MauledAgain

Special rules apply when a taxpayer disposes of property and receives one or more payments for the property in a year or years after the year of sale. In the Graduate Tax Program property dispositions course, at least four 50-minute classes are required to explore the applicable provisions. Nothing of that sort can or should be attempted in a basic J.D. tax course. Instead, my goal is to get the students to understand the “spreading” of the gain across the years of payment and the option to elect out and report all gain in the year of sale, to focus on the computation of the gross profit ratio, and to appreciate the serious tax consequences of making transfers of installment obligations. Even though pressed for time, I usually manage to accomplish these goals in less than the scheduled 50 minutes. Yes, I speak a little more quickly, but having warned the students in the previous class to look again at how annuities are taxed, I know that the students who have assimilated that topic will recognize the similarities with installment sale treatment.

So the students don’t explore what happens when there is debt secured by the property being sold. They don’t learn about the treatment of wrap-around mortgages, in part because of the time shortage and in part because few of them know what they are. They don’t examine dispositions to related parties or the acceleration of the depreciation recapture portion of the gain. They don’t delve into conditional payments. The list of what they don’t study is far longer than the list of what is assigned.

Next: The tax benefit rule

Although throughout the semester students have touched on the question of when gross income or a deduction is taken into account, they don’t examine the application of the cash and accrual methods until the course is nearly finished. Again, to dig into these issues before both gross incoe and deduction topics have been completed would be premature.

Students are told there are yet other methods of tax accounting but because they are used in relatively narrow situations their definitions and application are ignored. Instead, students are asked to consider issues such as constructive receipt, the “all events” test, and economic performance. The opportunity arises to have them again visit the concept of time value of money, and to consider whether it always makes sense to try postponing income and accelerating deductions. Usually someone in the class picks up on the possibility that the taxpayer will be subject to a much higher or lower rate in the following year, either because of changes in other income and deductions or through legislation.

Of course, all of this is compressed. The scheduled 50 minutes don’t exist, so coverage is limited to what fits into 25 or 30 minutes, at best. This means many of the assigned problems go unexamined.

Next: Installment sales

Another component of gain characterization is depreciation recapture. Simply put, the portion of gain that reflects previous depreciation claimed with respect to the property does not qualify for capital gain treatment unless the property is real property and the depreciation was computed using the straight-line method or is no more than what would have been computed using that method.

It would make no sense to discuss this aspect of gain characterization when teaching the gross income from property dispositions topic because at that point in the course few, if any, students have a clue with respect to the depreciation deduction. In contrast, by this point in the semester the students have had several encounters with the recapture concept.

I teach students the “short cut” method rather than the technical statutory method for computing depreciation recapture. Why? Because, yes indeed, there isn’t sufficient time to focus on the statutory construct. At least the students will leave the course with at least some sense of yet another concern that will affect decisions that they and their clients will be making.

Next: It’s time to discuss timing

After taking the students through the basic definitions relating to capital gains and losses, my next goal is to have them explore the provision that turns net gains from the sale of certain business property, to use an imprecise phrase, into capital gain but that turns net losses from those sales into ordinary losses. It’s a “best of both worlds” approach from which the students can learn much, not only in technical terms but also in policy respects.

There are all sorts of wrinkles in the provision. Before the gains and losses are compared, a subset of the gains and losses, those involving casualty events, are compared, and the net result is included in the basic comparison only if it is a gain. Special rules bring certain condemnation gains and losses into the picture. Some gains and losses with respect to property that is not business property enter the fray. A variety of gains and losses from certain types of business property are precluded from the computations. Special rules for certain animals exist. Overlaying this entire morass of definitions and exceptions is a recapture rule designed to prevent yet another game that taxpayers play in an attempt to steer gains into one year and losses into another in order to make the “best of both worlds” even better.

Again, pressed for time, the students end up with not much more than a conceptual explanation and one or two simple examples. The special inclusions, the exceptions, and the recapture rule fall by the wayside. Students are encouraged to do the assigned reading and to try solving the problems, but the time pressure problem is not a secret and students know, from the experiences of their predecessors, that they will not be taken as deeply into these topics as they are taken into the other topics. Students who take themselves into the Graduate Tax Program’s course on property dispositions, whether or not matriculated in the program, don’t suffer in the long run but the other students sadly are being shortchanged. What is truly disappointing is that many students are happy that the material is being abridged, when in fact it will disadvantage them when they reach the practice world.

