PROBLEM SET # 1

1. Jessica is an associate with a large law firm in Chicago. Generally, Jessica’s work period
ends at 5:00 PM on weekdays. However, when an assignment needs to be completed
within a specified time, and if the assignment cannot be completed within that time if the
normal working hours are followed, the firm requires its employees to work as late into
the night as is necessary. When that occurs, and it occurs frequently, the firm will
reimburse an employee for the amount the employee expended to purchase supper in one
of several nearby restaurants. Is the reimbursement that Jessica received for the cost of
having supper income to Jessica?

- This is meal is (1) not furnished by the employer and (2) not on the premises. Thus, IRC
§ 119 DOES NOT apply.

- However, the de minimis exception, IRC § 132(a)(4), may apply.

o How infrequent is it?
 NOTE difference between statute and reg.
 IRC § 132(3)  look at all employees
 Reg  only go to all employees if can’t find frequency for specific
employee.
- Suppose now that Jessica comes to make out a tax return and explains that she has
frequent meals @ work. I know that IRS never seems to enforce this provision as a
practical matter. What do you do then?
o KHAN says play by the rules, and likened this to speeding. Is a law a law if not
enforced?
2. The same facts as those stated in Question 1 except that the law firm purchases dinners
from a nearby restaurant and has the meals delivered to the employees at their desks in
the firm’s office. Does Jessica have income from the receipt of a meal on the days she
works late at the firm? Would it matter to the determination of the tax question whether
the law firm ordered the same meal for everyone who was working late or whether the
employees were permitted to select their meal from a menu provided by the restaurant?
- See § IRC 119. The meal is on premises and for convenience of employer. It is not
income.
o Convenience of empoloyer  substantial noncompensatory purpose. Reg 1.119-
1(a)(2)(i).
 Meals for both noncompensatory AND compensatory purpose STILL
excludable! Reg 1.119-1(a)(2)(i).
 See Reg. 1.119(a)(2)(ii)(a)-(d) for examples of convenience
 Emergency call; short meal period; employee’s inability to get
meals reasonably within meal period; food service/restaurant.
3. The same facts as those stated in Question 1 except that Jessica is not required to work
late, but she does so voluntarily. The firm reimburses its employees for supper costs
incurred on days when they work late on projects that are subject to time constraints. Are
the reimbursements income to Jessica?
- This is probably not income. KAHN thinks that the meal can be SELF IMPOSED by the
employee as well as ORDERED by the employer.
o The fact that the employee may accept or decline such meals is not taken into
account. See IRC § 119(b)(2).
4. Peter is an officer of Joy Unlimited, Inc., a toy manufacturing company. In December,
2000, Joy Unlimited and Peter came to an agreement concerning his salary for that year
and for future years. Joy agreed that Peter was to receive his salary free and clear of any
federal income taxes. To accomplish that, Joy agreed to pay to the Internal Revenue
Service any federal income tax that Peter incurred because of his salary. Peter’s salary for
the calendar year 2000 was $350,000. Peter had almost $70,000 of other income in
addition to his salary. The federal income tax on the salary he received from Joy was
determined to be $95,000. Peter filed his tax return for the year 2000 on April 14, 2001,
and he enclosed a check drawn by his employer, Joy, in the amount of $95,000 plus
Peter’s own check for the additional amount of federal income tax that he owed. What
was the tax consequence of this transaction to Peter?
- Since there is no exception to cover this income, Peter must include include it for tax year
2001. He would pay tax on this in 2002. This would end up causing pyramiding income
(paying the tax on the taxable income year after year). The SCOTUS in a case like this
(Old Colony) decided to decide later. KAHN thinks this is wrong. SCOTUS should
have said “we don’t care whether it pyramids” – IT’S INCOME!
o Side notes
 Tax rate insurance
 Suppose you get reimbursed for tax. KAHN thinks this is not
income. But, insurance contracts usually have a rider to pay extra
for the extra tax to compensate for pyramiding.
 If the tax from paying all at once and pyramiding are the same,
you’re better off pyramiding.
5. Sarah Thomas hired a domestic maid to clean her house, cook meals, wash, iron, etc. In
addition to a regular salary, Sarah provides meals for the maid during the period that she
is working at Sarah's home. Are these meals income to the maid? Would the maid realize
taxable income if Sarah provided breakfast for her when she arrived in the morning,
before she commenced work?
- The meals provided during working hours are excludable from gross income. § 119(a).
o For convenience? Yes.
o On business premises? Yes.
 Business premises  place where the employee works.
- The meals before work are probably income.
 o Meals immediately before or after work are generally not for convenience of
employer. Reg. 1.119-1(a)(2)
 There is an exclusion for meals immediately before work for food service
workers, Reg. 1.119-1(a)(2)(d), but Sarah probably does not qualify.
6. An historical society owns a house in Philadelphia that was once owned and occupied by
a former president of the United States. During the day, the house is open to the public.
The Society is concerned that if the house is left unoccupied at night, it will be
burglarized or vandalized. To prevent that from occurring, the Society employs Ralph to
live in the house at night. The Society permits Ralph to live in the house with his wife,
but he is required to be there only outside of the visiting hours. Outside of visiting hours,
Ralph and his wife can occupy any part of the house they wish, including the kitchen; but
during visiting hours, they are limited to a part of the house that is not open to the public.
Ralph receives no compensation for his services other than the use of the house. What are
the tax consequences to Ralph? To Ralph’s wife?
- Ralph and his spouse can live in the house without attributing it to his gross income
because he is required to live there as a condition of his employment. IRC § 119(a)(2).
o On business premises yes
o For convenience of employer?  yes. Facilitates work.
o Required for employment?  yes.
- Problem – is there any doubt in your mind that this is compensatory?
o Reg. 1.119-1 does not address this with lodging, but wrt meals, if there is both a
noncompensatory AND a compensatory purpose, it is still excludable from
income.
7. George is hired to be the manager of the Ocean View Apartments in Daytona Beach,
Florida. The employer requires George to live on the premises of the apartment complex.
George informs the employer that he is married, and that he has two young children (ages
2 and 4) who live with him and his wife. In addition, George’s mother-in-law also lives
with him, and so does his cat. The employer then offers to rent George a three-bedroom
apartment in the complex for a monthly rental of $300. Comparable apartments in the
building rent for $2,200 a month. The employer requires George to rent the apartment as
a condition of holding his job. George accepts, and he, his wife, two children, mother-in-
law, and cat all move into the apartment. George is paid a salary of $5,000 per month. In
addition, the employer pays George a cash allowance of $150 a month to pay for meals
for George and his family. What amount of gross income does George have because of
these transactions?
- Kahn thinks only $4700 is income.
o If you are charged an unvarying amount for meal or lodging, then it is not treated
as part of your compensation. See Reg. 1.119-1(b).
 THEN see if the value of the lodging is excluded altogether. Id
- Wife, dependent kids are excludable under IRC § 119(a).
o For dependents, see IRC § 152.
- The mother in law may or not qualify as a dependent depending on the facts. See IRC §
152.
 o If the mother in law is NOT a dependent, George would have to pay tax on her
living there. Regs. Under IRC § 61 discuss this. KAHN thinks it would be very
harsh for the IRS to tax George.
- The cat is like moving furniture. No tax.
- What about the $150?
o Employer must furnish the meals in kind. Since this is a reimbursement, this is
clearly income.
o If they were using the $150 to buy groceries, there is a SPLIT on this. It depends
on how narrowly or broadly the judge reads it.
o Look at Reg. 1.119  cash receipts for meals/lodging are income to the extent
that they are compensation.
8. The same facts as those stated in Question 7 except that the employer does not provide
George a cash allowance for meals. Instead, the employer permits George and his family
to take their meals at a dining room that is on the first floor of the apartment building and
is operated by George’s employer for the occupants of the apartments. Although other
occupants of the apartments pay a fee for the meals they receive in the Dining Room,
George and his family receive their meals without any charge. What is the tax
consequence to George and his family?
- IRC § 119 is a generous rule.
o The wife and children would probably be included because of the meals and
lodging provision read into the statute.
9. John Hill is a student at the University of North Carolina. He is employed at the school
cafeteria. John receives no cash compensation for his work but receives his meals free.
He is required to eat his meals in the cafeteria immediately before mealtime. The average
price of a meal is $5.75. What tax consequence to John?
- John’s meals are excluded because of the food service worker provision in Reg. 1.119-
1(a)(2)(d).
10. Steve is an employee at Corporation Inc.’s San Francisco office. Corporation Inc. offers
Steve a choice of benefits: (a) a monthly parking spot in downtown San Francisco
(normally the parking garage charges $150 a month for a monthly spot) or (b) $150 cash
per month. What are the tax consequences to Steve if he picks option (a) or option (b)? If
Steve chooses option (a), what are the tax consequences if Steve personally pays for the
parking spot and Corporation Inc. reimburses Steve for the payment?
- If steve picks the parking space, it is not income to him. See IRC § 132. It is under the
limit of $175/mo.
o There is an adjustment for inflation. IRC § 132(b)(6)
- If Steve is reimbursed, see IRC § 132(f)(3). This can be excluded.
- If Steve just takes the $150 and doesn’t park, he must report it as imcome. See IRC §
132(f)(4).
 PROBLEM SET #1.5

1. Al Slone owns a house worth $42,000. He is in need of cash and, after a series of sessions
with hard driving realtor Joe Babcock, he sells out to Joe for $34,000. What gain does Joe
recognize on his bargain purchase?

- Joe does not realize any gain

o Is this disguised compensation? NO! they are dealing at arm’s length. There is
no reason why Al would compensate Joe. Joe takes this with a basis of $34k. If
people are operating at arm’s length, whatever price they choose represents the
price of the property.
2. In 1992, Boswell purchased a home in the suburbs on 6 acres of choice land. He paid
$250,000 for the land and the home. The home itself was worth $150,000. In 2001,
Boswell sold off 3 acres to Carter for $100,000. Any gain to Boswell on his sale to
Carter?
- Rule: When a part of a larger property is sold, the cost or other basis of the entire
property shall be equitably apportioned among the several parts, and the gain/loss on the
part of the entire property sold is the difference between the selling price and the cost or
other basis of each part. The sale of each part is a separate transaction, and the
gain/loss shall be determined at the time of sale of each part. Reg. 1.61(6)(a).
o If the home was worth $150k, the land must be worth $100k, or $16,666 per acre.
Selling 3 acres of land for $100k with a basis of $50k is $50k in income to
Boswell.
o Think: if some land is worth more than other parts of land, you must apportion
the land equitably
3. Helen is a lawyer who specializes in divorce. Malcolm is a real estate agent. Ralph and
Helen have been friends since childhood. In Year One, Helen decided to sell her home,
and she contacted Malcolm to represent her. The home was sold, and Helen offered to
pay Malcolm for his services. Malcolm refused payment, saying that they had been
friends for so long that he did not wish to charge her. Malcolm’s normal fee for selling a
comparable house would have been $14,000. Three months later, Malcolm and his wife
had a terrible argument and decided to divorce. Malcolm asked Helen to represent him in
the divorce, and she did so. The divorce became final in Year Two. Malcolm offered to
pay Helen for her services. Helen would have liked to charge Malcolm, but she felt
constrained not to charge him because of his refusal to charge her the previous year. Her
normal fee for the services involved in Malcolm’s divorce would be $20,000. Helen told
Malcolm that there was no charge for her services. What were the tax consequences of
these transactions to Malcolm and to Helen?
o Rule: If services are paid for in exchange for other services, the FMV of such
services taken in payment must be included in income as compensation. Reg.
1.61(2)(d).
  In year one, Helen realized income of $14,000, and in year two, Malcolm
realized income of $20,000.
 The question is “is this an exchange and not mutual gifts?”
 Malcom seemed to give a true gift. But, Helen felt constrained to
perform.
4. Robert and Susan have a 16 year-old son, Wyatt. They employ Wyatt to mow the lawn,
take out the garbage, and clean his bedroom. They pay Wyatt a weekly salary of $20 for
these services. In Year One, Wyatt earned $20 from his parents for each week of the year,
and he also earned $4,000 for part-time work he did at a local grocery store. What
amount of gross income did Wyatt have in Year One?
o $4,000 for grocery store.
o KAHN thinks the kid working at home would not be income. More like a gift.
 If in the form of a wage, does that substantively make it a wage?
 Just within the family, probably not. Kahn knows of no cases that
have taxed this.
o EXAMPLE: are married couples exchanging chores recognizing income?
 No.
 Measuring it would be ghastly
 One aspect is that marriage is like a joint enterprise. People are
sharing duties in a common goal.
 Nobody has ever written a suggestion that this is an exception, but
Kahn thinks it will be Reg’d.
o Income tax law is designed to regulate COMMERICAL
TRANSACITONS – some kind of professional activity.
 Illustrations
 We have X and Y living in an urban
environment and want to raise vegetables.
Each of them independently buys an area of
land in a suburb where there is vacant land
and they plant a garden. They have to leave
their home to go out there and garden.
Rather than each of them doing their own,
they take turns doing each other’s work.
o Technicically, this is an exchange of
services. But KAHN thinks this is
not taxable because it is not in a
commercial market.
 Babysitting situation  not a formal club;
just one neighbor exchanges sitting with
another neighbor. Clear to Kahn that these
are not compensatory exchanges.
o BUT if you are in a barter club and
it is formalized, it can be argued that
 it is a commercial activity which is
taxable.
5. During the period 1961 through 1975 Allen purchased corporate stock. Allen's office was
destroyed in a fire in 1999. Also lost in the fire were all of his records containing the
dates of purchase and cost of all of his corporate stocks, and these dates and costs cannot
be determined. In 2002, Allen sells all of the stocks. Does Allen realize any gain on this
sale?
o Yes.
 Taking an average might be very generous.
 Wouldn’t want to leave him with advantage, but at least give him
credit for some basis.
o How about taking the lowest price? KAHN doesn’t know
what they do for sure. KAHN thinks lowest.
 The tax law requires you to keep records. It puts the burden of proof of
basis on taxpayer.
 It would be harsh to say the whole thing is gain.
6. Buyer purchased an office building from Seller. Buyer paid Seller One Million Dollars
($1,000,000) for the building, but the terms of the sale permit Seller to occupy the
building, rent free, for four years. The fair rental value of the building is $150,000 per
year. What are the tax consequences of this transaction to Buyer and to Seller?
o To Buyer
 Nothing?
o To Seller
 Seller is taxed on FMV of rental value at 150,000 per year. See Reg. 1.61-
6(a) – gain realized on the sale … is included in gross income, unless
excluded by law … includes intangible items (in this case, rent) ….
 (Sale – basis) for the building
o KAHN SAYS:
 ONE WAY TO LOOK @ IT
 We need to know the amount realized from the sale.
o The building must have been worth more than a million,
and Buyer won’t get to use it for 4 years.
 Let’s assume the building is worth 1,545,000. Rent for the
building for 4 years is worth 545,000. Buyer says I’ll pay you
1,545,000, but Seller wants to pay up front (present value – was
discounted from $600,000 to $545,000). Why bother exchanging
checks, let’s just sell for $1mm. Is that what happened here?
 Extra amortization? WHAT WENT ON HERE? CHECK.
 Then there was a prepayment of rent.
o Regs say prepayment of rent is income.
 Buyer has income there
  Concept of present value of money – pay tax
now and get it back over 30 years is not
equivalent.
 What about the seller? He is constructively paying rent of $550k
for use of 4 years. He can deduct this rent, but he has to amortize
it over a four year period. He’s converted the cash into an asset,
and has to amortize it over 4 years.
o This might be a better deal for the seller, a long term capital
gain which has lower rates.
 ANOTHER WAY TO LOOK AT IT
 You’re a seller, retain the first four years. You’ve sold a future
(remainder) interest in the property.
o In that case, he’d have to allocate this basis. Keep it on the
four year he retained, the rest of the basis would go on what
he sold, and then measure the baiss with that.
 Dramatic tax consequence realized.
o Lower basis, not as big a gain as using $1.5 million.
o Constructive rent = no ordinary deductions
 How decide which scenario to use?
o Look at the economic aspects of what actually takes place.
You might not fool people.
 PROBLEM SET #2

1. X negligently operated his automobile which resulted in Y’s suffering physical injuries.
Y sued X for damages. In a decision by the trial judge (sitting without a jury), Y obtained
a judgment for $1,650,000, which was the total of the specific amounts listed below. X
paid Y the amount of the judgment. What amount of the payment to Y is included in Y’s
gross income?

$325,000 for wages that Y did not earn prior to the judgment because of her injuries
$600,000 for future wages that the court determined Y will not earn because of her
injuries
$400,000 for pain and suffering
$200,000 for emotional harm that Y suffered
$125,000 reimbursement of Y’s medical expenses
$1,650,00 Total amount of award
0

o The scope of inclusion of 104(a)(2) is very broad. The following would be

excluded from GI:
 Lost wages ($325k) and lost future earnings ($600k)
 Pain and suffering ($400k)
o These are debatable:
 Reimbursement for medical expenses  were these deducted in the prior
tax year?
 Emotional harm  did it stem from the physical harm?

o KAHN SAYS:
 What about the wages? How justify not taxing this?
 Not usually gonna be verdict broken out like this. Usually get a
lump sum. Harsh to not tax lump sum, but not here.

2. R owned an antique vase which had a value of $15,000. R’s basis in the vase was $4,000.
T negligently caused the destruction of the vase when it was being transported to a
museum to be displayed on a temporary loan. T’s insurer paid R $15,000 cash to
compensate for the loss of the vase. What amount of that payment is income to R?

o The income is $11k. Value ($15k) – basis ($4k) = $11k.

 KAHN SAYS
 Hard to find a particular provision that says to exclude basis, even
though it makes sense to do so. It’s not a constructive purchase.
 As long as R owned property similar to vase, he can avoid taxes.
IRC § 1033. We will get into this later.
 What if R insured the vase for $15k? Is he taxed on this?
 o No. There is nothing that says this though! It’s just
assumed.
 A lot of professors say he should be taxed

3. D was sued by P for physical damages caused by D’s negligent operation of an
automobile. The case was tried to a jury, and D requested the judge to give the following
two instructions to the jury. How should the judge rule?
(1) The judge should inform the jury that P will not have to pay any federal
income tax on any of the damages they award to P.
 Too broad – should explain that it is not included in income for physical
injury.
 This also might make the jury award less. Why even say it at all?
 KAHN THINKS
 Everyone should get the same instruction
o

(2) In determining the amount of income P lost because of his injuries, the jury
should take into account the amount of income taxes that P would have paid on
that income, and only the net amount remaining after payment of taxes should be
awarded to P.
 No, courts don’t do this.
 It’s not really compensating for lost wages – it’s just a proxy for
the loss.
 Why should we take the tax exclusion which was intended to the
benefit of the injured party and give it to the tortfeasor?
o Counter: maybe state law does not care about this. This is
federal law.
 In real life, there has been a division of results
o Last time KAHN looked …
 28 disallowed evidence of wages and taxes
 6 allowed it
 There is a SCOTUS case on this.
o Involved FELA and tort injuries to railroad employees.
o SCOTUS said tell jury not taxable
 Required that allow evidence in determining wages
o Federal courts since then have said this is limited to the
FELA
 Some say it depends on TP’s bracket

4. M sued Q for employment discrimination. M obtained a judgment for $300,000

compensatory damages and $600,000 punitive damages. The compensatory damages
were for lost income and for emotional harm and mental stress. What amount of that
award is included in M’s gross income when paid?
 o All of it.
 Discrimination is not a physical injury, IRC § 104(a) does not cover it.
 The 1996 amendments to § 104(a) make nearly all punitive damages
taxable, and the wrongful death exception does not apply here.
o If she got medical care, as long as not in excess to medical PAID.

5. Z sued K for personal defamation because of statements that K had made about Z’s moral
character. Z obtained a judgment for $25,000 compensatory damages and $500,000
punitive damages. What amount of that award is included in Z’s gross income when
paid?

o All of it.

6. Larry was physically injured by David’s negligent operation of an automobile. Larry sued
David for damages in tort, and Larry’s complaint listed the following request for
damages:

$200,000 Loss of income due to the injuries (20%)

$300,000 Emotional harm and pain and suffering (30%)
$100,000 Medical expenses incurred (10%)
$400,000 Punitive damages (40%)
$1,000,00 Total damages requested
0

Larry and David settled the law suit by David’s paying Larry $400,000. The settlement
did not state how much was paid for the several items for which Larry had requested
damages. How much of that $400,000 settlement is included in Larry’s gross income?
o If no allocation is made in a settlement agreement, the payment will often be often
be allocated in the ratio requested in plaintiff’s complaint.
 40% of $400k = $160k
o Emotional harm and pain and suffering is debatable
 30% of $400k = $120k
o KAHN SAYS – kind of off topic …
 Medical e expenses might be taxed; punitive damages are clearly income.
 The code, in § 104(a) says, not in excess of deductions ALLOWED under
§ 213 for medical expenses, uses the words allowable and allowed as
terms of art. We need to be very careful with these.
 Allowable  permissible
 Allowed  a deduction was taken
 Suppose he took a deduction for medical expenses and had no income.
 100K in medical expenses and 0 income.
o He could file a return to show the deduction; he wouldn’t
save anything.
 
