Main Body

3 Exclusions from Gross Income

Chapter 3

Exclusions from Gross Income

In this chapter, we take up exclusions from gross income. Congress has chosen – for various reasons – to permit taxpayers not to “count” certain accessions to wealth in their gross income. An exclusion is not the same as a deduction. A deduction is a reduction (subtraction) from what would otherwise be “taxable income.” An exclusion does not even count as “gross income,” and so cannot become “taxable income” – even though it usually is quite clearly an “accession to wealth.” We are still focusing on the first line of the “tax formula” – only now we are examining accessions to wealth that are not included in gross income as opposed to those that are. Deductions come later.

The availability of exclusions may have several consequences:

• Taxpayers may feel encouragement to seek wealth in forms that the Code excludes from their gross income. They will do this at the expense (opportunity cost) of procuring wealth in a form subject to income tax.

• The fact that a taxpayer may acquire a particular form of wealth without bearing any tax burden does not mean that the taxpayer necessarily enjoys the full benefit of the exclusion. Others may “capture” some or all of the benefit.

• The fact that many taxpayers find a particular benefit to be attractive will most certainly affect the market for that benefit, e.g., health care. Taxpayers acting as consumers will bid up the price of the benefit and so must spend more to acquire such forms of wealth (benefits) than they would if all taxpayers had to purchase the benefit with after-tax dollars. The price of acquiring the tax-favored benefit will change. Entrepreneurs may be encouraged to enter fields in which their customers can purchase their goods and services with untaxed dollars. Such entrepreneurs might have created more societal value by selling other goods and services.

• The Treasury obviously must forego tax revenues simply because these accessions to wealth are not subject to income tax.


The Tax Formula:

→ (gross income)

MINUS deductions named in § 62

EQUALS (adjusted gross income (AGI))

MINUS (standard deduction or itemized deductions)

MINUS (personal exemptions)

EQUALS (taxable income)

Compute income tax liability from tables in § 1 (indexed for inflation)

MINUS (credits against tax)


In light of these points, you should consider the net effectiveness of exclusions from gross income as a means of congressional pursuit of policy. Consider also whether there are better ways to accomplish these objectives. We will consider the parameters of some exclusions and note others. This text groups excluded benefits very roughly into three overlapping categories: those that encourage the development of the society and government that we want, those that encourage the creation of social benefits – perhaps of a sort that the government might otherwise feel obliged to provide, and those that are employment-based.

I. The Society and Government that We Want

The Code excludes from a taxpayer’s gross income certain benefits that (seem to) encourage taxpayers to make certain decisions that foster development of a certain type of society and government. You might see in such provisions as §§ 102, 103, 107, and 121 the policies of generosity, federalism, spiritual growth, and home ownership. Consider:

• Whether these are policies that the government should pursue;

• Whether tax benefits are the appropriate means of pursuing these policies. After all, those who choose to avail themselves of the benefits of these tax benefits do so at the expense of taxpayers who do not;

• Whether the tax provisions by which Congress pursues these policies lead to unintended consequences and/or capture by those other than the intended beneficiaries.

A. Gifts and Inheritances, § 102, and Related Basis Rules, §§ 1014, 1015

Read § 102. There has always been an exclusion for gifts and inheritances from the federal income tax in the Code. Perhaps Congress has always felt that it would be inappropriate to assess a tax on the generosity of relatives who give birthday and Christmas gifts – sometimes very expensive ones. But:

• Is it possible that this may lead to a culture of gift-giving in contexts other than the family – whose effects may not reflect generosity or affection?

• If so, is it possible that the costs of such gifts will escalate, and is it not certain that the donor will (at least try to) deduct the escalating costs of such gifts?

Commissioner v. Duberstein, 363 U.S. 278 (1960)

MR. JUSTICE BRENNAN delivered the opinion of the Court.

These two cases concern the provision of the Internal Revenue Code which excludes from the gross income of an income taxpayer “the value of property acquired by gift.”  … The importance to decision of the facts of the cases requires that we state them in some detail.

