Tax Chart Production Heats Up

The last time I posted about Andrew Mitchel's new tax charts, I titled my comments "It's Sleeting Tax Charts," a spin-off of the title to my previous post on Andrew's charting activities, "It's Raining Charts". It turns out that yet another person put the summer to productive authoring use, joining myself and Julian Block in generating information useful to the tax practice community. It's too soon to say it's snowing charts or even falling charts, so I had to go with the post title you see above. Eventually I'll run out of weather analogies and will be required to put the chill on that approach to keeping up with the steady stream of charts from Andrew Mitchel.

Andrew has out-done himself this time. He added 129 charts to his collection. Yes, that's not a typo. It's not twenty-nine, it's ONE HUNDRED AND TWENTY-NINE. There are now more than 500 charts on his web site. They can be accessed by topic or chronologically. I've noticed what might be old news, but is new for me, and that is people can order color prints of the charts.

What's in the batch of 129 new tax charts? According to Andrew:

The latest installment includes charts of the recent Heinz case, 28 examples from recently proposed spin-off regulations, as well as charts of basic section 351 exchanges, section 721 exchanges, and much more!

The tax law being what it is, a complex ever-changing conglomeration of rules and exceptions to rules, it isn't surprising that Andrew was required to update "twenty-seven charts with examples of indirect stock transfers under section 367 ... to reflect changes made by Treasury Decisions 9243 and 9311."

For those needing cross-references to my previous commentary on Andrew's chart work, look here, here, here, here, here, here, here, here, here, here, here, here, here, here, here, here, and here.

Happy navigating!

Tax Travels and Tax Moves: Book It with Block

It seems I wasn't the only person who did some tax writing over the summer, though I don't think Julian Block tapped on a keyboard while out on an ocean. Julian has added another title to his expanding list of tax books that permit a tax novice or someone not educated in tax law to grasp a discrete topic while working through a text of manageable size.

In February 2006, I reviewed his "MARRIAGE AND DIVORCE: Savvy Ways For Persons Marrying, Married Or Divorcing To Trim Their Taxes - And They’re Legal," in Tax and Relationships: A Book to Read and Give. August brought a review of Julian's "THE HOME SELLER’S GUIDE TO TAX SAVINGS: Simple Ways For Any Seller To Lower Taxes To The Legal Minimum," in A New Book on Taxation of Residence Sales: Don't Leave Home Without It. Julian's 2006 hat trick of books closed with my December review of "TAX TIPS FOR SMALL BUSINESSES: Savvy Ways For Writers, Photographers, Artists And Other Freelancers To Trim Taxes To The Legal Minimum," in A Tax Advice Book for People Who Write and Illustrate Books. Early this year, I reviewed "Year Round Tax Savings" in Another Tax Book for Tax and Non-Tax People to Read.

Summer 2007 brings Julian's latest work, "Travel and Moving Expenses: How To Take Maximum Advantage Of Every Tax Break The Law Allows." Off I go on a trip, and out comes Julian with a book about the tax implications. How nice. Now perhaps if I could deduct the cost, but that's not going to happen, and if I had any inclination to think that it would, and I don't, Julian's book would have steered me away from running aground with a bad tax return.

Julian's book is helpful not only because it showed up with coincidental timing and with good advice for me, but also because it takes the reader through what can best be described as a maze of tax law dead-ends, roundabouts, detours, and temporary roadblocks. Moving from the theoretical statement that travel expenses paid or incurred in carrying on a trade or business or the principle that moving expenses are deductible to the practical task of applying those concepts to a taxpayer's bundle of receipts and business records is about as daunting as finding one's way around Europe without a GPS. Julian's book is a nice, entry-level GPS for those trying to navigate the travel and moving expense deductions.

Julian begins in the same place I do when I teach these topics, specifically, the rule that commuting expenses are not deductible, unless one of several exceptions applies. He takes the reader on a tour of cases and rulings in which taxpayers have and have not docked their specific circumstances within the safe harbor of the tools exception and the "between jobs" exception. Drifting beyond what I have time to cover in the basic course, he takes readers on a tour of the restrictions applicable to the expenses of having one's spouse come along for the ride, so to speak. He explores the challenges faced by spouses who work in different cities, once a rare concern but now a situation faced by increasing numbers of couples. Julian closes out the travel expense section of the book by reminding all of us, myself included, that deductions are not allowed for the cost of travel that is in and of itself educational, in contrast to travel that is deductible because it transports the taxpayer to a place where the taxpayer takes courses the cost of which qualify for the education expense deduction. This is a subtle distinction that often derails students dealing with these issues for the first time.

With respect to moving expenses, Julian takes the reader on a path that leads from the distance test, through direct costs of moving household items and expenses of travel to the new location, past the time time test and the closely-related test, and to the cul-de-sac of nondeductible moving expenses. He outlines the paperwork that the taxpayer needs to prepare and maintain. He describes how taxpayers can accelerate the tax savings from the deduction by adjusting withholding so they are taking home more money each pay period rather than waiting for a larger refund the following spring.