Next: And then there’s that depreciation recapture thing

Early in the course, when studying gross income derived from property transactions, students with some previously acquired tax knowledge will use the term “capital gain” in crafting an answer, perhaps correctly or perhaps as a technically incorrect substitution for the term “gain realized” or “gross income.” To their chagrin, I tell them that I am postponing the discussion of capital gains.

Why is the discussion of capital gains delayed until near the end of the course? There are several reasons. First, the characterization issue affects both gains and losses and to delve into the issue when focusing on gross income would be premature. Second, understanding the impact of characterization as a double-edged sword that benefits those with net capital gains and disadvantages those with net capital losses is easier at this point in the semester. Third, some of the elements incorporated into the definitions reflect issues that weren’t covered until later in the course or that are more easily understood at this point.

My goal is to introduce students to the definitions and to illustrate the impact of the special treatment of capital gains and the disadvantageous treatment of capital losses. They need to understand why and how the “make ordinary income look like capital gain” and the “make capital losses look ordinary” games are played. They should understand the whipsaw situation that has given the tax law a variety of cases that treat the same transaction differently depending on whether it generated a gain or loss and which position the IRS took. What I do not try to do is to have the students compute tax liability when a portion of taxable income consists of capital gain. A quick peek at the form or the statute is enough to persuade anyone that putting J.D. law students enrolled in a basic course through that computational nonsense would be counter-productive.

As a practical matter, at this stage of the semester I’m so far behind that this topic receives 15 or 20 rather than the planned 50 minutes of class time. Some of the time savings comes from omitting some problems and taking students through others without asking them to contribute. In other words, with one or two classes remaining, I shift to lecture mode, not by desire but by dint of circumstances.

Next: Gains and losses from transactions involving business property

The next topic receives at best one minute of class time, and the message essentially is a repeat of what was noted during the overview presented near the beginning of the semester. After computing tax liability, a taxpayer compares that amount with the applicable credits. If tax liability exceeds total credits, the difference must be paid. If tax liability is less than total credits, the difference can be refunded or left with the Treasury as an advance on subsequent year tax liabilities. Students learn that there are two types of credits. There are genuine credits, those that reflect amounts already paid by the taxpayer, such as amounts withheld from compensation and amounts paid as estimated taxes. There are policy credits, those that reflect policy determinations by the Congress that a particular activity or expenditure by a taxpayer warrants reducing that taxpayer’s tax liability by some amount.

The list of policy credits continues to grow at a rapid rate. There now are dozens. Many involve very narrow and specific transactions, and a few affect a significant number of taxpayers. All are structured on an arrangement of definitions, exceptions, computations, and limitations. In theory, if a student needed to learn about a specific credit, he or she should be able to read the provision and parse the language.

Unfortunately, there isn’t any class time available to explore the details of any specific credit. Thus, students are instructed to read several pages in the course text that describe the more important credits in general terms but they are not responsible for learning the details. Although many of the credits would not deserve attention even if time were available, there are several that should get a closer look, such as the earned income tax credit. There are good arguments for covering these credits but there simply isn’t anything that can be removed from the course to “make room.”

Next: Characterization of income and loss

The tax law is structured so that after taxable income is computed, a taxpayer must compute tax liability. Again students arrive with the same uninformed impression that often is voiced by other faculty and people who have never taken the course. They expect to put on green eyeshades, crank up the abacus, or perhaps power on a Texas Instruments calculator. Nothing could be further from the truth. Students quickly learn that with a printed chart or software program, a person can “plug in” the taxable income amount and filing status to get the tax liability. The course is not an arithmetic course, and I tell the students I will not test them on their ability to look up numbers in a chart or to do the actual tax liability computations. Yet, despite this, two 50-minute class sessions are allocated to the topic. Why?

The students do sit through illustrations because there are several important concepts that those examples provide. First, by showing how tax liability is computed I introduce students to the concept of progressivity in taxation. Second, by showing the impact of phase-outs I introduce students to the “bubble effect,” which generally causes the effective marginal rate of taxation on high income taxpayers to be less than the effective marginal rate of taxation on middle-income taxpayers, a phenomenon that begins to help those students who have not already done so to figure out where some of my undisguised disdain for the tax system originates. Third, by showing how tax liability differs depending on filing status, I introduce students to the joys and frustrations of the marriage penalty, and, yes, the marriage bonus. I provide the students with an illustration that involves a taxpayer who could easily be one of them in a few years. I show the tax consequences of this person marrying someone with similar income and, alternatively, someone with no or little income. It is one of the priceless moments in the course. Students who did not look at this illustration before class, and perhaps some who did but who didn’t quite figure out what was going on, become visibly shocked or even annoyed when they see how the tax law encourages and discourages different “types” of marriages. My warning early in the semester that tax law is everywhere and affects everything finally is hammered home.

