Friday, July 27, 2007
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
Wednesday, July 25, 2007
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
Monday, July 23, 2007
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
Saturday, July 21, 2007
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
Thursday, July 19, 2007
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
Tuesday, July 17, 2007
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
Sunday, July 15, 2007
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
Friday, July 13, 2007
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.
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
Wednesday, July 11, 2007
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
Monday, July 09, 2007
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
Saturday, July 07, 2007
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
Thursday, July 05, 2007
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
Tuesday, July 03, 2007
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?
Sunday, July 01, 2007
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