Julian then devotes a chapter to travel expenses that qualify for the charitable contribution deduction, another chapter to those that qualify for the medical expense deduction, and yet another to those that qualify for the for-profit activity or investment deduction. These are travel expenses often overlooked by taxpayers and their return preparers.

As he has done in earlier books, Julian makes certain that the reader sees examples of the rules as applied to specific facts. Students who are trying to go further into tax law than time permits their course instructors to take them will benefit from strolling through this book. So, too, will taxpayers and tax return preparers who need to learn or refresh their understanding of these two very specific areas of tax law.

Compensation is Compensation

Joe Kristan responds to my analysis of the special low tax rates on hedge fund manager compensation with two concerns. Both are valid but neither should get in the way of fixing an injustice.

In response to my comment that "there's no unanimity in the mechanics of the reform, but once the competent put their minds together it ought not take long to work out the details" Joe notes that it is the Congress, and not the competent, that writes tax laws. Yet why not permit competent reformers to prepare the language of the statute in much the same way that special interest group lobbyists and their staffs have prepared much of what has been shoved into the Code during the past decade or two? Members of Congress haven't drafted tax statute language for decades, and one cannot expect them to produce anything of quality, but having let the lobbyists overshadow the tax-writing staffs is a bad trend reversal of which can begin with this particular reform.

Joe's seemingly bigger concern is that amendments making partnership interests received for services taxable as ordinary income would "disrupt.. the management structures of any number of LLCs operating real businesses." Good. A hedge fund is a business. So is the management of any business, including real estate, shoe stores, and lawn mowing services. I'm all for taxing compensation as compensation, and that means ordinary income tax rates should apply. Joe explains that "'Carried interests' are really just 'profits interests,' which are a way to let management share in the growth of a business without having to make a big cash investment or pay a bunch of taxes before they earn anything. Exactly. Profits interests, in contrast to capital interests, represent economic gains that taxable as ordinary income. That they get paid at a later date goes to the timing issue, which I address in my proposal. Joe then points out that carried interests "provide a result very similar to a grant of restricted stock coupled with a Section 83(b) election," which in some respects is an accurate representation. The difference is that because of the way C corporations are taxed, all sorts of ordinary income gets treated as capital gain. There is, for example, no section 751 equivalent for C corporations, aside from a few narrow situations. Even so, when a person receives stock from a corporation as compensation, its value is taxed as ordinary income either when received or when vested, depending on whether the section 83 election is made. By choosing to be taxed at the outset, the recipient is taxed at capital gain rates on future increases in the stock's value. I'm content to have a similar provision apply to compensation received by hedge fund and other managers and employees of partnerships. What currently happens with the hedge fund arrangement is that capital gains treatment applies without the employees and managers paying the price of having ordinary income at the outset. That doesn't happen in the C corporate context, which is why "in some respects" is the critical part of my comment that Joe's analogy "in some respects is an accurate representation." It's that difference that matters very much.

The bottom line is that tax reform of any sort must elevate the common good over the special interests, no matter how entrenched the special interest provisions are or how accustomed the select few are to their special tax breaks. The fact that the tax treatment of partner-employees has been wrong so long is no reason to worry about the supposed disruption that fixing an injustice will cause to those who benefitted from the unwarranted consequences of glitches in the tax law.

Taxing Compensation Of a Select Few at Special Low Rates Is Wrong

Now that the summer sojourn is over, and I've returned from journeys in places where Internet access is neither as available or as inexpensive as it is here, I can turn my attention to a variety of topics that made their way into my consciousness even though I was far away. I'm taking them in no particular order, neither alphabetical nor chronological.

Today I turn to an issue that brings out the worst in the tax law. It's the tax treatment of so-called carried interests. To put that in English, it's the question of what tax rate should apply to the money that someone earns for performing services, when that money is paid in the form of a partnership interest that can be "cashed out" at some time after the services are performed. Because of quirks and disjointness in the way partnerships and partners are taxed, people being paid to provide services to hedge funds, investment services enterprises, and similar operations are being taxed long after they are compensated with partnership interests and at those special low tax rates applicable to capital gains. In the meantime, people performing services for factory owners, service station owners, hospitals, fire and police organizations, fast food outlets, and other enterprises are taxed when they paid and at regular tax rates. Even the service station owner, fast food entrepreneur, and factory mogul are taxed at regular tax rates on the profits they generate from running a trade or business. I wonder how many of them know what is going on, and understand the realities that lie underneath all the arguments and spin being offered in defense of an unjustifiable situation. So I add one more item to the list of reasons that some basic tax policy ought to be taught in high school.

