ASPEN PUBLISHERS

Sixth Edition

William D. AndrewsEli Goldston Professor of Law EmeritusHarvard University , - . 1-

PeterJ. WiedenbeckJoseph H. Zumbalen Professor of the Law of PropertyWashington University in St. Louis

Walters KluwerLaw & Business

AUSTIN BOSTON CHICAGO NEW YORK THE NETHERLANDS

Preface . xxiii

Chapter 1 — Introduction . 1

A. In General . 1B. Procedure and Administration 12

1. The Internal Revenue Service 122. Annual Returns 143. Investigation, Assessment, and Collection of Deficiencies • 154. Refund Procedure 155. The Tax Court • ;, 166. Appellate Review . 167. Statutes of Limitations 178. Interest, Penalties, and Costs 189. Withholding and Estimated Taxes • 18

C. Constitutional Background • 19D. Sources of Federal Income Tax Law 20E. A Glossary of Basic Terms and Issues , 22Bibliography : • ., 30

Part I — Income • " 33

Chapter 2 — Income in Kind 35

A. Noncash Receipts in General ' 35

Old Colony Trust Co. v. Commissioner 35Arthur Benaglia ' • 39Reginald Turner 43Haverly v. United States 46

B. Statutory Exclusions ' • 48

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1. Meals and Lodging: §119 48Commissioner v. Kowalski 50Sibla v. Commissioner 60

2. Certain Other Fringe Benefits: §132 67Fringe Benefits Provisions [new §§132 and 117(d)] 67

C. Imputed Income 721. Owner-Occupied Housing 722. Other Consumer Durables 733. Household Services " 734. Leisure " 735. Borderlines 74

D. Alternative Formulations 76E. Deductions 78F. Microeconomic Effects 78G. Taxing Employers in Lieu of Employees 79

1. Withholding 792. Other Possibilities 80

H. Other Items 80

Chapter 3 — Compensation for Losses 83

A. Damage Payments (In General) 83Edward H. Clark ' . - 83Raytheon Production Corp. v. Commissioner 86Commissioner v. Glenshaw Glass Co. 90

B. Personal Injuries . " • . 961. In General •' 962. Nonphysical Injuries and Nonphysical Sickness 97

Revenue Ruling 74-77 99Murphy v. Internal Revenue Service 100

3. Punitive Damages 118C. Insurance 119

1. Medical Insurance 1192. Deducting Extraordinary Medical Expenses

(Self-Insurance) , . . 126Ochs v. Commissioner 127

3. Disability Insurance 1354. Life Insurance . . 136

D. Previously Deducted Losses 1401. Annual Accounting 140

Burnet v. Sanford & Brooks Co. 1402. Tax-Benefit Limitations 145

Dobson v. Commissioner 1453. The Inclusionary Side of the Tax-Benefit Rule 155

Contents xiii

Chapter 4— Gifts and Kindred Items 157

A. Income Interests 157Irwin v. Gavit 157Commissioner v. Early 160

B. Appreciated Property 1651. Inter Vivos Gifts: §1015 165

Taft v. Bowers 1652. Property Acquired from Decedents: §§1014, 1022, & 691 168

C. Gratuitous Transfers Outside the Family 1731. Prizes and Awards 173

Pauline C. Washburn 173Paul V. Hornung 175Maurice M. Wills 177

2. Scholarships and Fellowship Grants 1783̂ Commercial and Compensatory Gifts 179

Commissioner v. Duberstein 179Stanton v. United States 189United States v. Kaiser 191Revenue Ruling 61-136 193Estate of Sydney Carter v. Commissioner 200

4. Social Insurance and Welfare Payments 205

Chapter 5 — Capital Appreciation 207

A. Unrealized Gains 207Eisner v. Macomber . 207

B. Time Value of Money 2351. Interest 2362. Present Discounted Value 2373. After-Tax Returns . 2374. Effective Tax Rates 2385. Tax Deferral as a Source of Capital 2396. Fruits and Trees 2417. The Equivalence of Tax Deferral and Yield Exemption 241

C. Realization 2421. Leasehold Improvements 242

Helvering v.*Bruun • 2422. Mortgage Participation Exchanges 247

Cottage Savings Assn. v. Commissioner 2473. Constructive Sales 256

D. Nonrecognition Exchanges . 2581. Like-Kind Exchanges 258

Alderson v. Commissioner 258

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Revenue Ruling 79-143 264Jordan Marsh Co. v. Commissioner 265