If this wasn’t enough, the discussion then turns to the computation of tax liability for children who have not yet attained the age of 18. Once assured that they will not be required to do the calculations, students settle in for several illustrations of how this needlessly complicated provision operates. As a provision affecting all taxpayers under 18 and all taxpayers with children under 18, it is a provision with broad application. Although software exists that can handle the numbers, the concepts are much easier to comprehend when examples are presented. Those examples also illustrate the many practical problems arising when a theoretical solution was applied to a real concern.

Next: Tax credits

Many students share the same mistaken impression of the basic income tax course as do some law faculty and people not involved in the law. They perceive it as a tax return preparation training course. Nothing could be further from the truth. Students in my course are not required to prepare returns. Those who cannot wait for the opportunity are invited to invest time in the pro bono activities of the Tax Law Society, among which are the preparation of returns for low-income individuals under the IRS VITA program. Students do have copies of forms so that they can look at them to obtain a more complete perspective on an issue or to enjoy a more robust context for considering the inter-connections of tax law analysis.

This topic, computation of taxable income, is mostly a one-class examination of how the pieces already studied fit together. To the array of gross income, deductions allowable in computing adjusted gross income, itemized deductions, and the deduction for personal and dependency exemptions are added two phase-outs and a study of the standard deduction.

One phase-out that requires attention is the one applicable to itemized deductions, and the other involves the deduction for personal and dependency deductions. The computation reflects adjusted gross income, which is why they are discussed at this point. Each is computed differently, in ways that appear, and are, arbitrary. When students discover that one of the phase-outs depends in part on how many $2,500 amounts are included in the excess of adjusted gross income over an inflation-adjusted amount dependent on filing status, they roll their eyes. I don’t blame them. Those who have read several of my articles know that I consider the phase-outs not only nonsense but fraudulent deception of taxpayers by manipulative politicians, few of whom remain in office but whose legacy continues to afflict taxpayers and law students. Making things worse is the phase-out of the phase-outs, which itself is scheduled for phase-out in 2011. Finding ways to help students comprehend these complexities without taking them into the depths of a numerical world is a significant challenge, because expressing the concept without using numbers and illustrations is counter-productive. The saving grace is that the students know that I will not ask them to do a tax return or these sorts of computations on the exam or in a semester exercise.

The standard deduction, an alternative to itemized deductions for taxpayers with itemized deductions less than the applicable standard deduction, consists of two elements, both consisting of dollar amounts set forth in the statute and adjusted for inflation. Students have visited inflation adjustments when dealing with some earlier topics so that aspect of the analysis is review. The standard deduction also reflects the taxpayer’s filing status, and that topic is examined briefly because students are not required to learn the niceties of the rules applicable to more complex marital transformations.

It is fitting that when dealing with this topic the students return to a point emphasized very early in the course. They see first-hand that the tax law is dynamic and not static. Two phenomena confuse them, even after I explain it to them. First, the dollar amount for the standard deduction that appears in the regulations does not match what is in the statute or the revenue procedure containing the inflation-adjusted amounts. The explanation is simple. The IRS and Treasury attorneys responsible for updating regulations are so swamped that they leave to the back burner the changes that people should be able to figure out for themselves. Students share my doubts and their facial expressions confirm their disappointment at how tax law administration leaves much to be desired. Second, the regulations interpreting the terms used in the definition of one of the standard deduction components are not found where one would expect to find them. They continue to exist as an interpretation of the personal exemption deduction even though this particular tax break for age and blindness long ago moved from the latter deduction to the standard deduction. Some students bemoan how confusing it is, especially because the situation is preventable. Such are the realities of law practice that I try to share with my students.

Next: With taxable income in hand, let’s compute tax liability

It takes very little time to work through the computation of adjusted gross income. It’s simply a matter of looking at a list of those deductions which qualify for subtraction from gross income in order to compute adjusted gross income. Oh, well, sure, the list in the applicable statutory provision isn’t complete, and students learn that a few of these “preferred” deductions are hidden elsewhere. Why they’re not listed with the others is a question I cannot answer other than to guess sloppiness.