The outcry over this discrepancy has climbed to a crescendo during this past summer. Critics have made their voices heard, and proposals for "fixing" the problem, chiefly the flaw in the partnership taxation structure, have been advanced. For example, several members of Congress introduced this proposed legislation. Defenders of the status quo, initially caught off guard, have marshaled their resources and are lobbying the Congress most furiously, throwing time and money into preservation of a totally unjustified tax break. Even a few folks who seemingly have no stake in the matter have spoken or written in favor of special low tax rates for hedge fund managers. Oh, if you haven't figured out by this point where I stand on the matter, I'll give a hint with a question. What is it that hedge fund managers and others of that ilk do that entitles them to being taxed on compensation at rates far lower than those applicable to the compensation of other workers and sole proprietors?

To be fair, hedge fund managers and their advisors aren't doing anything legally or technically wrong. The tax law is flawed, and it leaves open an opportunity for what the hedge fund managers and their advisors have done and are doing. That flaw was not created by the hedge fund managers or their advisors. It exists because Congress tried to make everyone happy when it enacted, and continued to amend, the partnership taxation structure, without thinking through to the end the consequences of what it put into the statute. Surely the hedge fund managers and their advisors should get high grades for detecting the opportunity and taking advantage of what Congress carelessly provided. But now that the tax defect has been identified, it's time to fix it.

Congress, to its credit, has been holding hearings on the issue. It took testimony on July 12 and on July 31. In fact, more testimony is scheduled for tomorrow. Statements by some witnesses and by a few members of Congress suggest that they don't truly understand the justifications for the existence of special low tax rates on capital gains or, more importantly, why those special low rates ought not apply to a person's compensation income. A very good explanation of the "sentimental sophistry" in their reasoning can be found in the testimony of Professor Darryll K. Jones, a rising bright star in the world of partnership taxation.

The arguments raised by supporters of this unintended tax break range from the erroneous to the misleading. A helpful summary has been presented by the Citizens for Tax Justice in "Myths and Facts about Private Equity Fund Managers — and the Tax Loophole They Enjoy".

Consider this argument from the National Venture Capital Association (NVCA): "But the reality is this is always the way it's been. We basically say, It's worked for years, so why change it?" The answer is simple. Because it's wrong. It wasn't intended, it isn't the sort of activity that comes within the protective mantle of capital gains taxation, even if one is to accept, arguendo, that there should be special low tax rates on capital gains.

The NVCA also claims that taxing compensation at regular tax rates would discourage innovation. Really? If that's true, then ought not scientists, medical researchers, space shuttle engineers, highway bridge designers, and just about everyone else whose creativity and intellectual skills contribute to society, often contributing far more than some fund manager sitting at a desk shuffling other people's money does, get a similar tax break? Are we somehow to conclude that those folks aren't innovative and that the only innovation taking place is whatever it is that investment services advisors and hedge fund managers are supposedly contributing, when in fact it's their clients who are coming up with the few truly good ideas that have come out of the tens of thousands of wild ideas that have been financed with venture capital?

Then there is the old chestnut, the "changing our good deal will destroy the economy" argument. Used almost annually by the real estate industry to justify such things as depreciation of appreciating buildings and treatment of nonrecourse debt as recourse debt for at-risk purposes, the not-so-veiled and pipe-dream threat often succeeds in getting members of Congress to cave in to some special interest. Eventually every special interest will get special low tax rates, leaving the bulk of the tax burden to fall on the not-so-special interests. Of course, since (and I say this sarcastically) all of us are special, there won't be anyone left to tax at regular rates. The reason the "economy will suffer" argument is such nonsense is that the taxation of ALL compensation at regular tax rates will not stop the planet from rotating and will not stop people from doing their jobs. In other words, life will go on and the economy will continue to function. It is interesting how special interest groups not only consider themselves deserving of special treatment but somehow conclude that their presence on the planet is the sina qua non of everything good that happens to anyone. What nonsense.

Another argument, that fixing the flaw and taxing the compensation of hedge fund executives at regular rates would damage pension plans, has been refuted by the pension funds themselves. One would think that, for all their alleged brilliance, these super-special low-taxed employees would have touched base with the pension fund experts.

Two other arguments are suggested in this Wall Street Journal article. One is that there's not much revenue involved and the other is that Congress has other, more important things to do. To the first, I respond that every bit helps, and that the message sent by a Congress countenancing special low tax rates on the compensation of a select few further distances itself from an increasingly frustrated population. To the second, I respond that all of us have long "to do" lists and the Congress is quite capable of getting its work done if the members truly wish to do so. The second argument isn't very different from one that advocates letting bank robbers run wild because the police have too many homicides to handle.

What do these selected special few do with their tax savings? Apparently they contribute to the campaigns of members of Congress. These are partisan supporters. They send money to politicians of every party and every persuasion. They don't care who protects their tax break, and they're willing to pay. Considering the Administration's reluctance to support reform, the President being "very, very hesitant" to make changes, I wonder if this is the sort of political atmosphere that it prefers and that it is trying to export abroad.