No. 376, Commissioner v. Duberstein. The taxpayer, Duberstein, was president of the Duberstein Iron & Metal Company, a corporation with headquarters in Dayton, Ohio. For some years, the taxpayer’s company had done business with Mohawk Metal Corporation, whose headquarters were in New York City. The president of Mohawk was one Berman. The taxpayer and Berman had generally used the telephone to transact their companies’ business with each other, which consisted of buying and selling metals. The taxpayer testified, without elaboration, that he knew Berman “personally,” and had known him for about seven years. From time to time in their telephone conversations, Berman would ask Duberstein whether the latter knew of potential customers for some of Mohawk’s products in which Duberstein’s company itself was not interested. Duberstein provided the names of potential customers for these items.

One day in 1951, Berman telephoned Duberstein and said that the information Duberstein had given him had proved so helpful that he wanted to give the latter a present. Duberstein stated that Berman owed him nothing. Berman said that he had a Cadillac as a gift for Duberstein, and that the latter should send to New York for it; Berman insisted that Duberstein accept the car, and the latter finally did so, protesting, however, that he had not intended to be compensated for the information. At the time, Duberstein already had a Cadillac and an Oldsmobile, and felt that he did not need another car. Duberstein testified that he did not think Berman would have sent him the Cadillac if he had not furnished him with information about the customers. It appeared that Mohawk later deducted the value of the Cadillac as a business expense on its corporate income tax return.

Duberstein did not include the value of the Cadillac in gross income for 1951, deeming it a gift. The Commissioner asserted a deficiency for the car’s value against him … [T]he Tax Court affirmed the Commissioner’s determination. It said that “The record is significantly barren of evidence revealing any intention on the part of the payor to make a gift. … The only justifiable inference is that the automobile was intended by the payor to be remuneration for services rendered to it by Duberstein.” The Court of Appeals for the Sixth Circuit reversed.

No. 546, Stanton v. United States. The taxpayer, Stanton, had been for approximately 10 years in the employ of Trinity Church in New York City. He was comptroller of the Church corporation, and president of a corporation, Trinity Operating Company, the church set up as a fully owned subsidiary to manage its real estate holdings, which were more extensive than simply the church property. His salary by the end of his employment there in 1942 amounted to $22,500 a year. Effective November 30, 1942, he resigned from both positions to go into business for himself. The Operating Company’s directors, who seem to have included the rector and vestrymen of the church, passed the following resolution upon his resignation:

“Be it resolved that, in appreciation of the services rendered by Mr. Stanton …, a gratuity is hereby awarded to him of Twenty Thousand Dollars, payable to him in equal instalments of Two Thousand Dollars at the end of each and every month commencing with the month of December, 1942; provided that, with the discontinuance of his services, the Corporation of Trinity Church is released from all rights and claims to pension and retirement benefits not already accrued up to November 30, 1942.”

The Operating Company’s action was later explained by one of its directors as based on the fact that

“Mr. Stanton was liked by all of the Vestry personally. He had a pleasing personality. He had come in when Trinity’s affairs were in a difficult situation. He did a splendid piece of work, we felt. Besides that …, he was liked by all of the members of the Vestry personally.”

And by another:

“[W]e were all unanimous in wishing to make Mr. Stanton a gift. Mr. Stanton had loyally and faithfully served Trinity in a very difficult time. We thought of him in the highest regard. We understood that he was going in business for himself. We felt that he was entitled to that evidence of good will.”

On the other hand, there was a suggestion of some ill feeling between Stanton and the directors, arising out of the recent termination of the services of one Watkins, the Operating Company’s treasurer, whose departure was evidently attended by some acrimony. At a special board meeting on October 28, 1942, Stanton had intervened on Watkins’ side and asked reconsideration of the matter. The minutes reflect that

“resentment was expressed as to the ‘presumptuous’ suggestion that the action of the Board, taken after long deliberation, should be changed.”

The Board adhered to its determination that Watkins be separated from employment … [T]he Board voted the payment of six months’ salary to Watkins in a resolution similar to that quoted in regard to Stanton, but which did not use the term “gratuity.” At the meeting, Stanton announced that, in order to avoid any … embarrassment or question at any time as to his willingness to resign if the Board desired, he was tendering his resignation …, which … was [eventually] accepted.

