that it relies on the capital expenditure theory - money spent to acquire goodwill is valuable to the business and should not be deducted, but rather, should be capitalized. However, the extent to which this decision relies on the preoccupation of it being ordinary pulls against what really matters, which is to track income.
(1) If Welch is spending money to make money, then he should be able to deduct the cost, regardless of whether other people would make the same expenditure. The extent to which other people would make the same expenditure is only important as sort of an evidentiary matter. If no one else is making the same expenditure, then maybe is not an honest business decision.
(2) Even with Cardoza's definitions of ordinary and necessary, it is not clear that his holding is right. Paying debts for business is arguably frequent. For example, it is not uncommon for the parent company to pay off a subsidiary's debt, even if it is not legally liable for it.
Facts: Welch was secretary for small grain company that went bankrupt. He then started selling on commission for Kellogg. Although he was not legally obligated to, he personally repaid debts leftover from small grain company to rebuild name and reputation because he is going back to a lot of the same sellers. Commissioner argued that these expenses were not deductible as ordinary and necessary business expenses but were rather capital expenditures because they were for the development of reputation and goodwill.
Issue/Holding - Cardoza: Whether payments made by taxpayer to the creditors of a bankrupt corporation in an endeavor to strengthen his own standing and credit are ordinary and necessary business expenses under IRC §162? - No, although the payments were arguably necessary under §162, they were not ordinary under §162, so they are not deductible, but are rather capital expenditures.
(1) Necessary: appropriate or helpful
(2) Ordinary: does not mean habitual, but rather, means what you would expect an individual in in that industry (not the individual himself) to do
(a) Mr. Welch may be in habit of paying of debts all the time, but the question is whether it is customarily in that industry, not for the individual
iii) Best Argument for Mr. Welch:
(1) Analogize to Midland Empire and argue that it is a repair for the damage done by unpaid debts
(2) Argue that it is an advertising/promotional expense, and therefore, it is currently deductible under §262A Rule: Legal fees not incurred as an ordinary expense of a trade or business are not deductible under federal tax law.
Facts: Gilliam is a famous painter who has suffered from psychiatric disorders. Shortly after boarding a plane for business (to paint and teach), he took an anti-anxiety medicine he had never taken before. After taking the medicine, he acted in irrational manner, tried to exist plane, and ended up injuring another passenger. He attempted to deduct legal settlement and attorney fees from suit with the injured passenger.
Issue/Holding: Are the expenses ordinary expenses within Gilliam's trade or business and therefore, deductible under §162? No, the court holds that the business expenses are not ordinary in the course of Gilliam's business; therefore, the expenses are not deductible.
(1) Note, there is no definition defining "scope" for what is ordinary - ex. do you compare to ordinary business traveler or business traveler with anxiety?
(2) Petitioner relied on Dancer v. Commissioner (Tax Court, 1980) Clark v. Commissioner (Tax Court, 1958), and Commissioner v. Tellier (Supreme Court, 1966) but that court distinguished the present case from both those cases.
(a) In both Gilliam and Dancer, petitioners were traveling for business and the cases both involved the expense of an incident that occurred while in the course of the trip for which the taxpayer was as responsible. However, in Dancer, automobile travel was an integral part of taxpayer's business and "lapses by drivers seem to be an inseparable incident of driving a car."
(i) Hayashi: This is undoubtedly true but focusing on the frequency of an event is also irrelevant to the question of whether it should be deduced because it occurred during his business.
1. Ex. If a visually impaired lawyer hires an assistant, it is not ordinary during business of being a lawyer, but there's no personal benefit and it is not a capital expenditure. Therefore, it is deductible in the present. Hayashi argues that we should look at Gilliam's deduction in the same way and focus on broader picture of business and personal expense.
(b) Disanalogous from Clark v. Commissioner and Commissioner v. Tellier because Gilliam's expenses were not activities directly in the conduct of his trade or business, while those were. Rule: When taxpayer is victim of theft, he is allowed to deduct his basis in the property (Theft deduction = amount initially invested - amounts withdrawn + amounts reinvested - reimbursements/recoveries - claims as to which there are reasonable prospects of recovery) in the year discovered, not the year the theft occurred.