Very little of what I've written is ground-breaking, and perhaps none of it is. While I was away, more than a few tax faculty chimed in on the issue. As Victor Fleischer points out in "The Academic Consensus on Carried Interest ", there is an "academic consensus" on the question. I find myself in agreement with a group of faculty whose perspectives are all over the tax policy spectrum, including some with whom I sometimes disagree on other matters. When the academic tax community is this much in agreement, it speaks volumes about the need for reform. As Victor points out, there's no unanimity in the mechanics of the reform, but once the competent put their minds together it ought not take long to work out the details. I would require inclusion in compensation income, taxed at regular rates, of the value of what is received, and if it cannot be valued, I'd require that the taxable year be held open until the interest is sold, liquidated, gifted, or passed at death, at which point I'd have the tax for the earlier year recomputed, and then paid, with interest, by the recipient or the recipient's estate.

But the academics are not unanimous in calling for reform. One academic who has come out in favor of the current special low tax rates on hedge fund managers, obtained funding for the research from the Private Equity Council. Another academic, a person I know and hold in high regard, points out that he addressed the subject in "The Taxation of Carried Interests, 116 Tax Notes 183," in which he addresses the "practical difficulties" that reform would generate. He notes that communication between tax academics and tax practitioners has declined significantly, an observation with which I agree, asserting that "these academics really don’t know much about what lawyers do." Yet the fact that some tax practitioners are, as he points out, "intellectual and curious" doesn't mean that the deals they cook up are appropriate or deserve a Congressional imprimatur. The proposal that I offer in the preceding paragraph deals with the practical problem of valuation in a manner not unlike that used in other areas of the tax law where valuation might otherwise be an obstacle. I'm simply not persuaded that there are any insurmountable practical problems, and if there is a challenge in making a transition to appropriate taxation of compensation, that's a small price to be paid for an unwarranted tax break that has been enjoyed for far too long. What might be impractical is going back and collecting the taxes that would have been paid had the compensation been taxed all along at regular compensation rates, so perhaps the advocates of this unjustifiable special tax break ought to consider seriously the risk of facing truly impractical legislative reactions.

Of course, all of the reform proposals, including mine, merely deal with a symptom. The issue would not exist if there were no special low tax rates for capital gains. To its credit, the Wall Street Journal article calls for the same genuine reform that I've advocated for more than three decades. Abolish the special low tax rates on capital gains. Those rates account for almost one-third of the Internal Revenue Code, as the Congress has had to apply piecemeal fixes to a bad idea gone very wrong. It is true, as some defenders of the tax break for hedge fund managers claim, surely some other arrangement will be structured that uses some other flaw in the tax law to turn ordinary income into capital gains. In the long-run, until and unless Congress repeals special low tax rates for capital gains, we will continue to learn about new and improved mechanisms for giving a select few an unintended tax break, we will continue to read and write about the outrage and the call for reform, we will continue to listen to the defenders of the unintended tax break hail its importance to the economy and all that is good, and we will continue to ride a never-ending tax circle. So I doubt this is the last word I will have to say on the issue.

Structuring the Basic Tax Course: Part XL

The course concludes with a study of the assignment of income doctrine. Actually, the course concludes with my ten-minute summary that projects what the students have done into their future professional careers and, after I depart, with the course evaluations.

There has never been a semester in which more than 10 or 15 minutes have been left for the assignment of income topic, despite the budgeted 50 minutes. What prevents this from becoming a major problem is that the students have dealt with the question of whose income is it and whose deduction is it throughout the course. Early in the course the students are given a problem in which an employer makes a transfer to an employee’s spouse as incentive for the employee to refrain from resigning, and thus early on they come to understand the concept of indirect transfers, the step transaction doctrine, and the principles that income is taxed to the person who earns it and to the person who owns the property that produces it. Of course, underneath those rules lurk all sorts of questions that arise when specific fact patterns are analyzed.

Students also encountered the assignment of income issue when they looked at the deduction of taxes paid by one person with respect to another person’s property and when they focused on the reasons for the existence of the provision taxing the unearned income of certain children at the parents’ marginal rates. They would have learned much more if the chapters in the text addressing the taxation of trusts and business entities were covered, but those matters have always been left to other courses, with the expectation that students would enter them possessing a knowledge and understanding gleaned in the basic course that would serve them well. Ultimately, whether that happens pretty much is in the student’s hands.

The course is not finished. There remains the final examination, the score on which at the moment counts for 2/3 of the course grade, the other 1/3 coming from the dreaded but necessary semester exercises that ultimately earn the respect and even gratitude of most students. Even when the students are finished with the examination, I continue to tend to the course, investing time in the very educational process of grading the examination. And then it’s off to find and learn the next batch of annual changes and to update the course for the next academic year. That process is one I will describe some day, because few people, even my colleagues, grasp the complexity and depth required to update a tax course.