… There was undisputed testimony that there were in fact no enforceable rights or claims to pension and retirement benefits which had not accrued at the time of the taxpayer’s resignation, and that the last proviso of the resolution was inserted simply out of an abundance of caution. The taxpayer received in cash a refund of his contributions to the retirement plans, and there is no suggestion that he was entitled to more. He was required to perform no further services for Trinity after his resignation.

The Commissioner asserted a deficiency against the taxpayer after the latter had failed to include the payments in question in gross income. After payment of the deficiency and administrative rejection of a refund claim, the taxpayer sued the United States for a refund in the District Court for the Eastern District of New York. The trial judge, sitting without a jury, made the simple finding that the payments were a “gift,” and judgment was entered for the taxpayer. The Court of Appeals for the Second Circuit reversed.

The Government, urging that clarification of the problem typified by these two cases was necessary, and that the approaches taken by the Courts of Appeals for the Second and the Sixth Circuits were in conflict, petitioned for certiorari in No. 376, and acquiesced in the taxpayer’s petition in No. 546. On this basis, and because of the importance of the question in the administration of the income tax laws, we granted certiorari in both cases.

The exclusion of property acquired by gift from gross income under the federal income tax laws was made in the first income tax statute passed under the authority of the Sixteenth Amendment, and has been a feature of the income tax statutes ever since. The meaning of the term “gift” as applied to particular transfers has always been a matter of contention. Specific and illuminating legislative history on the point does not appear to exist. Analogies and inferences drawn from other revenue provisions, such as the estate and gift taxes, are dubious. [citation omitted]. The meaning of the statutory term has been shaped largely by the decisional law. With this, we turn to the contentions made by the Government in these cases.

First. The Government suggests that we promulgate a new “test” in this area to serve as a standard to be applied by the lower courts and by the Tax Court in dealing with the numerous cases that arise. We reject this invitation. We are of opinion that the governing principles are necessarily general, and have already been spelled out in the opinions of this Court, and that the problem is one which, under the present statutory framework, does not lend itself to any more definitive statement that would produce a talisman for the solution of concrete cases. The cases at bar are fair examples of the settings in which the problem usually arises. They present situations in which payments have been made in a context with business overtones – an employer making a payment to a retiring employee; a businessman giving something of value to another businessman who has been of advantage to him in his business. In this context, we review the law as established by the prior cases here.

The course of decision here makes it plain that the statute does not use the term “gift” in the common law sense, but in a more colloquial sense. This Court has indicated that a voluntarily executed transfer of his property by one to another, without any consideration or compensation therefor, though a common law gift, is not necessarily a “gift” within the meaning of the statute. For the Court has shown that the mere absence of a legal or moral obligation to make such a payment does not establish that it is a gift. Old Colony Trust Co. v. Commissioner, 279 U.S. 716, 730. And, importantly, if the payment proceeds primarily from “the constraining force of any moral or legal duty,” or from “the incentive of anticipated benefit” of an economic nature, Bogardus v. Commissioner, 302 U.S. 34, 41, it is not a gift. And, conversely, “[w]here the payment is in return for services rendered, it is irrelevant that the donor derives no economic benefit from it.” Robertson v. United States, 343 U.S. 711, 714.49 A gift in the statutory sense, on the other hand, proceeds from a “detached and disinterested generosity,” Commissioner v. LoBue, 351 U.S. 243, 246; “out of affection, respect, admiration, charity or like impulses.” Robertson v. United States, supra, at 343 U.S. 714. And, in this regard, the most critical consideration, as the Court was agreed in the leading case here, is the transferor’s “intention.” Bogardus v. Commissioner, 302 U.S. 34, 43. “What controls is the intention with which payment, however voluntary, has been made.” Id. at 302 U.S. 45 (dissenting opinion).