If he had 80k in income and 70k in deductions apart from the
deductions …
o He only would have been able to deduct 10k for medical.
 So do we only deduct that part for which he took the benefit, or
does it not matter?
o KAHN SAYS – about this problem …
 Use the ratio in the complaint
 40% of 400k = $160k
 This is similar to what happened in Glenshaw
 Might say – they asked for $600 compensatory and only got $400, so they
only got compensatory. They never even got all the compensatory
 Another possibility – PROVE to me what your compensatory damages
are.
 Court will make a determination
o This is most expensive and cumbersome; generally not
done.
 1 or 2 cases involving anti-trust awards
7. Wilma was seriously physically injured by George’s negligence. Wilma obtained a
settlement from George for the damages she suffered. Wilma’s husband, Harold, sued
George for the damages Harold incurred as a consequence of the injuries that Wilma had
suffered. Harold obtained a judgment against George for $250,000 for loss of consortium,
and another $100,000 for the emotional harm that Harold suffered because of Wilma’s
injuries. George paid the judgment. How much of the payment to Harold is included in
Harold’s gross income. If any part of the payment is income, should it be included in
Harold’s gross income or in Wilma’s?
o Damages received by an individual for loss of consortium due to the physical
injury of a spouse are excludable from gross income even if they are not the ones
injured. PLR 200121031.
 In this case, $250k would be excluded from Harold’s income.
o Emotional damages are also excluded in the gross income because they are a
derivative of the wife’s injury.
 Weird but true.

o KAHN SAYS …
 His own reaction is that it should NOT cover this.
 PLR 2001121031
 Two different kinds of suits
o Survivorship
 Sue on behalf of plaintiff FOR death
o Wrongful death
 People who suffered loss BECAUSE of death
 e.g. loss of consortium
 letter ruling says this is ALL excludable from GI
  rememeber, be cautious to the weight you give PLRs. If not
coming from Washington, even more suspect.
 ANSWER: This will be excluded. Maybe not great policy, but given the
conference committee report, but it policy might be headed this way.
 Emotional harm?
 This is allowable too. Same basis as consortium.
8. F obtained a judgment for compensatory damages against Z for physical injuries F
suffered as a consequence of Z’s negligence. The award included $15,000 for interest on
the amount of the judgment computed as interest from the time that the complaint was
filed until the judgment was entered. An award of that type is sometimes called “pre-
judgment interest.” Is the pre-judgment interest excluded from F’s gross income? Would
interest payable on the judgment for the period between the entry of the judgment and the
time when Z makes payment be excluded from F’s gross income?
o Pre-judgment is not excluded.
o All interest is taxble

o KAHN says …
 Look at IRC § 104.
 Gross income does not include the amount of any damages recived
on account of personal physical injury.
 If we didn’t get the injury, we wouldn’t have gotten the interest.
 But hey, it’s income.
9. Your client has a tort claim against X Corporation for a physical injury she suffered from
the negligence of an employee of X. The parties have agreed that X is liable and that the
amount of your client’s actual damages total $500,000. This figure includes $65,000 in
medical expenses, none of which has been deducted by your client. Your client’s other
income places her in the 35% marginal tax bracket (the top tax bracket for an individual),
and so any income she recognizes from payments she receives from X or from the
investment of such payments will be taxed at a 35% rate.
X has offered your client a choice of: (1) receiving a lump sum of $500,000 cash, or (2)
receiving annual payments of $66,000 for the next ten years. Your client is satisfied that
$500,000 is a good figure for settlement. Your client has told you that if she accepts the
$500,000 lump sum settlement, she will invest that amount with an insurance company to
purchase an annuity for a ten-year period. The annuity provided by the insurance
company will earn income at a 7% rate, and so your client would receive approximately
$71,250 each year for 10 years. Your client has complete confidence that X can and will
make the annual payments of $66,000 if she should choose that option, and so risk of
nonpayment is not a factor in making her choice.
Which of the alternatives that X has offered your client would you advise your client to
take?
o Take the installments.
  The $500k is not taxed, but
o KAHN SAYS …
 Take the annual payments.
 Buying the annuity, against the 71k, need to deduct 50k. income of 21k @
35% rate. This comes out to be a little to be 7400 yearly in taxes. She’d
get less than 66k a year if she went this way.
 Total is around 22k less than if she took the yearly payments.
 Of course, this all depends on the 66k being interest free.
 In real life, this might happen.
o Relying on § 104(a)(2)  damages, whether as lump sums,
or periodic payments …
10. Martha was employed by the Ellsworth Corporation. Martha’s supervisor frequently
made lewd comments in her presence and made proposals to her of a sexual nature.
Martha filed numerous complaints with her employer about the behavior of her
supervisor, but the company took no action. One day, the supervisor pinched Martha’s
buttocks. The pinch caused a minor bruise that remained for a few days. Martha sued
Ellsworth for permitting the sexual harassment to have continued to take place. The court
awarded Martha: $1,000 for the bruise she suffered, $600,000 for the emotional distress
that the incident caused, and $2,000,000 punitive damages. Ellsworth paid the award to
Martha. Is all or any part of Martha’s award taxable to her? If the pinch had not caused a
visible bruise, what part of the award would be taxable to Martha?
o Only damages relating to the pinch are excluded from GI.
 $1000  bruise itself
 Bruise does not matter
 $600k  need to know which % of distress actually caused by pinch and
not other factors
o $2 mm in punitive  include in GI; taxable.
o KAHN SAYS …
 Damages not stemming from the pinch should be taxable.
 See Schlier case.(SCOTUS)
o doesn’t matter that the same act caused the personal
injury and loss of income having nothing to do with injury.
 How do you apportion this? Particularly because the problem is a
continuum.
 Service will not rule on this.
 PLR is worth talking about
 Touching before pain is excludable
 The PAIN incident is what troubled Kahn.
o Service left this open.
 KAHN ASKS is pain enough? Interesting question.
They imply that it is. They mentioned extreme pain
2x in the ruling.
11. The same facts as those stated in Question 10 except that Martha and Ellsworth settled
her suit. Assume again that Martha had suffered a visible bruise from the pinch. The
settlement agreement provided that Ellsworth was to pay Martha $2,500,000 as
compensatory damages for her physical injury and emotional harm. The settlement
agreement expressly states that no amount is to be paid to Martha as punitive damages.
Ellsworth paid Martha the amount that the settlement required. Is any part of the amount
that Martha received from Ellsworth taxable to her?
o Probably taxable
 No punitive might be shady, commissioner might elect to redetermine
allocation.
 This is at the commissioner’s discretion
o KAHN SAID
 Court might not accept this
 Appears to be excessive compensatory
 By and large the court will accept a settlement at arms length
o Problem here is that defendant did not have anything at
stake, and to plaintiff it makes a lot of difference.
 PROBLEM SET # 3

A “net operating loss” is a term of art and refers to something other than a net loss. See IRC
§ 172. In answering the questions in Problems # 2 and # 3, assume that no net operating
loss carryover is available.
1. D owed a business debt of $20,000 to M. In Year One, M determined that the debt was
not collectible, and M claimed and was allowed a bad debt deduction of $20,000 on his
tax return for Year One. The marginal rate at which the $20,000 that was reduced by that
deduction would have been taxed was a 25% rate. In Year Ten, D sold the rights to an
invention he had created that year for several million dollars. Being then able to repay the
debt to M, D repaid the debt of $20,000. If the $20,000 that M received from D in Year
Ten is included in M’s income, it will be taxed at a marginal rate of 35%. How should the
$20,000 payment to M in Year Ten be treated for income tax purposes? If the statute of
limitations on D’s debt expired before Year Ten, but D voluntarily repaid the debt
anyway, how should the repayment be treated for tax purposes?

o If the $20k is paid back in year 10, D must include it in GI in year 10, even if it
will be taxed at a higher rate.
 Gets taxed $7k.
o The SoL is not determinative of when a debt is uncollectable, should still be
reported.

o KAHN SAYS
 The SoL may have run on amending the return – he would have rather
done this and pay at 25% than pay at 35%
 The answer would be the same regardless of the SoL
 This was a court-made rule. Courts were faced with this problem – they
had no authority to tell TP to amend return if SoL had run. Congress
codified this in § 111.
 Two issues  gratuitous recovery?
 Detached and disinterested generosity?
o Is this sufficient to supplant TBR?
 Commissioner ruling said NO.
 KAHN thinks not gratuitous recovery
o This person feels obliged to repay debt. People do repay
loans on which SoL has run.
 They might want to borrow again in the future
 So long as the payment is traceable to the payment of the debt, this
is a repayment of the debt, and lender has to recognize it as
income.
2. In the year 2002, Rick and his spouse, Marie, filed a joint income tax return in which they
correctly reported adjusted gross income of $22,000. Rick and Marie were not entitled to
any tax credits for that year. On their joint return for that year, Rick and Marie claimed
and were allowed three exemptions for which they properly took a deduction of $9,150.
In addition, Rick and Marie claimed and were allowed an itemized deduction of $15,000
for a real estate tax payment they made that year. The basic standard deduction for the
year 2002 for married taxpayers was $7,950. Since their itemized deductions were greater
than the basic standard deduction, Rick and Marie elected to itemize their deductions
rather than to use the standard deduction.
Rick and Marie had objected to the local taxing authority that the $15,000 real estate tax
levied against them in 2002 was excessive. They had paid that tax under protest and
appealed. In 2004, the appeals board agreed that the 2002 real estate tax that was paid by
Rick and Marie was excessive and ordered that a refund of $5,000 be paid to them. The
refund was duly paid in 2004. Rick and Marie filed a joint income tax return for the year
2004. How much of that $5,000 refund is included in Rick and Marie’s joint income for
2004?
o $22k – $9150 (exemptions) - $15k (itemized real estate tax deduction) = - $2150.
 -$2150 + $5000 (refund)= $2850 included in GI

o KAHN SAYS
 You have a choice:
 All itemized deductions
 Standardized deductions
 Pick the one that adds up to more money to pay less in taxes.
 Of the deduction, they didn’t get a benefit of $2150. They didn’t get
anything back from the government.
 Another way to deal with this
 They got back $5000, and in effect, their real estate tax would be
$10,000
 What would taxable income be if $10,000 instead of $15,000?
o It would have been $2850.

3. The same facts as those stated in Question 2 except that the amount ordered by the
appeals board to be refunded to Rick and Marie in the year 2004 was $10,000, and that
amount was refunded to them. How much of that $10,000 refund is included in the joint
income of Rick and Marie?

o KAHN SAYS
 In this case, they could have taken the standard deduction. They took the
itemized because of $15k in tax. Now, we’re down to $5k in tax, and now
they would have taken the standard deduction.
 22k (gross income) – $9,150 (exemptions) – $7950 (standard deduction
for married couples) = 4900.
 $4900 in income; $5100 is excluded.
4. In Year One, Penny made a gift of unimproved land to the Beth El temple. At the time of
the gift, the land had a value of $120,000, and Penny was allowed a charitable deduction
of that amount from which she obtained a tax benefit. Penny had a basis of $30,000 in the
land, and she had held the land for more than 15 years. Penny gave the land to the temple
to permit the temple to construct a building thereon to be used for the religious education
of children. In Year Three, the temple abandoned its plan to build a new school building.
The temple than returned the land to Penny. The land had a value of $100,000 when it
was returned to Penny. Seven months later, Penny sold the land to an unrelated party for
$105,000. What were the tax consequences of the return of the land to Penny and of
Penny’s sale of the land to the unrelated party?

o Return of land
 It is unsettled whether she would have to include the $120k or only the
$100k in her year 3 income.
o Sale of land to unrelated party
 Penny gets income of 75k
 $105k (value) – $30k (basis) = $75k

o KAHN SAYS
 In some kinds of charitable contributions of property, you can deduct the
FMV, not just the basis.
 Conditions
 None listed here.
 Hillsboro said that if the event is fundamentally inconsistent, the TBR
applies.
 But partly what Hillsboro said was – we’ve got an annual
accounting system. We can’t see if she’s going to get the land
back – we’ll give her a deduction. We need something to
recognize that the transaction turned out differently.
 Part 1
 Let’s assume it’s $100,000.
o What’s her basis?  no court has discussed this.
 There is a regulation § 1.83-6.
 KAHN thinks that the basis should be $30,000.
 What do you do with the fact that she has 20k left in
deduction that in come?
 KAHN thinks she should NOT take it 20 out
of the basis. The deduction was based on
FMV, not basis.
 This is like a gift to charity.
 Part 2
 How long did she hold the property?
o Probably as long as she actually held it. We can probably
tack the prior period on the 7 months. To do otherwise
would circumvent the TBR.
 PROBLEM SET # 4

1. Assume A purchases stock for $2,000 and gives the stock to his daughter, D, at a time when
the fair market value of the stock is $4,000. How much gain or loss (if any) is recognized by
D on a sale to an unrelated person for the following amounts?

- For purposes of determining a donee’s gain on donee’s subsequent disposion of donated

property, the donee’s original basis is equal to basis donor had at time of transfer. IRC
§ 1015.
- For purposes of determining donee’s loss on subsequent disposition of donated property,
donee’s original basis is lessor of
o Donor’s basis @ time of transfer
o FMV of donated property on date of transfer.

a. $10,000
o Gain of $8k
b. $3,000
o Gain of $1k
c. $1,000
o Loss of $1k (using $2k basis instead of FMV)

o KAHN SAYS …
 a) gain of 8k
 b)

2. Assume B purchased stock for $5,000 and gave the stock to her son, S, at a time when the
fair market value of the stock was $2,000. How much gain or loss (if any) is recognized by S
on a sale to an unrelated person for the following amounts?

a. $10,000
o Gain of $5k ($10k value - $5k basis)
b. $3,000
o Neither gain nor loss. See Kahn § 2.4232.
 No gain because basis was $5k.
 KAHN SAYS
 When in between bases, no gain or loss
 Congress did not want one TP to be able to transfer to another
another that was already built in in the hands of the first.
o Didn’t want to transfer deductions.
o But we can transfer gains. This has potential for abuse
also.
 Giving gift to donee in lower tax bracket to avoid
paying more in taxes.
c. $1,000
 o $1000 loss ($1k value - $2k FMV at time of transfer)
3. In Year One, A paid $100,000 to purchase 1000 shares of X stock. In Year Ten, A made a
gift of the 1000 shares of X stock to B. At the date of that gift, the fair market value of the
1000 shares of stock was $35,000. In Year Twenty, B made a gift of the 1000 shares of X
stock to C. At the date of that gift to C, the fair market value of the 1000 shares of stock was
$50,000. In Year Twenty-Four, C sold the 1000 shares of X stock to an unrelated person for
$30,000, which was the fair market value of the stock at that time. What is the amount of loss
that C recognized on that sale?

Year 24 (C
Year 10 (A Year 20 (B
sells to
Year 1 (A buys stock) gifts stock to gifts stock to
unknown
B) C)
person)
Basis $100k [$100k] [$35k] [$35k]
FMV $100k $35k $50k $30k

o In year 24, C sold stock to U.

 Basis in a gift shall be the same as it would be in the hands of the donor.
EXCEPT if basis is greater than FMV, basis shall be FMV. IRC §1015(a)
 See chart above.
 So, C’s basis was $35k, and he sold it for $30k.
o Therefore, $5k loss.
o KAHN SAYS
 In § 1015(a), we have to know WHICH gift.
 More natural reading is the gift from BC.
o Let’s reverse the figures to show why.
 At time A B, it was worth $50k
 When B  C, it was worth $35k
 Is this a $20k loss or a $5k loss?
 Spirit of the law suggests that we’d go with
$5k loss.
 So, the moral of the story is to use the last transfer available.

4. The same facts as those stated in Question 3 except that the person to whom C sold the stocks
in Year Twenty-Four was the sister of C. What amount of loss that C recognized on that sale
is deductible?

o See IRC §267(a)(1): no deduction allowed for any loss when exchanging property
within family. BUT WHAT IS RECOGNIZED? WHAT IS THE ANSWER?

5. Fred owned 500 shares of stock of the Widget corporation. Fred has a basis in those 500
shares of $80,000. Fred wished to dispose of those shares to his niece, Mary, but he was
unwilling to make a gift of the entire value of the stocks. Fred solved that problem by selling
the stocks to Mary at a bargain price (i.e., a price that was lower than the value of the stocks).
The difference between the value of the stocks and the amount paid by Mary constitutes a
gift from Fred. Determine the tax consequences to Fred and to Mary in each of the following
alternative circumstances.

a. Fred sold the 500 shares to Mary for $40,000. The fair market value of the shares at
that time was $100,000. Four years later, Mary sold the 500 shares to an unrelated
party for $60,000, which was its value at that time.

o Fred
 Did not realize a loss on the sale because on a bargain sale, you can
never realize a loss. Reg. 1.1001(e)(1).
o Mary
 Received a gift of $60k ($100k value - $40k purchase price Mary paid)
less $11k annual exclusion for gift tax purposes.
 $20k loss
 80 - 60
o KAHN SAYS
 Remember, under IRC § 267, nieces are not related persons.
 Under the regs, you don’t apportion basis between sale and gift
 Look at reg 1.1001(e)
 No loss is realized on such a transfer.
 The fact that M paid less than F’s basis should not change the fact that
she uses his basis!

b. Fred sold the 500 shares to Mary for $40,000. The fair market value of the shares at
that time was $120,000. Four years later, Mary sold the 500 shares to an unrelated
party for $100,000, which was its value at that time.

o Fred
 No gain or loss because he did not get more than his basis in a bargain
transaction.
o Mary
 Received a gift of $80k ($120k value – $40k purchase price) less $11k
annual exclusion for gift tax purposes
 Mary had a gain of $20k.
 100k value – 80k Fred’s basis. IRC § 1015.

c. Fred sold the 500 shares to Mary for $100,000. The fair market value of the shares at
that time was $180,000. Four years later, Mary sold the 500 shares to an unrelated
party for $160,000, which was its value at that time.

o Fred
 Has a gain of $20k because it is above his basis in a bargain transaction.
o Mary
 Her basis is $100k. See Reg. 1.1015-4(a)(1).
 Therefore, she has a gain of $60k.
 d. Fred sold the 500 shares to Mary for $10,000. The fair market value of the shares at
that time was $60,000. Four years later, Mary sold the 500 shares to an unrelated
party for $50,000, which was its value at that time.

o Fred
 Fred never realizes a loss on a bargain sale because we never apportion
basis.
o Mary
 Mary has a loss of $10k.
 Her basis is the donor’s basis ($80), but for loss, her basis is $60k.

6. A gave B stocks in 1976. A died in 1980. In 1981, B sold the stocks for $10,000. There is no
record or evidence of what A’s basis was in the stocks, but it is shown that he purchased
them sometime between 1940 and 1951. How is B’s gain or loss determined?

o Find and take the lowest figure on record – take all presumptions against the
taxpayer.

7. Your client, an elderly widower, desires to make a present of $20,000 to his son. Your client
has three different stocks, any one of which he is willing to use as the corpus of the gift. The
stocks have the following basis and fair market value:

Basis FMV
A Stock $30,000 $20,000
B Stock $15,000 $20,000
C Stock $20,000 $20,000

Which of the three stocks (A, B or C) should your client give to his son?
o Stock C. The son can turn around and sell it, and he will not have to include any
gain in his GI because the basis and the FMV are the same.

o KAHN SAYS
 Stock A
 A is a depreciated stock. Basis of 30, value of 20.
o Plusses
 If he holds the stock until death, the basis will step
down to the FMV.
 If son sells the stock for $20k, he won’t get any gain
or loss. The only way he would get gain is if it were
gaining up to $30k.
 Normally, you would not hold this stock to death.
Recognize the loss now.
o Minuses
  Stock B
 This is an appreciated property
o Positive
 Widower might be in a higher tax bracket
 Having son take the gain might be a lower
rate of tax.
o negative
 This stock wouldn’t be as good to give him because
he’ll have to pay tax on the gain of $5k.
o Normally, you don’t want to get rid of B because if
widower dies, the basis steps up.
 Stock C
 If he gives it to him now, he has a basis of $20k.
 Can’t have anything lost by it – if died then, basis is $20k.
 Only bad thing is lost opportunities on stocks a and b.