Next: There is no nextin this series, though there are many planned "nexts" for MauledAgain, especially if the list of pending post topics holds up. Hopefully this series of posts about the basic federal tax course have been instructive not only to those who teach basic tax courses but also to the students who enroll in them, to practitioners who hire law graduates who have been in them, and to people who are curious about this particular law school course even though they are not lawyers or law students. There surely are other effective ways to structure a basic federal tax course and to select depth of coverage for its topics, but perhaps my explanation of why I do what I do with the course will give someone an idea or two for their own course. In some ways, this series of blog posts is inspired by the fact that during the upcoming semester two of my colleagues will be joining me in teaching the basic federal tax course when they step in to succeed two colleagues who no longer will be teaching it. I figured that my responses to their articulated and anticipated questions would be of interest to more than just the two of them. And I also figure that there will be more questions.

Structuring the Basic Tax Course: Part XXXIX

The tax benefit rule is one of those tax doctrines that at one time or another affects almost, if not, all taxpayers. The core question is how to treat the receipt of money or property in one year that represents a return of amounts spent and deducted in an earlier year. For J.D. students in a basic tax course, the issue is best illustrated by its most common occurrence, the state income tax refund.

The basic rule is fairly simple. The amount received must be included in gross income to the extent it provided a tax benefit. In the case of a state income tax, the determination of whether a tax benefit occurs is accomplished by computing what the taxpayer’s taxable income would have been without the refunded tax having been deducted with what the taxpayer’s taxable income was with the refunded tax having been deductted.

There are two aspects of the topic that make a fitting next-to-last topic for the course. First, it requires the students to look again at the computation of taxable income and the big picture that illustrates the overall structure of the federal income tax. Second, it drives home the point made early in the semester and reiterated several times, namely, the tax law is dynamic. Students learn that in order to determine how much of a state income tax refund received in 2006 with respect to a tax paid and deducted in 2005, the preparation of the 2006 return requires a hypothetical reconstruction of the 2005 return, using 2005 law and inflation-adjusted amounts.

Next: So whose income is it?

Structuring the Basic Tax Course: Part XXXVIII

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

Structuring the Basic Tax Course: Part XXXVII

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

Structuring the Basic Tax Course: Part XXXVI

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

Structuring the Basic Tax Course: Part XXXV

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

Structuring the Basic Tax Course: Part XXXIV

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

Structuring the Basic Tax Course: Part XXXIII

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

Structuring the Basic Tax Course: Part XXXII

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

Structuring the Basic Tax Course: Part XXXI

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

Structuring the Basic Tax Course: Part XXX

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

Structuring the Basic Tax Course: Part XXIX

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

Structuring the Basic Tax Course: Part XXVIII

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?

Structuring the Basic Tax Course: Part XXVII

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

Structuring the Basic Tax Course: Part XXVI

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

Structuring the Basic Tax Course: Part XXV

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

Two Years In a Row: BlawgWorld and MauledAgain

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.

Structuring the Basic Tax Course: Part XXIV

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?

Structuring the Basic Tax Course: Part XXIII

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

Structuring the Basic Tax Course: Part XXII

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

Structuring the Basic Tax Course: Part XXI

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

Structuring the Basic Tax Course: Part XX

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

Structuring the Basic Tax Course: Part XIX

The gross income segment concludes with a close look at the tax consequences of alimony, child support, and property settlements. It is not too difficult to learn what needs to be done to cause an alimony payment to be includible in the gross income of the payee spouse, which makes it deductible by the payor spouse, One can see the transition developing in this topic, as it is impossible to understand the gross income aspect of alimony without considering the deduction.

The challenging aspect of this topic is alimony recapture. This is the students’ first encounter with recapture, one that they will meet again and again as the course progresses. Recapture is yet another timing concept. What makes it frustrating is the absurd computational scheme. Ignoring the computations removes the ability to illustrate how it works, and without the illustrations students simply don’t “get it.” So I end up using at least 2 50-minute classes working through the basic alimony definition, recapture, child support, and property settlements.

The topic involves not only the timing impact, but also the impact of tax rate differentials. These include not only differences between the spouses’ rates, but also differences between the rates applicable to each spouse in the year or years of payment and in the year of recapture.

The topic also provides a marvelous example of why domestic relations lawyers need to understand tax. One or two tales of malpractice gets the students’ ears, though the ones who need to hear this aren’t in the course. Students learn, for example, that the timing of the first payment and one spouse’s departure from the household can have significant adverse or beneficial tax consequences.

Next: It’s deduction time

Structuring the Basic Tax Course: Part XVIII

Because the taxation of damages depends on what the damages represent, it makes sense to leave this discussion to near the end of the gross income segment of the course. Afer all, if a person successfully sues for an unpaid annuity, the damages are taxed as though an annuity had been paid. Damages representing unpaid tax-exempt interest are excluded from gross income. To tackle damages earlier in the course would be counterproductive.

