TAXATION AND THE FAMILY

Whose income is it? Who is the “true taxpayer” for reporting the item of income or expense?
(Question #4 from page 7 of the syllabus)
- Fundamental Questions:
o What are the guiding legal principles for determining “who” is the taxpayer?
 Whose income?
 Whose deductions?
o How can one have “multiple runs up the bracket ladder”?
o When can one attribute income/deductions to another taxpayer?
Choices for possible income/deduction shifting:
-Spouses
-Children
-Other family members
-Family entities (trusts, corporations, partnerships)
o Alternative: the entire family
Comparing Income Tax Rates:
- Rate Brackets for Individuals – Code §§1(a)-(d) & (h)
- Marginal rate – tax rate applicable to the last taxable dollar
o Cf. Effective Rate (or Average Rate)
- Tax Rates for Corporations: Code §11

I. INTERSPOUSAL INCOME ATTRIBUTION

ASSIGNMENT OF INCOME
Lucas v. Earl (p. 983) (March 17, 1930)
1. Facts: Earl earned income through his salary and attorney’s fees
a. At this time people were not allowed to file jointly as a married couple;
each citizen was required to report his/her own income.
b. He and his wife entered into a contract upon marriage that stated any
property acquired by the two (including salaries) was to be treated as joint
income
c. Earl filed a tax return for just half of the income earned (as he was a joint
tenant of that property)
2. Issue: Could Earl be found to only be taxable for half of his salary as a joint tenant
with his wife?
3. Holding: NO – he was to be held taxable on the whole of his earnings
a. Regardless of the validity of the K between the husband and wife, the tax
statute (which allows for taxation from whatever source derived) allows
for taxation on the person who earned the salary
b. Fruit and Tree Doctrine: Income is taxable to the one earning the wages –
not the “legal owner”
i. Can’t assign the fruits to another tree in which they did not grow;
must assign the fruits to the proper tree (p. 984)
ii. Justice Holmes doesn’t really make any cites to authority here, just said
Congress could have done this in the statute if they wanted to
1. Why does Justice Holmes believe this is why this is what the
statute requires?
 a. By putting in effect §1(a) – a progressive income tax –
Congress has implicitly said the income needs to be
assigned to the right person for this regime to make any
sense at all
b. And we are not going to allow the true owner to shift his
income to someone else, if we are going to have a
progressive income tax.

NOTE: §704(e) permits recognition of those partners who have a capital interest in the
partnership where capital is a “material income-producing factor.”
Poe v. Seaborn (p. 984) (November 24, 1930)
1. Facts: Husband and wife filed separate tax returns for the year in which they each
claimed one half of the income earned for the year; and deducted one half of the
community expenses to arrive at the net income returned.
a. Couple’s income was comprised of: Seaborn’s salary, interest on bank deposits
and bonds, dividends and profits on sales of real and personal property.
b. The couple lived in Washington which was a community property state
2. Commissioner’s Decision: All of the income should have been reported in the
husband’s return, and made an additional assessment against him.
3. Holding:
a. Court finds that:
i. Property acquired during marriage with community funds becomes an
asset of the community and not the sole property of the one in whose
name the property was bought, although by law husband was given the
control of property. Husband was exclusive agent and not sole owner.
b. Court concludes that under state law the entire property and income of the
community can no more be said to be that of the husband than it could be
termed that of the wife.
c. This case is different than the Earl case because here, by law, the earnings are
never the property of the husband, but that of the community.
d. The split of the income into community property here was valid; as the state
was not reassigning the fruit like in the previous case
e. Here it was a matter of state law, with no tax payer discretion, the income was
assigned elsewhere
f. We are not going to allow the taxpayers to voluntarily shift his/her
income to another family member. But, when it is involuntarily and the
state is the one reassigning the income, and there is nothing the
taxpayer can do, then this action is valid.
g. The shifting that is allowed in this case is just between married spouses.

II. Same Sex Couples Marital Status

Revenue Ruling 2013-17 (p. 991)

- Rev. Rul. 2013-17, issued on August 29, 2013, the IRS ruled that post-
Windsor that marriage would be construed to include same-sex marriages if
the marriage were entered into in a state that recognized such marriages.
Once entered into, that married status would be respected for federal tax
purposes regardless of the laws of the state where the couple resides.
III. The Marriage Bonus and the Marriage Penalty
 - Effect of joint return income tax status – twice the tax on ½ of combined income
- Objective: To enable equality with community property jurisdictions – where an
automatic split of the income occurs under state law

IV. Marriage Penalty/Bonus: Code §1 (2015 Rates)

- Bonus (only one earner):
o Single taxpayer and married taxpayer have income of $464,850 – 140,420 tax
(single) vs. 129,997 (married); $10,423 benefit for marrieds
- Penalty (two equal owners):
o Two single taxpayers & each married taxpayer has income of $232,425 –
single taxpayers have 60,036 each (total -- $120,612); married taxpayers have
$129,997 of tax; $9,385 penalty for marrieds

Mapes v. United States (p.999)

- Mapes argues that tax rates create a marriage penalty and that this is
unconstitutional.
- Court upheld existing tax rates as constitutional. Court noted that
o “[T]here cannot be a ‘‘marriage-neutral’’ tax system. The policy of taxing
all couples with equal incomes equally, a major factor in the 1948
income-splitting provision, is not unreasonable. Nor is it unreasonable
to attempt to tax the household economies enjoyed by married
people. . . . In short, the foregoing serves to illustrate that tax
disparities will exist no matter how the rates are structured. This is
simply the nature of the beast. The tax law is complicated enough
already without the added complexity a full solution to this problem
would apparently require. We in the judiciary, are neither equipped nor
inclined to second guess the legislature in its determination of
appropriate tax policies.”
Boyter v. Commissioner (p. 1013)
- Couple travelled to Haiti every year in between Christmas and Thanksgiving in order
to get divorced in order to file taxes individually
o The general divorce rule hold true and still doe today
- Court walks through the sham transaction doctrine (from Helvering)
o Finds this is a sham transaction and does not recognize the divorce in the
present scenario
- Sham Transaction Doctrine:
o Doctrine applies to this case
o Simply because I have done something that is legal under state law, and the
federal income tax leaves it to state law to decide, then that is the beginning
point.
o Under federal income tax principles, this was not a valid divorce
 The underlying purpose of the transaction, viewed as a whole, is for the
taxpayers to remain effectively married while avoiding the marriage
penalty in the tax laws.
 It is the prompt remarriage that defeats the apparent divorce when
assessing the taxpayer’s liability.
V. Children and Dependents (p. 1025)
- §1(g) – “Kiddie Tax”
- Dependent Personal Exemptions available under §152 if parent provides more than
half of the child’s support for the year -- §152
o Unearned income
o The passage of large investemetn assests that would have been taxed to the
grantor.
o The child’s tax will be equal to the greater of the
 The tax imposed by this section or
 The sum of
 Such child’s share of the allocable parental tax
- Standard Deduction allowed under §63
- Child Tax Credit under §24