8. In Year One, Helen made a gift of Blackacre (unimproved land) to her husband, Ralph.
Helen had a basis of $100,000 in Blackacre, but its fair market value at the time of the gift
was only $75,000. In Year Four, Ralph sold Blackacre to an unrelated party for its then value
of $80,000. What was the tax consequence to Ralph of that sale?

o KAHN SAYS …
 Use rule IRC § 1041(b). When there is a gift between spouses, transferee
has transferor’s basis. Harod would use Helen’s basis of $100k.
 $100k basis - $80k value = loss of $20k

9. In Year One, Susan sold Whiteacre (unimproved land) to her husband, Paul. The fair market
value of Whiteacre was $190,000, and Paul paid that amount to Susan. In other words, Paul
paid Susan an amount equal to the fair market value of the property. Susan’s basis in
Whiteacre was $125,000. In Year Six, Paul sold Whiteacre to an unrelated party for
$300,000. What was the tax consequence to Susan of her sale of Whiteacre to Paul, and what
was the tax consequence to Paul of his sale of Whiteacre in Year Six?

o Straight up sale
 Susan
 No gain. IRC § 1041(a).
 Paul
 Gain of $175k ($300k FMV – $125k basis)
o Husband takes wife basis.
1.
 PROBLEM SET # 5

1. On five days a week, Franklin stands on a corner and begs for money. Franklin is successful
at this venture and collects over $40,000 per year. Are the amounts Franklin receives treated
as gross income to him?

o Yes. Under IRC § 61(a),gross income is income from any source derived.
Begging might be a business. IRC § 61(a)(2). See also Olk v. United States,
where “gifts” of casino tokes were deemed income to a casino card dealer
because of their regularity to the dealer and dealer’s anticipation of receipt. A
donor’s intent is not exclusive test for whether a transfer is a gift.

o KAHN SAYS …
 Moral obligation is too broad a term. Not really a great measuring stick.
 From the transferor’s perspective, this is probably a gift. From the
transferee’s perspective, it probably is not
 SCOTUS said in Duberstein that the intent of transferor
determines. But are there circumstances where a transferree’s
intent should be examined? KAHN thinks yes → Duberstein left
open the possibility that there are circumstances when this is
appropriate. Courts have never expressly done this. But in order
to carry out the intention of the donor, they have went into strange
constructions.
 The point is that this a professional donee.

2. Henry’s nephew, Dennis, told his family that he planned to drop out of college. To induce
Dennis to remain in college, Henry promised that he would give Dennis $40,000 if Dennis
would graduate from college. Dennis remained in college and did graduate. Henry fulfilled
his promise and gave Dennis $40,000. Is any of that payment included in Dennis’s gross
income?
o If it was really a gift, then no. IRC § 102(a).
 This is likely the case – made out of love/affection
o KAHN SAYS …
 The uncle promised the $40k because he wanted to improve the well-being
of the nephew. Isn’t this altruistic?
 He’s getting consideration for his money, but the consideration is
for the person getting the benefit.
 He can either give $1000 or create an obligation to give $1000.
o KAHN SAYS there is no difference here. Same effect. This
is a gift.

3. The same facts as those stated in Question 2 except that when Dennis graduated, Henry
reneged on his promise and refused to pay. Dennis sued Henry and obtained a judgment for
 the $40,000 which had been promised to him. Henry paid the judgment. Is any of the
payment included in Dennis’s gross income?

o KAHN THINKS this is a gift → see above. Collecting on the judgment is

collecting/enforcing the gift. This is weird, but this is what he said.

4. Paula received welfare payments from the State of Utopia to support her and her three minor
children. Are those payments included in Paula’s gross income? Would it affect your answer
if Paula received the payments under a welfare program in which the recipients of payments
are required to provide services?

o Welfare fund distributions are generally not gross income. Rev. Rul. 73-87.
o If Paula was required to provide services, this would not change the fact that the
welfare payments are excluded from her GI. See Rev. Rul. 71-425.

o KAHN SAYS …
 This is not a gift, although it sort of seems like one. This is a transfer
payment, but there is no statute that says this is excluded. Common law
excludes it. Remember, there is a fair amount of tax law that is court
made or out of administrative practice.
 You need to know more about the payments to decide excludability
 For need? Etc.

5. Hillary is a candidate for election to a federal office. A testimonial dinner is held to raise
money for her campaign. The dinner raises $450,000 which amount is turned over to Hillary
to assist in financing her campaign. What are the tax consequences to Hillary?

o They are probably not gifts and Hillary must include them in the GI of her
campaign fund. The diners at the dinner probably expect Hillary to act a certain
way if elected, thus the donors were not disinterested.
o KAHN SAYS …
 Not GI unless Hillary used the funds for her personal consumption
 If the money is not mixed with the personal funds → not income for
candidate. Treated just like a trust.
 Problems sometimes arise because politicians mix campaign funds for
personal purposes. They go to jail.
 What do you do with the leftover money?
 Hold it for the next campaign, or contribute it to a charitable
organization.

6. Randolph has worked for five years as an employee of his father in his father’s real estate
business. This year, Randolph married, and his father gave him a wedding gift of $150,000.
Is any of that amount included in Randolph’s gross income?
 o Probably not included in Randolph’s GI.
 Even though IRC § 102(c) suggests that it is income, Prop. Reg. 1.102-1(f)
(2) suggests that it isn’t.

o KAHN SAYS . . .
 Remember, proposed regulations are given some weight, but they are not
binding. A final regulation is not a statute, but is given a lot of weight
unless inconsistent. Proposed regs get considerably less weight.
 IRC § 102(c) directly clashes with this on its face. But distinguish it by
thinking of § 102(c) as prohibiting gifts from employers to employees in
their capacity as an employee – if he gets a gift in his capacity as a family
member, it’s OK
 TP has burden of showing that the gift has nothing to do with the
employment, and the burden “is extraordinary.”
o KAHN THINKS this is wrong. Suppose a parent gave a kid
an allowance, and the kid also works in the family
business. Is this extraordinary? No. What about
birthday/Christmas gifts? Extraordinary? No. That word
seems inappropriate.

7. Patricia worked as a domestic servant for the Hawthorne family for over 30 years. On the
death of Frances Hawthorne, she made a bequest of $50,000 to Patricia in appreciation of the
loyal service that Patricia had provided. At the time of Frances’s death, Patricia was still in
her employ. Is any of that bequest included in Patricia’s gross income? Would it affect your
answer if Patricia had retired two years before Frances died?

o The bequest is in her gross income. IRC § 102(c)(1).

 But what about the relationship they had?
o If Patricia retired two years before Frances died, it might change it because it
cannot be tied to performance or incentive. But KHAN THINKS this doesn’t
matter, and all I care about is what Kahn thinks.
o KAHN SAYS …
 Part 1
 There are a number of ways to approach an employer gift to
employee.
o Compensation for past service
o Encouragement to stay, work harder, whatever …
 In this case, the relationship as a domestic servant puts this one on
the line. It has a personal relationship. The proposed reg
suggests family, but does not require it.
 One of the issues is whether IRC 102(c) should apply AT ALL in
testamentary transfers.
 Look at the title of 102(c) – employee gifts. This clearly is
distiniguished from bequests and devices. Does this limit it?
 Part 2
  KAHN doesn’t think that 102(c) should be limited to current
employees.
 Can’t have a gift if the employer was an entity.

8. In 2004, Oprah Winfrey gave her audience free Pontiac automobiles. As reported by Fortune
Magazine:
Oprah Winfrey, one of the world's richest entertainers, surprised her fans
Monday by giving each of her 276 audience members a new car to
celebrate the premiere of her show's 19th season.
The billionaire talk show host told the audience that everybody will get a
new Pontiac G-6 midsize 2005 sports sedan. Winfrey screamed and
jumped up and down on the stage, shouting: "Everybody gets a car!
Everybody gets a car!"
Assume Oprah told the winners that not only do they get the cars, but they are tax-free since
they are gifts. As an IRS representative, briefly respond to Oprah’s statement.
- KAHN SAYS …
o If not from detached and disinterested generosity, why gift given? This is really a
form off advertising.
o Prize and award is generally taxable by statute.IRC § 74.
 PROBLEM SET # 7

1. Fred borrowed $5,000 from the Friendly National Bank. The terms of the loan provided for
adequate interest payments. Fred is not an employee or otherwise related to the bank. Is any
of the loan included in Fred’s gross income?

o It does not seem to be a gift, so it is not income.

o KAHN SAYS …
 There is an understanding that he will pay back the loan – not income.

a. Two years after the loan was made, the bank agreed to accept a payment of $3,000 in
satisfaction of the loan, even though Fred was solvent. The bank determined that it
was not worth the cost and difficulty it would incur in seeking to collect the full
$5,000 owed to it. What was the tax consequence to Fred?

o Fred has $2k in income. Fred was solvent, so there is no exception to the general
rule that GI includes income from discharge of indebtedness. IRC § 61(a)(12);
IRC § 108(e)(1).

b. The same facts as those stated in Question 1(a) except that the lender was Fred’s
father instead of a bank. What was the tax consequence to Fred in that case?

o In this case, it seems more like a gift. The 2k Fred saves should be considered a
gift, and is excluded from his income. IRC § 102(a).
o KAHN SAYS …
 Does this conflict with IRC § 61(a)? No.

c. The same facts as those stated in Question 1(a) except that the bank did not offer to
accept a lesser amount and no part of the loan was ever repaid. The statute of
limitations for a suit to collect the loan expired in June of Year Five. Did Fred
recognize any income, and, if so, in what year?

o In the absence of any indication that Fred intended to pay after the SoL expired,
an expired SoL is a discharge of debt. Fred is no longer liable for the debt, see
IRC § 108(d)(1)(A), so it has been discharged and the $5k is income for Fred in
year 5.

2. Martha purchased an oil painting from Rhoda, an art dealer. The price for the painting was
$40,000. Martha paid Rhoda $10,000 cash plus Martha’s promissory note in the amount of
$30,000, bearing adequate interest. Martha subsequently complained that Rhoda had made
false and misleading statements about the painting. Rhoda denied those claims. After some
negotiation and threats of litigation, Rhoda agreed to accept a new promissory note from
Martha in the amount of $15,000 in exchange for the original note on which $30,000 was still
 owing. The terms of the new note were identical to those of the original note except that the
face amount of the new note was a lesser figure. What was the tax consequence to Martha?

o Martha’s debt to Rhoda arose out of the purchase of the painting, so we use IRC
§ 108(e)(5). Since Martha is solvent, see IRC § 108(e)(5)(B), the debt can be
considered to be reduced. Thus, Martha’s debt is reduced in part, and not
included in GI.
o KAHN SAYS …
 This is an example of the transactional approach. There would be no
income, even though the deal was changed in a subsequent year. If
Martha is solvent, § 108(e)(5) is a specific application of the transactional
approach.
 Suppose Martha was insolvent when this took place, and remained
insolvent after debt was cancelled. We can’t apply IRC § 108(e)(5)(a).
What do you do then?
 Suppose Martha was insolvent by an amount of $5k. As a result of the
forgiveness, she is $10k solvent.
 If we go back to the insolvent exception, her exception is limited to
$5k. can (e)(5) apply to the $10k that is not covered by (e)(1)?
The language says the section does not occur when the purchaser
is insolvent. When is “when?” Congress didn’t think about it.
KAHN thinks the $10 should be excluded because it fits the policy
of what the statute was trying to achieve.
 Suppose Martha is disputing this, and then decides to sell the painting for
$30k. Martha claimed a loss of $10k upon sale. A year or two later she
settles with Rhoda, and they cancel the debt. Martha is solvent.
 If there was a gain on the sale, one could argue the TBR could
apply.

3. The Zion Baptist church of Willsboro initiated a fund raising campaign to obtain the funds to
build a new church. Rupert Walters made a written pledge of $35,000 to the church.
Subsequently, Rupert went to the officers of the church and asked them to reduce his pledge
to $10,000 because he had suffered significant business losses in the interim, although he was
solvent. Under local state law, a promise to make a contribution to a charitable organization
is enforceable by the charity regardless of whether the obligor received consideration for the
promise. Nevertheless, the officers of the church accepted $10,000 from Rupert and
cancelled the remaining $25,000 of his obligation. What was the tax consequence to Rupert?
Would it affect your answer to that question if the church officers had agreed to cancel
$25,000 of Rupert’s pledge because they were under the mistaken belief that they had no
right to enforce Rupert’s promise since no consideration was given for his promise?

o Even had he paid, Rupert would have later been able to deduct the donation, so
even though he was discharged of $15k worth of debt, there would be no income
to him. See IRC § 108(e)(2).
o No, it wouldn’t change my answer.
 o KAHN SAYS …
 One way to look at this – transactional approach. They just changed the
deal.
 If the church was confused and made a mistake… still no income.
 He didn’t induce them
 If there was fraud, maybe there would be income! This is just speculative.
 Inducing people to “give you money” – compare to fraudulently
inducing a loan with no intent to repay.

4. Rachel owns and operates a boutique retail dress shop in Columbus, Ohio. In Year One, she
bought a line of dresses from a French manufacturer for 4,000 Euros. She bought the dresses
on credit, and so she made no cash payment and owed the manufacturer the Euros. At the
time she purchased the dresses, 4,000 Euros were worth $6,000 in U.S. dollars. By March of
Year Two, the Euro had fallen in value as compared to U.S. dollars, and so Rachel was able
to purchase 4,000 Euros for only $3,000 in U.S. currency. Rachel then paid the 4,000 Euros
she had purchased for $3,000 to the French manufacturer in satisfaction of her debt. What
was the tax consequence to Rachel of this transaction?

o The $3k savings should be viewed as a reduction in price of the dresses

(inventory). The transactional rule applies in this case because the credit
element of Rachel’s purchase was an integral part of the purchase.
o Note: In English Shoe v. Commissioner, something exactly like this happened,
but the purchaser was taxed on the gain.

o KAHN SAYS …
 One issue is do you look at debt independently, or as a purchase money
debt tied to the purchase of the dresses?
 English Shoe Case
 TP purchases English shoes on credit, value of pound had fallen,
and then TP paid in cheaper pounds.
 Court said this would be income unless loss on whole transaction.
Since TP failed to prove that she had a loss on sales, it was
income. KAHN THINKS THIS IS TOTALLY WRONG
APPLICATON OF TRANSACITONAL RULE
o Does Not matter if loss or profit on sale.
o If debt is tied to transaction, what it should have done was
to reduce the basis.
 How reduce basis?
 Start out @ beginning of year and
determinie opening inventory. Then add cost
of purchases during the year. @ end of
year, determine closing inventory.
Diffrence is the cost of goods sold during
the year.
 Just subtract from the opening inventory the
$3k. this would reduce the cost of goods
 sold and increase income from the year by
$3k.

5. In Year One, Paul opened a gourmet restaurant in Grand Rapids, Michigan. Paul hired a
prominent chef for the restaurant and contracted to pay the chef a salary of $20,000 per
month. The term of the contract was 5 years. In its first two years of operation, the restaurant
did not produce the amount of income that Paul had anticipated. Consequently, Paul was
unable to pay the chef the entire amount of salary that was owing to him under the contract.
By the end of Year Two, Paul owed the chef $25,000 for wages that had not been paid.
Despite these disappointments, the chef was convinced that the restaurant would prosper in
the immediate future. In Year Three, Paul asked the chef to forgive the $25,000 of unpaid
salary, and Paul promised to meet the payroll thereafter. The chef agreed, and the $25,000
debt was cancelled in July of Year Three. Paul reports his income from the restaurant on the
accrual method of accounting, and the chef reports his income on the cash receipts and
disbursement method of accounting. What are the tax consequences to Paul of the
cancellation of the $25,000 debt in each of the following alternative circumstances?

o First, KAHN SAYS

 Cancellation would not be treated as a gift.
 Earlier Supreme Court case which said if creditor forgave a debt
because it thought it was the best thing it could do, it could be a
gift. This got repudiated. In a commercial setting, it is not a gift.

a. On his tax returns for Years One and Two, Paul had accrued and deducted the
$25,000 of unpaid salary, and Paul obtained a tax benefit from those deductions.

o When an accrual method taxpayer is allowed a deduction for an accrued but

unpaid expense, the subsequent discharge of that debt may cause TP to recognize
income under the TBR. See Kahn § 2.1280. There is no exception under IRC §
111 because Paul has derived a tax benefit.
o Another way to look at this – Paul has to pay tax on $25k because of the tax
benefit rule.

o KAHN SAYS
 If it HAD been a gift, would he have had to report it?
 There is no good reason not to tax this.
 Rev. Rul. ___ when interest was owing, and the debtor had accrued and
deducted unpaid interest, then forgave it as a gift.
 Ruling said TBR applies and they had income anything.
o KAHN SAYS probably wrong.
o Putoma said this was not income.
 When using salary as gift to corporation, employee should have income.
 But in 1980, congress gave it to the corporation in that limited
circumstance.
 b. In his tax returns for Years One and Two, Paul had erroneously failed to claim a
deduction for the unpaid salary.

o KAHN SAYS …
 Tax benefit rule deals ONLY with taking of deduction.
 You can go back to the transactional approach. The whole notion of
casuing income on CoD is that the debt gave rise to a benefit.
 This didn’t prevent any income and provided no benefit.
 The cancellation of the debt can be looked at as a change of the
salary of the chef.
o An argument against this is to say “he got the value of the
chef’s services at a bargain.”
 But if they agreed at the outset for this salary, there
would have been no income anyway!

c. In his tax returns for Years One and Two, Paul had taken deductions for the unpaid
salary, but Paul had obtained no tax benefit from those deductions.

o Same answer as above. IRC § 111.

o TBR applies in this case too.

6. In Year One, Sylvia borrowed money from the Friendly National Bank. The debt was not
secured, but Sylvia was personally obligated to repay it. At the beginning of Year Four, the
unpaid balance of Sylvia’s debt to the bank was $60,000. Sylvia had no other debts. The only
assets that Sylvia had were $23,000 cash and an acre of unimproved land with a fair market
value of $12,000. Sylvia’s basis in the land was $28,000. Sylvia had no net operating losses
or capital losses in Year Four, and she had no loss carryovers to that year. In March of Year
Four, the bank cancelled $50,000 of Sylvia’s debt in exchange for Sylvia’s payment of
$20,000 cash to the bank. Thus, the bank forgave $30,000 of the debt. After that payment,
Sylvia had $3,000 cash, and the unimproved land; and the outstanding balance of her debt to
the bank was $10,000. What was the tax consequence to Sylvia of the cancellation of
$30,000 of her debt? As of January 1 Year Five, what basis does Sylvia have in the land that
she owns?

Assets Liabilities Notes

23 (cash) 60 (unpaid debt)
12 (land’s FMV)
35 60 -25 (insolvent)
3 cash (paid 20 to bank) 10 (bank forgave 50)
12 (land’s FMV)
15 10 5 (solvent)

o Tax consequence to Sylvia

  Insolvency is determined by [FMV of assets – liabilities]. IRC § 108(d)
(3).
 In this problem, before the debt was forgiven, Sylvia was insolvent
by 25k.
 Since Sylvia is insolvent by $25k, the amount of the forgiven debt shall not
be income, IRC § 108(a)(1)(B), but the amount excluded shall not exceed
the amount by which Sylvia is insolvent. IRC § 108(a)(3).
 Sylvia was forgiven $30k, but was only insolvent by $25k.
Therefore, she should include $5k in taxable income.

 KAHN SAYS
 § 108 is a codification of common law
o If you cancel debt of insolvent debtor, and still insolvent →
no income.
o Then, a case came along when someone became solvent,
and they did what § 108 does.
 Why not have income because insolvent?
o We tax insolvent people on wages …
o Reason given is not convincing.
 Go back to Kirby Lumber → no increase in net
worth.
o KAHN THINKS that there is a disincentive to the creditor
to forgive the debt if she was taxed on it. If the whole idea
is to get the person recovered so a business relationship
can be continued, getting them further in debt via taxation
would be a deterrent. This is not out of sympathy; we want
to encourage fresh starts.

o Basis in Sylvia’s land

 When an amount is excluded from GI under IRC § 108(a)(1)(A)-(C), that
amount shall be applied to reduce the tax attributes of TP in the order as
provided in IRC § 108(b)(2). The first thing available to reduce is basis
of property. The statute redirects us to IRC § 1017(i). IRC § 1017 says
that the reduction in basis shall not exceed the aggregate bases of the
property held by TP immediately after discharge over the aggregate of the
liabilities of TP immediately after discharge. IRC § 1017(b)(2).
 Aggregate bases of property (her single property!) = $28k
 Liabilities = 10 – 3(assets) = 7 in total liabilities
 $28k - $7k = $21k. This is the maximum amount by which we can
reduce the basis.
 $28k basis – $21k reduction = $7k new basis.