In recent years, the Supreme Court has addressed the taxation of damages more than a few times. For me, the question is what to remove from the course to “make room” for the more recent decisions. It’s not an easy choice. It is one factor in the decision to reduce significantly the emphasis on like-kind exchanges. It is, though, an opportunity to explore the policy issues underlying the exclusion of damages for physical injuries and to ponder the meaning of physical in this context.

Next: Alimony and child support

Structuring the Basic Tax Course: Part XVII

When it comes to teaching the taxation of investment income, I let the students teach themselves the two easiest topics, and use classroom time for two topics that are more difficult for students to learn on their own. It ought not take students more than a few minutes to learn that interest and dividends are included in gross income, and that tax-exempt interest is not. I tell them not to worry about the technical requirements that must be satisfied in order for the interest to qualify as tax-exempt. It also is not yet time to examine the special low tax rates that apply to most dividends. I also let the students teach themselves the basics of the education bond interest exclusion, because it is helpful for them to appreciate that they can teach themselves something new, an experience sure to occur many times while they practice law.

It is with life insurance and annuities that the students need assistance. Though many have heard of life insurance, very few have a clue as to what annuities are. Those who have heard of life insurance rarely understand its components or how it works beyond providing a death benefit. Once again, the challenge is not the tax law but the underlying transaction. This phenomenon is consistent with the observation that first-year students have more difficulty with, and thus less fondness for, civil procedure and contracts than torts, because they are less familiar with the transactions involved in the former courses. I’ll resist the temptation to write an essay on the need for undergraduate institutions to teach their students about two subjects with which every person must cope, whether or not in law school.

So why include these two topics in the course? Both introduce students to another timing concept, that of basis recovery over a period of years. Both are key ingredients of subsequent tax courses, including corporate and partnership tax and estate planning. Annuities are the foundation of retirement plan distributions, so students intending to practice in that area, and students intending to receive retirement plan distributions, benefit from the brief introduction they receive in the course. In other words, these are topics with practical implications for the students’ lives and professional careers. It is frustrating that only 25 minutes can be allocated to this topic.

Next: Taxation of damages

I Doubt I Agree, But I'm Not Complaining

OK, so I don't interrupt my blog series on designing the introductory J.D. income tax courses to comment on the recent change-of-heart in Murphy, but I do need to interject this bit of information. On Murphy, what could I add to what others have said. I doubt anyone else will comment on this bit of information.

According to the editor of CollegeDegree.Com, a site dedicated to providing reviews and advice about on-line college and graduate degrees, I've made their list of 55 of the Hottest, Smartest, Most
Talked About College Professors. I'll buy one of the smartest, small ego that I have. I don't think anyone, including myself, could go with hottest. Talked about? Who knows? Perhaps some folks are so bored they need to amuse themselves talking about a tax law professor and author.

So I'll enjoy one of my fifteen minutes of fame. Surely I'll be bumped off the list by some parvenu whose name appears with that bullet with which so few of today's music fans are familiar.

Structuring the Basic Tax Course: Part XVI

There are dozens of nonrecognition provisions in the Code. Many would require several classes to study in detail. Putting all of them, or even the major ones, on the syllabus would require a 6-credit course. What’s a tax law professor to do?

Nonrecognition cannot be ignored. It is one of the pillars of corporate tax, partnership tax, taxation of real estate transactions, international tax, and several other areas. It is a concept essential to the courses to which some students will progress. It is a key ingredient of the basic federal income tax course.

Some tax law faculty try to cover three or four of the provisions, especially like-kind exchanges and involuntary conversions. In the Taxation of Property Dispositions course, these two topics together require at least 6, and preferable 8, 50-minute class sessions. There’s simply no way to assign as much as 20% of a 3-credit basic tax course to nonrecognition.

Much of the time required to learn a nonrecognition provision arises from the need to absorb a wide array of definitions and limitations. My goal in the basic tax course is to familiarize the students with the concepts common to nonrecognition provisions, particularly the use of adjusted basis to “preserve” the gain or loss that has been deferred.

So after giving the students a 3-minute introduction to the scope of the most common nonrecognition provisions, I use the provision applicable to transfers between spouses and former spouses to get across to the students the practical application of what is a fairly simple nonrecognition provision. This gets the point across with a minimum investment of time.

Next: Taxation of investment income

Structuring the Basic Tax Course: Part XV

Only 25 minutes are budgeted for a study of section 121, the exclusion of gain from the disposition of a property owned and used as a principal residence for the requisite amount of time. I easily could take the students on a journey of 2 or 3 classes and still not get into the plethora of interesting issues arising with respect to this provision.