Students do need to learn why adjusted gross income is important. I tell them that a good mental exercise is to review their notes and to identify every instance in which adjusted gross income is a component of the analysis. I mention that it would make a good exam question. Does that qualify as motivation? Students also are told to think back to the beginning of the course, when they first met the overall structure of the taxable income computation and to ask themselves if corporations need to compute adjusted gross income. It’s a review question, I tell them. If they know the answer, I see a smile. If they don’t, I see frowns and sometimes worse.

Next: It’s time to compute taxable income

Finally, it is time to turn the students’ attention to the deduction for personal and dependency exemptions. It is yet another topic that reaches close to home for them, because all of them can identify with the special rules applicable to dependents who are students.

There are two major aspects of the topic. One reflects the definitions and the other is computational. I leave the computation issue, namely, the phase-out of the deduction, to the topic during which the students are taken through problems requiring the computation of taxable income.

The definitions are not, on the surface, particularly challenging. The elements are, for the most part, concepts with which the students are familiar. There are a few surprises, of course. Some students know that the spouse of a spouse’s sibling is not a brother-in-law or sister-in-law. Others learn this for the first time sitting in the tax classroom. The same phenomenon takes place in the decedents’ estates and trusts course that I teach, when some students learn that the spouse of their aunt or uncle is not their aunt or uncle, except under rather uncommon circumstances.

Another element in the definitions, namely, abode, causes special problems for students who are away at school and who otherwise qualify as a dependent. Because this particular issue is significant for most of their families, I let the students work through the analysis. If they learn anything, it’s that mundane decisions about driver licenses, voting registration, and selection of a permanent address to give to school officials end up affecting someone else’s tax return.

And, yes, they read about the disappearance of millions of dependents when taxpayers were required to provide social security numbers for dependents. They look at me, dumbfounded. There was that much cheating? Yes, and it simply has moved to other provisions. They laugh when I tell them that some people have claimed dependency deductions for pets. By this point, they know the outcome. Of course they laugh. Else they’d cry.

Next: It’s time to compute adjusted gross income

After working through the deductions that are covered in the course, it is time to turn to the overall restrictions that apply to deductions. Most students initially are confused, and it’s no wonder. Many deductions are subject to restrictions that apply solely to the deduction. For example, when the students are studying the deduction for home mortgage interest, they learn that only the interest allocable to the first $1,000,000 of acquisition indebtedness is deductible. When they are learning about the casualty loss deduction, they are introduced to the $100 floor and the ten-percent-of-adjusted-gross-income limitation. It’s no wonder that they are baffled by the addition of yet more restrictions.

What makes this part of the course, and this aspect of the tax law, confounding is the existence of multiple restrictions that apply to clusters of deductions. In some instances a particular deduction may be subject to more than one of these overall deductions. I don’t push J.D. students too far in dealing with how multiple restrictions interact because it simply is too complicated. Even tax practitioners get frustrated at the chaotic nature of the computations that reflect the inability of unwillingness of Congress and the inventors of these limitations to coordinate them in sensible ways.

There are five overall deduction restrictions that I put before the students. These are the at-risk limitations, the so-called hobby loss limits, the limitations on deductions with respect to rental residences and offices in home, the passive loss limits, and the general policy restrictions. Because I can allocate only three 50-minute class sessions to overall deduction restrictions, I limit coverage and I direct the students to teach themselves the policy restriction. I made that decision because the policy restriction does not involve computations, and requires analysis more similar to what they did during their first year of law school than is most of the analysis applicable to other topics in the course.

Coverage of the at-risk limitation includes a very basic introduction to the concept, a streamlined definition of amount at risk, an explanation of why the limitation was enacted and how it failed, the wrinkle that considers taxpayers at risk for their share of nonrecourse debt secured by real estate, and a quick peek at the recapture concept. I assure the students that they are not expected to do at-risk limitation computations.

The hobby loss restrictions are much easier to understand, and therefore I take the students through several examples. I do expect them to understand how the limits are computed, because they are not particularly difficult, though some students struggle with translating the statutory language into application. I cannot resist pointing out to the students the special rules for horse-related activities, just as I do not resist pointing out similar special provisions when I teach the depreciation material. On several occasions, comments to the effect that I hate horses or dislike horse lovers make their way onto evaluations and even into classroom discussion. I always invite students who wish to do so to defend the special treatment of horse-related activities. No student has ever taken up the challenge.