I. Separate and Divorce

a. Support Payments: Alimony §71

- Bernatschke v. United States (p. 1031)
- Tax payers got divorced and husband transferred an annuity to his wife
- Is the annuity payment subject to taxation under §71 (alimony) or §72 (annuity
payment)?
- This was a property settlement and wife became owner of annuity and thus held
taxpayer was entitled to §72 treatment
o Record showed that at no time during the negotiations of the settlement
was there any mention of alimony. Nor was any attempt to determine the
extent of the husband’s support to espouse.
o Court found that the payments given to wife did not have a character of
alimony.
 Amounts paid by husband were not based on the marital obligation to
support and were not intended to be payments in discharge of an
obligation.
b. Alimony Payment Requirements
i. Cash payments (not property).
ii. Payment received under “an instrument.” Written Instrument
iii. Payments must not be agreed to be nontaxable to the payee and
nondeductible by the payor. Can opt out per §71(b)(1)(B).
iv. Payments cannot be among members of same household
v. Terminate the obligation at the death of the payee. §71(b)(1)(D).
vi. No disguised child support
vii. Also, no excessive front-loading. §71(f).
c. Alimony Payment Tax Treatment
o Alimony is now deductible by payor under §215(a) (ATL Deduction) and
taxable to the payee
o No longer have need to prove amount is subject to legal obligation to be
alimony but parties can now designate whether an amount is or is not
alimony
d. §682 (Exception)
 e. You can put income into a trust and the corpus of that trust in order to
fund support obligations then that won’t be treated as alimony. The
receiving spouse will be responsible for the proceeds of the trust.
f. Child Support Payments Tax Treatment §71(c)
i. No deduction and no income inclusion for child support and all other
payments. All non-alimony payments (as alimony is defined in the tax
code) made to the former spouse are:
1. (1) not income to the recipient, and
2. (2) are not deductible to the payor.
ii. These items do constitute an accession to the wealth of the recipient
(former) spouse.
iii. Custodial parent entitled to child’s dependent personal exemption but
parent’s can agree otherwise.
iv. Ordering rule of §71(c)(3) - payments are considered as first being child
support before being deductible alimony.
g. Indirect Alimony Payments
i. Example: Sally and Harry divorce. She pays (1) his mortgage payments
on his residence and (2) premiums on a life insurance policy on her life
& he owns the policy.
ii. Question: Is this taxable alimony? Is this “cash paid.” Answer:
1. Yes, taxable alimony to Harry if Harry owns (1) the house and (2)
the life insurance policy. Remember the Old Colony Trust Co.
case.
iii. But, if Sally’s payment is not “cash,” then the answer is different.
h. Alimony Planning Points:
i. If I am representing the party that is going to receive an alimony, then
my interest is to avoid characterizing the income as “alimony.”
1. If any of this requirement is not met or there is an agreement
that this “alimony” should not be treated as alimony for federal
income tax purpose then payment is not going to be considered
as alimony.
2. Try to get the benefit of the deduction for the recipient of the
alimony who is the one who will be taxed. Make the alimony
payment a little higher to be put at the same position as the one
paying the alimony.
3. I would agree on the base of the amount of the alimony but lets
top up number by another 20%.
4. What I am not going to do is allowed the other party characterize
this as an “alimony” completely.
ii. If I am representing the party who will be giving the alimony:
1. I want to make sure I characterize payment as an alimony
a. I am not reserving the alimony as income for tax purposes

II. Property Transfers

- United States v. Davis (p. 1041)

a. Husband is the taxpayer, he is the one transferring property. He is
transferring securities (worth 80,000 dollars) to his wife in consideration for
the surrender of her marital rights.
b. Court basically says the transfer of the appreciated property was a taxable
disposition (seller exchange) on which the husband realized and recognized
 gain equal to the excess of the property’s fair market value over its adjusted
basis
- §1041 (Overruling Davis)
- Provides that a transfer of property between spouses or between former spouses
where the transfer incident to the divorce, shall be treated as a gift.
- §1041(a) No gain or loss shall be recognized by the transferor-spouse and receipient
spouse will receive a carryover basis §1041(b). §1015 does not apply at all, only
§1041
- Davis continues to control transactions between spouses that fall outside the aegis of
§1041 (e.g., transfers to a nonresident alien spouses and an antenuptial transfers of
property in settlement of any later-arising marital rights is not expressly covered by
§1041).

- Farid-Es-Sultaneh v. Commissioner (p. 1046)

c. Facts:
i. On December 1923 Kresge delivered 700 shares of the common stock of
the S.S. Kresge Company to taxpayer for her benefit and protection in
the event that Kresge died prior to contemplated marriage.
ii. On April 24, 1924 taxpayer and Kresge executed a written ante-nuptial
agreement through which she acknowledged she had received the
stocks in consideration of the promise to marry Kresge and through
which she released all dower and marital rights. They got divorce in
1928.
iii. Taxpayer sells stocks for $230,000, amount which was in excess to
their cost to her.
iv. Stocks given to her prior to the marriage
d. Issue: Tax basis for shares received in a pre-nuptial transfer
i. Stocks had a FMV of $315 when taxpayer received them.
ii. Her adjusted basis for the stock she sold in 1938 was $10.66 per share
iii. Mr. Kresge’s adjusted basis on the stocks would have been $0.15
e. Taxpayer claims that she has a FMV basis in the stocks at the time of receipt
i. She gets the basis on when she exchanged her rights for the stock – IRS
never contested the basis of her marital rights in the stock
ii. This is a harder argument than that of Davis (above) – because she
doesn’t yet have a vested marital right – as they weren’t married yet
f. Kresge would have had a taxable event at the time of the transfer of the stock
as the FMV of the stock granted and compare that to his basis
g. §1041 was enacted because of this conundrum…
i. 1041 only works for spouses or former spouses
1. Here, she was not a spouse at the time of the transfer, they were
only engaged
h. Holding
i. The transaction was a seller exchange instead of a gift. Kresge
purchased dower in rights in consideration of the stocks. The basis
of the stocks then is the FMV of the stocks at the time they were
received. Taxpayer paid for the stocks with her dowry rights which
had the same FMV of the stocks when she received them.
ii. Court held this was not a gift because the “gift” on the ante-
nuptial agreement was contingent upon Kriesge death before
marriage, an event (death) that did not occur.
 1. Thus, no gift was made before the ante-nuptial agreement,
and taxpayer took title to the stocks under its terms, in
consideration for her promise to marry him.
2. Consideration was fair and taxpayer held stocks not as a
donee but as a purchaser.
iii. This is not a gift, the transfer is not being made with complete
disinterest generosity. There is a seller-exchange transaction.
i. What would be the result for Mr. Kresge?
i. U.S. v. Davis would apply, because he made a transfer outside the
scope of 1041
ii. He would have a seller-exchange transaction and he would be
responsible for any gain or loss on this transaction.