The Government says that this “intention” of the transferor cannot mean what the cases on the common law concept of gift call “donative intent.” With that we are in agreement, for our decisions fully support this. Moreover, the Bogardus case itself makes it plain that the donor’s characterization of his action is not determinative – that there must be an objective inquiry as to whether what is called a gift amounts to it in reality. 302 U.S. at 40. It scarcely needs adding that the parties’ expectations or hopes as to the tax treatment of their conduct, in themselves, have nothing to do with the matter.

It is suggested that the Bogardus criterion would be more apt if rephrased in terms of “motive,” rather than “intention.” We must confess to some skepticism as to whether such a verbal mutation would be of any practical consequence. We take it that the proper criterion, established by decision here, is one that inquires what the basic reason for his conduct was in fact – the dominant reason that explains his action in making the transfer. Further than that we do not think it profitable to go.

Second. The Government’s proposed “test,” while apparently simple and precise in its formulation, depends frankly on a set of “principles” or “presumptions” derived from the decided cases, and concededly subject to various exceptions; and it involves various corollaries, which add to its detail. Were we to promulgate this test as a matter of law, and accept with it its various presuppositions and stated consequences, we would be passing far beyond the requirements of the cases before us, and would be painting on a large canvas with indeed a broad brush. The Government derives its test from such propositions as the following: that payments by an employer to an employee, even though voluntary, ought, by and large, to be taxable; that the concept of a gift is inconsistent with a payment’s being a deductible business expense; that a gift involves “personal” elements; that a business corporation cannot properly make a gift of its assets. The Government admits that there are exceptions and qualifications to these propositions. We think, to the extent they are correct, that these propositions are not principles of law, but rather maxims of experience that the tribunals which have tried the facts of cases in this area have enunciated in explaining their factual determinations. Some of them simply represent truisms: it doubtless is, statistically speaking, the exceptional payment by an employer to an employee that amounts to a gift. Others are overstatements of possible evidentiary inferences relevant to a factual determination on the totality of circumstances in the case: it is doubtless relevant to the over-all inference that the transferor treats a payment as a business deduction, or that the transferor is a corporate entity. But these inferences cannot be stated in absolute terms. Neither factor is a shibboleth. The taxing statute does not make nondeductibility by the transferor a condition on the “gift” exclusion; nor does it draw any distinction, in terms, between transfers by corporations and individuals, as to the availability of the “gift” exclusion to the transferee. The conclusion whether a transfer amounts to a “gift” is one that must be reached on consideration of all the factors.

Specifically, the trier of fact must be careful not to allow trial of the issue whether the receipt of a specific payment is a gift to turn into a trial of the tax liability, or of the propriety, as a matter of fiduciary or corporate law, attaching to the conduct of someone else. The major corollary to the Government’s suggested “test” is that, as an ordinary matter, a payment by a corporation cannot be a gift, and, more specifically, there can be no such thing as a “gift” made by a corporation which would allow it to take a deduction for an ordinary and necessary business expense. As we have said, we find no basis for such a conclusion in the statute; and if it were applied as a determinative rule of “law,” it would force the tribunals trying tax cases involving the donee’s liability into elaborate inquiries into the local law of corporations or into the peripheral deductibility of payments as business expenses. The former issue might make the tax tribunals the most frequent investigators of an important and difficult issue of the laws of the several States, and the latter inquiry would summon one difficult and delicate problem of federal tax law as an aid to the solution of another. Or perhaps there would be required a trial of the vexed issue whether there was a “constructive” distribution of corporate property, for income tax purposes, to the corporate agents who had sponsored the transfer. These considerations, also, reinforce us in our conclusion that, while the principles urged by the Government may, in nonabsolute form as crystallizations of experience, prove persuasive to the trier of facts in a particular case, neither they nor any more detailed statement than has been made can be laid down as a matter of law.

Third. Decision of the issue presented in these cases must be based ultimately on the application of the factfinding tribunal’s experience with the mainsprings of human conduct to the totality of the facts of each case. The nontechnical nature of the statutory standard, the close relationship of it to the date of practical human experience, and the multiplicity of relevant factual elements, with their various combinations, creating the necessity of ascribing the proper force to each, confirm us in our conclusion that primary weight in this area must be given to the conclusions of the trier of fact. Baker v. Texas & Pacific R. Co., 359 U.S. 227; Commissioner v. Heininger, 320 U.S. 467, 475; United States v. Yellow Cab Co., 338 U.S. 338, 341; Bogardus v. Commissioner, supra, at 302 U.S. at 45 (dissenting opinion).