The residence limitations consume at least half of the allocated time because they are important. They affect many taxpayers. Though it is a guess, I tell the students that I’m confident at least half of them, and probably many more, will encounter these limitations in their own lives. Of course, that’s not to say they will be happy with the outcome. Most lawyers, for example, who have home offices are subject to the limitations. Because the IRS continues to adhere to its losing position in Bolton, despite losing every case it has litigated, the time required to teach the computation of deductions allowable in any event allocable to rental activities is twice what it would and should be. This situation provides an opportunity to describe to students the practical realities of taking a return position that is inconsistent with an IRS position but that will almost certainly be approved by a court if the matter is litigated. The intersection of theory and practice is a fascinating boundary to take students through.

Then it gets worse. The students meet the passive loss limitations. A topic that could be made the subject of an entire 2-credit LL.M. (Taxation) course gets squeezed into 30 minutes. To say that the students get just the basics is an understatement. There simply is no time to explore in depth the definition of passive, or the application of the rules to multiple activities. The carryforward rules and those applicable to disposition of a passive activity are left to some other time and place.

At least by this point, students understand why so many taxpayers who do their own returns are frustrated, why tax return preparers have become increasingly disenchanted, why tax software has more errors than there should be, and why my bias against the mess that passes for our income tax system is so difficult for me to hide. True, I don’t make much effort to disguise my evaluation of the tax law. Not surprisingly, few if any students disagree with me. The struggle is the realization that they need to learn so much nonsense because, as I tell them, no matter what I think and no matter what they think, it’s waiting for them when they enter practice.

Next: What do you mean there is no deduction for my dog?

There are three deductions available only to individuals that I consider essential for J.D. students to understand, even if only in general terms. These are the moving expense deduction, the medical expense deduction, and the higher education expense deduction. These deductions are relevant to many taxpayers, and of all three, the last should be of particular interest to the students.

Once upon a time, in a basic tax course long ago, I used classroom time to explore the first two deductions, the third not having yet been invented. As Congress added more and more provisions to the tax law, as it layered more exceptions and exceptions to exceptions onto the existing provisions, and as it piled more limitations onto the law, something had to be removed. First, it was the moving expense deduction. Ought not second and third year law students, at this point in the semester, be able to read and learn about these deductions without my in-class assistance? Is this not graduate school? My response, to the chagrin of most students, was yes to both questions. A few years later, the same treatment was accorded to medical expense deductions. In this instance, I limited the reading and carved away many of the peripheral issues. When Congress added te higher education expense deduction, my two thoughts were that students must become familiar with it and that there was nothing that could be removed from the course to create classroom time space for the topic.

My concern is that as each year passes, more and more topics will be added to the “learn on your own” list. It’s not that I think law students ought not be required at times to learn something by reading and thinking rather than listening. It’s a sense that over time the number of issues demanding attention will be more than double the number that can be handled adequately and sensibly during 42 50-minute class sessions. Is it any wonder I have no admiration for the Congress when it comes to taxation?

Next: Deduction restrictions

Wouldn’t it be nice if the applicable tax principle were so simple as the allowance of a deduction for the value of property or money transferred to a charity? That’s the general rule. It’s the exceptions that make this topic one that requires a significant number of class hours in an LL.M. (Taxation) program. For J.D. students, there’s not much of a choice. Keep it simple, keep it basic. Ignore most of the special rules. Do what can be done in 25 minutes.

For J.D. students, I break the topic into two pieces. One is the requirement that there be a gift to a qualified organization. The other is the concept of limitations.

For the first piece, I put to the students a series of questions that encourage them to focus on the concept of gift. Is the transfer of money to the local volunteer fire company a gift or should the payor’s desire for fire-extinguishing services in the event of a blaze negate the deduction? There is a long list of these sorts of questions, and usually student participation picks up. They understand the underlying transaction and they’ve heard about the deduction from family and news sources.

Because there’s no time to get into the qualification issue, I simply tell the students that most of the charities with which they are familiar, such as the American Red Cross and the National Multiple Sclerosis Society, are qualified. I let them know that most schools, including Villanova, religious organizations, and places of worship are qualified. If there is time I give them a two-sentence description of what being a qualified charity requires. The most important point I make is that they must verify the status of the donee organization before claiming a deduction.