2. Nonrecognition on Dispositions for Cash 2693. Corporate Reorganizations and Transfers to Controlled

Corporations 272E. Deferred and Contingent Payment Sales 273

Bernice Patton Testamentary Trust v. United States 2 73F. Capital Gains 281G. Inflation ^ 284

1. Bracket Creep " ' "" 2842. Income Mismeasurement 285

H. Taxing Consumption Instead of Total Accretion 286

Chapter 6 — Return of Capital and Timing Issues 291

A. Return of Capital , 2911. Timing Alternatives 291

Fairfield Plaza, Inc. v. Commissioner 294Revenue Ruling 70-510 297

2. Capital Expenditures, Depreciation, and Loss Deductions 299B. Annuity Contracts . 305

1. Life Annuities 3052. Deferred Annuities 308

Deferred Annuities [§72] 308C. Cash Method Accounting and Its Limits 311

1. Constructive Receipt 311Revenue Ruling 60-31 311

2. Inclusion in Advance of Receipt: Debt Instruments 324' D. Accrual Method Accounting and Its Limits 328

1. Prepaid Income 329American Automobile Ass 'n. v. United States 329Revenue Procedure 2004-34 . • 340

2. Security Deposits f 351Commissioner v. Indianapolis Power & Light Co. 351

3. Inventories . 357Thor Power Tool Co. v. Commissioner < > 359

4. Accruing Future Expenses 369United States v. General Dynamics Corp. ' 369Premature Accruals [§461 (h)] 376

E. Inconsistent Methods and Matching 3841. Related Party Transactions 384

Treatment of Certain Related Party Transactions [§267] 3842. Inconsistency Between Years 386

a. Erroneous Treatment in Closed Year 386

Contents xv

b. Changes in Accounting Method , 389F. Compensating Employees 389

1. Deferred Compensation 389Albertson's, Inc. v. Commissioner 389

2. Stock Options and Restricted Property 400Commissioner v. LoBue 400Alves v. Commissioner 405

Chapter 7 — Receipts Subject to Offsetting Liabilities . . 415

A. Cancellation of Indebtedness 415United States v. Kirby Lumber Co. • 415Bankruptcy Tax Act of 1980 f 417David Zarin • • 421Zarin v. Commissioner 428

B. Claim of Right . 431North American Oil Consolidated v. Burnet 431United States v. Lewis 433Alcoa, Inc. v. United States 436

C. Embezzled Funds 446James v. United States 446McKinney v. United States 454

D. Nonrecourse Borrowing 456Crane v. Commissioner 456Parker v. Delaney 464

1. Inadequately Secured Nonrecourse Debt - 468Commissioner v. Tufts 468Revenue Ruling 91-31 478

2. Mortgaging Out 481Woodsam Associates, Inc. v. Commissioner 481

3. Gifts of Encumbered Property 484Estate of Levine v. Commissioner . • 484Diedrich v. Commissioner , 491

Chapter 8 — Tax Expenditures: State and Municipal Bond Interest 497

A. The Exclusion of Interest on State and Local Obligations 4971. Constitutional Considerations . 498

South Carolina v. Baker 4982. The Subsidy to Issuers of Tax-Exempt Obligations 501

Municipal Taxable Bond Alternative Bill of 1976 5013. Tax-Exempt Borrowing to Finance Private Activities 504

Tax-Exempt Bonds 504

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B. Tax Expenditures in General 509Analytical Perspectives, Budget of the U.S. Government,

Fiscal Year 2009 510Rethinking Tax Expenditures 519

C. Concepts of Income .. 533

Part II — Deductions and Credits 537

Chapter 9—Deductions, Credits, and Computation of Tax 539

A. Adjusted Gross Income 5401. Costs Incurred in Carrying on a Business (Other than

Employment) 5402. Other Nonitemized (Above-the-Line) Deductions 541

B. Personal Exemptions and the Standard Deduction " 543C. Itemized Deductions 545D. Miscellaneous Itemized Deductions 546E. Applying the Rate Schedules 548F. Credits 550G. Additional Taxes 551

Chapter 10 — Interest, Taxes, and Casualty Losses (Home Ownership) 553

A. Interest 5531. What Is Interest? §163 (a) 554

Knetsch v. United States 554Goldstein v. Commissioner 559

2. Debt to Purchase or Carry Tax-Exempt Obligations:§265(a)(2) • 565

Revenue Procedure 72-18 5653. Investment Interest 570

Estate of Yaeger v. Commissioner- • • > 5704. Home Mortgage and Other Personal Interest 576

White, Proper Income Tax Treatment of Deductions forPersonal Expense • ' ' , 5 7 7