Facts: In year 1, investor invests $100 into investment account (basis in account is $100). In year 2, Madoff reports that the account earned 10X income. Investor pays income on his purported earnings and reinvests the earnings. In year 3, investor contributes an additional 20X. Also in year 3, the account earned an additional 10X of income, which was reinvested. The new basis in the property is 140 (100 + 10 earnings + 10 earnings + 20 additional contributed). Each of next three years, Madoff reports 10X of income on which he pays tax and increases investment on account. At end of year 7, takes 30x out and 10x income reported. Basis falls by 30 but increases by 10. The final basis is 150.
Issue/Holding: The overall issue is how should we treat the money that the investor lost. Overall, the taxpayer is allowed to deduct his basis in the account. Notwithstanding the fact that he sustained a loss in year 1, he was allowed to deduct in year 8.
(1) More specifically, the following four specific questions are:
(a) Is a loss from criminal fraud or embezzlement in a transaction entered for profit a theft loss under §165 of the IRC? A loss from criminal fraud or embezzlement in a transaction entered for profit is a theft loss, not a capital loss, under IRC §165.
(i) Taxpayer claiming a theft loss must prove that:
1. The loss resulted from a taking of property that was illegal under the law of the jurisdiction in which it occurred and was done with criminal intent
2. Taxpayer is not required to show conviction for theft
(b) Is such a loss subject to personal limits in §165(h)? No, theft loss is deductible under §165(c)(2), so §165(h) is not applicable.
(c) In what year is such a loss deductible? A theft loss in transaction entered for profit is deductible in year loss is discovered, provided that the loss is not covered by a claim for reimbursement or recovery with respect to which there is a reasonable respect for property
(d) How is the amount to be determined? The amount of theft loss in transaction entered for profit = amount initially invested - amounts withdrawn + amounts reinvested - reimbursements/recoveries - claims as to which there are reasonable prospects of recovery Rule: A taxpayer can deduct education expenses if the if the education maintains or improves the taxpayer's skills that are required in the taxpayer's employment, trade or business.
Facts: Kopaigora worked for Marriott as an established finance and accounting business manager. In July 2010, Kopaigora enrolled in a weekend EMBA program. Kopaigora took classes that included Introduction to Management, Corporate Financial Reporting, and Human Resources Management. In April 2011, Marriott fired Kopaigora. Kopaigora continued to attend classes, while also searching for a full-time job in the corporate finance and accounting industry. In August 2012, Kopaigora graduated with his EMBA. In September 2012, Kopaigora was hired as a Vice President of Finance at a small finance firm. On his federal income tax return, Kopaigora claimed a deduction for his education expenses.
Issue/Holding: Are Kopaigora's expenses for his EMBA program deductible under §162(a)? Yes, they are deductible because
(a) When petitioner was enrolled in the EMBA program, he was a well-established finance and accounting manager at Marriot
(b) The courses that petitioner chose to take wee in line with what he was familiar with and did not qualify him for a new trade or business
(c) Petitioner's unemployment did not prevent him from continuing his trade or business as finance and accounting business manager for section of 162
(d) Nothing in record states that EMBA degree was necessary for his subsequent employment Rule: Substance is more important than form. If there is not a true business purpose and the transaction is executed only for tax purposes, then the transaction will not be honored.
Facts: Ms. Gregory owned all the stock of the United Mortgage Corporation (United) and was entitled to receive dividends from United. Among its assets, United owned 1,000 shares of the Monitor Securities Corporation (Monitor). To avoid the ordinary tax treatment of dividend payments received from United, Gregory facilitated a corporate reorganization of United and formed a new corporation (Averill). United then transfers the shares to Averill, which Gregory subsequently liquidates. At this point, Gregory holds the Monitor stock, which she subsequently sells and realizes gain on.