The limitations piece gets a few minutes of class time. The 50-percent limitation is described. The other two may or may not be mentioned. The limitations applicable to the donation of inventory, partial interests in property, interests in trusts, conservation easements, and a variety of other restrictions simply must be left for an advanced course. That’s unfortunate, because it appears to me that more and more of our J.D. graduates are getting involved with charitable organizations, either as advisors or participants.

Next: The special deductions for individuals

There are at least two ways to teach the casualty loss deduction. One is to cover the core concepts. The other is to examine not only the fundamental principles but also the many twists and turns that are encountered in most casualty situations. For example, rarely is only one item of property damaged or destroyed, but time limitations and concern for the students’ mental health compel me to limit discussion to the destruction of one or two items. Likewise, I don’t take the students into the complex matter of post-deduction adjusted basis computations. At best, I can give this topic one 50-minute class session.

This is another topic well suited to a checklist, and so the students get one. I learned years ago that even by this point in the semester, it’s expecting too much to leave the students to their own design of a checklist. By providing the checklist, I get another opportunity to hammer home the essential nature of sequential, logical, and disciplined analysis. Some of the better students pick up on the similarity of tax analysis with computer programming, not in the numerical sense but in the logical sense.

Even the basic rules are complicated. Distinctions are drawn between business and personal casualty losses and between total destruction and partial damage. The concept of casualty gain must be introduced. The rules applicable to taxpayers who incur both taxable casualty gains and casualty losses cannot be ignored. The $100 floor and the ten-percent-of-adjusted-gross-income limitation also add complexity, particularly because one is applied per casualty and the other per year.

There is at least one fun issue that is part of this topic. One of the questions in the checklist is whether the loss was caused by a casualty. What is a casualty? Events such as fire, shipwreck, and storm are fairly obvious. Students are familiar with them. But what of massive Southern pine beetle attacks? Or the burning down of a house by a fire started when a man, angry with his wife, puts her clothes on the stove top and turns on the flame? What of houses that collapse when the effects of termites enjoying one too many meals manifest themselves? For the curious, the IRS takes the position that the damage fails to meet the “suddenness” requirement. Some courts have concluded to the contrary. So what does one tell a client if the house collapses days after the arrival of the so-called super termite. Apparently they are very hungry. I’ve learned so much teaching this course. So do the students who continue to be fascinated by the reach of taxation.

Next: Charitable contributions

For the second year in a row, MauledAgain has been featured in the latest Blawgworld. Take a look at BlawgWorld 2007. This honor follows the inclusion of MauledAgain in BlawgWorld 2006, which I reported in MauledAgain Featured in Blawgworld 2006. What I wrote then is worth repeating, in fewer words: I'm delighted that MauledAgain has been spotlighted, especially when there are so many new blogs popping up throughout the cyberworld. Please, do visit Technolawyer and consider joining. Law blogging has continued to grow, and it's most helpful to have Technolawyer providing guidance as we navigate through the options. When you visit, tell them I sent you. Tell them thanks for featuring a law blog that you read. And rather than tell you which of my postings was featured, I'll let you find out when you browse through your copy of the e-book.

Teaching J.D. students about the deduction for taxes is less challenging than teaching most of the other topics. Essentially, the Internal Revenue Code provides two lists. One is a list of taxes that are deductible and the other is a list of taxes that are not deductible. Of the more advanced issues that arise with respect to this topic, two get some attention.

One issue is the treatment of taxes connected with the acquisition and disposition of property. Because the students have already studied amount realized and adjusted basis, it is relatively straight-forward to examine the appropriate treatment of taxes, such as transfer taxes, paid by a buyer or seller of property. For students who have assimilated the property disposition material, dealing with this issue is easy. Students who by this point in the semester are weeks behind in their assimilation are lost, because they are presented with an examination of step 2 before they have incorporated step1 into their brains.

Another issue involves payment by one person of another person’s taxes. This issue is the flip side of the assignment of income doctrine, which is scheduled for coverage on the last day of the semester but which gets mentioned in passing several times earlier in the semester. The analysis is similar to the “two steps from one” approach used in determining the tax consequences of an employer making payments to a third party on behalf of an employee. Again, students who have assimilated the gross income and employment topics can absorb the rules quite easily while those who haven’t done so become even more frustrated with the course and with me.