 KAHN SAYS …
 Remember “next taxable year” clause!
 Basis of her property was 28k
 o The $3k cash she had left was included in the basis.
o Basis = 31k
 Liability = 10k
 We can reduce as much as $21k
 Therefore, new basis of $7k
 PROBLEM SET # 8

1. In Year One, George had taxable income of $80,000. George’s marginal rate of federal
income tax for that year was 30%, and $25,000 of George’s taxable income was taxed at
that 30% marginal rate. George’s total federal income tax for Year One was $18,000.
Consequently, the average rate of George’s tax for Year One was 22.5%. Part of
George’s $80,000 taxable income was a commission of $25,000 that George received that
year from his employer for sales that George initiated.
In Year Four, George’s employer discovered that George had received commissions for
sales that should have been credited to another employee. After some negotiations,
George and his employer agreed that George should have received a commission of only
$10,000 in Year One, and George returned the excess $15,000 to his employer. The
overpayment to George created a debt that he owed to the employer, and the statute of
limitations for repayment of that debt had not expired when George repaid the amount to
the employer. In Year Four, without taking the repayment of the commission into
account, George had taxable income of $40,000. $30,000 of that income was taxable at a
federal income tax rate of 15%, and the remaining $10,000 was taxable at a 20% federal
income tax rate. What was the tax consequence to George of the repayment of $15,000 of
the Year One commission? Would it effect your answer if the statute of limitations on
George’s obligation to repay the $15,000 had expired before the employer discovered the
error, but George had nevertheless repaid that amount?
o George make a deduction in year 4 because he did not have an unrestricted right
to the $15k of income in year 1. IRC § 1341(a)(1)-(3). The tax imposed for year
four will be the lesser of …
 [The tax for the taxable year computed with the deduction]. IRC §
1341(a)(4)
 Deduction
o George will deduct tax payable on $15k (the overpayment
from year 1.) Remember to calculate the tax payable in
different tax brackets! Start off with the highest bracket
and work your way down.
 ($10k * 20%) + ($5k * 15%) = $2750 deduction.
 Tax Payable for year 4
o ($30k * 15%) + ($10k * 20%) = $4500 + $2000 = $6500
in tax payable
 Total
o $6500 tax payable year 4 - $2750 deduction = 3750 total
tax payable

OR
  [Tax for taxable year without deduction] – [decrease in tax for the prior
taxable year which would result solely from the exclusion of such item
from gross income for the prior taxable year]. IRC § 1341(a)(5).
 Tax for year 4
o [$30k * 15%] + [$10k * 20%] = $4500 + $2k = $6500.
 Year 1 Tax on overpayment to be deducted
o 15k * 30% (marginal tax rate) = $4500
 Total tax payable for year 4
o $6500 (year 4 tax) – ($4500 decrease in tax from year 1))
= $2k tax payable.
 Thus, GEORGE MUST ELECT 1341(a)(5).

o George might be restricted in the fact that he wants to keep his job, thus 1341
might be applicable even though the SoL is expired. It all depends on how
broadly 1341 is read.

o KAHN SAYS …
 Note: (a)(4) and (5) are not electable
 The first one is 2750. Check this out!!!!
 Remember the difference between a deduction and a credit. The amount
excluded from year 1 will be credited in year 4.
 How determine tax in year 1
 Look at marginal rate. Look at tax you owe reported in year 1.
Take out the …
 30% marginal rate. If you took 15k out, it would all be at that rate.
 4500
 If he takes the deduction in year 4, he will rduce tax liability by
2750. If he uses a5, he has a lower tax than a4.
 If this was a large capital gain, it will have to be characterized as income
 [BUT WHAT ABOUT THE AVERAGE TAX RATE? WHY IS THIS IN
THERE?]

2. The same facts as those stated in Question 1. George’s employer was in a marginal
federal income tax bracket of 30% in Year One, and she was in a marginal federal
income tax bracket of 50% in Year Four. The employer did not pay the other employee
the $15,000 of commission owing to her until Year Five, and since the employer used the
cash receipts and disbursements accounting method, she got no deduction for that
payment until Year Five. What was the tax consequence to the employer from receiving
the return of the $15,000 of George’s commission in Year Four?

o KAHN SAYS …
 1341 does not apply to employer. This is an example of the tax benefit
rule. This is harsh, but he has to pay the tax on it.

3. The same facts as those stated in Question 1 except that in Year One, George’s
deductions were so large that he had a net loss of ($20,000) for that year, and his tax
 return showed a net loss of ($20,000). George’s loss did not constitute a net operating
loss or a capital loss, and so George could not carry the loss forward or back to other
taxable years. Consequently, if George had not received the $15,000 of commissions that
were erroneously paid to him, he would have reported a loss of ($35,000) on his tax
return for that year, but there would have been no effect on his tax liability. What was the
tax consequence to George of repaying the $15,000 to his employer in Year Four?

o KAHN SAYS …
 At the moment, this is undecided.
 There is little decided about the “converse tax benefit rule.”
 One decision allowed the deduction, and the government acquiesced. The
little authority there is on this issue allowed it. Don’t be too confident
about the strength of this because it is not evidence the court considered
the issue carefully.

4. The same facts as those stated in Question 1 except that the amount of commission that
was erroneously paid to George in year one was only $2,000. In Year Four, George
repaid to the employer the $2,000 of commissions he had erroneously received in Year
One. What was the federal income tax consequence to George of making that $2,000
repayment?

o KAHN SAYS …
 1341 does not apply. Minimum amount is $3k.
 You can still get the deduction
 A ruling by the service allows this.
 In the state …
o In (a)(2), it indicates there is a deduction existing under
1341 itself
o In 1341(b)(3). there is a provision that if you use (a)(5),
indicates that there must be a deduction existing outside
1341 which indicates you can take it, or else there would
be no reason for this provision.
 Itemized deduction
o Employee business expense
o § 67 – miscellaneous itemized deduction?
 Check (b)(9) – excludes 1341 deductions. But here,
in this problem, 1341 DOESN’T apply. So is it
allowed to be a miscellaneous deduction? KAHN
ISN’T SURE. HE THINKS that the 2000 ought not
to be miscellaneous

5. Mary Walters is the sole proprietor of a wholesale business that is engaged in selling
appliances. In Year Two, one of Mary’s customers was overbilled by $6,000 because of a
clerical error of an employee of Mary’s, and the customer paid that bill. In Year Four, the
customer discovered the error, requested Mary to return the $6,000 overpayment, and
Mary did so. Mary was in a marginal federal income tax bracket of 50% in Year Two, but
 she was in a marginal federal income tax bracket of 30% in Year Four. What was the tax
consequence to Mary of returning the overpayment?

o IRC § 1341 does not apply to the return of an overpayment received as a

consequence of clerical error. See Rev. Rul. 68-153; Kahn § 13.4323.
 Rationale → taxpayer had an unrestricted right to the item based on facts
known at the end of the year
 But this rationale would blow § 1341 out of the water!
o Consequence to Mary returning the overpayment?
 There’s no reason why this shouldn’t be a loss/business expense.
 It will be a deductible item.
o

o KAHN SAYS …
 Didn’t it appear that she had an unrestricted right? What in the statute
prevents Mary from using §1341? NOTHING!
 But the service’s position has never been tested in court.
 Is there a distinction between mistake of fact and mistake of law?
 Lewis
o SCOTUS characterized this as mistake of fact
 But it was a mistake of law. Had to do with
construction of contract.
 Lewis was entitled to % of profits. How was
this to be calculated?
o It’s apparent that congress is willing to do this for a
mistake of fact.
 KAHN THINKS there is no reason why math error is any different
than any other kind of error. A mistake was made – it has a harsh
result because of differences of tax rates. Congress was trying to
provide relief.
 What about § 1341(b)(2)
 On the other hand, you can say the cause of overpayment was
BILLING.
 This section is not applicable to sales, returns, allowances, and
similar items.
o The focus is on the item that was sold – it doesn’t say that
absolutely.

6. Franklin Jones was the president and sole shareholder of Win All, Inc. In Year One,
Franklin received a salary of $250,000. Upon auditing the corporation’s Year One tax
return, the IRS determined that the maximum reasonable salary for Fred was only
$180,000, and consequently the excess $70,000 paid to him in Year One was a
nondeductible dividend. (See Treas. Reg. ' 1.162-8). The denial of the deduction would
increase the corporation’s tax liability for Year One. The corporation litigated that issue
with the IRS, but in Year Five, the Tax Court held that the Service was correct and that
$70,000 of the salary paid to Franklin was excessive. The corporation did not appeal that
decision, and Franklin promptly paid $70,000 to the corporation as a return of the
excessive compensation. What was the tax consequence to Franklin of making that
repayment in the following alternative circumstances?
o KAHN SAYS …
 A corporation would like to pay salary rather than dividends because
salary is deductible, but dividends are not. They might pay salaries and
rents that are too high in order to avoid paying taxes on dividends. That’s
what this problem is about.

a. In Year One, Franklin and the Win All corporation executed a contract that required
Franklin to return any part of his salary that was determined by the IRS or by a court
to be excessive compensation.

o There are two views on whether IRC § 1341 would apply. See Kahn § 13.4322
 Commissioner
 IRC § 1341 would not apply because Franklin had an unrestricted
right to the money in the year he received it, and a subsequent
event made him pay it back. Therefore, it was not under §1341.
o This ruling is in doubt.
 Sixth Circuit
 IRC § 1341 would apply because Franklin appeared to have an
unrestricted right to money when he received it. The later
determination that his salary was excessive did not change that
fact. See Van Cleave v. United States.

o KAHN SAYS …
 Does a slight possibility that it has to be returned mean he doesn’t have
an unrestricted right?
 Claim of right doctrine
o If you claim amount is yours, even if you’re wrong, it’s
income in that year.
 Subsequent events?
 Very little in favor of this
 This might make sense if the event was a condition of getting the
payment

b. The contract between Franklin and the Win All corporation that is described in
paragraph (a) above was executed in Year Three, which was prior to the audit of the
corporation’s tax return. The contract covered salary paid to Franklin by the
corporation prior to and subsequent to its execution.

o KAHN SAYS …
 This is not a §1341 problem. He had a right to the salary when he got it;
he contractually gave it back.
 c. There was no contractual agreement between Frederick and the corporation for
Frederick to return the excessive element of any salary paid to him.

o IRC § 1341 does not apply in this case. Fred still has a right to the money (he
had a right all along) even though the compensation was excessive.

7. Margaret was employed as the manager of a retail clothing store. In June of Year One,
Margaret discovered a very attractive investment opportunity that promised to turn over a
substantial profit in a short period of time. To take advantage of that opportunity,
Margaret needed to invest $40,000, but she had no funds available, and she could not
borrow that amount. In order to make the investment, Margaret took $40,000 from the
retail store and hid her action by altering the store’s books. Margaret was confident that
the investment would turn over with a profit within a year, and she fully intended to
repay the $40,000 to the store as soon as she had the funds to do so. In Year One,
Margaret was in a 30% marginal federal income tax bracket. On January 5, Year Two,
Margaret sold her interest in the investment for $46,000. The profit of $6,000 that she
earned thereby was less than she had anticipated, but she was satisfied. On January 8,
Year Two, Margaret returned the $40,000 to the store, and altered the books to explain
how that $40,000 suddenly appeared in the store’s accounts. Unfortunately for Margaret,
her actions were discovered by her employer on January 26, Year Two, and she was fired
on that date. Margaret was charged and convicted of a crime. She was sentenced to two
years in prison. Without taking the repayment of $40,000 into account, Margaret had
taxable income of $4,000 in Year Two.
CHECK THE ANSWERS TO THIS QUESTION IT MIGHT BE WRONG

a. What were the tax consequences to Margaret of taking the $40,000 from the store in
year One, and of the return of the $40,000 to the store in Year Two? What effect
would it have on your answer if Margaret had repaid the $40,000 to the store in
December of Year One instead of in January of Year Two?

o Taking the $40k

 Margaret taking the $40k from the store is income. She is under a duty to
report it, although she likely won’t.
o Returning the $40k in year 2 [CHECK THIS!]
 Margaret does not qualify for the relief of IRC §1341 (she did not have an
unrestricted right to the money)
 KAHN SAYS
o Even if you take the position that “all this means is that the
money was taken under the claim of right doctrine” this
still doesn’t hold up.
 Does not follow Janes case – not a claim of right
issue.
o If Margaret repaid the $40k to the store in Dec. of year 1 …
  IRC § 1341 would not apply because the item was not included in a prior
taxable year. IRC § 1341(a)(1).

o KAHN SAYS
 Remember, criminally earned income is still taxable


b. What were the tax consequences to the retail clothing store (an incorporated
organization) of Margaret’s actions? In answering this question, see IRC §165(c)(3),
(e).
o IRC § 165(e) says that any loss arising from theft shall be treated as sustained
during the taxable year in which TP discovers such loss. The store discovered
this in year 2. The store can take a deduction in year 2. IRC § 165(a).
 [But IRC § 165(a) says that there shall be a deduction for losses not
compensated. Since Margaret repaid the embezzlement, is this
compensation?]
 PROBLEM SET # 9

In answering these questions, if a nonrecognition election is available, assume that it was or will
be made.
1. Hilton purchased unimproved land. Hilton paid $40,000 cash for the land and took it subject
to a $100,000 mortgage. Hilton did not assume personal liability to pay the mortgage. What
is Hilton’s basis in the land?

o $140k.
 When TP purchases property subject to an encumbrance, the
encumbrance is treated as part of TP’s purchase price and is included in
TP’s basis. See Kahn § 16.2200.
 It does not matter whether TP has personal obligation underlying
debt to pay property.
o Note: IRC § 1301 does not apply because the properties are not of a like kind.

2. Smith owned Blackacre (unimproved land) which he held for investment. Smith had a basis
of $200,000 in Blackacre. In each of the exchanges described below, determine the amount
of gain or loss that was realized by Smith, and the amount of gain or loss that Smith
recognized. Also, determine Smith’s basis in the properties he received in the exchanges. All
of the exchanges were at arms’ length, and so it is presumed that properties of equal value
were exchanged. Smith is not related to the persons with whom he exchanged properties.
There were no encumbrances on Blackacre or on any of the properties Smith received in the
exchanges.

o KAHN SAYS
 Differentiate amount realized v. gain realized.
 Amount
o All the money you get
 Gain
o Your actual gains

a. Smith exchanged Blackacre for a warehouse that he then used in his business. The
fair market value of the warehouse was $600,000.

 Realized
 Gain of $400k.
o ($600k FMV factory – $200k Blackacre basis)
 Recognized
 $0
o No gain or loss shall be recognized on exchange of
property held for productive use in trade or biz or for
 investment if such property is exchanged for property of a
like kind held for either productive use or investment. IRC
§ 1031(a).
o KAHN SAYS …
 Is the property like kind?
 Grade or quality does not matter.
 Is it held for investment or use in business?
 Blackacre is in investment, warehouse is in
business. They don’t have to be matched.
Reg. 1.1031.
 Unrecognized
 $400k
 Basis
 $200k

b. Smith exchanged Blackacre for a commercial franchise that had a value of $400,000.
Smith used the franchise to conduct a business.

 Realized
 Gain of $200k
o ($400k FMV franchise - $200k basis Blackacre)
 Recognized
 $200k.
o Same calculation as above
o Blackacre is not the same kind of property as the franchise.
 Unrecognized
 0
 Basis
 $400k.

c. Smith exchanged Blackacre for an office building having a value of $500,000 plus
$100,000 in cash. Smith used the office building in his business.

 Realized
 $400k
o (500 FMV + 100 cash) – (200 basis)
 Recognized
 $100k
o IRC § 1031 applies to the exchange of the buildings
o It does not apply to cash.
 The cash is “boot” and not subject to
nonrecognition. IRC § 1031(b).
 Unrecognized
 $300k
 Basis
  $200k.
o Start with 200, increase by gain (100), reduce by cash
(100) =200.

d. Smith exchanged Blackacre for an office building having a fair market value of
$450,000 plus 1000 shares of stock of the X corporation having a value of $150,000.
Smith used the office building in his business.

 Realized
 $400k
o (450 office FMV + 150 stock FMV) – (200 basis)
 Recognized
 $150.
o No nonrecognition for stock. IRC § 1031(a)(2).
 Unrecognized
 $250k
 Basis
 Look at § 1031(d).
 200k basis + 150 gain recognized – 0 cash – 150 noncash boot

e. Smith exchanged Blackacre for Greenacre (unimproved land) having a value of

$80,000 plus 100 shares of Y stock having a value of $50,000. Smith held Greenacre
and the Y stock as investments.

 Realized
 -$70k
o (80k Greenacre Basis + 50k stock basis) – (200 Blackacre
basis)
 Recognized
 Does not recognize any loss. IRC § 1031(c).
o If you have a like kind transaction and recognized a loss on
the exchange but get boot, you can’t recognize the loss.
 Unrecognized
 -$70k
 Basis
 200k original basis + 0 gain – 0 loss – 0 money received = 200k
 Must allocate FMV to boot.
o Put 50 on the boot
o 150 to go on greenacre

f. Smith exchanged Blackacre for Greenacre (unimproved land) having a value of

$180,000. In addition, Smith received in the exchange $40,000 in cash and 100 shares
of Z stock having a value of $60,000. Smith held Greenacre and the Z stock as
investments.
  Realized
 $80k
 (180k FMV Greenacre + 40k cash + 60k FMV stock) – (200
Blackacre basis)
 Recognized
 80k – remember, you are only taxed on boot up to the amount of
the realized gain
o 40 cash is boot, which is always recognized. IRC §
1031(b).
o 60 is stock. Excluded from nonrecognition, even if held for
investment. IRC § 1031(a)(2)(B).
 Unrecognized
 0
 Basis
 180 to the land
 60 to the boot (stock)

3. Mark had a basis of $250,000 in Redacre (unimproved land) which he held as an investment.
Mark had a basis of $20,000 in 100 shares of stock of the X corporation. The fair market
value of Redacre was $395,000, and the fair market value of the 100 shares of X stock was
$5,000. Mark transferred Redacre and the 100 shares of X stock to Joan in exchange for
which Joan transferred Greenacre (unimproved land) to Mark. The fair market value of
Greenacre was $400,000. Mark held Greenacre as an investment. Mark and Joan are not
related. What basis does Mark have in Greenacre? Did Mark recognize any gain or loss on
that exchange?

o Mark’s Basis in Greenacre

 The basis of property acquired by TP via IRC § 1031 exchange = [basis
in property transferred by him] – [money received on exchange] +/-
[gain/loss recognized.] IRC § 1031(d)
 [250 basis in Redacre] – [0 money] + [0 gain] = 250 basis.

o Gain/Loss recognized on exchange

 Gain Realized = $130k
 (400 FMV of Greenacre) – (250 basis Redacre + 20 basis stock)
 Gain recognized
 $0
o No boot or anything else nonrecognizable in this
transaction going to mark
o KAHN SAYS
 Mark has 2 assets
 Redacre
o 395 value
o 250 basis
 Stock
 o Value 5000
o Basis 2000
 realized gain of 145k on redcare, loss of 15k on the stock.
 Recognized the loss on the stock
 Basis in Greenacre?
 Total basis of 270k in redcare and stock - 15000 loss – 0 cash
recieved
 1031(c) says you can’t have a loss on the nonrecognition property,
but can recognize loss on other parts.

4. Lane had a basis of $800,000 in an apartment building he owned. The apartment building had
a fair market value of $1,210,000 and was subject to a mortgage of $250,000. Scott had a
basis of $650,000 in an office building he owned. The office building had a fair market value
of $1,260,000 and was subject to a mortgage of $370,000. Neither Lane nor Scott had any
personal liability to repay the mortgage debt on their respective properties, and so those
mortgages were nonrecourse debts. Lane and Scott each held his building in connection with
his real estate rental business. Lane and Scott are not relateed.
Lane transferred the apartment building to Scott in exchange for which Scott transferred to
Lane $70,000 cash and the office building. Lane took the office building subject to the
$370,000 mortgage debt thereon, and Scott accepted the apartment building from Lane
subject to the $250,000 mortgage debt on that property. Land and Scott held the buildings
they received in the exchange for business use.
a. What amount of gain or loss did Lane and Scott realize and what amount of gain or
loss did they recognize from the exchange?

o Remember, when property is subject to mortgage or other encumbrance is

transferred in a § 1031 exchange, the amount of the encumbrance given is treated
as boot received by the transferor.

 Lane
 Lane’s gains
o 1,260,000 (FMV of Scott’s apt) [nonrecognizable]
o 250,000 (release of mortgage on Lane’s apt)
o 70,000 (money from Scott)
o TOTAL = 1,580,000
 Less …
o 800,000 (basis in Lane’s apt)
o 370,000 (assumption of Scott’s apt mortgage)
o TOTAL = 1,170,000
 Totals
o Remember, since the mortgage accepted is GREATER
than the mortgage released, Lane did not receive any boot
from the mortgage.
o Therefore Lane …
  Realized
 (1,260 + 250 + 70) – (800 + 370) = 1580 –
1170 = gain of $410,000.
 Recognized
 $70k. Money is boot. IRC § 1031(b).
 Regs prohibit mortgage offsetting cash.

 Scott
 Scott’s gains
o 1,210,000 (FMV of Lane’s apt) [nonrecognizable]
o 370,000 (release of mortgage on Scott’s apt)
 Less …
o 650,000 (basis in Scott’s apt)
o 250,000 (assumption of Lane’s apt mortgage)
o 70,000 (cash to Lane)
 Totals
o Remember, since the mortgage accepted was LESS than
the mortgage he was released from, he has received boot.
In this case, the boot is 370k – 250k = $120k.
o Therefore Scott …
 Realized
 (1,210 + 370) – (650 + 250 + 70) = 1580 –
970 = gain of 610k
 Recognized
 Boot = 120 (mortgage gain) – 70 (cash paid)
= $50k.

b. What basis does Lane have in the office building he acquired in the exchange, and
what basis does Scott have in the apartment building?

o The basis of property acquired by TP via IRC § 1031 exchange = [basis in

property transferred by him] – [money received on exchange] +/- [gain/loss
recognized.] IRC § 1031(d)
 Lane
 [800k (basis)] – [70k (cash)] + [70k (gain)] = $800k
 800 – 70 – 250 +370 +70 gain
 Scott
 [650 (basis)] – [0 (cash)] + [50 (gain)] = $700k
 650 + 70 cash paid – 370 mortgage released + 250 mortgage
assumed + 50 gain recognized = 650

5. Paula owns a dress shop. Through an error in buying, Paula discovers that she has an
oversupply of maternity dresses, and a shortage of cocktail dresses. Paula mentions her
problem to John, who is the owner of another dress shop. John offers to swap 20 cocktail
 dresses with a value of $10,000 for 50 maternity dresses of equal value. Paula agrees, and the
exchange takes place. Paula had a basis of $6,000 in the maternity dresses that she
exchanged. Paula and John are not related. Did Paula recognize a gain on that exchange?

o Yes. The dresses are property held primarily for sale and are excluded from §
1031. IRC § 1031(a)(2)(A).