Ex.
Stock
FMV: 600
Basis: 300

Family Home
FMV: 600
Basis: 250
Gain exclusion as per house. Tax code permits individuals to exclude amount of gain when
they are disposing personal property such as a home.
I want the property that has a loss, and I want the property that meets criteria for gain
exclusions.
 Capital Gains

Assignment of Income: Investment Income

Ownership of investment property can be divided by putting it in trust
j. Control of the trust is vested in trustees
k. Benefits of the trust is vested in the beneficiaries
i. Can be vested in multiple people – born and unborn
l. Trustee may or may not be a beneficiaries
Leads to a question of who may be taxed and whose income it is
Whose income is it?

- First discussed this question in Lucas v. Earl.

- If you are the earner of the income then you are the one who is responsible of
that income and of paying taxes on that income.
- Issue here is income from capital, this is not my wages that I am trying to
defelect away. What is the tree here? The tree is the property itself.
- The owner of the property is the one responsible for the income it produces
and the tax consequences it may produce.
- When do we respect that transfer of property from the donor as being a
complete transfer?

I. The Basic Supreme Court Cases

Corliss v. Bowers (p. 1059)

1. The petitioner created a revocable trust for the benefit of his wife and children. Court
held that the grantor’s power to revoke the trust and to stop payment to the income
beneficiary was equivalent to actual ownership of the trust. Thus, the income that is
subject to a man’s command and that he is free to enjoy may be taxed to him as
income.

Douglas v. Willcuts (p. 1060) (Trust in liu of Alimony)

- Trust was created by husband with the wife as a beneficiary in lieu to alimony.
- Trust earns income, whose income is it?
- If I have a trust that pays my personal obligations, the husband is retaining the
corpus and wife is life tenant.
- Your personal obligation is paid on your behalf.
- Trust created to pay the wife in lieu of alimony; the wife was the beneficiary of the
estate and the remainder man was the husband
- The husband still had control of the remainderman interest – and thus the IRS found
that the trust was income as to him
- Subsequent event: §682(a) –
a. changes the result for alimony trusts
b. If I set up an alimony trust, then instead of treating the income to belong to
the person that created the trust the income will be treated as the income of
the receiving spouse. The settlor won’t get an alimony deduction.
c. This is favorable to the receiving spouse
 Capital Gains

Burnet v. Wells

- Trust was created to pay life insurance premiums for him and his children.
- Court held this was income to the grantor. An insured person is under an
obligation to continue to pay the premiums on his life insurance, and
Congress could reasonably that the use of trust income for that purpose
conveyed a taxable benefit to the grantor.

Blair v. Commissioner (p. 1069)

a. Petitioner owned the life interest in a trust; but not the remainder interest
a. He assigned a percentage of his life interest to his children
i. He wanted the income to be realized under his children’s name; and the
IRS wanted the income to be realized under the father’s name
b. Assignments were valid under state law
c. Commissioner ruled that the income was taxable to the petitioner.
d. Blair’s argument: Once he made assignments interests in the life estate are
not his anymore and thus should be taxed to the assignees.
e. Issue: Whether treating the assignments as valid, the assignor was still
taxable upon the income under the federal income tax act.
f. Held:
ii. Assignment was valid
1. The decision of the state court upon this question is final.
iii. Income attributed to the children and not to the assignor father
1. Tax here is not upon the earnings which are taxed to the one
who earns them. Nor is it a case of income attributable to a
taxpayer by reason of application of the income to the discharge
of his obligation.
2. Here, the taxpayer is not reserving the control of the corpus.
3. The one who is to receive the income as the owner of the
beneficial interest is to pay the tax. If under the law governing
the trust the beneficial interest is assignable, and if it has been
assigned without reservation, the assignee thus becomes the
beneficiary and is entitled to rights and remedies accordingly.
4. Why is the income not attributed to the father?
a. Here the interest was not carved out, he no longer held a
right in the “tree”
b. He is no longer the owner of the tree

Helvering v. Clifford (p. 1076)(§676(a))

a. Grantor transferred funds into trust, the income of which would be for the
benefit of the wife
b. Trust was to terminate in 5 years and the grantor was the remainderman. This
was a short-term trust.
c. Grantor was also the trustee and had broad discretionary powers
iv. During the continuance of the trust grantor was to pay over to his wife
the whole or such part of the net income as he in his “absolute
discretion” might determine.
d. Issue: Whether the grantor after the trust has been established may still be
treated as the owner of the corpus.
 Capital Gains

e. Held:
v. The grantor did not cease to be the owner of the corpus after the trust
was created.
1. The short duration of the trust, the fact that the wife was the
beneficiary, and the retention of control over the corpus all lead
to the conclusion that grantor was the owner of the corpus.
2. He retained wide powers over the corpus.
3. Describes this transaction as a temporary reallocation of income
within the intimate family group.
a. The income remains in the family and the husband retains
control over the investment.
vi. Income of the trust was taxable to the grantor

Helvering v. Horst (p. 1080)

III. In 1934 and 1935 a father who was owner of negotiable bonds detached from the
bonds negotiable interest coupons shortly before their due date and delivered
them as a gift to his son who in the same year collected them at maturity.
Issue: Whether the gift, during the donor’s taxable year, of interest coupons
detached from the bonds, delivered to the donee and later in the year paid at
maturity, is the realization of income taxable to the donor.
Commissioner:
The interest payments were taxable, in the years when the interest is paid to the
donor.
Holding:
Court said this was NOT a property transfer – because the father still owns the “tree” –
rather the father just gave away the fruit from the tree
a. Donor here, by transfer of the coupons, has precluded any possibility of his
collecting them himself, he has nevertheless, by his act, procured payment
of the interest as a valuable gift to a member of his family.
b. The power to dispose income is the equivalent of ownership of it. The
exercise of that power to procure the payment of income to another is the
enjoyment, and hence the realization of the income by him who exercises
c. Not treating interest as the property right, but rather a result of the
property right
d. The tree is the source of the fruit
e. True owner of the bond always remained Horst
IV. Notes:
a. This is a gift. Children had the cash. The holder of the bond is responsible
for the interest produced by the bond.
b. Look at the relationship:
i. Employer-employee income: If employer gives interest on the bonds
to an employee due to a good performance on a job, then this is
salary income to the employee. This is not a gift.
ii. Parent-son situation is different.
c. If I have income and before I receive it I assign it to someone else, that
income is going to be taxable to donor.
i. When I have the assignor who owns the corpus and is redirecting the
income but he is keeping control over the property then we are going to
tax the true owner of the corpus.
 Capital Gains