Issue/Holding -Justice Sutherland: Can a taxpayer rely on literal words of the statue to reach a result that may be inconsistent with legislative purpose or intent? - No, a taxpayer cannot, by relying on the literal words of statute, reach a result that is wholly inconsistent with legislative purpose or intent. The important component for determination is whether what was done, apart from the tax motive, was the thing which the statute had intended.
(i) 2nd Circuit: "The meaning of a sentence may be more than that of separate words, as a melody is more than notes."
(ii) In this case, the reorganization had no business purpose but was a mere device which put Rule: A federal taxpayer may deduct the depreciation in a property's value only if he has invested in the property, showing that he is the true owner and has equity (equity = assets - liabilities) in the property.
Facts: Romneys owned a business motel, which they sold to "The Associates" which was a business partnership of 8 doctors. The purchase price of $1,224,000 far exceeded the motel's real value, which the partners knew or could have known at the time. There was no evident reason why the partners agreed to pay the higher price. The partners made a $75,000 down payment on the purchase. Under the complex terms of the purchase agreement, the Romneys continued operating the motel, received all motel revenue, paid all of the motel's costs, and were legally liable for the motel's debts. No purchase deed was to be recorded until the expiration of a 10-year nonrecourse mortgage, and the partners were not personally liable for repaying this mortgage. For 10 years, the Romneys made leaseback payments that effectively offset the value of the partners' mortgage payments. Other than their down payment, the partners invested no money in the motel for 10 years. At the end of those 10 years, the motel's value was still not equivalent to its 1968 purchase price. In 1979, the partners paid off the mortgage. However, because the mortgage payoff exceeded the motel's value, each of the partners, including Franklin, was able to claim a federal tax depreciation deduction for a share of the resulting loss.
Issue/Holding - Circuit Judge Sneed: May the associates deduct the depreciation in a property's value? - No, they are not the true owners and had no equity in the property.
(1) Tax Benefits to Associates:
(a) In Year 1:
(i) No net benefit - can deduct interest payments but offset by the income from lease payments.
(ii) They can depreciate the basis in the property (under §112) over the useful life using the applicable depreciation method of (§168).
(b) When Associates Default on Loan and Return Hotel to Romneys:
(i) They will have satisfied a 1.2 million debt. If recourse loan, they will have cancelation of indebtedness. If not recourse, will have gain = amount realized - adjusted basis.
(c) Overall Benefits:
(i) Timing - current deductions but gains recognized at end of five years
(ii) Type - deductions reduce ordinary income, gain is taxed at capital gains rate Rule: In order for travel expenses to be deductible under §162, three prongs must be satisfied:
1. The expense must be a reasonable and necessary traveling expense, as the term is generally understood - this includes transportation fares, food, and lodging while traveling.
2. The expenses must be incurred while away from home.
3. The expense must be incurred in the pursuit of business. This means that there must be a direct connection between the expenditure and carrying on the trade of business of the taxpayer of his employer. Such an expense also must be necessary or appropriate to the development and pursuit of business trade.
Facts: Flowers lived in Jackson, Mississippi, but took a job in Mobile, Alabama. He did not want to move from Jackson, so he commuted into Mobile. Deducted commuting expenses from his taxes.
Issue/ Holding - Justice Murphy: Are Flowers' travel expenses deductible? - No, Flowers' commuting expense are not deductible because they are not ordinary and necessary business expenses.
(1) Flowers fails the third prong discussed below because Flowers's travel to and from work in Mobile was no different than a taxpayer choosing to live in one city and commute to work in another. Next, Flowers's choice to live in Jackson and work in Mobile was a personal one. Thus, Flowers's travel expenses were not incurred by any necessity of Railroad's business, as required by the third condition of the test. Finally, a determination of whether Flowers was away from home is unnecessary, as the other two conditions have not been met.
(a) "The costs were incurred solely as a result of taxpayer's desire to maintain home in Jackson while working in Mobile, a factor irrelevant to the maintenance and prosecution of railroad's legal business." Rule: For federal tax purposes, a taxpayer with a long-term goal of generating a profit may deduct current business expenses.