One of the assigned problems also provides the opportunity to re-visit withholding, a concept introduced early in the semester when I provided to the students an example of why a first-year law associate’s take-home pay is less than gross salary. The students learn why the employee does not deduct social security taxes and why the employer does. They learn the difference between the tax treatment of employees and self-employed individuals for purposes of social security taxation. They learn why they are being set up for bad news in April if they are employed as “independent contractors” rather than as employees when hired by an attorney to work as a law clerk. That practice, which has put some lawyers and law firms in a bad tax spot, fortunately has abated, as indicated by the clicker question that I present, but to my surprise there continue to be some students who receive a check for a gross compensation amount and don’t know that come April they’ll be on the hook for a good chunk of social security taxes and perhaps federal income taxes. Usually I end up with a few students stopping by my office or emailing me after this class is finished.

Believe it or not, I try to cover all of this in 25 minutes. Usually I succeed in doing so, though sometimes I need 30 or 35. Yes, the joys of a three-credit course.

Next: The house burned down, the car crashed, the pine beetles ate the tree, and now it’s tax time?

Once upon a time, when I was first teaching the course, I used three minutes to teach the interest deduction. Interest was deductible, with one exception that received a two-and-a-half minute explanation. The limitation on the deduction of investment interest was conceptually easy to examine and its technical details did not need or warrant a huge time investment. The few other exceptions then in existence were narrow and of no value to a basic course.

All of that changed when Congress enacted the limitation on the deduction of personal interest and carved out exceptions to that limitation. One major exception is the deduction for qualified mortgage interest. It’s a very important exception, both in terms of tax policy impact and the number of affected taxpayers. It’s something that some students have encountered, in general terms, when watching or reading news or listening to parents and other older family members talk about taxes or home purchases.

From a tax teacher’s perspective, the details of the applicable provisions are a treasure trove of educational opportunity. Cross-references, exceptions to exceptions, and taxpayer options abound. Unresolved issues demonstrate the challenges of crafting hyper-technical tax laws. Terms are given definitions for tax purposes that are at odds with their use in the world generally. For example, lenders use the term “home equity loan” in a way that conflicts with the tax definition. Indeed, the tax definition conflicts with the definitions used in other areas of the law.

Congress also made this one-time brief topic an excursion into a tax thicket by enacting the imputed interest rules. There are three, but I turn the students’ attention to the provision imputing deemed transfers between family members when there is a low-interest or no-interest loan. I invest a few minutes highlighting the parallel provisions for employment and corporate ownership low-interest and no-interest loan transactions. Again we meet a provision filled with an array of definitions and exceptions. I do my best to simplify or marginalize the computational aspects by short-cutting the interest computations. I prefer to focus on the conceptual twists, namely, the bizarre notion that a parent who makes an interest-free loan to a child will have, under many circumstances, gross income. This aspect of the provision is particularly frustrating for the students. But to ignore it would be to mislead them and to increase the risk that they would run into tax problems, either in their personal lives or while structuring deals for clients.

I must point out that this topic was one of the first that found its way into Powerpoint slides. The illustration of the deemed transfer and deemed re-transfer make it easier for the students to comprehend what Congress has designed, and to understand that other Code provisions, already studied, are the ones that specify the outcomes.

Next: Some taxes are deductible and some aren’t

The provision permitting deductions related to for-profit activities, to use a loosely-formulated succinct description, is fairly easy to cover after having considered trade or business deductions because several of the definitional components are the same. Having set aside only one-half of a class to examine the topic, I emphasize two points.

One important consideration is the very subtle, yet important, difference between the requirements for a deduction arising from a for-profit activity and a deduction for a loss arising from a transaction entered into for profit. The best example is that of a person who tries to sell a principal residence but then rents it out to tenants because the housing market is not favorable. There are cases permitting the rental expenses as deductions of a for-profit activity but disallowing the loss incurred when the property is sold. Some students struggle with the distinction, especially if they are not accustomed to working in areas demanding significant precision. At this point in the semester, students who are having difficulties understanding the technical difference between the meanings of similar, yet distinct, phrases need to know that they would benefit from more intense statutory interpretation practice.

Another important consideration is the allowance of a deduction for the expenses of preparing tax returns and obtaining tax advice. I take the opportunity to reinforce a point I made when dealing with the inclusion and deductibility of alimony, namely, how essential it is for attorneys to provide clients with invoices broken down into the specific tasks performed by the attorney so that the portion attributable to providing tax advice can be identified with little or no effort by the tax return preparing. Finally, I inject some humor into the picture by describing the case of an LL.M. student who, failing to qualify for an education expense deduction, tried to obtain a deduction for his LL.M. tuition because he characterized the education as an expense of preparing his tax return. Goodness, part of me admires his courage and his inventiveness, especially when I consider how much one needs to know and understand to prepare a tax return. Yes, he lost. But the students again have the chance to appreciate why tax can be fun.