d. An interest on a bond is being treated as property under state law, but we are
not going to treat it as property for federal income tax purposes.
i. Interest piece is not property for federal income tax purposes but we are
going to treat it as income.
ii. Except when the interest is a life interest.
e. Timing of income recognition is when the dividends are paid to the
donee.
i.
Helvering v. Eubank (p. 1085)
a. Eubank was an insurance agent who made assignments in 1924 and 1928 of
renewal commissions (presumably as gifts) to become payable to him for
services which had been rendered in writing policies of insurance under two of
his agency contracts.
b. Commissioner: Renewal commissions paid to the assignees in 1933 were
income taxable to assignor in that year.
c. Issue: Whether renewal commissions payable to a life insurance agent after
the termination of his agency and assigned by him prior to the taxable year,
must be included in his income despite the assignment.
d. Held:
e. All I am doing here is assigning my future income. If I am trying to assign
away my current compensation I AM NOT GOING TO ALLOW THE TRUE
OWNER TO ASSIGN THAT INCOME AWAY.
ii. If I instead have a future compensation, Earl says no! this is not going
to be treated as a transfer of property. This is deferred compensation.
This is a gift from Eubank to whoever received that compensation.
iii. This is assignments of service-income.
1. Here the true owner of the income is the one who will be
responsible for the income.
f. Why is it not property yet?
iv. A mere right to collect future payments, for services already rendered, is
not presently taxable as income derived from such services. It is
property which may be assigned. Whatever the assignor receives as
consideration may be his income.
v. He hasn’t received property yet; at the moment he receives property
(§61) he should be taxed on the FMV of that property
g. If the income relates to the personal services of the individual, they cannot
assign that away from the earner
vi. If not taxed on the services, then they are not yours to assign over
vii. Once you have been taxed on the property you can give it away to
others
h. When is Eubank taxable on the renewal premiums?
viii. When the children are paid from the renewal premiums/when the
income is paid directly to the children
i. Fundamental question in the following case: is the income from the property
or is it from the services? Are we dealing with a transfer of property or not?
ix. Property obligates the true owner of the property
x. If income arises from services/efforts – then Lucas and Eubank doesn’t
apply as you cannot assign away the income from the services
 Capital Gains

Estate of Stranahan v. Commissioner (Supp. 84-86)

a. Estate sold dividend strip to beneficiary for $150,000
xi. Estate reported the transaction as immediate income to the estate
xii. IRS disagrees and claims this is an anticipatory assignment of income
f. The decedent sold his interest in estate to his son. Assignment to decedent’s
son is valid.
g. The son acquired an independent right against the corporation since the latter
was notified of the private agreement. Decedent completely divested himself of
any interest in the dividends and vested the interest on the day of execution of
the agreement with his son.
h. Donor retains underlying property and sells a carved-out interest in income.
Income to the donee.
i. Income recognition occurs when the assignor sells the interest, and not when
the dividend is paid out.

Direct Facts of Helvering v. Horst has been overturned statutorily: §1286 – Stripped Bonds
(p.577)
V. SLIDE 13
VI. §1286 (p. 607 of statute book)
a. §1286 ONLY applies to bonds
b. Because of this rule, Congress has tacitly agreed that anything outside of the
bonds that the basis stays with the “tree”

VII. The owner of the property should be the one who has the income attributed for that
property
a. Sale of property for immediate payment
i. Acceleration of income; you realize the income immediately, and the
new owner has a cost basis

Heim (Supplement p. 86)

b. Assignment of patent license royalties to wife and children
c. Were royalties received by wife and kids taxable to the
inventor/husband/parent?
i. Held: gifts of income producing property – and not merely gifts of
income
ii. A copyright or patent is effectively assignable because it is property
rather than mere personal service claim
1. A royalty contract derived from the transfer of a copyright or
patent is therefore also property.
2. My self effort materializes into a property form, a tangible
product. When I GIVE THIS property away, I am assigning away
my right to income. How do I view this area where the patent is
the result of the self created work of an inventor. In this situation
the property is a separate property right. This is a property itself.
iii. What would the basis of the assignees be?
 Capital Gains

1. Carryover basis – stepping into the shoes of the donor under

§1015

Income from Gift and Bequest Property

a. §102(b)(1) – the income exclusion does not extend to the income received from
the gifted property
b. Consider several trust interests:
iv. The life tenant’s portion
v. the remainderman’s portion.
d. Trust income is entirely taxed to the life tenant. E.g., gift of “income only” is
not excluded from gross income; the entire benefit of the §102 exclusion is for
the remainderman (when eventually receiving the remainder interest).
Remainderman gets the basis under either §1014 or §1015. The life estate
does not get any basis in the trust.
Trusts

- Tax either to (1) trust or (2) beneficiary.

- §§651-652 – simple trusts – merely a conduit (p. 593).
- §§661-662 – complex trusts – taxation to the trust if income retained by the
trust; or, tax to beneficiaries to receive income distributions.
- Very steep income tax brackets for trust income taxation §1(e).
- §671 provides for grantor trust (i.e., ownership) status,
- where: property is still owned by the grantor and whatever income is
produced by property is taxed to grantor.
- §673 – reversionary interest of grantor
- §674 – certain beneficial powers
- §675 – administrative powers
- §676 – revocation power
 Capital Gains

- §677 – subsequent distribution to grantor or spouse (or to satisfy support

obligation)
Interest Free Loan § 7872

- For tax purposes if you made a loan we are going to impute that
adequate interest is paid on that loan. The child will be making a
payment of interest and he will get a deduction for that imputed interest
to reduce
- Parent is treated as constructively receiving the foregoing interest.
- Second step: gift non-deductible
Partnerships
- Partnerships are conduit entities, not subject to federal income taxation
- Each partner is allocated his share of each income deduction item
- Informational tax return to be filed, including K-1s (a W-2 or 1099 equivalent)
- Tax basis in the partnership interest enables loss flow through; tax basis includes
debt (note Tufts case) & allocated income
-
Schneer v. Commissioner

Petitioner worked for a law firm and received payments for referral fees. Petitioner
then became partner of another law firm.
Government is saying that the petitioner is the one who should report the income.
Petitioner says that it is the partnership that should report that income. Each
partner gets a distributive share on that income.
Once I have partnership establish, partnership pays no tax. Partnership is treated as
entity but responsibility of tax is at the individual level. Partnership is a pass thorugh
entity . Each partner based upon their share of partner ship profits has the tax
liability
If I have an agreement that has a partnership then I will allow the income to be
allocated among the partners.
Favorable holding to tax attorneys.
Fogleson v. Commisioner

- Owner of a personal service corporation owned stock and gave preferred stock
his children. The corporation earned commission income and paid Foglesong
a salary.
- IRS: Commissions taxable to Foglesong under assignment of income
principles.
- Holding: Commissions are taxable to corporation, not Foglesong but
Foglesong must be paid reasonable salary.
-
Capital Gains:

Capital Asset
 Capital Gains

- Defining the Term “Capital Asset” Code §1221

o Code §1221 defines “capital asset” as property held by the taxpayer (whether or not
connected to his trade or business), but does not include:
(i) inventory and property held primarily for sale to customers
(ii) Real property or depreciable property used in a trade or
business, but see §1231.
 §1231 property applies to any property that is depreciable but under
§1231(b)(1) it limits it to property that is held for more than one year
 What happens to recapture after §1231 applies
o §1245(a)(3) where it talks about definition of §1245 property
 Scope cover all personal property but a small subset
covers “fixtures” of real property
(iii) Copyrights and similar property
(iv) Accounts receivable
(v) US government publications
o Listing things that are not included as capital assets does not mean that the rest of
things that are not listed are all capital assets. Case law has also determined what
taxpayer’s property is not going to be considered a “capital asset” under this section.
- Capital Gain Preference Rate: When Capital Gains exceed capital losses
o Capital Gains - Section 1 (h) – lower tax rates
 For purposes of the exam we will assume that the capital gains rate is 20%
 What would your tax rate normally be if there weren’t a capital rate tax
preference?
 If your tax rate would normally have been for ordinary income some amount
below 25% on ordinary income, then capital gains rate is 0% §1(h)(1)(B).
 If your tax rate would normally be some amount below 39.6% but equal to or
greater than a 25% rate, then capital gains rate is 15% §1(h)(1)(C).
 If your tax rate would normally be 39.6%, then capital gains rate is 20% §1(h)(1)
(D).
o Determining Net Capital Gain §1222
 §1222(11) Net Capital Gain (Only construe that creates a Net Capital Gain)
 The excess of net long-term capital gain over net short-term capital loss
o What is net long-term capital gain?
 §1222(7): Means the excess of long-term capital gains
for the taxable year over the long-term capital losses for
such year.
 What is a long-term capital gain?
o §1222(3): Means gain from the sale or
exchange of a capital asset held for more
than 1 year, if and to the extent such gain
is taken into account in computing gross
income.
 Capital Gains

 What is a long-term capital loss?

o §1222(4): Means loss from the sale or
exchange of a capital year held for more
than 1 year, if and to the extent that such
loss is taking into account into computing
taxable income.
o What is a net short-term capital loss?
 §1222(6): Means the excess of short-term capital losses
for the taxable year over the short-term capital gains
for such year.
 What is a short-term capital loss?
o §1222(2) means loss from the sale or
exchange of a capital asset held for not
more than 1 year, if and to the extent that
such loss is taking into account into
computing taxable income.
 What is a short-term capital gain?
o §1222(1) means gain from the sale or
exchange of a capital asset held for not
more than 1 year, if and to the extent such
gain is taken into account in computing
gross income.
 If I have a gain that is a capital gain but does not fall under this
definition, it does not receive tax rate preference.
 I get a rate preference only if I have net capital gain
 Principles:
o Tax preference rate is not given for short-term gains and losses.
 For you to be entitled to a capital gains rate preference you need to
have a seller exchange that produces long-term gains
 This is a different meshing than §1211
 §1211: Limit ability to use a loss (for deduction purposes) to the extent
you have a capital gain
 This does not apply to rate preference
 In order to determine the rate preference I need to know the amount of my net
long-term capital gain (long-term capital gains – long-term capital losses), then
I subtract net short-term capital losses (short-term losses – short-term capital
gains, but only when this net short-term capital meshing results in a loss) from
net long-term capital gains.
 So that, the rate preference is only going to be applied to long-term
capital gains after being reduced by long-term capital losses and
provisionally reduced by short-term capital losses to the extent they
exceed short-term capital gains.
 Capital Gains

o Planning Considerations “Harvesting Losses”

 Sell gain and loss assets in the same year? No (except for those individuals
regularly having significant capital gains and losses); stagger gains and losses so
as to (a) first use capital losses against $3,000 of ordinary income, and (b) then
have long term gains taxed at the preferable 20% tax rate per §1(h)(1)(D) (or in
reverse chronological order).
 No, if I have long-term capital gains. I would prefer to sell my short-term
capital losses or long-term capital losses in a year that do not have long-
term capital gains.
 I would prefer to sell those assets that have long-term capital loss only
in years where I have short term capital gains
 I would prefer to stagger my long-term capital gain transactions so that
they are in years that could not me meshed with these other types of
attributes.
 What would be preferable to do?
o Trigger losses first and use those losses against short-term
capital gains plus $3000 of ordinary income, and then in next
year I would sell my long-term capital gains all by themselves in
a period where I do not have short-term capital losses/net short
term capital losses, and also I would not want to have any long-
term capital losses in that year.
 Realization events are in our hands.
- Cases
Sell of Business
- Williams v. McGowan
o Facts: Williams sold hardware business to Corning Building Company for $63,926.28
plus $7,000 for favorable closing balance sheet for working capital (cash= $8,100;
receivables=$7,000; fixtures=$800; inventory=$49,000 minus accounts
payable=$1,000). Total purchase price was $70,000.
 Williams would have a cost basis equal to the basis McGowan had in
property.
o Issue:
 Taxpayer wants to claim ordinary loss
 Wants to mesh gains and loss together
o Analysis:
 The sale must be treated as a sale of the separate assets; it must be
comminuted. Regardless that a partner’s interest in a partnership may be a
capital asset, when Williams bought out his partner he became a sole owner
and must be thought of as owning directly each asset of the business.
 How are we going to determine what is a gain or a loss in this transaction?
 Every single asset will be disaggregated and treated as sold for its FMV,
and then will compare the sale price to each of the assets’ basis.
 Capital Gains

o At this point I will know if I had a gain or loss for each particular
asset.
o If asset is not a capital asset, and a loss or gain results from sale,
then that gain or loss would be ordinary income or ordinary loss.
o But if asset is considered a capital asset and a loss results from
sale then I will have a capital loss on that specific asset.
o Principle 1: Even if contract does not contain purchase price allocation, the parties did
not plan or intend to sell assets on an asset by asset basis. For tax purposes, we are
going to take singular purchase price, and we are going to disaggregate that purchase
price to be the purchase price for each individual asset. Then, we are going to compare
that disaggregated amount realized to the basis individually of each asset and that is
going to create a gain or loss, asset category by asset category.
o Planning Point:
 When you are involved in a disposal of a business, and you are doing the
purchase agreement, and your client is going to make $10M, to know the tax
consequences we need to know the gain and losses that are implied in that
overall purchase
 If I have losses that are capital losses and gains that are ordinary
income then client may have greater taxable income then there is
going to be gain in that transaction because losses won’t be used in
that situation.
TEMPORARY TAKINGS
- Commissioner v. Gillette Motor Transport
o Facts: Taxpayer received a sum received by respondent from the United States as
compensation for the temporary taking by the Government of its business facilities
during World War II.
 Taxpayer says his business, an asset, was taken away from him as an
involuntary conversion but he gets compensated for it.
 Taxpayer wants to report that as a gain, we don’t know basis
 Hypothetical: If taxpayer taken the money from government and reinvested
within two years then §1033 would had applied.
 Seller-exchange
 Non-recognition of proceeds
o IRS: Says compensation is ordinary income. Even though this transaction may appear
to be a seller-exchange transaction this was not intended to be a permanent taking
and thus, this was not a seller-exchange.
o Issue: Was this payment ordinary income or a capital gain?
o Held: Payment was ordinary income. The relinquishment of the property right of use
of the facilities was not a capital asset. In short, the right to use is not a capital asset,
but is simply an incident of the underlying physical property, the recompense for
which is commonly regarded as rent. That is precisely the situation here, and the fact
 Capital Gains