Rule: To determine whether an individual is engaged in an activity for profit, look at the factors listed in Treasury Regulation §1.183-2(b):
1. Manner in which the taxpayer carries on the activity
2. The expertise of the taxpayer
3. The time and effort expended by the taxpayer in carrying on his activity
4. Expectation that assets used in activity may appreciate in value
5. The success of taxpayer in carrying on other similar or dissimilar activities
6. The taxpayer's history of income or losses with respect to the activity
7. The amount of occasional profits, if any, which are earned
8. The financial status of the employer
9. The elements of personal pleasure or recreation
Facts: Nickerson acquired an abandoned dairy farm that had been out of business for eight years. Nickerson visited the farm on weekends during growing season and twice per month for the rest of the year. Farming the land in its current condition was impossible, and Nickerson did not acquire any livestock or equipment. Whenever Nickerson visited the property, he worked on gradually renovating the farmhouse, hay barn, and equipment shed. Nickerson expected that generating a profit from the farm would take 10 years. Nickerson leased the property to a farmer, who, in addition to paying rent, aided Nickerson by cultivating the land to prepare it for farming. Nickerson deducted the farm-restoration costs as business expenses on his federal tax return.
Issue/Holding - Circuit Judge Pell: Can Nickerson deduct the losses associated with the farm. - Yes, because his primary purpose in acquiring the firm was to gain a profit. Rule: Under federal tax law, assets held as inventory for sale to customers are not capital assets, so losses on them are not limited to $3,000.
Facts: Gary Bielfeldt speculatively purchased and sold U.S. Treasury securities. When Bielfeldt identified an opportunity to make a short-term profit on Treasury securities, he entered into buy-and-sell transactions with primary dealers. Bielfeldt participated in Treasury auctions only a few weeks each year at most. Bielfeldt would also go for months without owning any Treasury securities at all. After sustaining heavy losses on the securities transactions, Bielfeldt sought a refund of $85 million on his federal income taxes, which exceeded the annual capital-loss deduction limit
Issue/Holding: Are the securities that Bielfeldt holds capital assets? - Commissioner's position is that he is a trader.
(1) He claims that he is dealer, and the treasuries are his inventory. Commissioner's position is that he is trader, so the securities are capital assets. Therefore, his losses are capital losses and he can only deduct up to $3,000. (This is "backstop" rule - if evaded anti-abuse rules and generated tremendous losses, still cannot deduct more than $3000)
(a) Definitions:
(i) Dealer: income is based on the service he provides in the chain of distribution of goods he buys and resells rather than on fluctuations in the market value
1. Section 1221(a)(1) permits a dealer holding inventory for sale to customers to treat his gains from those sales as ordinary income.
(ii) Trader: income based not on any service he provides but on fluctuations in the market
(b) Bielfeldt is a trader, not a dealer.
(i) Bielfeldt was in business of speculating in the value of Treasury securities
(ii) Unlike a dealer, Bielfeldt did not maintain an inventory of securities of derive income from providing a service to customers. Rather, he generated income from the fluctuations in value of the assets that he bought and sold. Therefore, he is subject to capital losses, not ordinary losses and the $3,000 limit applies. Rule: To determine if a property was held primarily for sale to customers in the ordinary course of trade or business under §1221(1), evaluate the Winthrop Factors (substantiality and frequency of sales, solicitation of advertising, improvements, and brokerage activities).
i) Facts: Biedenharn Realty Company, Inc. (Biedenharn) (plaintiff) was formed to hold and manage family investments, including commercial and residential real estate, farm properties, and a substantial stock portfolio. Biedenharn acquired a 973-acre property as a farming investment. Biedenharn farmed the property and leased some of it to farmers. After being approached by buyers interested in building homes on the property, Biedenharn subdivided the land and sold the resulting lots. Biedenharn improved the property with streets, water, sewer, and electricity, and hired brokers to market the lots. Biedenharn continued to farm a large part of the land while the lots were being sold. Biedenharn listed $254,409.47 in real-estate profits on its federal tax returns for 1964, 1965, and 1966. Biedenharn listed 60 percent of the gain as ordinary income and 40 percent as capital gains. The United States Internal Revenue Service (IRS) (defendant) later determined that Biedenharn's profits were entirely ordinary income and thus assessed additional taxes and interest. Biedenharn sued the IRS for a refund of $32,006.86, claiming that the entire profit represented capital gains.
ii) Issue/Holding: Was the subdivision held by the taxpayer primarily for sale to customers in the ordinary course of its trade or business under §1221(1)? - Biedenharn began to purchase properties as investments, but as time passed, Biedenharn's regular business became focused on selling properties to prospective purchasers.