This conclusion may not satisfy an academic desire for tidiness, symmetry, and precision in this area, any more than a system based on the determinations of various factfinders ordinarily does. But we see it as implicit in the present statutory treatment of the exclusion for gifts, and in the variety of forums in which federal income tax cases can be tried. If there is fear of undue uncertainty or overmuch litigation, Congress may make more precise its treatment of the matter by singling out certain factors and making them determinative of the matters, as it has done in one field of the “gift” exclusion’s former application, that of prizes and awards. Doubtless diversity of result will tend to be lessened somewhat, since federal income tax decisions, even those in tribunals of first instance turning on issues of fact, tend to be reported, and since there may be a natural tendency of professional triers of fact to follow one another’s determinations, even as to factual matters. But the question here remains basically one of fact, for determination on a case-by-case basis.

One consequence of this is that appellate review of determinations in this field must be quite restricted. Where a jury has tried the matter upon correct instructions, the only inquiry is whether it cannot be said that reasonable men could reach differing conclusions on the issue. [citation omitted]. Where the trial has been by a judge without a jury, the judge’s findings must stand unless “clearly erroneous.” Fed. Rules Civ. Proc. 52(a). … The rule itself applies also to factual inferences from undisputed basic facts citation omitted], as will on many occasions be presented in this area. [citation omitted]. And Congress has, in the most explicit terms, attached the identical weight to the findings of the Tax Court. I.R.C. § 7482(a).

Fourth. A majority of the Court is in accord with the principles just outlined. And, applying them to the Duberstein case, we are in agreement, on the evidence we have set forth, that it cannot be said that the conclusion of the Tax Court was “clearly erroneous.” It seems to us plain that, as trier of the facts, it was warranted in concluding that, despite the characterization of the transfer of the Cadillac by the parties, and the absence of any obligation, even of a moral nature, to make it, it was, at bottom, a recompense for Duberstein’s past services, or an inducement for him to be of further service in the future. We cannot say with the Court of Appeals that such a conclusion was “mere suspicion” on the Tax Court’s part. To us, it appears based in the sort of informed experience with human affairs that factfinding tribunals should bring to this task.

As to Stanton, we are in disagreement. To four of us, it is critical here that the District Court as trier of fact made only the simple and unelaborated finding that the transfer in question was a “gift.” To be sure, conciseness is to be strived for, and prolixity avoided, in findings; but, to the four of us, there comes a point where findings become so sparse and conclusory as to give no revelation of what the District Court’s concept of the determining facts and legal standard may be. [citation omitted]. Such conclusory, general findings do not constitute compliance with Rule 52’s direction to “find the facts specially and state separately … conclusions of law thereon.” While the standard of law in this area is not a complex one, we four think the unelaborated finding of ultimate fact here cannot stand as a fulfillment of these requirements. It affords the reviewing court not the semblance of an indication of the legal standard with which the trier of fact has approached his task. For all that appears, the District Court may have viewed the form of the resolution or the simple absence of legal consideration as conclusive. While the judgment of the Court of Appeals cannot stand, the four of us think there must be further proceedings in the District Court looking toward new and adequate findings of fact. In this, we are joined by MR. JUSTICE WHITTAKER, who agrees that the findings were inadequate, although he does not concur generally in this opinion.

Accordingly, in No. 376, the judgment of this Court is that the judgment of the Court of Appeals is reversed, and in No. 546, that the judgment of the Court of Appeals is vacated, and the case is remanded to the District Court for further proceedings not inconsistent with this opinion.

It is so ordered.

MR. JUSTICE HARLAN concurs in the result in No. 376. In No. 546, he would affirm the judgment of the Court of Appeals for the reasons stated by MR. JUSTICE FRANKFURTER.

MR. JUSTICE WHITTAKER, … concurs only in the result of this opinion.