that the transaction was involuntary on respondent’s part does not change the nature
of the case.
 No permanent loss of the tree itself but you are being compensated for the
short-term use of your property. This was as if government was leasing
property, and thus, this was not a seller-exchange.
 Compensation was a fee. Substitute for rent. Didn’t lose tree.
 When I use the term property under 1221(a) I must have a seller exchange in
order to have a capital gain or loss. Property taken by government is not within
the meaning of 1221(a)
 This is income from property and no income for property.
 If I am being compensated for the fruit, then there is no property sale or
exchange.
 Taxpayer did not sell property but he sold fruit of property.
 I am ignoring that this is property but I am treating it as income of property. To
have a capital asset that is being disposed we need to have a property
disposition.
DISCOUNTED NOTES & BONDS
- United States v. Midland-Ross Corp
o Facts: Taxpayer bought non-interest bearing promissory notes at less than face and
sold them shortly before maturity at a gain. The gain that arose from the sale of the
financial instrument was the economic equivalent of interest (representing the time
value of money of holding the debt instrument).
o Held: Even though a debt instrument can be a capital asset in the hands of the
taxpayer, the gain arising from the sale of that capital asset that represents earned
original issue discount is not entitled to capital gain treatment. It is not gain but a
substitute for ordinary income.
o Notes:
 Taxpayer purchases a bond. He purchases this bond before maturity and the
bond is a zero coupon bond meaning that it pays no interest but it will pay a
lump sum in the future.
 We have a capital asset; I have no income, from a corporate perspective, that
has been earned from this investment (it has a zero coupon bond) but,
 I buy bond at a discount at $90 and in one year it pays $100. Court says
this is just like interest
 What does the discount between the price paid when bond was issued
and the price of redemption represent?
o It represents the time value of money or the interest that will
accrue on that instrument between the time of its issuance and
its maturity.
 So the Court says even though the bond may be a capital asset and sale
of this asset has resulted in a gain, but this gain is like the fruit, like the
annual income that I would have earned on this bond
 Capital Gains

 This is not a bond that is issued with no interest, it is a bond that in

effect is the same as a $90 bond that has an interest rate of 10%, and
when I get paid at the end, those extra $10 is really additional interest.
To that end, the interest is not capital gain but it is ordinary income that
will be subject to the normal progressive tax rate.
 This is income from property and not the property itself.
PURCHASED REMAINDER INTEREST
- Jones v. Commissioner
o Taxpayer purchased remainderman interests in trusts and sells them after the death of
the holder of the life interest but before the trust pays out. Taxpayer claims capital
gain treatment on the sale of this investment.
o Court remanded for trial to determine whether gain was related to time value of
money.
o Notes:
 If the remainderman interest had never had disposed of the remainderman
interest the remainderman would have a basis equal to the FMV of that
instrument at the time of the bequest by reason of §1014. If we were dealing
with this person, we would know his basis on trust but it is this person that sells
the remainderman interest in this case
 Remainderman needs money before it pays out from the life estate.
Jones buys remainderman interest. Remainderman interest will pay
$100 at the time the life estate expires (in 4 years) but Jones pays a
discounted value of $80. Now my basis is a cost basis.I have an $80
basis (§1012).
 Life estate terminates and Jones gets paid $100. How do I treat those
$20 that Jones receives upon termination of life estate? Is this a capital
gain or ordinary income?
o If I have a discount of $20 and if the person really did live the
four years, then all the $20 would represent the expected time
value of money and there would be no capital gain, but what if
o The life estate holder dies in a year. Jones bought an instrument
for $80 expecting the it would defer for four years, and the $20
represent the interest to be paid in four years, but I am getting
them paid in year 1.
 To the extent that the $20 of discount represents that
one year then that amount would be interest but if we
have a finding of fact that the remainder of that discount
relates to a period that is not going to be compensation
for the time value of money, I take it that that extra
amount would be capital gain.
 If I own a remainderman interest, I pay a discount of $80
for something that will pay me $100 in the future and I
 Capital Gains

look at the mortality tables, the life estate will live for
four years, and life estate lives less than that then a
portion of that discount is not related to the time value
of money and it is gain that resulted of a good bet. I
invested in an instrument that paid me a gain above the
time value of money return. And that portion would be
entitled to capital gain treatment.
 If I buy a remainderman interest and I have a discount that reflects one
expected time period and I get paid quicker, then a portion of that discount
represents the actual time value of money and the remainder is just a gain
because I actually invested in an asset that was beneficial than what the market
believed at the time I purchased it.
SALE TO “CUSTOMERS”
- Curtis Co. v. Commissioner
o Housing Sales: Taxpayer built 1,098 rental housing properties that initially were
intended to be held and rented. When price controls were removed after WWII, the
taxpayer sold all these houses. A 45-acre parcel acquired and was intended to be
developed into an apartment complex. Due to zoning problems, taxpayer sold out
their interest in the property.
o Issue: Whether this type of property is eligible for capital gain treatment
o Held: Capital gain even though these were sold with professional staff and as
individual sales.
o Unimproved land: Taxpayer bought and sold unimproved real estate for resale.
o Notes:
 What is the controlling statutory provision of whether or not property is
subject for capital treatment? §1221(a)(1)
 Assets that are held primarily for sale to customers are not considered
to be capital assets.
o In this situation the gain that I am earning is akin to my normal
business activity
 Is this real estate developer primarily holding the real estate (asset) for
sale to customers?
o Court looks at the purpose of the business
 Factors the court considered to determine the purpose for which the
taxpayer was holding property:
o Intent
o Timing of the sales
o Number of assets sold
 Even though several assets were sold, selling activity did
not raise to the level of a business activity.
 The sale to customers at the time of the sale is what is relevant
 Capital Gains

 Taxpayer was able to demonstrate the he did not have the intent, at the
outset, to own the property to resale it to customers. BUT this is not the
dispositive fact. We are going to look at the activity that was done to the
property, the way it was held and the manner in which it was sold.
- Malat v. Ridell
o Facts: A 45-acre parcel acquired and was intended to be developed into an apartment
complex. Due to zoning problems, taxpayer sold out their interest in the property.
o Issue: Was the gain capital gain or ordinary income?
o Supreme Court: the determination is whether the property was or was not held
primarily for sale to customers. “Primarily” means “of first importance” or
“principally.” Case remanded to determine what is of first importance.
 What is the significance of the term “primarily”?
 When do I determine is my primary intent as to the property I am
disposing?
o The intent that we are looking at is the intent at the time of the
sale
o Factors considered in other cases:
1) Frequency and substantiality of sales
2) Development and improvement activities for the land
3) Seller’s solicitation and advertising efforts in sales
4) Relative earnings – property sales vs. earned income
5) Bulk sales
6) Liquidation of investments?
If I simply own the apartment building, without developing it then it looks like I am not in a developer role. This
does not look like business income.