Next: The three-minute topic that became a three-hour topic

Six specific trade or business deductions receive more than passing mention in the course. Two of these are left to the students to learn on their own, namely, the deduction for reasonable compensation and miscellaneous business deductions, such as the deduction for work tools and work clothing. Four 50-minute class sessions are set aside for a greater or lesser scrutiny of travel and transportation expenses, education expenses, losses, and depreciation.

Over the years coverage of the travel and transportation deduction has diminished, to the point where describing it as cursory would be generous. At best, students come away understanding that the cost of commuting is not deductible, learn that meals are not deductible unless the travel is overnight, and examine the concept of tax home and away from home. They don’t dig into all the permutations of business travel. For example, the rules applicable to meetings on cruise ships are passed by.

Education expenses get attention. Once again, the students meet a topic that relates directly to their lives. Once again, they’re unhappy. No, they can’t deduct their tuition. Sometimes I hear expressions of disappointment. Even though they aren’t education expenses, I toss in bar admission fees, bar dues, and several similar items. There’s something gratifying about making a course relevant.

Trade or business losses don’t require much time. I take the opportunity to bring the section 267 loss disallowance and nonrecognition rules into the line-up, because they involve situations in which bad planning triggers bad tax consequences.

The substantial portion of the allocated time is dedicated to depreciation. Even without sinking into the details, there are all sorts of issues to explore. The dynamic nature of the tax law is demonstrated by the existence of three major depreciation systems. The timing aspect of the deduction needs attention. The difference between straight-line and accelerated depreciation must be understood. There are conventions, methods, and sub-systems. There is the section 179 expensing overlay. This is another example of how the tax law constantly changes. This provision has been amended almost every year during the past decade.

Many law faculty try to reduce depreciation to concept, but I think that without visualizing the way the deduction “spreads out” under the different combinations of section 179 and the depreciation methods there’s no way to appreciate the significance of the choices faced by the taxpayer. The depreciation computation is simple, at least at the level to which I take the students, because it consists chiefly of finding the appropriate table and doing a simple multiplication. Lest anyone think it’s too complicated, rest assured I do nothing with the additional layer imposed by section 280F other than to point out its existence and general purpose and scope. It was worse when the section 168(k) bonus depreciation was in place. Fortunately, that’s gone, at least for the moment.

When I’m told that this is too complicated, I reply that I do the students a disservice if I portray the law as something less than it is. The Congress doesn’t smooth things over for lawyers. Even so, I do oversimplify much of this topic, and others, so I resist further attempts to water this topic, or the course, down to something so simple it’s useless when applied to the practice world as it exists.

Next: For-profit activities

Finally, usually 2 or 3 classes behind schedule, we reach deductions. After a brief overview of the four groups of deductions, I jump into the first, trade or business deductions. Waiting for their turn later in the semester are for-profit activity deductions, deductions allowable in any event, and deductions limited to individuals.

About one 50-minute class is used to understand the core ingredients of section 162(a), namely, ordinary and necessary, paid or accrued, trade or business, and carrying on. Also included in this cluster is the distinction between repair expenses and capital expenditures.

As one might imagine, none of these definitional elements or concepts is treated in ultimate detail. As has been the case all along, there simply isn’t enough time. So my goal is to sensitize the students to the issues. Ultimately, the questions are factual ones, which frustrates the students. Whether something is ordinary and necessary, whether someone is carrying on a trade or business, whether an activity constitutes a trade or business, and whether an outlay must be capitalized depends on the specific facts of the transaction. All I can do is to have the students think about some specific instances and hopefully acquire a sense of how it all works out.

To convey the significance of the “carrying on” requirement, I use a problem that involves job search expenses. This resonates with law students. Of course, they’re not happy with the result of applying the law to their own circumstances. It is enlightening for me to hear all the clever, but futile, arguments that they raise in their attempts to persuade me that they are carrying on the trade or business of practicing law when they work as law clerks. Even if they accomplished the impossible, they would need to persuade the IRS. What matters, though, is that they try, and in trying they exercise their brain cells.

Next: Specific trade or business deductions