B. Taxes 579Revenue Ruling 79-180 581

C. Homeowners 5851. Distortion Produced by the Deductions 5852. Exclusion of Imputed Rental Value 586

Analytical Perspectives, Budget of the U.S. Government,Fiscal Year 2007 .-••:• ^$7

President's Advisory Panel on Tax Reform, Simple, Fairand Pro-Growth 589

Contents xvii

D. Casualty Losses 595William H. Carpenter 596

Chapter 11 — Charitable Contributions and Tax Exemption . 601

A. Qualified Organizations 601Regan v. Taxation with Representation of Washington 601Bob Jones University v. United States 607

B. Unrelated Business Income -. — i •..• 621United States v. American Bar Endowment 621

C. What Is a Contribution? 631Dowell v. United States ' 631

D. Appreciated Property 637Hilla Rebay 637

Chapter 12 — Personal, Living, or Family Expenses • , 643

A. Childcare , 643Henry C. Smith • • • 643

B. Clothing . 647Pevsner v. Commissioner 647

C. Traveling: §162(a)(2) 6501. Away 650

United States v. Correll , 6502. From Home 654

Commissioner v. Flowers -• 654Revenue Ruling 75-432 658Hantzis v. Commissioner 662

D. Travel and Entertainment 668Rudolph v. United States 668Sanitary Farms Dairy, Inc. 672Moss v. Commissioner 676Cohan v. Commissioner 680

1. The 1962 Legislation , 6802. The 1986 Legislation . 684

Percentage Reduction for Meals &Entertainment 684

E. Activities Not for Profit (Hobbies) . 688Bessenyey v. Commissioner 688

F. Housing 6951. Loss on Sale 695

Weir v. Commissioner 6952. Rental Losses 6993. Home Offices 701

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Drucker v. Commissioner 701Commissioner v. Soliman 704

G. Marital Litigation 714United States v. Gilmore 714United States v. Patrick 720Hunter v. United States 722Ruth K. Wild 722

H. Education and Training 7271. Business Expense Deduction 727

Jorgensen v. Commissioner "' 7272. Tax Benefits for Education 741

Chapter 13 — Business and Investment Expenses 751

A. Ordinary and Necessary 751Welch v. Helvering 751

B. Public Policy Limitations 755Commissioner v. Tellier 755Raymond Mazzei 758

C. Capital Expenditures 766Mt. Morris Drive-In Theatre Co. 766Mt. Morris Drive-In Theatre Co. v. Commissioner 770Commissioner v. Idaho Power Co. 770INDOPCO, Inc. v. Commissioner 779

D. A Reasonable Allowance for Salaries 787Patton v. Commissioner 787

E. Carrying on Any Trade or Business 792Estate of Rockefeller v. Commissioner 792

Chapter 14 — Losses 801

A. In General: §165 801United States v. S.S. White Dental Manufacturing Co. 801

B. Wash Sales and Transactions Among Related Parties 805McWilliams v. Commissioner 805

C. Capital Losses: §1211 . 811O. L. Burnett 812

D. Section 1231 8151. Property Used in a Trade or Business 8152. Involuntary Conversions 8163. Statutory Structure and Interpretation . 817

E. Bad Debts 817Whipple v. Commissioner 817

Contents xix

Chapter 15— Capital Cost Recovery 829

A. What Is Depreciable . 8301. Antique Musical Instruments 830

Richard L. Simon 8302. Land and Improvements 838

World Publishing Co. v. Commissioner 8383. Goodwill and Other Intangibles 845

Newark Morning Ledger Co. v. United States 8454. Section 197 v - •— 857

Amortization of Goodwill and Certain Other Intangibles 857B. Rates and Methods 861

1. The Straight-Line Method . . 8622. Declining Balance Methods 8623. Useful Lives 8634. Optional Expensing 8645. Alternative Depreciation — §168(g) , 8646. Purposes for Setting Rates and Methods 864

C. The Economics of Capital Cost Allowances 8661. Complete Acceleration, or Expensing 8672. No Acceleration — Economic Depreciation , 8693. Other Cases . 872

D. Other Investment Stimuli 872E. Disposition of Depreciable Property: Recapture or

Conversion 874F. Depletion of Mineral Deposits 876

Chapter 16 — Leverage, Leasing, and Tax Shelter Limitations 881

A. Leverage 8811. Overvaluation 881

Estate of Franklin v. Commissioner 881Pleasant Summit Land Corp. v. Commissioner 886