- Bramblett v. Commissioner
o Bramlett and his partners bought Mesquite East Ranch and it was formed as a
partnership.
o Mesquite East sells the Ranch to Town East for 9.8 million dollars. Town East then
subdivides the ranch and sells the lots to the partners.
o Notes:
 If Mesquite East had directly subdivided the ranch and sold the lots to partners,
they would have had 9.8 million in ordinary income.
 Why would Mesquite East have a long-term capital gain instead of ordinary
income?
 I bought an asset at a low price, and then I am benefitting from the
market appreciation from being an investor on that asset.
 Capital Losses

Capital Losses
Arrowsmith v. Commissioner (p. 1147)
- Company is liquidated by the taxpayer in year 1 and reported long-term capital
gains.
- Several years later a judgement was rendered against the corporation and
corporation had to give money back to buyers. Corporation sought to deduct this
payment as an ordinary business expense.
- Court treated the payment as a capital loss as a matter of consistency and tax
symmetry.
o Because company reported gain in year 1 as capital gain, it had to report
reimbursement of same payment as capital loss and not ordinary loss
- What is the buyer’s treatment?
o Buyer paid $200,000 in year 1, but really only had to pay $100,000 and buyer
took depreciation deductions.
o Buyer gets reimbursed $100,000 in a later year
o Upon receipt of reimbursement, buyer would have to reduce adjusted basis
because buyer was using a higher basis in year 1.

Merchant National Bank v. Commissioner (p. 1150)

- Taxpayer held the promissory notes for loans that went bad and wrote them off
completely as ordinary losses
- Sold the remaining notes for a small fee
o Bank wanted to account for the money from the sale as capital gains
- Court held that they were ordinary income
- A wooden view of the statute would not get you to this answer – rather the court is
reaching a symmetry point; as the sale of the asset here was the sale of a capital
asset

Two bookends – Arrowsmith and Merchant National Bank

Skelly Oil
- Unique fact pattern; odd way to show the Arrowsmith principle
- Skelly Oil sold gas, but was allowed to deduct 22.5% of the gas sold
o Doesn’t make sense as they don’t have a basis in the gas
- Court didn’t allow a deduction of 100% of the repayments; rather only allowed a
deduction of 72.5% (which is what was previously taxable)
- Claim of right doctrine: Match the deduction in subsequent year in the same amount
and same character as to the way I characterized income in earlier year.

Corn Products Refining Co.

- From the very beginning there are two separate contracts; but they are integrated
- How do you treat this type of hedging transaction?
o As the trade of the future commodity is something of an insurance policy
- Court said we should treat the hedging transaction as creating ordinary income
o But the problem is that there is a statute
- P. 1153 – first paragraph
 Capital Losses

o Narrowly construe the term capital asset and broadly construe the exceptions
o Court created a class of property, which wasn’t inventory nor stock in trade,
 Property acquired for a purpose integral to the taxpayer’s business
which is excepted from capital asset definition
 This type of property includes:
 Profits and losses arising from everyday operations of the
business” which must be regarded as ordinary
 Emphasized taxpayer’s motive for acquiring property
Arkansas Best Corp (p. 1155)
- Stock held in a Dallas bank and sold at a loss after the bank became a problem bank
- Tax Court held the stock purchases during the bank’s problem phase were made
exclusively for business purposes
- Reversed by the 8th Circuit and Supreme Court affirmed
- Acquisition purpose not deemed relevant
- Court is not walking back the holding of Corn Products, but rather holding that the
commodity connected to an inventory asset (how it is linked to inventory
management)
o Those assets derive their character due to their link with the inventory
management process
o If the inventory itself would meet the §1221(a)(1), the assets used as inventory
management would be colored under that statute
- Stating that just because something is related to the business it cannot be colored by
the statute, it has to be linked/bootstrapped to the inventory itself (usually dealing
with risk management)
- Corn Products doctrine (just to inventory) applies only to inventory, assets that are
surrogate for inventory or insurance
o If I engage in hedging or insurance the nature of that hedging will be the
derivative of the other transaction that the hedging/insuring transaction is
related to.
 If that other transaction creates ordinary income then that will be the
nature of hedging/insurance
- Arkansas says to look at the underlying asset

As a result Congress changed §1221: Exceptions to Capital Gains Definition:

- §1221(a)(6) – commodities derivative financial instruments
- §1221(a)(7) – hedging transactions (timely identification required)
- §1221(a)(8) – supplies of a type consumed by the taxpayer in ordinary course of
business
o E.g. airlines purchase of fuel
 Capital Losses

Future Income Streams

Hort v. Commissioner (p. 1162)
- Cancellation of a lease resulted in payment received in lump sum as a substitute of future
rent
- “Substitute for Ordinary Income” proves too much, so what is going on?
- P. 1164 – “The consideration received for cancellation of the lease was not a return of capital.
We assume the lease was ‘property’ whatever signifies abstractly.”
- What if the lessee built a building worth $140,000 and walks away from the lease?
o §109 – would not be income to the person and they would have a 0 basis in it
- Court says this is not property, but rather a substitute for ordinary income

P.G. Lake (p. 1171)

- Corporation transferred 600x oil payment to officer to pay loan
- Treatment of assignment of income as a capital asset transfer
o Because they were stating that they sold part of the well
- Held taxable as ordinary income since a substitute for ordinary income
o Just as if you had sold the ordinary income stream from underneath the property
o Essentially just been prepaid for the operation of the well
o Holding that it is not property; just ordinary income
- Response is Code §636 – treat the transaction as a loan

Commissioner v. Carter (p. 1181)

- Carter received 32 oil brokerage contracts in liquidation of corporate exchange for stock
- These contracts had no ascertainable value in 1942
- In 1943, Mrs. Carter was paid $34,000 on the contracts
- Is the 1943 payments ordinary income or capital gain to Mrs. Carter?
- Tax Court held this was a capital gain
- Second Circuit affirmed – generally receipt of cash on business contracts would be ordinary
income
- However, Mrs. Carter’s stock was a capital asset, and this $34,000 was received as part of
the overall sale or exchange of her stock in the 1942 liquidation
- Because the 1943 relates to that 1942 liquidation, the additional proceeds take their
character from that earlier transaction

Commissioner v. Brown (p. 1185) – Bootstrapping Sale to Charity

- Complicated fact pattern – need to read this case carefully!
- Brown and his family owned all of the shares of the C&B company
o Hypo: What if the company owned the company earned $100,000
 Corporate tax rate of 52% -- they would keep $48,000 and distribute that as
dividends
 Which would then be gross income to the taxpayer
o This case is a unique period of tax history
 Dividends has almost always been ordinary income, and it is such here at 70%
o Do you see the double tax here?
 Taxing the company
 Taxing the taxpayer as ordinary income – comes to an all in tax rate
 52% of $100K
 Capital Losses

 70% of $48K
- Brown doesn’t want to pay this tax – so what does he do?
- Sale of the assets to an exempt company who then rents the assets to another company
owned by Clay Brown
o Which then can be deducted
- The charity is going to keep 8% of the profits & Clay Brown not subject to a dividend tax
o He is getting proceeds from the sale of a business at capital gains rates
- All-in the payments made through the charity would result in a tax cost of $22,500
o Cf Clay Brown getting dividends – he pays $85,000 tax cost
- IRS says this is a fictional sale – it looks like the business that Clay Brown owns ends up in a
Clay Brown entity
o Court says no – just because the amount is dependent on how the business does; the
charity still gains something
 This is a true seller exchange
- Congress had a partial response to this by amending §512(b)(3)(B)(iii)
o Tax exempt entity will be responsible for the corporate level tax
- Two main thoughts from this case:
o A contingent sales price may still be treated as a seller exchange subject to capital
gains treatment
o Today – the dividend issue is not a big of deal; but the hypo can be changed where the
underlying income stream is rent (or some other type of ordinary income) and then the
problem may arise
 Then Clay Brown would provide an effective way to work through that problem