6. Renee collects paintings for a hobby. Renee does not hold the paintings as investments. One
of the paintings that she acquired is titled “the Blue Girl,” and Renee had purchased that
painting in Year One for $3,000. At all times in the following questions, the fair market value
of the painting was $5,800.

a. Renee transferred the Blue Girl painting to an unrelated art collector in exchange for a
painting by a different artist having a value of $6,000. How much gain (if any) did
Renee recognize on that exchange?

o Renee recognized and realized a gain of $3k. Since the painting is not used in
business or for investment, IRC § 1031 does not apply.
 Renee is taxed on the amount of what is received.

b. The Blue Girl painting was destroyed by a fire caused by the negligence of Peter. To
compensate Renee for the loss, Peter offered her a painting from his collection, and
Renee accepted the offer. The value of the painting that Renee received from Peter
was $6,000. Renee and Peter are not related parties. How much gain (if any) did
Renee recognize?

o Any gain Renee would have had can be avoided by IRC § 1033. Mandatory
recognition.

c. The same facts as those stated in Question 6(b) except that Peter gave Renee $5,800
cash to compensate her for her loss. A month later, Renee purchased another painting
for $5,500. Renee made no other purchases of paintings for the next four years. How
much gain (if any) did Renee recognize?

o The money was used for replacement property, so 1033 applies.

 1033 requirements
 Involuntary conversion → OK
 Purchase property for purpose of replacing
o If buy property and treat as replacement, this will work.
Very thin requirement.
 Time limit
o 2 years from date of disposition of converted property
o Can give legitimate excuse to district director for extension
of time.
 Remember, in this situation, it’s elective.
o She actually has to replace the property.
  The extra 300 will be recognized as income because money is not covered
by 1033.
o Basis in the painting that she bought
 5500 – 2500 unrecognized gain; basis of $3k in new painting

d. The same facts as those stated in Question 6(b) except that the painting that Peter
gave Renee to compensate her for the loss had a value of only $2,000. Nevertheless,
Renee accepted that painting as full compensation. Did Renee recognize a gain or
loss?

o 1033 applies only to gains. This statute is elective and also does not apply to a
loss.
o This is deductible as a casualty loss.

7. Melvin owned a building in a run-down area of Detroit, and he held that property as an
investment. Melvin had a basis of $50,000 in the building. Melvin read an article in a local
newspaper that the city planned to condemn an area that included his building. Melvin
telephoned the mayor who confirmed the newspaper report. Melvin then purchased
unimproved land in Ann Arbor at a cost of $65,000, which he held as an investment. Eight
months later, the city of Detroit did condemn Melvin’s building and paid him $70,000 as
compensation for the condemnation. Is Melvin entitled to nonrecognition of the gain he
realized on the condemnation? What is Melvin’s basis in the land he purchased in Ann
Arbor?

o Recognized 5k gain based on § 1033?

 Problems with 1033
 Must have bought land in AA with purpose of replacing.
o Fact that checked on condemnation suggests that he did.
 Other property was not sold yet
o Land in A2 was purchased before conversion – but was
there a “threat?”
 Is the newspaper article enough? Do we have to go
to the mayor?
 The service ruled that an unconfirmed news
article is not enough. It has to come from a
gov’t body.
 The mayor would be OK.
o Any official within applicable
department = adequate.
 What kind of property did he purchase v. condemned?
o See Reg. 1.1033(a)-2(9)
 This doesn’t help
o See 1033(g)
 This satisfies the like-kind standard
 Gives an extra year to replace the property
  Amount realized was 70k, amount reinvested was 65, so he didn’t
invest the 5k.
 Basis in ann arbor land
o See 1033(b)


8. Hicks wished to acquire Blackacre (an apartment house) from Leslie. Hicks and Leslie are
not related. Leslie had a basis of $85,000 in Blackacre which had a fair market value of
$212,000. Leslie refused to sell the property to Hicks, but she offered to exchange Blackacre
for a lot in another part of town if Hicks would purchase that lot and construct an office
building on it in accordance with specifications that Leslie would provide. Hicks agreed.
Hicks purchased the lot at a cost of $40,000, and he had the building constructed according to
Leslie’s plans at a cost of $165,000. Hicks then deeded the lot and building to Leslie in
exchange for her deeding Blackacre to Hicks. What were the tax consequences of those
transactions to Hicks and to Leslie?

o IRC § 1031 would apply because they are exchanging like kind
investment/business properties. Nonrecognition.
o Leslie
 She would not recognize a gain because she held property as an
investment, and exchanged it for property held as an investment as a like
kind. No boot.
 Will take basis of 85k, but most allocate between land and building.
o Hicks
 Has to have held the property he transferred for investment. He never held
it for investment – he got it to trade. The service has a ruling that this
qualifies for Leslie, but does not qualify for hicks on the argument that
hicks purchased for exchange, not investment. KAHN SAYS that the
ruling is questionable.
 There are several CoA cases which have allowed 1031 in
analogous situatiins
o Esp the 9th Cir. case he quoted.
 PROBLEM SET # 10

1. In Year One, Mona, a single mother, had adjusted gross income of $30,000. Compute the
amount of medical deduction allowable to Mona in each of following circumstances. in
answering these questions, assume that Mona itemizes her deductions, and that all of the
payments described below were made in one taxable year.

a. Mona paid premiums for medical insurance covering her and her 4-year old daughter
whom she supports. The premiums she paid for that year amounted to $2,000. In that
same year, Mona paid $125 to a dentist for dental work she incurred.

 Mona can deduct medical expenses paid, and not compensated, in excess
of 7.5 % of her AGI. IRC § 213(a).
 Expenses
o $2,000 (premiums) (deductible via IRC § 213(d)(1)(D))
 Dependent daughter allowed via IRC § 213(a)
 Dependent defined in IRC § 152
o $125 (dental work) (deductible via IRC § 213)(d)(1)(A))
 Deductions?
o $2,000 (premiums) + $125 (dentist) = $2,125
o $2,125 (expenses) / $30000 (AGI) = 7.1%.
o 7.1% does not cross the 7.5% threshold; no deduction.

b. In addition to the payments noted in (a), Mona paid $300 to purchase medicines that
were prescribed by Dr. Jones for Mona’s daughter. Mona also paid $20 for pills
providing pain relief, which pills were neither prescribed nor required to be
prescribed by a physician. Mona also spent $20 for an electric toothbrush, and $5 for
toothpaste.

 Expenses
 $2,000 (premiums) (deductible via IRC § 213(d)(1)(D))
 $300 (prescription medicine) (deductible via IRC § 213(b); 213)
(d)(3))
 $125 (dental work) (deductible via IRC § 213(d)(1)(A))
 $20 (non prescription pills) (NOT deductible). IRC § 213(b))
 $20 (electric toothbrush) (not deductible. Reg. § 1.213-1(e)(iii)
 $5 (toothpaste) (not deductible). Reg. § 1.213-1(e)(iii)
 Deductions?
 $2000 + $300 + $125 = $2425
 $2,450 / $30,000 = 8.1%
 This is over the 7.5% threshold (in Mona’s case, $2,250)
 $2425 (total expenses) - $2250 (7.5% threshold) = $175
deductible.
2. Phil has an asthmatic condition that adversely affects his heart. Phil’s doctor advised him to
purchase an air conditioning system for his home. Phil pays $400 for an air conditioning unit
and pays another $30 to have it installed in a window in his bedroom. Without regard to the
floor on deducting medical expenses, are any of the payments that Phil made deductible? If
instead of a window unit, Phil had paid $2,600 to purchase a central air conditioning unit and
have it installed in his house, would that cost be deductible?

o RULE: Capital expenditures for betterment or improvement of property may

qualify as a medical expense to the extent they increase the value of the related
property. Reg
 Capital expenditures for betterment or improvement of property may
qualify as a medical expense to the extent they don’t increase the value of
the related property. Reg § 1.213-1(e)(iii). If the value of the property
was not increased, the cost is a medical expense. Id.

o Air conditioner and installation

 Probably not going to increase the value of the property – it’s just an air
conditioner sticking out the window. Probably deductible.
 Maintenance and operating is also deductible
 KAHN THINKS
 This deduction is allowed because of the floor.
o Hard to ever get a deduction if you had to amortize thinks
like this
o Central air
 Probably going to increase the value of the property. Difference between
cost and value added will be deductible.

3. Mike has an ulcer. His doctor requires him to go on a diet of bland foods that must be
specially prepared. As a result of his special diet, Mike’s weekly food bill is $20 greater than
it was before he went on that diet. Can Mike deduct the extra cost he incurs?

o Tax court has held that excess cost is deductible if TP can prove that special diet
is necessary for medical purposes and can prove the amount of extra cost
incurred.
 If Mike can show via receipts that his bill is different, probably deductible.
This will be tough though. See Kahn § 8.4000 (pp. 353-54).
 Half the extra cost is deductible. IRC § 274(n)
o KAHN SAYS
 Remember, doctor doesn’t PROVE medical purpose, but helps establish.
 Bland food is a whole lot less questionable than going to palm beach.
 How much will be allowed?
 Only the extra cost of having it specially made.
 Apart from that, no deduction at all if food meets nutritional
needs.
4. Ted is advised by his doctor to join Alcohol Anonymous. Ted joins and spends $15 per week
on transportation to and from the AA meetings. Are those costs deductible? Would those
costs be deductible if Ted had not been advised by a doctor to join AA, but instead Ted had
joined on his own initiative?

o These costs are deductible. IRC § 213(d)(1)(B).

 Alcoholism is probably recognized as a disease if obesity and smoking are
issues where people can deduct.
 Mitigates or eliminates a consequence of a disease. Fits IRC §
213(d)(1)(A).
 Even if Ted joined of his own initiative, these would be deductible because
“an expense need not have been incurred on advice of doctor to qualify as
deductible medical expense. Nature of services rendered is what counts.”
Brown v. Commissioner. See e.g. Kahn § 8.1140 (pp. 340-41)
 Doctor’s instruction can be significant factor though.
o Only time doctor’s opinion is necessary because of doing
normal everyday thing.

5. To alleviate a heart condition, Kelly’s doctor advises her to leave Virginia and live
temporarily in Arizona until her condition improves. Kelly goes to Tucson, rents an
apartment there, and lives there for four months at which time her condition is much
improved.

a. Are Kelly’s transportation expenses of moving from her residence in Virginia to

Tucson and return deductible?

o This is a doctor prescribed treatment to alleviate a specific condition, not general

health. Expenses for transportation are deductible. Reg. § 1.213-1(e)(iv);
o KAHN SAYS
 Meals and lodging are not allowed while in Tuscon.

b. Are Kelly’s expenses for meals and lodging in Tucson deductible?

o No. Reg. § 1.213-1(e)(iv)

c. If Kelly traveled by car to Tucson and return, could she deduct the cost of her meals
and lodging incurred en route?

o travel costs need to be distinguished from transportation costs. IRC § 213(d)(1)

(B) covers the later, not the former. Tax courts have held these are included
though. So has the 6th Circuit.
o KAHN SAYS
 What about incidental things?
 Sleeper car on train?
o Significant price difference
 Meal on plane?
 o Too incidental
 This is an open question.

6. Donald is admitted to a hospital for an operation. He spends two weeks in the hospital and
pays a bill to the hospital of $40,000, which includes the cost of his food and room. Is all of
that $40,000 amount deductible?

- IRC § 213(d)(2): if TP stays in licensed hospital, no element of personal pleasure →

deduct $50 per night.
o 14 nights x $50 = $700 deductible.
- Food and lodging in in-patient hospitals are deductible medical expenses. Reg. 1.213-
1(e)(1)(v).

7. William has an illness the symptoms of which are relieved by marijuana. Pursuant to a
physician’s prescription, William purchased marijuana at a pharmacy. The purchase and use
of marijuana for medicinal purposes is permitted by the laws of the state in which William
resides, but is prohibited by the federal Controlled Substance Act. Does William’s cost of
purchasing the marijuana qualify as a deductible medical expense? See Rev. Rul. 97-9.

- The regulations deny a deduction for medical care expenditures that are illegal. Reg. §
1.213-1(e)(1)(ii).
- KAHN SAYS
o If it has to come by statute, and there is no statute, should there be a deduction?
 It’s open to question.

8. Matilda is a devout Christian Scientist. Matilda become ill, and she seeks the services of a
Christian Science practitioner to remove her symptoms. The practitioner talks with Matilda
and prays with her to remove the spiritual blight that they believe to be the source of her
symptoms. Is the cost that Matilda incurred in obtaining the services of the Christian Science
practitioner deductible as a medical expense?

- It might. This is still open to question. See Kahn § 8.1120 (pp. 338-40)
- A treatment need not be administered by a a licensed medical doctor to qualify
- There was a case where the amount paid for services rendered by an authorized
Christian Science Practioncioner qualifies as a medical expense (look to factors).

- KAHN SAYS …
o Even though 213(d)(1)(A) does not specify that this needs to be done by a
licensed doctor.
 The doctor’s permission can be vital to have when the item expensed is
not extraordinary to the illness.
o What about the Christian Science practitioner?
 Reasonable probability of success standard?
 Objective factors
 Motive for treatment
 Linkage between disease and treatment
  Proximity in time of onset of disease and treatment
 The Christian scientists prevailed = why not the Lourdes visitor?
o BETTER RULE
 What is the purpose of allowing the medical expense?
 If you believe the purpose of allowing a deduction is a subsidy the
gov’t gives, then you might say that its legit that there be a
reasonable means of addressing the illness.
 If you take KAHN’s position that it is not a subsidy, that
progressive tax rates are built on a concept that there is a
declining utility of a commodity received, even money, and the
justification of progressive rates is to equalize sacrifice, and the
notion of allowing expenses is an adjustment to the utility curve.
 Are they bona fidely done for that purpose?
o Laetril example
 There was a view that this would be helpful to cancer patients, but the
FDA regarded this as a fraud and the it was illegal in the US
 People went to Mexico to get it. Is that deductible?
 Hey, there is some basis of reasonableness.
o Hypo
 Individual goes to doctor. Doctor says you have 6 months to live and
there is nothing you can do. The individual flies to France and prays for
a cure. Expense deductible?
o Ruling involving scientologists
 Person with gall bladder problem got audited by scientologists. Sign
statement for spiritual experience and not a cure.
 This is allowed as a charitable deduction.
o Tax expenditure concept/budget
 Gov’t was required to set out a budget for tax expenditures
 Tax expenditures → simply an expenditure of the gov’t via credit
or deduction to carry out a congressional program.
o How identify?
 Have a baseline which represents an ideal tax
based loosely on hage simons definition.
 KAHN thinks this is just a political device to make
items more vulnerable.


9. Henry has been working long hours for some time, and he becomes lethargic. At Henry’s
annual medical check-up, his doctor becomes concerned that Henry’s run-down condition
will lead to a serious medical problem for him. The doctor tells Henry that he needs to take
time off for work and go on an extended vacation. The doctor recommends that Henry take a
cruise. Henry does so, and his condition improves greatly. Is the cost of the cruise deductible
as a medical expense?

- No, it is for his general welfare, not a specific health problem. Needs to be for treatment
or prevention of disease. See IRC § 213(d)(1)(A). See also Reg. § 1.213-1(e)(ii).
 o If just for general well being, can’t deduct.
- KAHN SAYS
o Can you deduct annual checkup?
 Techinically no, but nobody will challenge this.

10. Peter smoked a pack of cigarettes a day. Peter became concerned that his continuing to
smoke would be harmful to his health. In order to end his craving for cigarettes, Peter joined
a program, conducted by a psychologist, designed to break the habit of smoking. The
program was successful, and Peter no longer smokes. Peter chose to enter the program on his
own initiative and was not advised to do so by a doctor. Is the cost that Peter incurred to
participate in the program deductible as a medical expense? See Rev. Rul. 99-28.

- The cost of treatment for an addiction to a harmful substance is a medical care expense.
- KAHN SAYS
o For weight loss, need to see specific illness
 E.g. hypertension
o If Peter had insurance that he bought with his own money, not his employer, and
it paid for medicine or drugs that didn’t require a prescription, it would be
excludable.
 For employer provided insurance see § 105.
 (b) is a very large exclusion. → very large umbrella.

11. Do the premiums for the following insurance policies qualify for medical expense
deductions?

a. The insurer will pay the policyholder $400 per week during a period in which the
policyholder is disabled.

o Premiums paid to provide specified amounts of payments to the insured in the

event that the insured becomes disabled are not deductible as medical care
expenses. Treas. Reg. 1.213-1(E)(4)
 This is really a wage supplement

b. The insurer will reimburse the policyholder for medical expenses incurred by the
policyholder or his spouse. In addition, in the event of the policyholder’s death, or
loss of sight, the insurer will pay a specified amount to the policyholder or his estate.

o Only the amount which is attributable to the medical care is deductible. IRC §
213(d)(6)

12. Gladys is covered by a medical reimbursement insurance plan provided by Blue Cross.
Gladys paid the premiums for the policy herself. In Year One, Gladys incurred and paid
medical expenses totaling $5,600. Blue Cross paid Gladys $5,000 to reimburse her for most
of those expenses. Gladys had adjusted gross income of $64,000 in Year One.

a. Is any part of the $5,000 reimbursement included in Gladys’s gross income?

  Gladys must include $5k in her gross income because it was reimbursed.
IRC § 213(a).
 KAHN SAYS
 It is no included because it was all in the same year. WHAT?
o

b. The same facts as those stated above except that the premiums for the Blue Cross
insurance policy were paid jointly by Gladys and her employer (each paid half of the
premiums). The employer paid part of the premiums as a fringe benefit to Gladys.
Was the employer’s payment of one-half of the premiums included in Gladys’s gross
income? Was any part of the insurer’s reimbursement of $5,000 included in Gladys’s
gross income?

 KAHN SAYS
 106(a) excludes from income employer contributions to accident
and helath plans
 104(a)(3) excludes half of the payments
 105(a) says the other half is included unless 105(b)(c) apply.
o 105(b) excludes the other half.
 NOTE: this must be a REIMBURSELEMNT for a
cost that is a medical expense.

c. The same facts as those stated in Question 12(b) except that Gladys did not receive a
reimbursement from the insurer in Year One. In her tax return for Year One, Gladys
claimed and was allowed a medical expense deduction of $800. Gladys could not
deduct $4,800 of the $5,600 of medical expense she paid in that year because of the
7.5% floor on the deduction of medical expenses. In Year Two, Gladys received
$5,000 from Blue Cross as reimbursement for part of the medical expenses she
incurred and paid in Year One. What amount (if any) of that reimbursement is
included in Gladys’s gross income in Year Two?

o $800 due to the tax benefit rule

o KAHN SAYS
 104(a), 105(a). check these bitches out.
 PROBLEM SET # 11

1. Pursuant to a divorce, H and W execute a written separation agreement under which H

agrees to permit W to remain for life, rent free, in their former home which is owned by
H alone. H also agrees to make any required mortgage payments on the house for so long
as W is living. The mortgage payments are $4,000 per year. The agreement expressly
provides that H has no obligation to make any payments to W (or on her behalf) during
her life or after her death, other than the mortgage payments during her life. Does W
recognize any income when H carries out the terms of that agreement after their divorce?

o KAHN SAYS
 Temporary regs say this is not alimony. Reg. § 1.71-T A-6
 The payment of the mortgage is really for his benefit, not hers.

2. In a written separation agreement, H agreed to pay W $30,000 in cash one month after
their divorce decree provided that W is living at that date. The agreement expressly states
that H has no liability to make any other payments to W during her life or after her death.
The parties are divorced, and H made the required payment of $30,000 in Year One. Did
W recognize income from receiving that payment in Year One? Did H recognize income
in a subsequent year because of having made that payment?

o W received $30k as income. See IRC § 71(a)

 There is nothing to prevent a lump sum payment required by a divorce or
separation agreement from qualifying as alimony if the terms of § 71 are
satisfied. See Reg. § 1.71-T A-3; see also Kahn § 2.415-1 (pp. 106-07).
 The terms are satisfied. IRC §§ 71(b)(1)(A)-(D)
o Payment received under instrument
o No designation of payment as not includible in GI and not
allowable as § 215 deduction.
o H and W not living in same household @ time of payment.
o No liability to pay after death or substitute payments.
 KAHN SAYS …
 Lump sum make any difference?
o No, it did at one time but not any more.
 Would it matter if H and W were still in same house?
o Here, the payment is not pursuant to a divorce decree. See
Reg § 1.71 Q9, a written speration agreement and no
divorce, payment can still qualify as alimony.
o If either spouse is preparing to leave, and either spouse
leaves after 1 month, there is some leeway.
 Does H get a deduction for this?
o Yes. See IRC § 215
 o H recognizes subsequent income?
 IRC § 71(f)
 Amount of alimony payments from year 1: $30k
 Sum of …
o Average of …
 Alimony paid in year 2 (0) – excess payments (0) =
0
 Alimony paid in year 3 = 0
 0+0 / 2 = 0.
o $15k
 $15k in GI in post separation year 1 will be included H’s income in year
3.
 W will get a $15k nonitemized deduction in year 3.
 The whole idea is income splitting
 This forces income recognition in the 3rd postseperation year, which in
effect wipes out any deduction you got in the first year.
 3 year period for front loading.
o Year 1 = 30k, year 2 = 0, year 3 = 0.