MR. JUSTICE DOUGLAS dissents, since he is of the view that, in each of these two cases, there was a gift …

MR. JUSTICE BLACK, concurring and dissenting.

I agree with the Court that it was not clearly erroneous for the Tax Court to find as it did in No. 376 that the automobile transfer to Duberstein was not a gift, and so I agree with the Court’s opinion and judgment reversing the judgment of the Court of Appeals in that case.

I dissent in No. 546, Stanton v. United States. … [T]he Court of Appeals was … wrong in reversing the District Court’s judgment.

MR. JUSTICE FRANKFURTER, concurring in the judgment in No. 376 and dissenting in No. 546.


… While I agree that experience has shown the futility of attempting to define, by language so circumscribing as to make it easily applicable, what constitutes a gift for every situation where the problem may arise, I do think that greater explicitness is possible in isolating and emphasizing factors which militate against a gift in particular situations.

… While we should normally suppose that a payment from father to son was a gift unless the contrary is shown, in the two situations now before us, the business implications are so forceful that I would apply a presumptive rule placing the burden upon the beneficiary to prove the payment wholly unrelated to his services to the enterprise. The Court, however, has declined so to analyze the problem, and has concluded

“that the governing principles are necessarily general, and […] that the problem is one which, under the present statutory framework, does not lend itself to any more definitive statement that would produce a talisman for the solution of concrete cases.”


… What the Court now does sets factfinding bodies to sail on an illimitable ocean of individual beliefs and experiences. This can hardly fail to invite, if indeed not encourage, too individualized diversities in the administration of the income tax law. I am afraid that, by these new phrasings, the practicalities of tax administration, which should be as uniform as is possible in so vast a country as ours, will be embarrassed. … I agree with the Court in reversing the judgment in Commissioner v. Duberstein.

But I would affirm the decision of the Court of Appeals for the Second Circuit in Stanton v. United States. … The business nature of the payment is confirmed by the words of the resolution, explaining the “gratuity” as

“in appreciation of the services rendered by Mr. Stanton as Manager of the Estate and Comptroller of the Corporation of Trinity Church throughout nearly ten years, and as President of Trinity Operating Company, Inc.”

Notes and Questions:

1. On remand of the Stanton case, the federal district court reexamined the evidence and determined that the Vestry was motivated by gratitude to a friend, good will, esteem, and kindliness. Hence the payment was a gift. Stanton v. U.S., 186 F. Supp. 393, 396-97 (E.D.N.Y. 1963). The court of appeals affirmed because the determination of the federal district court was not clearly erroneous. U.S. v. Stanton, 287 F.2d 876, 877 (2nd Cir. 1961).

2. The Supreme Court stated:

A gift in the statutory sense … proceeds from a “detached and disinterested generosity” [citation omitted], “out of affection, respect, admiration, charity or like impulses.” [citation omitted]. And in this regard, the most critical consideration … is the transferor’s “intention.” [citation omitted].

Do people give gifts because they are detached and disinterested – or very attached and intensely interested?

3. The donee is the one who will invoke § 102. How is the donee to prove the donor’s intent? Consider:

• Taxpayer first joined a bakery workers’ union in 1922 and gradually rose through the ranks. In 1947, he was elected international vice president. He was an effective leader and was instrumental in the merger of several locals into one large local. Other officials of the local decided to give him and his wife a testimonial dinner at which the local would present him with sufficient funds to purchase a home. Taxpayer had nothing to do with the planning of the dinner and objected to it. The local raised money by selling insertions in a special souvenir journal. More than 1300 persons attended the dinner. There were six groups who contributed journal insertions:

• Employers of bakery workers who wanted to stay on good terms with the local made deductible payments from their business accounts. Many employers had known taxpayer for many years and were on good terms with him. Most of this group’s journal insertions included a greeting such as “congratulations” and “best wishes.”

• Employer trade associations made payments from assessments on employers, who in turn deducted payments that they made from their business accounts.

• Businesses who sold supplies to the baking industry and treated payments for journal insertions as deductible advertising expenses.

• Other union locals who made payments from funds accumulated from dues that they collected from members.