(1) Court focused on Winthrop factors:
(a) Substantiality and Frequency of Sales - there was a substantial number of sales (158) and a substantial number of lots sold (208)
(i) This is the most important factor!!!
(b) Solicitation an Advertising Efforts - there were no efforts here, but one could infer that the property was for sale
(c) Improvements - added streets, drainage, sewerage, and utilities
(d) Brokers Activities - plaintiffs exerted significant control over the brokerage activities Rule: For federal tax purposes, assets held by a business to hedge operating risks are not capital assets.
Hayashi: Sound result, but it is to within the literal language of §1221(a)(1), rather it is in tension with the language. Before Arkansas Best had been interpreted that any property that is integral to business and has business purpose outside of investing is a capital asset.
Facts: Corn Products Refining Company bought and sold corn-futures commodity contracts in order to ensure that Corn Products had an adequate supply of corn at economical prices. On its corn-futures contracts, Corn Products netted a profit in 1940, followed by a loss in 1942. Corn Products asserted that its gains and losses in corn futures should have been treated as arising from the sale of capital assets. Corn Products claimed that its futures-buying program was an investment program separate from its manufacturing business. The federal tax commissioner determined a deficiency in Corn Products' taxes. Corn Products petitioned the United States Tax Court for a redetermination.
(1) Note, options give rights but not obligation, whereas a futures/forward contract gives you an obligation unless you can sell the contract and get someone else to realize the obligation!!
Issue/Holding: Are assets held by a business to hedge operating risks capital assets for federal tax purposes? No, the futures were capital assets because they were an "integral part of taxpayer's business."
(1) The program's purpose for Corn Products was to serve as a form of insurance against fluctuations in the market for corn. Thus, the futures were not an investment for Corn Products, but rather were ordinary assets. Accordingly, Corn Products' gains and losses associated with its sales of corn-futures contracts constitute ordinary income and losses, not capital gains and losses. Rule: A loss incurred in connection with the exchange of a capital asset in a prior taxable year must be treated as a capital loss.
Facts: Frederick R. Bauer and another taxpayer (plaintiffs) had equal stock ownership in a corporation. In 1937, the plaintiffs decided to liquidate and divide the proceeds of the corporation. They received distributions of the proceeds in 1937, 1938, and 1939. They received a final distribution in 1940. In their tax returns for each of these years, the plaintiffs properly classified the proceeds as capital gains. In 1944, a judgment was entered against the dissolved corporation and Bauer individually. The plaintiffs, as transferees of the corporation's assets, were liable to pay the judgment. Each classified the payment in their 1944 tax return as an ordinary loss and deducted the entire amount paid. Had they classified the payment as a capital loss, they would have only been able to deduct a portion of the payment. The Commissioner (defendant) ruled that the payment was related to the liquidation distributions and that the plaintiffs were therefore required to classify the payment as a capital loss.
Issue/Holding: Should a loss incurred in connection with the exchange of a capital asset in a prior taxable year be treated as a capital loss? Yes, losses sustained from the sale or exchange of a capital asset must be treated as capital losses, which are only deductible from capital gains.
(1) Any gains or losses arising in connection with liquidation distributions must be treated as capital gains or losses. And examining liquidation transaction events that occurred in prior taxable years for the sole purpose of classifying a present loss does not offend the annual tax accounting principal 15th Edition•ISBN: 9780073401805 (8 more)Douglas A. Lind, Samuel A. Wathen, William G. Marchal1,236 solutions
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