3. In Year One, Ralph and Jane were divorced. The divorce decree requires H to pay any
medical bills that Jane incurs at any time after the divorce decree is issued. Ralph has no
obligation to make any other payments. Two years after the divorce decree was issued,
Jane incurred medical expenses totaling $14,000, and Ralph paid those expenses in
accordance with the divorce decree. What were the tax consequences of that payment to
Ralph and Jane?

o KAHN SAYS …
 The problem here is that if she dies, is he still liable to pay the medical
expense? Does this fail to satisfy the requirement in 71(b)(1)(D).
 The fact that a payment is made late, but after death, does not deprive it of
being alimony. How do you distinguish that situation from this one?
 She COULD die before he paid. Because she MIGHT have died
before he paid, this takes it out of alimony. See the Webb case in
the teal book.
o In Webb, H and W signed agreement where H was to pay
lump sum immediately after execution of agreement. Court
ruled it did not qualify because she might have died
between time signing and paying check. Might have even
been a minute or two!
o Service says these cases are different from tardy alimony.
But Kahn doesn’t see any difference. The position of the
service is indefensible.
o In the medical reimbursement, it seems even more
plausible for the taxpayer. A medical expense is a support
payment, not a property settlement.
4. W owns a declining term life insurance policy insuring the life of H. H and W divorce,
and the divorce decree requires H to pay the premiums on the declining term life
insurance policy until the death of either H or W. H is not required to make any other
payments to or on behalf of W. In Year One, after the divorce, H paid the premium of
$3,000 on the policy. What was the tax consequence of that payment?

o This will qualify as alimony. Premiums paid by the payor spouse for term or
whole life insurance on the payor’s life made under the terms of the DSI qualify
as payments obo the payee spouse to the extent payee spouse is the owner of the
policy. Reg. § 1.71-T A-6
o KAHN SAYS …
 What if H owns policy, but decree makes him name her as beneficiary,
and pay the policy?
 The Reg. implies that if SHE owns the policy, it’s alimony. If HE
owns policy, inference is that it would not be alimony.
 Term life insurance → payment for a term, no equity in a policy.
All you have is on death, payment is made to beneficiary.
o It’s one thing if you have an equity interest in policyholder
– why should it make a difference if he or she owns it?
 Suppose she dies, and he is still alive? It would be
worthwhile for someone who got the policy to pay
the premium. The option to renew might be a
valuable element if he’s about to die and the
beneficiary can cash in.

5. H and W executed a written separation agreement under which W agreed to pay H the
following amounts in the indicated years:

Year One – $200,000

Year Two – $120,000
Year Three – $70,000
Year Four – $50,000

and $50,000 for each year thereafter for the rest of H’s life. No other payments are to be
made, and no payments are to be made after H’s death. H and W lived for more than 10
years after their divorce. W made timely payments to H of all of the payments required
by the agreement. What were the tax consequences to the parties of the payments made in
Years One through Four?
o Excess payments in 2nd PSY
 $120k (year 2 payment) – 85k (year 3 payment + 15k) = $35k (amount
recaptured in year 3 from 2 payment)
o Average Unrecaptured Payments Made in Years 2 & 3
 $70k (year 3 payment) + $85k (year 2 payment [$120k] – amount
recaptured in year 3 from year 2 payment [$35k]) = $155k
 $155k/2 = $77.5k
 o Excess Payments in 1st PSY
 $200k (payment in year 1) – $92.5k (average amount recaptured from
Unrecaptured payments made in years 2 & 3 [$77.5k] + $15k) = $107.5k
o Excess Alimony Payments for years 1 and 2
 $35 (amount recaptured in year 3) + $107.5 (Unrecaptured payments
made in years 2 & 3) = $142.5 deductible by H in year 3, same amount
included in W’s GI.
o KAHN SAYS …
 Be sure to say things about alimony and deduction first, then go into front
loading.
 Why take off excess payment for average recaptured payument in years
2,3?
 Don’t want to double-recapture
 Don’t design big payment late in the year to avoid finagling with the
numbers

6. Robert and Ellen divorced in Year One. The divorce decree required Robert to establish a
trust and contribute stocks having a value of $400,000 to the trust. The trust provided
Ellen an annual annuity of $25,000 for so long as she lived. Upon Ellen’s death, any
assets remaining in the trust are to be distributed to Robert or to his estate. No payments
were required to be made other than the settlement of the trust and the distributions from
the trust. Immediately after the divorce decree was issued, Robert established the trust
and transferred to the trustee appreciated stocks having a value of $400,000. What was
the tax consequence of Robert’s transfer of appreciated stocks to the trust? What were the
tax consequences of the annual payments of $25,000 that the trust made to Ellen?

o This is an alimony trust, and is covered in IRC § 682

 No amount is included in Robert’s GI. IRC § 682(a)
 A transfer to a spouse/former spouse and transferee takes same
basis as transferor. 1041 says that if the trust is transferred to a
former spouse incident to a divorce, made within 1 year of divorce
(1041(c)).
o If within six years. Still OK if related to cessation of
marriage.
 Because within 1 year, 1041 automatically applies.
 The amount is included in Ellen’s GI if the trust pays that amount. Id.
 The trust pays tax on the excess.
o KAHN SAYS
 What if they set up trust before they got married?
 PROBLEM SET # 12

1. Are the following losses deductible subject to applicable floors on the deduction for
casualty and theft losses?

a. Some trees and shrubs in the yard of John’s residence were uprooted by a tornado
and died.

 Yes, this is a storm and is explicitly provided for in the statute. See IRC §
165(c)(3)
 KAHN SAYS …
 The amount of the deduction is …
o Adjusted basis.
 If you bought a house that included trees, what would the basis
be?
o 1.165-7(b)(2). We don’t have to know the basis of the trees
and shrubs – the value of the trees and shrubs can be
deducted from the entire property.

b. A storm, in the middle of a cold winter, caused a power failure in the area in
which Martha and her family reside, and so Martha’s home had no heat or lights
for five days. Martha and her family moved into a suite at a motel for that five-
day period. Is the cost of renting the suite at the motel deductible?

 No. No deduction is allowed for additional living expenses incurred as a

consequence of the unavailability of a damaged residence. See Kahn §
7.200; IRC § 165(c)(3) (specifying “losses of property . . . ”).
 Only the damage to the property itself suffered that this applies to.
No deduction for loss you had to spend not because of
predictability – it didn’t damage the property.

c. The front porch of Mark’s residence became unsafe to use because of rust. Mark
incurred a cost to replace the porch. Does Mark qualify for a deduction? If the
porch had become unsafe due to damage caused by termites, would Mark qualify
for a deduction?

 Rust
 No, because rust is not swift and precipitous – it is gradual and
progressive. See Rev.Rul.72-592; Kahn § 7.2200.
 Termites
 Courts are divided on this issue, but commissioner says termite
damage is not deductible as a loss because it is not “sudden.” See
Kahn § 7.2210.
  Perhaps, if Mark noticed the problem and reacted quickly when he
first noticed the damage. In Short v. Commissioner, the court
acknowledged that a drought can be a casualty under the
appropriate circumstances – but not when there is a substantial
period of time between the cause and the discovery of the damage.
See Kahn § 7.2210.
 KAHN THINKS we ought to have a better standard than how fast
termites operate. We ought to be talking about the day to day
deterioration that reasonably comes with an item should not be
allowed because it fits into your rate schedule. If there is a
SUDDEN LOSS by an OUTSIDE FORCE, this is deductible.

d. Allen owned an automobile that he used for personal, nonbusiness purposes.

While driving the automobile, the automobile was badly damaged by a collision
with another car, and the collision was caused by Allen’s negligence. Is any of the
damage to Allen’s car deductible?

 Yes, as long as it was not gross negligence. Reg. 1.615-7(a)(3)(ii).

 There’s another element to this – unexecpectedness
 If you drive a car in an urban neighborhood, you have a reason to
think this is forseeable, but this standard has never been applied.
o Maybe it’s too close to a shipwreck.

e. The same facts as those stated in Question 1(d). Allen did not have liability
insurance. Because of his negligence, Allen was required to pay the owner of the
other car an amount equal to the loss of value that the other car suffered. Is
Allen’s payment deductible by him?

 No. Nothing in the statute or regs allows this.

f. Sue stored her fur coat in a closet. Moths ate holes in the coat, and it became
worthless. Is Sue’s loss deductible?

 Probably not. This is probably comparable to rust, and is a slow, gradual

deterioration of property. See Kahn § 7.2210.

g. Pat’s home was burglarized, and valuable pieces of jewelry were found to be
missing. The jewelry had been used by Pat for personal wear. Is Pat’s loss
deductible?

 Theft includes burglary. Reg. 1.165-8(d).

 If Pat can present evidence sufficient to support an inference that the loss
was due to theft, then yes. See Kahn § 7.3000.

h. Hilda wore a valuable diamond ring. One day, she discovered that the diamond
that had been in the ring was gone. The setting in the ring had given way, and the
 diamond had fallen out. Hilda had not noticed that when it occurred. A search for
the diamond was to no avail. Is Hilda’s loss deductible?

 If the ring gave way because it gradually deteriorated, the loss is not
going to be deductible. See Kahn § 7.2210.

2. Owen purchased an automobile in Year One for $30,000, and Owen used the vehicle only
for personal, non-business purposes. In Year Three, the automobile was demolished and
rendered worthless when a tree fell on it. Immediately before the accident, the fair market
value of the automobile was $20,000, and its value after the accident was zero. Owen’s
adjusted gross income (AGI) for Year Three was $80,000. In Year Three, Owen also
suffered a theft loss of $5,250 when a painting was stolen from Owen’s home. Owen held
the painting for personal use. Owen itemized his deductions for Year Three. What
amount of deduction is Owen allowed for the damage to his car and the theft of his
painting?

o Net Casualty Loss Calculation

 (REMEMBER: These are two separate incidents of loss, so the $100 rule
applies to each loss.)
 Amount deductible for casualty loss is [FMV immediately before loss] –
[FMV immediately after loss]. Reg. 1.165-7(b)(1)(i). Also account for
the $100 rule. IRC § 165(h)(1) (loss must be more than $100 for property
not used in trade/biz/income production).
 Car
o 20k – 0 – 100 = 19,900.
 Amount deductible for theft loss is [FMV immediately before loss] –
[FMV immediately after loss] - $100. (loss must be more than $100) Reg.
1.165-8(c).
 Painting
o 5,250 – 0 – 100 = 5,150.
 Net Casualty Loss = $19,900 + $5,150 =$25,050
o The Net Casualty Loss must exceed 10% of AGI to be deductible. IRC § 165(h)
(2).
 AGI = $80k;$80k x 10% = $8k
 Therefore, deductible casualty loss = $25,050 – $8k = $17,050.

o KAHN SAYS …
 Before the accident, this car reduced in value $10k. he couldn’t deduct
this because it was personal use if he sold it for $20k. Should the accident
afford him the $10k? No.
 The reg is a reasonable construction – 165a says that you deduct a
loss, 165b says you use “basis” – your investment. You shouldn’t
be able to deduct more.
 The loss must be sustained because of the accident. The other $10k
was not sustained because of the accident.
3. The same facts as those stated in Question 2 except that Owen used the automobile
exclusively in his self-employed business. Owen’s adjusted basis in the automobile
immediately before the accident was $22,000 (his adjusted basis is the difference
between his original cost of $30,000 and the depreciation deductions allowable to him
while he held the car). What amount of deduction is allowable to Owen because of the
destruction of his car?

o If the property is business property and is totally destroyed, the amount of loss is
the adjusted basis irrespective of whether the adjusted basis was greater or lesser
than the value of undamaged property prior to the casualty. Reg. 1.615-7(b)(1)
(ii).
 So, this is essentially the same calculation as in problem #2, but
substituting $22k (adjusted basis) as the casualty loss.
 [No 8k deduction for this, it is not a personal loss]
o KAHN SAYS …
 Remember, no $100 deduction on this because we are in IRC § 165(c)(1),
not (c)(3).
 How reconcile using the adjusted basis here, but not in personal
property?
 Shifting the business expense deduction from the future to now.
 They have essentially lapsed two different deductions into one.
 He has $2000 more basis he can never recover.
 Now, if he is an employee, and uses his own car exclusively in his business
as an employee …
 Now it’s an itemized deduction – it’s a personal loss.

4. If, in Questions 2 and 3 above, Owen’s automobile had not been destroyed by the
accident, and if its fair market value immediately after the accident was $5,000, What
amount of deduction for the damage to the car would be allowable to Owen in Question 2
and in Question 3?

o If property not destroyed, amount of loss = FMV. Reg. 1.615-7(b)(1)

o Question 2
 Loss: $20k (FMV before casualty) - $5k (FMV after casualty) - $100
(floor) = $14900
 Total casualty deduction: $14900 – 3k (10% of AGI) = $11900.
o Question 3
 Loss: $20k (FMV before casualty) - $5k (FMV after casualty) = $15000
 [Remember, no $100 floor because this was used in a trade/biz.
IRC § 165(c)(1).]
 Total casualty deduction: $15000 – $8k (10% of AGI) = $7k

o KAHN SAYS …
o In this situation, take lesser of basis or FMV before and after. Deduct $15k.
 No 100 floor, no 10 of AGI limitation.
 so the first part is 12,500
  [1:58 PM] Jason Mohr: the second part is 15,000?
 [1:58 PM] Paul Kuppich: u just forgot the painting
 [1:59 PM] Paul Kuppich: and that the agi was 80k
 [2:00 PM] Paul Kuppich: so 14900+ 5150-8000
 [2:01 PM] Paul Kuppich: come out to 12050

5. In Year One, Bert purchased a house that he used as his home. Bert paid $250,000 for the
property. Over time, the neighborhood in which the house was located deteriorated, and
consequently the value of the house fell. In Year Ten, Bert moved out of the house and
rented it to Richard for a fair amount of rent. Bert and Richard are not related. The fair
market value of the house at the time that Bert rented it was $130,000. The value of the
house continued to fall, and six months after renting the property, Richard offered to buy
it from Bert for $110,000. Bert accepted the offer and sold the house for that price. What
amount of deduction (if any) can Bert take because of that sale?

o When property is converted from personal use to an income-producing use, the

FMV of the property on the date of the conversion, if less than the adjusted basis,
shall be used as the basis for determining the amount of loss. The Regs provide
for residences explicitly in Reg. 1.165-9(b).
 Deduction: $130k (FMV) - $110k (sale price) = 20k.
 [Remember: This is still subject to Bert’s AGI. IRC § 165(h)(2).]
 [Remember: a loss sustained on the sale of residential property owned by
TP for personal use is NOT deductible under IRC § 165. Reg. 1.165-9(a)
o KAHN SAYS …
 For gain purposes, what would his basis have been?
 His adjusted basis at the time of the conversion.
 Justification for lesser of Adj. basis or FMV?
 He talked but I was on Facebook.

6. In Year One, Myra purchased improved commercial real estate for $400,000. Myra
intended to use the property as the base from which to conduct her advertising business.
Of the $400,000 that Myra paid for the building, $250,000 was attributable to the land
and the remaining $150,000 was attributable to the building. After moving into the
building, Myra discovered that it was not satisfactory for her purposes. consequently, five
months after purchasing the property, Myra paid $80,000 to have the building razed, and
she paid another $300,000 to construct a new building on the land. All of those costs
were incurred and paid in Year One. What amount of these costs is deductible by Myra?

[NOT IN BOOK!] IRC § 280B. Demolition of Structures.

In the case of the demolition of any structure—
(1) no deduction otherwise allowable under this chapter shall be allowed to the owner or
lessee of such structure for—
(A) any amount expended for such demolition, or
 (B) any loss sustained on account of such demolition; and
(2) amounts described in paragraph (1) shall be treated as properly chargeable to capital
account with respect to the land on which the demolished structure was located.

o So, this means that the $80k is not deductible. IRC § 280B(1)(A).
o The $300k to build a new structure is not demolition, but it is not a loss because it
is the creation of an asset. This should not get deducted either.
o The basis in the land is not $400k and the $80k she spent tearing it down.
 PROBLEM SET# 13

1. Are the following expenses deductible? If so, are they itemized deductions, and are they
miscellaneous itemized deductions?

a. Nick is a recent graduate of the Chicago Law School, and he has passed the New
York state bar examination. Nick contacted three large New York City law firms, and
they agreed to interview and consider him for a position as an Associate. At his own
expense, Nick flew to New York City, stayed at a hotel for several days while he was
interviewing, and had his meals in restaurants. Nick was not reimbursed for his
expenses. Can he deduct any of those expenses in the following alternative
circumstances?

i. Nick did not receive any job offers from those interviews.

 No. See Reg. 1.212-1(f); Kahn § 10.1470.

 KAHN SAYS …
 The reg (above) says No deduction under § 212 for seeking
employment.
o Litigation over this
 Difference between SEEKING and SECURING a
job.
 Eventually, this difference was abandoned by the
Service. KAHN AGREES.
o This is a capital expenditure, not an expense.
 If you’re already in the line of business, it’s an expense under §
162.


ii. Nick got an offer from one of the firms, and he accepted it.

 No. Id.
 KAHN SAYS …
 Code doesn’t say this, but the commissioner has ruled this.

iii. Nick did not get an offer from any of the firms, but one of the firms
reimbursed him for his expenses. Is the reimbursement included in Nick’s
gross income?

 The expenses are excluded from Nick’s income. See Rev. Rul. 63-77;
Kahn § 10.1475.
b. Will obtained a secretarial job through an employment agency, and Will paid the
agency $600 (one week’s salary) for securing the job. Is that payment deductible?

o When employees use employment agencies to find jobs within the same trade, the
expenses are deductible. See Primuth v. Commissioner; Kahn § 10.1471.
o KAHN SAYS …
 This depends on if Will’s work history.
 How long was a secretary? Was there a long break in his work
history? These are all facts which need to be considered.
 If he WAS a secretary, this would be a deductible expense under
IRC § 162(a)(1).
o This is an itemized deduction,and there is no exeption in
IRC § 67 to make it a miscellaneous itemized deduction.

c. An officer in the United States Army purchases a uniform. Can the officer deduct the
cost of that uniform? Does it matter whether the officer is in the Reserves or is in the
Regular Army?

o Deduction
 Yes. See Rev. Rul. 70-474; Kahn § 10.1490.
 Uniforms are probably required for officers
 Army uniforms are probably not readily adaptable to general use
as regular clothing, either subjectively or objectively.
o Reserves or regular?
 KAHN SAYS …
 Look at Reg. 1.262-1(b)(8)
o Says that a reservist can deduct cost of uniform because
the reservist can’t wear uniform outside of duty, and this
says by inference that the regular army solider CAN wear
his uniform off duty, thus it is not deductible. KAHN SAYS
this is probably out of date.
o The service says the uniform is deductible if …
 Required by emplouer
 True here
 Not adapatable for general use
 Meets this
 Don’t actually wear it
 Meets this too.

d. Helen, who works as a nurse at a hospital, purchases a nurse’s uniform. Helen is

required to wear the uniform when she is on duty. Is the cost of the uniform
deductible?

o Yes. See Rev. Rul. 70-474; Kahn § 10.1490.

 o KAHN SAYS
 Why isn’t this adaptable for general use?
 This means only that under normal community standards it would
be peculiar. [this seems to be the objective standard].
 Pevsner said that she cannot use a subjective standard, and had to
use a community standard.
o Keep in mind that styles do change, and what community
do you use? Town? State? Profession? This leaves open
a lot of issues.
 There has been a lot of litigation over uniforms.
 Conductor’s tails and tux? There are other events where this can
be worn.
o But if you had a costume where you were in a play, this
would be deductible.
 Clearest case
o Woman was a singer, had to be on TV, and she bought a
dress so tight she had to be picked up on carried away.
This was deductible.
 If this is an employee business exepense, this is a miscleaneous itemized
deduction. This puts a premium on reimbursements, because the
reimbursement will not be income to them.

e. Margaret works as a private nurse for a patient. The patient lives at home, and
Margaret works in the patient’s home. The employer does not require Margaret to
wear a uniform, but Margaret chooses to purchase a uniform and wear it when she is
working. Is the cost of the uniform deductible?

o Probably not. The employer does not require the uniform, which is necessary for
the deduction. See Rev. Rul. 70-474; Kahn § 10.1490.