• Lawyers and doctors who knew taxpayer personally and were in some manner associated with union activity in the baking industry. Some of these persons deducted their expenditure.

• Employees and other individuals, many of whom purchased dinner tickets but only a few of whom purchased journal insertions. Many in this group felt friendship, admiration, affection, and respect for taxpayer.

Taxpayers (husband and wife) received nearly $61,000 from these contributions in 1956 and claimed on their income tax return that the amount was excludable as a gift.

• What issues do these facts raise after Duberstein? Doesn’t the opinion of Duberstein seem to invite such issues?

• If you represented taxpayer or the IRS, how would you undertake to address them? See Kralstein v. Commissioner, 38 T.C. 810 (1962), acq. 1963-2 C.B. 3 (1963).

4. Does Justice Frankfurter have a point when he said:

What the Court now does sets fact-finding bodies to sail on an illimitable ocean of individual beliefs and experiences. This can hardly fail to invite, if indeed not encourage, too individualized diversities in the administration of the income tax law.

The Court combined two cases. How many possible outcomes for the two taxpayers were there? How many of them were espoused by at least one judge?

• No justice voted for Duberstein to win and Stanton to lose.

• Isn’t the disparity of views pretty good evidence that Justice Frankfurter was absolutely right?

5. There probably was a business culture that developed until the 1950s of giving very substantial business gifts in settings such as these. When the marginal tax bracket of the donor is very high, e.g., 70% and maybe higher, the cost of making a very substantial gift is actually quite low if its donor may deduct its cost. Is it possible that Berman felt that if his gift was not sufficiently generous, Duberstein might pitch some of that business to others?

6. Subsequent to Duberstein, Congress added § 102(c)(1) and § 274(b)(1) to the Code. Read these sections.

• Would § 102(c)(1) change the result of either Duberstein or Stanton?

• Would § 274(b)(1) change the result of either Duberstein or Stanton?

7. Notice: §§ 261 to 280H do not themselves establish deduction rules, but rather limit deductions that other Code sections might provide when the expenditure is for certain items or purposes.

• In the case of gifts, § 274(b) limits the deductibility of a gift(s) given to one individual to a total of $25 if its cost is deducted under § 162 (trade or business expenses) or § 212 (expenses of producing or collecting profit or managing property held to produce income).

• In Duberstein, § 274(b) would have limited Mohawk Corporation’s § 162 deduction to $25. If Mohawk had nevertheless purchased a Cadillac for Duberstein, Mohawk would have paid income tax on the cost of the gift (less $25). In essence, Mohawk would have been a surrogate taxpayer for Duberstein’s accession to wealth.

• Do you think that this cuts back on the number of Cadillacs given as business gifts?

• No matter what the merits of particular gifts, isn’t litigation of business gift issues likely to be much less frequent because of § 274(b)(1)?

• Is congressional reaction to Duberstein better than the position that the Commissioner argued for in the case? Of course, the congressional solution was not one that the Commissioner would be in a position to advocate.

• The congressional solution leaves the remainder of the Duberstein analysis intact.

8. Section 102’s exclusion also extends to bequests. Section 102(b)(2) provides that income from gifted property is not excluded from a taxpayer’s gross income. In Irwin v. Gavit, 268 U.S. 161 (1925), the Supreme Court held that the gift exclusion extended to the gift of the corpus of a trust, but not to the income from it. Id. at 167. An income beneficiary for life must pay income tax on that income; the remainderman does not pay income tax on the property.

• Notice that the value of a remainderman’s interest is less than the fmv of the property itself because s/he will not acquire it until the income beneficiary dies.

• If the donor had simply given the corpus outright without subjecting it to a life estate, the value of the exclusion would have been more. Where did this loss in value disappear to? Shouldn’t someone benefit from it?

• Might these points ever be important in matters of estate planning? How so?

9. Taxpayer was an attorney who entered into a contract with a client whereby he agreed to provide whatever legal services she should require for the remainder of her life without billing her. The client agreed to bequeath to taxpayer certain stock. Eventually the client died, and taxpayer received the stock. Taxpayer argued that the fmv of the stock should be excluded from his gross income under § 102(a).