2. The At-Risk Limitation ,, 8893. The Economics of Leverage and Taxes 890

B. Leasing . 8931. Real Estate . 893

Carol W. Hilton 8972. Machinery and Equipment 910

Objective Guidelines Used in Structuring Transactions 9113. Leasing to Tax-Exempt Entities 913

Reform of Tax Treatment of Certain Leasing Arrangements 913C. The Passive Activity Loss Limitation 915

1. Passive Activities 916

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2. Disposition of Interests 9173. Activities 9174. Portfolio and Earned Income • 9185. Rental and Oil and Gas Activities 918

D. The Alternative Minimum Tax 920Present Law and Background Relating to the Individual

Alternative Minimum Tax ' 920E. Corporate Tax Shelters 936

Part III—Attribution of Income Among Taxpayers 939

Chapter 17—Taxation and the Family 941

A. Interspousal Income Attribution 9411. First Principles 941

Lucas v. Earl ' 941Poe v. Seaborn 942

2. Split Income and Joint Returns 948B. The Marriage Bonus and the Marriage Penalty 950

1. Constitutionality of the Marriage Penalty 951Mapes v. United States 951

2. Legislative Relief 959Repeal Two-Earner Deduction 959

3. Self-Help 964Boyter v. Commissioner 964

C. Support, Gift, or Compensation? 970United States v. Harris 970

D. Children and Dependents 976Adjust Tax Rate on Unearned Income of Minor Children 976

E. Separation and Divorce 9811. Support Payments ' 981

Bernatschke v. United States 9822. Property Transfers 991

United States v. Davis 991Farid-es-Sultaneh v. Commissioner 996Transfer of Property Between Spouses or Incident to

Divorce [§1041] 1002

Chapter 18 — Investment Income 1007

A. The Basic Supreme Court Cases 1008Corliss v. Bowers ' " 1008Douglas v. Willcuts 1010

Contents xxi

Burnet v. Wells 1013Blair v. Commissioner 1019Helvering v. Clifford . 1024Helvering v. Horst 1030Helvering v. Eubank 1035

B. Statutory Rules for Nongrantor Trusts 10391. Simple Trusts and Distributable Net Income 10392. Complex Trusts and the Tier System 10403. Accumulation Distributions; 10414. Fiscal Years v - -~ 1041

C. Grantor Trusts 1042D. Interest-Free Loans 1044

Below-Market and Interest-Free Loans [§7872] 1045

Part IV—Capital Gains and Losses 1051

Chapter 19—Capital Gains 1053

A. The Statutory Scheme 10531. The Deduction for Capital Gains 10542. Maximum Rates for Capital Gains 10553. Capital Losses 10564. Short-term Capital Gains (and Losses) 10575. Section 1231 10596. Definitional Problems — Sale or Exchange 10597. Definitional Problems — Capital Assets 10608. Depreciation Recapture 10619. Qualified Dividends 1061

10. The Multiple Rate Ceilings in §l(h) 1062B. The Quest for a Concept 1065

1. Sale of a Business 1065Williams v. McGowan 1065

2. A Temporary Taking 1070Commissioner v. Gillette Motor Transport, Inc. 1070

3. Discounted Notes and Bonds 1074United States v. Midland-Ross Corp. 1074

4. Purchased Remainder Interests 1080Jones v. Commissioner 1080

C. Property Held Primarily for Sale to Customers 1080Curtis Co. v. Commissioner 1080Malat v. Riddell 1085

D. Reasons for Preferential Treatment of Capital Gains 1088

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Chapter 20 — Capital Losses 1093

A. The Arrowsmith Doctrine 1093Arrowsmith v. Commissioner 1093

B. The Corn Products Doctrine . 1096Corn Products Refining Co. v. Commissioner 1096Arkansas Best Corporation v. Commissioner • 1101

Chapter 21—Future Income Streams • —• • 1109

A. Receipt of a Lump-sum Payment for a Future IncomeStream . 1109

Hort v. Commissioner 1109McAllister v. Commissioner 1112Commissioner v. P.G. Lake, Inc. 1117

B. Receipt of Payments out of a Future Income Stream 1127Commissioner v. Carter 1127Commissioner v. Brown 1131Stern v. United States . 1145Busse v. Commissioner , 1150Commissioner v. Ferrer . . . 1153

Appendix — Rates of Return and Effective Rates of Tax on Investments 1169

Table of Cases ' 1179Table of Statutes 1183Table of Treasury Regulations, Revenue Rulings and Procedures, andMiscellaneous IRS Pronouncements . 1193Index 1195