2. Larry purchased a house in Year One for $350,000. Larry lived in the house and used it as his
residence until Year Five. In Year Five, Larry moved out and listed the house with a real
estate agent for rent or sale at the purchaser’s or renter’s option. At the time of the listing, the
fair market value of the house was $380,000. The agent was not successful in renting or
selling the house until Year Seven when it sold to an unrelated person for $320,000. Can
Larry deduct the loss he suffered on the sale in Year Seven?

a. Can Larry deduct maintenance costs he incurred between Years Five and Seven when
the house was on the market for rent or sale?

o Yes, Larry can deduct the costs.

 Merely attempting to sell an unwanted prior residence will not usually
qualify as a conversion to an income-producing activity. Kahn § 10.1370;
but a bona fide offering of a former residence for rent (or option for sale
at purchaser’s option) is sufficient to constitute a conversion. Id.
 KAHN SAYS …
  The position taken by the service is that offering for RENT does
not constitute a conversion.
 Offering for sale: generally no.
o when offering for sale immediately after moving out, then
almost unquestionable NO.

b. If Larry offered the house only for sale, and did not offer it for rent, could he deduct
maintenance expenses he incurred between Years Five and Seven?

o Probably not.
 Usually this can’t be deducted, but if Larry can show that he intended to
hold the property until post-conversion appreciation (which he probably
can’t here – no indication of this), it can qualify as holding the property
for the production of income and thus the exenses would be deductible.
Newcombe v. Commissioner; Kahn § 10.1370.
o KAHN SAYS
 Remember, loss basis is lower of FMV or adjusted basis.
 Might have a difference if he’s holding it for sale for improvement.

3. The same facts as those stated in Question 2 except that the real estate agent was successful
in renting the house in Year Five for a fair rental, and the fair market value of the house when
Larry listed it in Year Five was $280,000. During the period, Years Five to Seven, when the
house was rented, Larry claimed and was allowed depreciation deductions totaling $20,000
for the house. In Year Seven, Larry sold the house for $270,000. What amount of gain or loss
did Larry recognize on that sale?

o Renting a property will suffice as converting a former residence to an income

producing property. Kahn § 10.1370. Thus, depreciation deductions are
allowed.
o KAHN SAYS …
 Code section for maintenance expenses: IRC § 212 or IRC § 167
 For a loss to be allowed, the property has to decline in value after the
conversion.
 If we were allowed a deduction, it would be nonitemized. IRC § 162(a)
(4).
 Most 212 expenses are itemized, and mostly misc. itemized. This is
one of the few that are not.
 Original basis = 350k. while used as a residence, no depreciation
deductions allowed.
 When he lists it in year 5, value = 280k. depreciation deductions will be
based off this.
 $280 (loss Basis) – 20 (depreciation) – 270 = no gain; gain basis = 330k,
and he didn’t sell for more than that.

4. Are the following expenses deductible?

a. The fees that Susan paid her lawyer to represent her in litigation in which Susan
sought a divorce and alimony from her husband. Would it matter to the determination
of deductibility whether Susan was successful in that litigation?

o The portion of the legal fees for the divorce is not deductible, but the portion
related to alimony is. If she can’t separate them, no deduction is allowed. See
Rev. Rul. 72-545.
 Since alimony is includible in gross income, expenses of seeking alimony
are a deductible expense. Reg. 1.262-1(b)(7). Alimony relates to the
production of income, and it is deductible under IRC § 212.
 This expense is a misc. itemized deduction, subject to 2% AGI
floor and over all limitation imposed by IRC § 68.
 The success in this litigation would not matter – it is still an expense
relating to generation of income.
 KAHN SAYS
 The allocation must be reasonable
 Gilmore case: can this be squared with the claim for alimony?
 How close is the nexus between the claim?
o Example: wife makes defamatory statements to divorced
husband’s clients. Should that be deductible? The origin
test says this is related to marriage, but this is so much
closer to business activities that it seems totally
inappropriate to say this would not be deductible. The
origin test can be used in some circumstances, but to make
it a shibboleth you have to meet in every circumstance is
strange.

b. The same facts as those stated in Question 4(a) except that the divorce decree
required Susan’s husband to pay Susan’s legal fees. are those payments deductible
and by whom?

o These would be deductible by H as alimony so long as there was a provision

saying that the payments were to terminate in the event of Susan’s death.
o KAHN SAYS
 If H pays the legal fees, it’s not for the production of HIS income. He
cannot deduct his own legal fees.
 If it WAS alimony, SHE can deduct it, because it was constructively
received by her. Kahn thinks this might work even if it was not alimony.

c. Randolph and Jennifer got a divorce. Before the law suit was filed, the parties,
through their lawyers, negotiated and executed a settlement agreement. Randolph
paid his lawyer’s fees for tax advice he gave Randolph concerning the terms that he
should seek to obtain in the settlement agreement and for drafting the agreement. Are
any of those fees deductible?

o Federal Circuit says yes. See Kahn § 10.1360.

 
Expenses related to obtaining tax advice incident to a divorce proceeding
are deductible under IRC § 212(3), provided that there is a reasonable
basis for determining the amount of the legal fee allocable to tax advice.
o KAHN SAYS
 What about counseling/advice? Service has ruled YES. If you look at the
regs, 212-1(l) indicates counseling itself is deductible. But, it is a misc.
itemized deduction.

d. Hilbert and Phyllis decided to marry. Both parties had children and grandchildren
from a prior marriage, and both were wealthy. They consulted a lawyer to have him
draft an antenuptial agreement, which they executed. Is the lawyer’s fee deductible?

o Yes.
 PROBLEM SET # 14

1. Mary Lane is a professor of Archaeology at Holy Cross University. During the summer
period of Year One, when Professor Lane has no teaching duties, she traveled to Jordan and
conducted an expedition that uncovered archaeological data that formed the basis of a
scholarly article that she subsequently wrote and published in a learned journal. Professor
Lane paid for her own expenses in traveling, conducting the expedition, and for meals and
lodging in Jordan. She was not reimbursed. Can she deduct those expenses?

o Yes.
 Whether a trip is primarily related to TP’s t/b or personal depends on the
facts of each case. Reg. 1.162-2(b)(2).
 In this case, it looks like most of the expenses are directly attributable to
Mary’s t/b of being a scholarly professor, and they seem to be ordinary
and necessary expenses. IRC § 162(a)(2).
 Even if the trip was personal, expenses related to her t/b while at the
destination are deductible. Reg. 1.162-2(b)(1).
 The fact that she has no teaching duties during the summer should not
matter. See Reg to Reg. 1.162-2(d) (noting that employees going on
conventions during their vacation or leave time does not necessarily
prohibit the allowance of the deduction of the costs of attending the
convention.)
o KAHN SAYS …
 You can come under IRC § 162(a) even if not under (a)(2). If this is a
legitmate business expense, she has no problem with this. Her home is in
MA, not in Jordan.
 She can also be improving her skills as an archaeologist.
 Problem that arises here – can this be treated as a capital expenditure in
the production of the article, and just treated as her basis in the copyright
she has in the article.
 Check out IRC § 263A(a). Seems like this might be includible.
WTF.
 Also see IRC § 263A(h).
o No capitalization required other than for employees. (h)
will probably not save her.
 See also § 174, but this probably deals with R&D. not intended to
cover this.
 Other argument for Mary
 263A is about matching expenses with the income it produces.
You shouldn’t be able to take a deduction now to create income
over a number of years. Scholarly article of this kind does not
produce any income!
2. Joseph teaches Japanese in a public high school. During the summer of Year Two, when he
had no teaching duties, Joseph traveled to Japan and spent two months there immersing
himself in the language and culture of the country. Can Joseph deduct his transportation and
living costs?

o See IRC § 274(m) – travel is NOT a deductible form of education.

3. Henry is employed by a retail firm that has its headquarters in Detroit. Henry owns a home
and resides in Ann Arbor. Each year, for 10 months, Henry lives in Ann Arbor and
commutes to his office in Detroit. Two months of each year, Henry is required by his
employer to work at an office of his employer in Miami, and Henry lives in a hotel in Miami
for those months and takes a taxi from the hotel to his office and return each workday.
Henry’s wife and children do not accompany him when he is stationed in Miami. What
expenses can Henry deduct?

o Henry can deduct the round trip expenses incurred in traveling to his minor post,
including meals and lodging. See Kahn § 10.3230.
 If he is unreimbursed, he can only deduct 50% of his meals (IRC § 274(n))
and the travel expenses will be subject to the 2% AGI floor and itemized
deduction limitation. IRC §§ 67(b), 68.
o Henry can aso deduct the cost of commuting to and from his office from his
lodging if the costs are reasonable, because they are away from home. See Rev.
Rul. 63-145; Kahn § 10.3230.
o KAHN SAYS …
 Detroit
 Cannot deduct Ann Arbor to Detroit
 Cannot deduct meals, no sleep or rest
 Miami
 Can deduct meals up to 50%
 Can deduct hotel, laundr
 All of these expenses are employee business expenses
o Misc. itemized deductions. There are severe limitations on
the benefit.
o If his employer reimbursed him, they would be nonitemized
expenses.

4. Henry resides with his family at his home in Detroit. He works during the day at a factory in
Ypsilanti. Each workday, Henry drives from his residence to his workplace in Ypsilanti. In
the evenings, Henry moonlights by working as a security guard at a warehouse in Detroit that
is located three blocks from Henry’s residence. At the end of his workday in Ypsilanti, Henry
drives directly to the warehouse in Detroit. Henry’s wife prepares a meal for Henry which he
takes with him in a brown bag when he goes to the warehouse. When his work at the
warehouse is finished, Henry drives the three blocks to his home and goes to bed. Are any of
Henry’s transportation expenses deductible?
 o When TP works at several jobs during the same day, transportation cost of
traveling from one job site to the next is a deductible business expense. Rev. Rul.
55-109; Kahn § 10.3232. These expenses are deductible under IRC § 162(a).
o Driving to his first job and home from his final job is NOT deductible.

a. If, instead of driving directly to the warehouse from his job in Ypsilanti, Henry were
to stop at a diner en route and have dinner, would that effect his right to a deduction
for his transportation expenses? Would the cost of the dinner be deductible?

 If eating is a necessary/ordinary expense, the transportation expenses are

not required to be for transportation away from home, and would be
deductible. See IRC § 162(a) (which lacks an away from home
requirement)
 The meal probably cannot be deducted, because he is not away from
home. He does not require a night’s rest. See Kahn § 10.3220.
 Remember, home is the location of TP’s principal place of
business, not his residence. Kahn § 10.3200.
 KAHN SAYS
 You might be able to deduct it if you didn’t go too far out of your
route.

b. If, instead of driving directly to the warehouse, Henry were to drive home first, have
dinner, and then drive from home to the warehouse, would any of his transportation
expenses be deductible?

 This seems to be a commuter expense, which is prohibited from deduction.

Reg. 1.62-2(e). Same reason as above.
 KAHN SAYS
 At some point, it is no longer an interruption in the trip – it is a
termination of the trip. If you just stopped home and grabbed
some food and went right back out, this would be OK. Any
mileage diversion would not be allowed.
 PROBLEM SET # 15

1. Are the expenses of institutional advertising deductible?

Yes. Look at Reg. 1.162-20(a)(2). Something that builds the goodwill of the company, but
not related to any particular product that they are selling. If there is significant future
benefits, more than a year out, you should have to capitalize and amortize.

2. Martha is the president and major stockholder of a publicly held corporation, and her name is
also the name of the corporation. The corporation’s business has been very profitable. The
value and success of the corporation’s business rests on Martha’s personal reputation. The
federal government has accused Martha of insider trading and of lying to the investigators.
While Martha professes her innocence, the scandal has damaged the corporation’s
profitability and reduced the value of the corporation’s stock. The government has offered to
settle the issue with Martha by her paying a fine of $2,000,000. To terminate the bad
publicity that the charges against Martha have generated and the harm that it has caused the
corporation, the corporation urged Martha to accept the settlement, and the corporation will
pay the fine. Martha accepts the government’s offer, and the corporation pays the fine. What
are the tax consequences to Martha and to the corporation of the payment of the fine?

3. In Question 2, if Martha rejected the settlement offer and instead litigated the issue with the
government, could she deduct the legal fees she incurred in litigating the issue?

4. Hilda works as a CPA for a large accounting firm. She decided to go to law school in order to
improve her skills in her accounting work. Hilda had no intention to practice law. Hilda
enrolled as a student in the Notre Dame Law school, and she earned a J.D. degree. Can Hilda
deduct the tuition she paid to Notre Dame?

5. Pluto, Inc. is a corporation engaged in the retail furniture business. Pluto has three
shareholders who hold the indicated percentages of Pluto’s outstanding stock.

Peter B 40%
Paul - 40%
Mary - 20%
 All three shareholders work as employees of the corporation. In December of every year,
Pluto declares a bonus for Peter, Paul and Mary that is divided among them in the
following proportions: 40% for Peter, 40% for Paul, and 20% for Mary. Each year, the
total amount of bonus payments made by Pluto is approximately equal to the net profit of
the corporation exclusive of the bonus payments. Can the corporation deduct the bonus
payments it makes to its three employees?

6. Marina practiced law as an associate in a law firm in the State of New Jersey. Marina was
offered a position as a partner in a law firm in Atlanta. The salary and professional
opportunities in the Atlanta job are much greater than she had in New Jersey. Marina accepts
the Atlanta offer. To prepare for taking the Georgia bar examination, Marina pays $400 to
take a bar review course on Georgia law. Marina pays a fee of $100 to take the Georgia bar
exam. After passing the exam, Marina paid a fee of $200 to be admitted to the Georgia bar.
Are any of Marina’s expenses deductible? Are they nonitemized, itemized, or miscellaneous
itemized deductions?
 PROBLEM SET # 16

In answering the questions below, ignore IRC §§ 168(k) and 280F.

1. On January 1, 1971, John paid $30,000 for a new (note the difference!) machine that he used
in his business. The machine had a useful life of five years. The estimated salvage value of
the machine at the end of its useful life was $5,000. Since the machine was purchased before
§ 168 was adopted, that section is not applicable to the machine’s purchase. John did not
elect to take a deduction under § 179. Compute the amount of depreciation deduction
allowable to John for the taxable year 1972 under each of the following methods of
depreciation.

a. Straight line.

 $30k (basis) – $5k (salvage value) = $25k to be depreciated

 $25k/5 year useful life = $5k per year
 So, he can depreciate $5k in 1972

b. 150% declining balance.

 100% / 5 years = 20% per year straight line rate

 150% of 20% straight line rate = 30% for 150% declining balance
rate
 Deductions
 1971 = $30k (basis – remember to ignore salvage value) x 30%
(depreciation rate) = $9k
 1972 = $21k (adjusted basis) x 30% (depreciation rate) = $6300

c. 200% declining balance.

 100% / 5 years = 20% per year straight line rate

 200% of 20% straight line rate= 40% for 200% declining balance
rate
 Deductions
 1971 = $30k (basis – remember to ignore salvage value) x 40%
(depreciation rate) = $12k
 1972 = $18k (adjusted basis) x 40% (depreciation rate) = $7200

d. Sum of the years digits.

 Use the shorthand technique. See Kahn p. 524

 5 x (5+1) / 2 = 15
  1971 = $25k (price taking salvage value into account) x (5/15) =
$8,334
 1972 = $25k (price taking salvage value into account) x (4/15) =
$6667

2. On February 24, Year One, Helen purchased a used (remember, this doesn’t matter for
MACRS) machine for use in her business at a cost of $20,000, and she immediately placed it
in use in her business. The machine has a 5-year recovery period, and Helen elected to
depreciate the machine on the straight line method. Helen did not elect to expense any of the
cost of the machine under § 179. Helen made no other purchases that year. Assuming that
Helen continued to use the machine in her business, what amount of depreciation deduction
is allowable to Helen for Year One, Year Two, and Year Six?

o Remember, we don’t care whether new or used under MACRS

o Every class of property, except buildings, has same recovery period as class.
o Year 1 = $2k.
 Ignore salvage value
 $20k (basis) x 10% (remember, half year convention)
o Year 2 = $4k
o Year 6 = $2k
 Remember, half year convention again.

3. The same facts as those state in Question 2 except that Helen did not elect to depreciate the
machine on either the straight line or the 150% declining balance method. What amount of
depreciation deduction is allowable to Helen for Year One, Year Two, and Year Six?

o See table 1 on Rev. Proc.

 Year 1 = $4000
 $20k x 20%
 Year 2 = $6400
 $20k x 32%
 Year 6 = $1,152
 $20k x 5.76%
4. The same facts as those stated in Question 2. Helen miscalculated the amount of her
depreciation deductions, and so she claimed depreciation deductions of $3,000 in Year One,
and $6,000 in Year Two. On January 1, Year Three, Helen sold the machine for $15,000.
Helen did not claim any depreciation deduction for the machine for Year Three. Is any
depreciation deduction allowable to Helen for Year Three? What is the amount of gain Helen
recognized on the sale of the machine for $15,000 in Year Three?

o Depreciation for year 3?

 She bought this property in February in year 1, and we used the half-year
convention under MACRS. IRC § 168(d)(4)(a) says we treat this item as if
it was disposed of in the middle of the year (according to the half year
convention).
 KAHN SAYS The incorrect deductions in previous year have no effect on
year 3
 In year 3, Helen depreciates by 10% (half of 20%), which is a $2000
deduction.
o Is there a gain on the sale?
 First, find adjusted basis. Use IRC § 1016(a) – reduce the basis by the
greater of the amount allowable/allowed for which you got a tax benefit.
 REMEMBER! Allowed/allowable are terms of art
o Allowable: what was permissible under the method chosen
o Allowed: what was taken by TP and not overturned by the
IRS
 In Helen’s case …
Allowed Allowable Which is greater?
$3k $2k (half year!) $3k
$6k $4k $6k
$0 (no deduction taken) $2k (half year!) $2k
$9k $8k $11k

 We take the larger of the allowed/allowable year by year, so the

total is $11k.
 Therefore, the adjusted basis is $9k
 She sold for $15k, so there is a gain of $6k
5. The same facts as those stated in Question 4 except that Helen claimed a depreciation
deduction of $1,000 in Year One, and of $6,000 in Year Two. Helen did not claim any
depreciation deduction for Year Three. What amount of gain did Helen recognize when she
sold the machine for $15,000 in Year Three?

Allowed Allowable Which is greater?

$1k $2k $2k
$6k $0 $6k
$0 $2k $2k
$7k $4k $10k

o Do the same calculations as #4. Now, she has a gain of $5k because she has an
adjusted basis of $10k.

6. On February 5, 2002, Pete Kennedy, a widower, purchased an automobile for $34,000. Pete
purchased the automobile for use in his business, and it has been used exclusively for
business purposes. Pete elected to take the maximum deduction that was allowable by § 179
in the year 2002 for the purchase of the automobile; and the maximum amount that section
179 allowed in that year was $24,000. In 2002, Pete’s net earnings were $376,000 (thus,
there is no limitation because of this). Pete made no other purchases in 2002. The automobile
had a useful life in Peter’s business of seven years, and it had a salvage value of $3,000 at the
end of its useful life. What is the maximum deduction that Peter could take in 2002 for the
purchase and use of the automobile?

o Look at IRC § 168(e). This is 5 year property. Also, look at IRC § 168(e)(3)(B).
It says automobiles specifically.
o USEFUL LIFE DOESN’T MATTER IN MACRS! Class life matters.
o First, deduct $24k bonus depreciation via IRC § 179
o Then, deduct §2k depreciation via IRC § 168 (20% depreication rate, but half
year, so use $10)

a. In addition to the purchase of the automobile, Pete purchased a computer on October 3,

2002 for use in his business. Pete paid $26,000 for the computer. and immediately put the
computer into use in his business. The recovery period for the computer is five years, and
it has a salvage value of $2,000. Pete did not elect to use either the straight line or the
150% declining balance method to depreciate the computer. How should Pete allocate his
$24,000 ' 179 deduction between the automobile and the computer? What is the
depreciation allowable to Pete in 2002 for the use of the automobile and the computer?

 First, note that IRC § 168(e)(3)(B) says computers (technological

equipment) are 5 year property.
  The total basis for the year is $60k. the basis for the last quarter is $26.
This is more than 40% of the total basis for the year, so we use the mid
quarter convention. This looks terrible, so let’s take the half year
convention.
 Methods of depreciating
 If we used the half year convention, it’s 20% for the computer, and
20% for the car.
 Suppose we used the mid quarter. Property put in the first quarter
of the year would be depreciated 35%.
 For the computer in the fourth quarter, use table 5, the
depreciation would be 5%.
 Which looks better to Pete? 35% and 5%, or 20% and 20%?
 35% and 5%
o He’d rather have the larger figure in the first quarter,
which would result in more depreciation.
 Total 60K less 24K of 179 deduction = 36K. 14,401 basis in a comp.

b. The same facts as those stated in Question 2(a) except that Pete purchased the automobile
on August 10, 2002 instead of on February 5, 2002. How should Pete allocate his § 179
deduction for the year 2002?

 Now, it changes because we have the car in the 3rd quarter. Now we don’t
want mid quarter – 15 and 5 is worse than 20 and 20. We want mid-year.
 We want to make it mid-year convention. 14,399 basis in the computer.
There may be other considerations.