So students learn the basics. They learn that there is a limit on how much gain can be excluded and that the limit varies depending on filing status. They learn about the “2 years out of 5 years” ownership and use requirement. They learn about the exceptions to that rule for certain circumstances and how it reduces the dollar limitations. They do a few simple problems.

The students don’t get into the definition of principal residence. They don’t look at sales of land without sale of the home. They don’t explore sales of residences a portion of which was used for business purposes. They don’t learn about the intersection of the exclusion with like-kind nonrecognition. They don’t study dispositions in connection with divorce, or by married couples who own multiple homes. Nor do they study sales by surviving spouses and remarried spouses. What they don’t learn is far more than what they do, even if they’re absorbing fully everything being offered to them. This is what happens when class time is at a premium. Why bother at all with the exclusion? It invokes important policy and practical concerns, it affects most taxpayers, it helps the students understand why they should try to purchase a home as soon as they can, and it’s the only significant property disposition provision in the Code.

Next: Nonrecognition finally takes the spotlight

Structuring the Basic Tax Course: Part XIV

Once the employment issues have been explored, an almost abrupt shift occurs. The tax consequences of property dispositions takes center stage. Considering that there is a full 2-credit course in the Graduate Tax Program addressing, and called, Taxation of Property Dispositions, it’s no wonder that the J.D. students again receive a more cursory tour of the topic.

I set aside two and a half 50-minute classes to examine realization and bass. Students return to the realization concept they first encountered in the gross income overview topic and apply it to property dispositions. To some extent this is review, because several property sale examples were used in that earlier topic to solidify the understanding of certain points, and the principle that mere appreciation in value of property is not gross income was explained.

In the property disposition context, the focus is on amount realized, adjusted basis, and the resulting gain or loss realized. I continue to search for an approach that will eliminate fully the frequent errors made by students who confuse amount realized with gain realized. Again the need for precision so loathed by those who prefer to deal in generalities must be stressed emphatically.

The other element in the computation, adjusted basis, consumes at least three-fourths of the time allotted to this topic. Adjusted basis implicates both basis and adjustments to basis. Of the former, the emphasis is on cost basis, gift basis, and inherited property basis. Of the latter, the analysis is limited to improvements and the reduction on account of depreciation, a sort of sneak preview of an upcoming topic.

This module of the course is the one in which students meet part-sale, part-gift transactions. They also learn how liabilities are treated in computing basis and how liability relief affects amount realized. For most students, it is their first foray into the world of recourse and nonrecourse debt. So, yet again, a side trip into another area of financial principles and law is required.

Next: Another gross income exclusion

Structuring the Basic Tax Course: Part XIII

The next subtopic within the employment topic that I choose to include in the course is one that generates complaints from students and criticism from other tax law faculty. I think it is essential that students understand how social security benefits are taxed, and there is no sensible way to limit the observations to general theoretical constructs. Technically, this subtopic also includes the taxation of unemployment compensation, but because the rule and its application are as simple as tax law can be, I let the students use 30 seconds of their own time to learn it.

Unquestionably, the taxation of social security benefits is complicated. It reflects the product of serial Congressional tinkering that layers an 85% inclusion on top of a 50% inclusion, with two different thresholds for application of those inclusions. Compounding this complex array is a provision making adjustments for the boundary between the two inclusion layers. The statutory language is dense, not unlike other provisions waiting for the students. I move the students through a parsing exercise that demonstrates, yes, with numbers, the purpose and application of each phrase. I don’t require students to do the computations, though if they needed to do so they could slog through the examples I give them, following the pattern, or they could use the worksheet provided by the IRS in the Form 1040 instructions. That’s not the point. What matters is that the students understand how what should be simpler became so complicated. Flaws in tax policy generate flaws in the tax law.

Because social security benefits are taxed only if the taxpayer’s modified adjusted gross income, yet another defined term for students to learn, exceeds specified amounts, the application of the rules provides a “bubble” effect. In other words, the applicable marginal income tax rate for a social security recipient can exceed that applicable to a taxpayer with higher income but not receiving social security. This time the example is of a married couple, retired on a small pension and social security, one of whom returns to work because they need money. The actual marginal tax rate turns out to be higher than the nominal rate, thus causing the working spouse to bring home less money than was expected. This simple introduction to the bubble concept prepares the students for another visit much later in the course, when the impact of phaseouts are considered.

The employment topic closes with a summary of the taxation of income earned abroad. I leave this to the students to read for themselves, and if I include the topic on the examination it is at a very, very basic level.

Next: Disposing of property

Structuring the Basic Tax Course: Part XII

After dealing with the section 132 general fringe benefit provision, I spend about 30 minutes on the Code section applicable to employer-provided meals and lodging. This is another instance in which the rules themselves are fairly straight-forward, but application becomes interesting. I use this topic to focus on two matters. The first seems silly but is a magnificent example of statutory interpretation and yet more proof that tax law isn’t simply a computational exercise. If an employer provides groceries to an employee, had the employer provided meals? In other words, are groceries meals? Strange as it may seem, the matter has been litigated, and the courts have split on the question. Is there any area of life where a tax question isn’t lurking?