Lattera (Supplement p. 99)

- Won the lottery, and wanted to treat it as a lump sum amount/payment – or sale of a
property right
o And then wanted to treat it as a capital gain
- Court working through it was a capital gain or ordinary income:
o Synthesis of how to work through the law:
 Step One: Look to Type of Carve Out first. Horizontal carve out leads to ordinary
income. Vertical carve outs lead to Step #2
 Step Two: Because a vertical carve out could signal either capital gains or
ordinary income, we then look to the character of the underlying asset and
apply the “family resemblance test”
 Look to slides for the rest of the synthesis under this analysis
 Family Resemblance Test
o What does the transaction resemble?
 If it resembles stock or capital assets then it is “clearly” a
capital asset
o The right to receive lottery payments do not resemble capital gains or ordinary income
 Because a right to a lottery payment is a right to earned income
 Because there was a contractual right to just receive the income; gives
rise to ordinary income treatment
 When you don’t know what you are going to earn, then it may be subject
to a capital gain treatment
- NOTE: There is not a consensus among the circuits on this

Stern v. United States (p. 1199)

 Capital Losses

- Second Lieutenant for the Army during WWII creates the character and writes books of
Francis the talking mule
- Tries to treat Francis as a capital asset after he sold the movie rights to Universal
- IRS says that this was an asset held for purposes of selling to customers
o Court dismisses this
- But there is an exception to capital asset treatment which deal with art and literary material
o This exception excludes these types of things from capital asset treatment
o The author says that Francis was just an idea, so it doesn’t meet this exception
 Court disagrees and says if it weren’t for the books, the character of Francis
would not exist
- This provision was added in 1950 – which is in the middle of all of this; so anything earned
after 1950 was excluded from capital gains treatment
- Now we have landed on the spot that the creator has created an invention and it is the
creator who is transferring the invention.
o What is the character of that income that is produced
- Is this an appropriate recognition event?
o Once you pass those gains then you land on the question of character.
- If you do not have a seller exchange then you do not have to characterize the treatment of the
property being transferred. Whether it is a capital or ordinary asset.
- It was not part of a trade or business. ASSET WAS PART OF A HOBBY. It did not raise to the
level of an active trade or business.
- §1221(a)(3)
o Letters or memorandum ar
o Copyright literary work is not going to be entitled to capital treatment
o This transaction is a seller exchange indeed but it is not going to be characterized as
capital asset.
o Isn’t the money that inventor receives for copyright a compensation for the work he
performed?
General Comments: §1235

- This is limited to patents

- This will allow transfers that are patents to be treated as long-term capital gains.
- What benefit does 1235 have over 1221?
o 1221 may not apply in some instances while 1235 would.
o 1235 shall be considered as a long-term capital asset whether or not you hold asset
for more than one year.
 IF I SELL A PATENT IT WILL BE TREATED AS A CAPITAL ASSET THAT HAS
BEEN HELD FOR MORE THAN ONE YEAR. REGARDLESS OF THE TIME
PERIOD I HOLD THE ASSET FOR.
Notes: § 1221(b)(3)
- This provision came to the code in 2006.
- Would Stern be able to rely in this provision if his case had been decided after the drafting of
this provision?
o No, because his work is not musical
o This provision applies to musical copyrights only.
- Basic policy question: Why should anyone that sells his

Busse v. Commissioner (p. 1204)

- He created a patent and 505
- Contingent sales proceeds based on the patent for a machine that stacked cans on a pallet
 Capital Losses

- They sold the patent to a corporation in order to get the contingent sales agreement instead
of getting the gains through the ordinary sale
- §1235(a).
-
o Exception to this (c) – if you sell the asset to an entity which you do not control
- 1235 doesn’t control as this was a sale to an entity which he controlled
- So why did he get a capital gains treatment?
o Don’t need 1235 – which deals with something that is a non-capital asset
o Court says the patent was a property right which was sold and was a capital asset
under 1221(a)
 Why not 1221(a)(3)?
 Because it doesn’t mention patent
o It deals with literary works, etc.
- Court is trying to draw a line – but is constricted and can’t sale a sale or exchange didn’t
happen
- Once I have assigned the patent, the tree has been transferred and the patent is owned by
the assignee.
- If I own the patent and retain the patent then I can receive a royalty. You have tp pay me for
the use of the intellectual property of an asset that I still own.
- But if I transfer the property then I am not getting paid a royalty anymore. I have now a
seller-exchange that has a contingent sales price.
o This is the intermediate case where the sales price is the ongoing income of the
property itself.
- Was Bussee entitled to treat these amounts as long-term capital asset?
o No, we have the transfer of a patent. Why?
 Related person §1235(c)
 Shall not apply to any transfer between the holder inventor of a patent if
the transferee is related to the inventor of patent.
- Do requirements under §1221 apply?
o No carve-out applies and thus entitled to capital treatment under 1221.
- Not all the amount of the proceeds will be treated as capital gain. Why not?
o §483 normally applies and thus interest is not going to be treated as capital asset.
o Because the transaction is described
- If 1235 had applied then §483 would not have applied.
Notes:
- I am in effect being paid from th

Commissioner v. Ferrer (p. 1207)

- Actor who entered into a contract with the writer of Moulin Rouge to produce the film
o He purchased the right to have Moulin Rouge performed as a play or produced as a
movie
o John Houston wants to the rights to produce it as a movie
 Ferrer agrees to give the rights to Houston to film and releases the lease rights
of the play; and wanted to be in the movie
 He was going to participate in the play and provide personal services. This
amount of wage was ordinary income
 The lease of the play
 I own the right to produce play
 I have the right to prevent anybody else from participating in play
o How does court charactersize rights?
 Capital Losses

 Play right received capital gains treatment and analogized this right to a lease.
 Which party if received lease income would be entitled to ordinary
income?
o Lessor
o But if payment is received by lessee then that payment will be
treated as capital gain.
 Ferrer has a right to produce play and he is being paid to cancel license.
This is a lot like lessee being paid for getting out of building.
o He is being paid to cancel that right and thus payment is capital
gain
 Right to prevent person from participating in play
 Also receives capital gain treatment
 Right
 I am getting an assignment of the income but not the property itself.
 Ferrer is receiving an income interest and not the income producing
asset. This assignment should be treated as ordinary income.
o Court said that income had to be allocated according to the three rights described
above.
 The third right is probably the largest one.
- Whatever income Ferrer received as an actor in the play is ordinary income
- What about the proceeds from giving the rights of the play over to Houston?
o Capital gains, as it is a property right in exchange for cash = seller exchange under
1221(a) without any exceptions
o Why isn’t 1221(a)(3) applicable?
 He is not the inventor of the artistic work
- With the three things being sold – how do you determine the dollar amounts according to
each of the rights/services being sold?
o Remand it to the trial court, have them figure it out to be consistent with this opinion