7. Sarah purchased the assets of a going business. The contract of sale allocated $120,000 of the
purchase price to the purchase of the goodwill of the business. Can Sarah take depreciation
deductions for that goodwill?

o Yes, she can amortize it for 15 years via IRC § 197.

 PROBLEM SET # 17

In answering the questions below, ignore § 168(k).

1. In April of Year One, John purchased a computer for $20,000. John used the computer in his
business. The computer is 5-year property. John elected to depreciate the computer on the
straight line method. John did not expense any of the cost of the computer under § 179. John
deducted $2,000 depreciation for the computer in Year One, and $4,000 depreciation in Year
Two. On December 9, Year Three, John sold the computer to an unrelated party for $15,000.
John claimed no depreciation on his tax return for Year Three. What is the amount of John’s
gain and how is it characterized (i.e., ordinary income, capital gain, or § 1231 gain)?

o Computer’s Adjusted Basis

 $20k (original basis) – $2k (yr 1 dep allowed; half year convention) - $4k
(yr 2 dep allowed) - $2k (yr 3 depreciation allowable; half year
convention) = $12k. (See §1016 for basis reduction!)
o Computer’s Recomputed Basis (see IRC § 1245(a)(2)(A)
 $12k (adjusted basis) + $2k (yr 1 depr allowed) + $4k (yr 2 depr allowed)
= $18k
 Note! Yr 3 depreciation allowed ($0) was less than depreciation
allowable ($2k). If TP can show amount allowed is less than
allowable, use allowed. IRC § 1245(a)(2)(B).
o Gain/Loss?
 TP will recognize ordinary income in the amount by which TP’s adjusted
basis is exceeded by lower of either (a) TP’s recomputed basis ($18k); or
(b) either (1) the amount realized by TP on sale/exchange ($15k), or (2)
the FMV of property in case of other dispositions. See Kahn § 19.3230.
 So, we use $15k.
 $15k (amount realized on sale) - $12k (adjusted basis) = $3k. The entire
$3k is ordinary income.

a. The same facts as those stated above except that John did elect in Year One to expense
$5,000 of the cost of the computer. Consequently, John claimed depreciation deductions
of $1,500 in year one and $3,000 in Year Two. John did not claim any depreciation for
Year Three. When John sold the computer in December of Year Three for $15,000, what
was the amount of John’s gain and how is it characterized?

o Computer’s Adjusted Basis

 $20k (original basis) – $5k (via IRC §179)
 $15k – $1500 – $3000 – $1500 = $9k
o Computer’s Recomputed Basis
 $9k + $5000+ $1500 + $3000 + 0 (3rd year, allowed < allowable) =
$18,500
 o Gain/Loss?
 Use the lower of what you sold it for ($15k) or recomputed basis
($18,500).
 Therefore, $15k - $9k = $6k

2. In September of Year One, Bill purchased an automobile for use in his business at a cost of
$20,000. Bill did not expense any of that cost under § 179. Using the straight line method,
Bill took a depreciation deduction for the use of the car of $2,000 in Year One. Even before
taking the depreciation deduction into account, Bill had a taxable loss of ($1,200) in Year
One, and so the depreciation deduction increased Bill’s loss to ($3,200). However, Bill did
not qualify for a carryforward or carryback of any of his Year One loss. Bill sold the car to an
unrelated person on December 2 of Year Two for $19,000. Bill did not take any depreciation
for the car in Year Two. What is Bill’s gain on the sale and how is it characterized?

3. In Year One, Sam purchased a car for use in his business. The car cost $26,000. The car is 5-
year property, Sam elected to depreciate the car on the straight line method. Sam did not
expense any of the cost of the car under § 179. Sam deducted $2,600 depreciation for the car
on his Year One tax return, and $5,200 depreciation on his Year Two tax return. On February
18, Year Three, Sam gave the car to his nephew, Paul, who used it in his business. The value
of the car at the time of that gift to Paul was $20,000. Both Sam and Paul deducted the
correct amount of depreciation for the car in their returns for Years One through Four. Paul
sold the car for $15,000 to an unrelated person on August 12, Year Four. What amount of
depreciation is allowable for Paul to deduct in Year Three? What amount of gain did Sam
recognize on making the gift to Paul? What amount of gain did Paul or Sam recognize when
Paul sold the car in Year Four, and how is that gain characterized?

4. Bob purchased a tractor for use in his farming business at a cost of $30,000. Bob properly
took depreciation deductions for the tractor aggregating $18,000 before he died several years
later. At the time of his death, the tractor had a value of $15,000. Bob’s executor did not elect
the alternate valuation date for estate tax purposes. Bob devised the tractor to his widow,
Frances, who promptly sold it for $15,250. What are the tax consequences to Bob, his estate,
and to Frances?

5. On February 4 of Year One, Fred purchased a machine for use in his business. The machine
cost $110,000. The fair market value of the machine on April 8, Year Four was $90,000. On
that date, Fred sold the machine to his nephew, Carl, for $60,000. Fred deliberately sold the
machine to Carl for less than its value because he wanted to benefit Carl. Carl used the
 machine in his business until December of Year Five when he sold it to an unrelated person
for $95,000. The total amount of depreciation for the machine that Fred claimed on his tax
returns for the years he held the machine was $75,000, and the total depreciation claimed by
Carl on his tax returns was $10,000. You will assume that both Fred and Carl claimed and
were allowed the correct amount of depreciation. What are the income tax consequences to
Fred of his Year Four sale of the machine to Carl, and what are the income tax consequences
to Carl of his Year Five sale of the machine?

6. Same facts as question 5. If Fred had depreciated the machine on the straight line method,
would Carl also have been required to depreciate the machine on the straight line method, or
could Carl have elected to use the declining balance method?

7. In Year One, Bank cancelled a $20,000 debt that Alan owed to the Bank. Alan was insolvent
at that time, and so Alan did not recognize any income from the cancellation of the debt
because of § 108(a)(1)(B). Pursuant to § 108(b)(2)(E), because of the cancellation of the
debt, Alan’s basis in 1,000 shares of Win All, Inc. stock (a publicly held corporation ) that he
owned was reduced from $30,000 to $10,000. In Year Four, Alan sold the 1,000 shares of
Win All stock to an unrelated party for $18,000. What was the tax consequence to Alan of
that sale?
 PROBLEM SET # 18

1. In Year One, Roy purchased Blackacre (unimproved land) for $50,000. Blackacre was
unencumbered at that time. In Year Ten, Roy borrowed $80,000 from Bank and mortgaged
Blackacre as security for the loan. Under the terms of the loan, Roy has no personal liability
to repay the loan, and the Bank can collect only by foreclosure on Blackacre in the event of a
default.

a. What was Roy’s basis in Blackacre after the mortgage was effected?

b. Did Roy recognize any gain when he obtained the nonrecourse loan from the Bank?

c. If in Year Twelve, Roy sold Blackacre for $18,000 cash and the purchaser took
Blackacre subject to the outstanding balance of the mortgage debt, which then was
$75,000, what amount of gain would Roy recognize?

d. Instead, in Year Twelve, the value of Blackacre had fallen to $60,000. The outstanding
balance of the debt to the Bank was $75,000. Roy ceased to make payments on the
mortgage debt, and so the Bank foreclosed. The property was sold for $60,000 on the
foreclosure sale, all of the proceeds of which went to the Bank. How much gain, if any,
did Roy recognize on the foreclosure sale?

2. William owned 100 shares of stock of the X Corporation. The stock was pledged to secure a
$20,000 loan that William had obtained from the Friendly National Bank. In Year Four,
William donated the 100 shares of X stock to the Zion Baptist Church, a qualified charity.
The church took the stock subject to the $20,000 debt owing to the Friendly National Bank,
which debt was secured by the stock. At the time of the gift to the church, the fair market
value of the 100 shares of X stock was $60,000, and William had a basis of $36,000 in those
100 shares of stock. William claimed a deduction of $40,000 for the donation to the church
(i.e., the difference between the $60,000 value of the stock and the $20,000 encumbrance on
those shares). The IRS allowed the deduction.

What amount of income, if any, did William recognize because of making the donation to the
church?
 PROBLEM SET # 19

Unless expressly stated otherwise, all properties in the Questions below were held by the
taxpayer for more than one year. Except for Question 8, none of the depreciable assets in the
Questions below had any depreciation deduction allowed or allowable; while that is unrealistic, it
avoids dealing with recapture of depreciation issues. No expense deduction under
§ 179 was taken for any of the properties in the Questions below. In the years involved in
Questions 1 through 8 below, there were no Anon-recaptured net section 1231 losses,@ and so
the recapture provision of § 1231(c) does not apply in those Questions. All of the years
mentioned in the Questions below began after 1993. The taxpayers in the Questions below had
no relevant transactions other than the ones mentioned in the Questions.

1. Phil held Greenacre and Redacre both of which were realty that he used in his business. In
Year One, Phil sold both properties to an unrelated person. Phil recognized a gain of $80,000
on the sale of Greenacre, and he recognized a loss of ($45,000) on the sale of Redacre. How
are the gain and loss that Phil recognized characterized?

2. The same facts as those stated in Question 1 except that the gain that Phil recognized from
the sale of Greenacre was only $30,000. How are the gain and loss that Phil recognized
characterized?

3. In January, Year One, Rebecca purchased a machine to use in her business. Rebecca paid
$35,000 for the machine. In September of Year One, Rebecca sold the machine to an
unrelated person for $42,000. As noted above, although it is unrealistic, assume that none of
Rebecca’s gain was recapture of depreciation. How is Rebecca’s gain characterized?

4. Steve owned a painting which he hung in his home and held for personal enjoyment (i.e., it
was not held as an investment or for business use). In Year One, the painting was stolen, and
it was not insured. Steve had a basis of $30,000 in the paining, but its fair market value at the
time of the theft was $24,000. In Year One, Steve sold a parcel of undeveloped land that he
had held and used in his business for a $50,000 gain. Steve’s adjusted gross income for Year
One was $80,000. How are the gain and loss that Steve recognized characterized?
5. Melvin owned an apartment building which he used in his business and had depreciated on
the straight line method. In Year One, the apartment building was condemned, and Melvin
recognized a gain of $25,000 on the condemnation sale. In Year One, Melvin sold an office
building to an unrelated person. Melvin had used the office building in his business, and he
recognized a loss of ($12,000) on that sale. Melvin’s adjusted gross income for Year One
was $100,000. How are Melvin’s gain and loss characterized?

a. The same facts as above except that in Year One, Melvin also had a painting stolen from
him. Melvin had purchased the painting to hang in his office, and so it was purchased for
business use and was so used. The painting was stolen from Melvin’s office. Melvin had
a basis of $42,100 in the painting, which had a value of $51,000 at the time of the theft.
How is the $25,000 gain that Melvin recognized on the condemnation sale of the
apartment building characterized?

b. The same facts as those stated in Question 5(a) except that Melvin recognized a loss of
($32,000) on the sale of the office building, and Melvin sold the office building to a
corporation that he controlled, and so IRC § 267(a)(1) and (b)(2) barred Melvin from
taking a deduction for the loss he recognized on that sale. How is the $25,000 gain that
Melvin recognized on the condemnation sale of the apartment building characterized?

6. Sally had a basis of $175,000 in her home, and Sally leased the land on which her home was
situated. Sally’s home was completely destroyed by a fire. Sally had fully insured the house,
and the insurer paid Sally $400,000 for her loss. Sally did not reinvest the proceeds in similar
property. How is Sally’s gain from receiving the insurance proceeds characterized?

7. In Year One, Frank purchased a depreciable asset from Myra for use in his business. In Year
Two, Frank sold the depreciable asset for a loss of ($28,000). In Year Two, Frank sold
unimproved land that he had used in his business for a gain of $25,000. In Year Four, Frank
discovered that Myra had made material misrepresentations to him when she sold him the
depreciable asset. Frank than made a claim against Myra, and she paid him $28,000 to
reimburse him for the loss he suffered on the sale of that asset. How is the $28,000 payment
that Frank received in Year Four characterized?

8. In Year One, Don sold depreciable equipment that he had used in his business for a gain of
$22,000, of which $16,000 was a recapture of depreciation and taxable under § 1245. In Year
 One, Don sold realty that he used in his business for a loss of ($10,000). How is the loss that
Don recognized characterized?

9. In Year One, Vicki recognized a ' 1231 loss of ($75,000) and a ' 1231 gain of $30,000. Vicki
had no other ' 1231 gains or losses in that year or in the preceding five years. In Years Two,
Four and Five, Vicki recognized no § 1231 gains or losses. In Year Three, Vicki recognized a
' 1231 gain of $36,000. In Year Six, Vicki recognized a § 1231 gain of $20,000. How are the
§ 1231 gains that Vicki recognized in Years Three and Six characterized?

10. Carl had a net section 1231 loss of ($20,000) in Year One. Carl had a net section 1231 loss of
($10,000) in Year Three. Carl had a net section 1231 gain of $12,000 in Year Five. Carl had
a net section 1231 gain of $18,000 in Year Seven. How is Carl’s net section 1231 gain for
Year Seven characterized?

11. Jerry is an attorney. His client, Paula, comes to him in October of Year One and tells Jerry
that she has received an offer to purchase a building that she holds in her business and that
she would like to dispose of. Paula would recognize a substantial § 1231 loss from that sale.
Paula tells Jerry that she has a significant amount of § 1231 gains that year. While the loss
from the sale of the building would be her only § 1231 loss that year, the amount of that loss
will exceed her § 1231 gains. She asks Jerry whether, if she sells the building this year, the
loss she recognizes from that sale will have the same tax effect to her as would an ordinary
loss. What is the correct answer to Paula’s question?
 PROBLEM SET # 20

1. Rudy constructed an office building in Year One and leased the building to the United States
government on a net, net lease basis for a term of 15 years.

a. In Year Two, Rudy assigned to his daughter all of the rights Rudy possessed in the lease
of the property to the government. This assignment gave the daughter the right to the
rental income from the property for the next 14 years and it gave her the right to the
possession of the property for any remaining term of the lease if the tenant should default.
The daughter did collect the rents from the lease for the next 14 years. Who is taxed on
the rental income?

b. The same facts as those stated in Question 1(a). Rudy died in Year Four and devised the
office building to his brother. Who is taxed on the rental income that the daughter collects
from the government after Rudy’s death?

c. The same facts as those stated in Question 1(a). In Year Three, Rudy conveyed the office
building to his brother. Who is taxed on the rents that the daughter collected from the
government after that conveyance was made?

2. Larry owns a factory building that he leases to Ted for a six-year term.

a. In the second year of the lease, Larry sells all of his rights in the lease to Herman for
$80,000. What is the tax consequence to Larry? When Herman collects rent from Ted,
who is taxed on that rental income?

b. In the second year of the lease, Larry is offered a very attractive price for the factory, but
only if he can convince Ted to cancel the lease. Larry and Ted agree that the lease will be
cancelled in consideration of which Larry pays Ted $25,000. What is the tax consequence
to Ted?
3. On March 14, Year One, Win All, Inc. declared a dividend of $2 per share to be paid on May
3, Year One, to all holders of record of Win All stock on March 21, Year One. George owned
100 shares of Win All stock which had a fair market value of $200 per share immediately
before the dividend was declared on March 14. The stock’s value rose as a result of the
declaration of the dividend. George had a basis of $50 in each share of his Win All stock, and
he had held the stock for more than five years.

a. On March 15, George sold his 100 shares of Win All stock for $203 per share. How is
George taxed on that sale? Who is taxed on the dividend when it is paid on May 3?

b. Instead, on March 23, Year One, George sold his 100 shares for $203 per share, and as
part of that sale, George agreed that the dividend to be paid on May 3 would be paid to
the purchaser. Win All stock that was sold ex-dividend on March 23 was selling at
$201.50 per share. How is George taxed on the sale, and who is taxed on the dividend
when it is paid?

c. Instead, on March 16, Year One, George made a gift of his 100 shares of stock to his
daughter Kelli. Kelli collected the dividend on May 3. Who is taxed on the dividend?

4. Gertrude was appointed the personal representative of the estate of her deceased husband,
Rupert. Rupert devised his entire estate to the two children of his marriage to Gertrude.
Rupert left nothing to Gertrude because she is a wealthy woman in her own right. Gertrude
served as personal representative; and after completing her service, she became entitled to a
statutorily set fee of $225,000. When Gertrude was informed of her right to receive that fee,
she filed with the Probate Court a formal waiver of her right to the fee, and so Gertrude
received no payment for her services. What was the tax consequence of Gertrude’s waiver of
the fee?
 PROBLEM SET # 21

1. On March 4, Year Four, Will sold 500 shares of Prancer Corp. common stock for $30,000.
Will’s basis in those 500 shares was $10,000. Will also owned 100 shares of Blitzen Corp.
common stock having a fair market value of $20,000. Will had purchased the Blitzen shares
in Year One, and he had a basis of $40,000 in the Blitzen shares. Will desired to recognize
the unrealized decline in value of the Blitzen stock so that he could offset that loss against the
gain he recognized on the sale of the Prancer stock. Accordingly, on September 5, Year Four,
Will sold the 100 shares of Blitzen stock to an unrelated person for $20,000; and on October
1, Year Four, Will purchased 100 shares of Blitzen stock for $19,000. What were the tax
consequences of the two stock sales that Will made? If Will were to sell the 100 shares of
Blitzen stock on January 12, Year Five, for $30,000, what would be his gain and how would
it be characterized?

2. Hans bought 100 shares of Bilt Rite Inc. common stock for $5,000 in Year One. On
September 5, Year Three, Hans sold the 100 shares of Bilt Rite for $6,000; and the next day,
he purchased 100 shares of Bilt-Rite common stock for $6,000. What was the tax
consequence of Hans’s sale of the 100 shares of Bilt Rite common stock?

3. As of January 1, Year One, Nick owned 100 shares of the stock of Kewbie Corp., which he
had purchased several years earlier. Nick’s basis in the stock was $20,000, and its market
value was $8,000. On March 5, Year One, when the value of the stock was still $8,000, Nick
sold the stock to his sister, Mary for $8,000. What was the tax consequence to Nick of that
sale?

a. On June 10, Year One, Mary sold the 100 shares of Kewbie stock to her brother-in-law.
In each of the following two alternative circumstances, what was the tax consequence to
Mary of that sale to her brother-in-law?
(1) The purchase price that Mary received for the stock on the June 10 sale was
$11,000.
(2) The purchase price that Mary received for the stock on the June 10 sale was
$6,000.
b. Instead of selling the stock, Mary made a gift of the 100 shares to her son, Steve, on
January 18, Year Two. On February 14, Year Three, Steve sold the stock to an unrelated
person for $11,000. What was the tax consequence to Steve of making that sale in Year
Three?
4. Alice owned Blackacre (unimproved land) which she held as an investment. Alice had a
basis of $60,000 in Blackacre, but its value had fallen. Alice wished to recognize the
unrealized loss she had in Blackacre. On April 5, Year Two, Alice sold Blackacre to an
unrelated person for its value of $25,000. On that same date, Alice purchased Whiteacre
(unimproved land) for $25,000. Whiteacre was an adjoining lot to Blackacre, and the two lots
were virtually identical in every respect except for the slight difference in location. What was
the tax consequence to Alice of the sale of Blackacre?

5. In Year Two, Robert sold Blackacre to his brother, John, for its fair market value of $30,000.
Robert had a basis of $45,000 in Blackacre. In Year Three, John transferred Blackacre to
Helen, an unrelated person, in exchange for Redacre and Blueacre. At the time of the
exchange, Blackacre had a fair market value of $30,000, Redacre had a fair market value of
$20,000, and Blueacre had a fair market value of $10,000. The exchange qualified for
nonrecognition as a like kind exchange under section 1031. In Year Five, John sold Redacre
to an unrelated person for its then fair market value of $60,000. What amount of gain did
John recognize on that sale in Year Five?

6. Stephanie owned 400 shares of common stock of Tryon corporation, which is a publicly held
corporation whose stock is sold on the stock exchange market. On March 12, Year Five,
Stephanie instructed her broker to sell her 400 shares of Tryon stock, and the shares were
sold on that date for their value of $40,000. Stephanie's basis in the 400 shares of Tryon stock
was $100,000. On March 14, Year Five, Stephanie's adult daughter, Megan, purchased
through her broker 300 shares of Tryon's common stock for its then value of $32,000. What
was the tax consequence to Stephanie of the sale of her 400 shares of Tryon stock on March
12, Year Five? In Year Seven, Megan sold her 300 shares of Tryon stock to an unrelated
person for $50,000. What was the tax consequence to Megan of that sale?

7. The same facts as those stated in Question 6 except that instead of Megan's having purchased
300 shares of Tryon's stock, it was Stephanie's husband, Randolph, who purchased 300
shares of Tryon's common stock on March 14, Year Five. What was the tax consequence to
Stephanie of her sale of 400 shares of Tryon stock on March 12, Year Five? In Year Eight,
Randolph sold his 300 shares of Tryon stock to an unrelated person for its then value of
$25,000, what was the tax consequence to Randolph of that sale?