In the first comprehensive example of how tax planning takes advantage of tax rules, I illustrate the tax savings available when a sole proprietor incorporates, hires herself, and provides meals and lodging that are for the employer’s benefit. The students who delight in puzzle solving, chess, or similar endeavors sit up and become mesmerized by this example. Some begin to think, and a few actually say, usually to me privately, “Hey, tax can be fun. It’s not boring.” Of course. If it were boring, would I be teaching it?

Next: The taxation of social security benefits

Structuring the Basic Tax Course: Part XI

Most people who have been employed know that fringe benefits are an important consideration in selecting among jobs. Some people take jobs for the benefits and not the salary, especially second earners looking for health care, tuition remission, or similar benefits.

The tax law contains at least several dozen provisions specifying the tax consequences of particular fringe benefits. With a limited number of minutes, what can be covered in a basic tax course? The answer is, “Not much.” I let the students read summaries of certain provisions, such as the exclusion for employer-paid health care plan premiums and the exclusion for employer-reimbursed education. By this point, students should be able to look at the applicable Code section and see how the writers of the summaries extracted their explanations from the statutory language.

To show how these various provisions share the two themes of qualification by satisfying a definition and a limitation on the amount of the exclusion, I use section 132, which deals with, among other things, no-cost services, qualified employee discounts, working condition fringes, de minimis fringes, qualified transportation fringes, and a few others that get far less attention. Why these? They provide a variety of opportunities to explore tax policy. For example, why a tax benefit for employer-provided transportation? Students begin to understand how the tax law is used to accomplish most non-tax government policies, in this instance, energy and environmental concerns. They learn more about the power of lobbies and how the personal situations of members of Congressional tax writing committees affect tax law development when we visit the special fringe benefit treatment for parents of airline employees. They have a chance to see the administrative advantages and technical flaws in providing exclusions for amounts that would be deductible if paid by the employee. Some students have held jobs that provided employee discounts, a proportion I can now compute because it’s one of my “clicker” questions, and thus are especially interested in why their W-2s from years past may have reported gross income exceeding their cash pay. I get to learn what the particular employee discount policies of different employers has been.

Next: A Job With Free Meals and Housing?

Structuring the Basic Tax Course: Part X

After examining the several serendipitous transactions selected for close study, the course changes tack and focuses on employment. The topic is important because most taxpayers at some point are employed. Most, if not all, of the students will be employees, and many already have served in that capacity. Most arrive in the course knowing that wages are included in gross income. If it were that simple, there would be no need to allocate course time to the issues arising with respect to employment transactions.

I begin by taking the students through a list of the many ways in which employers can compensate their employees. The list is incomplete, of course, but includes the arrangements that are the subject of specific Code sections. I point out that we have time to study only a few in detail. I let them read, for their own edification, short summaries of some compensatory arrangements that they may encounter but for which there isn’t sufficient class time for more detailed discussion.

At this point I introduce them to the concept of deferred compensation. This is an area of tax law that deserves at least a full course, and in fact we offer several courses in our Graduate Tax Program which are available to J.D. students who are interested. All I am trying to do at this point is to convey the advantages of qualified deferred compensation plans: the exclusion when amounts are set aside, the deferral of taxation on plan earnings, the taxation of the distributions in later years when the taxpayer is probably looking at lower tax rates, and the benefits of deferring the tax liability until retirement. I don’t trouble the students with the technical requirements for qualification, though I do sensitize them to basic notions of vesting, non-discrimination, and several other major qualification principles.

This topic gives me the opportunity to teach the concepts that are the foundation of deferral benefit. Specifically, it is the first point in the course where time value of money, present value, and future value are important. These concepts are critical to understanding much of tax planning, and are at the root of the nonrecognition provisions looming on the horizon.

In an ideal world I wouldn’t need to shift time to the teaching of these concepts. They are essential to many areas of academic study and life generally. They ought to be taught in high school or college. They ought to be required. They are so pervasive in the law, and not just tax, that law schools should make them prerequisites to admission. Even though many law faculty claim that they can turn students into good lawyers no matter their academic backgrounds, a questionable proposition at best, the students in my courses who arrive with an understanding of these concepts learned them before they arrive in law school. Though I’d rather use the time to teach tax law and not financial principles, I’m stuck, because if I don’t bring the students up to speed they won’t learn or understand the tax law in question. The saving grace is that the power of compounding and the benefits of deferral can be illustrated with charts and graphs that widen the eyes of students unfamiliar with the concepts. At least they can begin to understand the advertising that banks and other financial institutions devote to the selling of IRA accounts.

Next: The taxation of fringe benefits