• Do you agree? See Wolder v. Commissioner, 493 F.2d 608 (2nd Cir.), cert. denied, 419 U.S. 828 (1974).

10. Read §§ 74 and 274(j) carefully.

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Do the CALI Lesson, Basic Income Taxation: Gross Income: Gifts, Bequests, Prizes, and Donative Cancellations of Indebtedness.

11. Recall from chapter 1: The Essence of Basis: Adjusted basis represents money that will not again be subject to income tax, usually because it is what remains after taxpayer already paid income tax on a greater sum of money. More pithily: basis is “money that has already been taxed” (and so can’t be taxed again).

• Section 1015 states a special rule governing a donee’s basis in property that s/he acquired by gift. Read the first sentence of § 1015(a). What rule(s) does it state?

12. Consider this hypothetical posed by the Supreme Court in Taft v. Bowers, 278 U.S. 470 (1929), where the Court held that the Code’s adjusted basis rules applicable to gifts are constitutional:

“In 1916, A purchased 100 shares of stock for $1000, which he held until 1923, when their fair market value had become $2000. He then gave them to B, who sold them during the year 1923 for $5000.”

• (i) On how much gain must B pay income tax in 1923? See § 1015(a).

• (ii) Suppose that A had purchased the shares for $5000 and gave them to B when their fmv was $2000. B sold the shares in 1923 for $1000. How much loss may B claim on her income tax return for 1923?

• (iii) Suppose that A had purchased the shares for $2000 and gave them to B when their fmv was $1000. B sold the shares in 1923 for $1500. How much gain or loss must B claim on her income tax return?

• (iv) Suppose that A had purchased the shares for $2000 and gave them to B when their fmv was $1000. B sold them for $5000. On how much gain must B pay income tax in 1923?

• (v) Suppose that A had purchased the shares for $2000 and gave them to B when their fmv was $3000. B sold them for $1000. How much loss may B claim on her income tax return?

13. The federal estate and gift taxes are in pari materia with each other. The federal income tax is not in pari materia with the federal estate and gift taxes.

• What does this mean?


Mixing taxes to increase basis: When we say that “basis is money that has already been taxed (and so can’t be taxed again),” we are referring to the federal income tax. The federal estate and gift taxes are not in pari materia with the federal income tax. Hence, payment of federal estate or gift tax does not affect liability for federal income tax, and vice versa. It follows that payment of federal estate or gift taxes should not affect a taxpayer’s income tax basis in his/her property. However, § 1015(d) makes an exception to this (quite logical) rule. Read § 1015(d)(1 and 6). What rule(s) does this provision state?


14. Now consider the effect of § 1015(d)(1 and 6). Assume that the gift tax on any gift is 20% of the fmv of the gift. Assume also that the gift was made in 2013. How does this change your answers to the first question immediately above?

15. Now imagine: Taxpayer wanted to give $800 as a gift to his son. Assume that the gift is subject to federal gift tax. Assume that the gift tax is 20% of the fmv of the gift. Instead of giving the son $800 and paying $160 in federal gift tax, taxpayer gave his son property with a fmv of $1000 on the condition that son pay the $200 gift tax. Must father recognize gross income? Read on.

Diedrich v. Commissioner, 457 U.S. 191 (1982)

CHIEF JUSTICE BURGER delivered the opinion of the Court.

We granted certiorari to resolve a Circuit conflict as to whether a donor who makes a gift of property on condition that the donee pay the resulting gift tax receives taxable income to the extent that the gift tax paid by the donee exceeds the donor’s adjusted basis in the property transferred. The United States Court of Appeals for the Eighth Circuit held that the donor realized income. We affirm.


Diedrich v. Commissioner of Internal Revenue

In 1972, petitioners Victor and Frances Diedrich made gifts of approximately 85,000 shares of stock to their three children … The gifts were subject to a condition that the donees pay the resulting federal and state gift taxes. … The donors’ basis in the transferred stock was $51,073; the gift tax paid in 1972 by the donees was $62,992. Petitioners did not include as income on their 1972 federal income tax returns any portion of the gift tax paid by the donees. After an audit, the Commissioner of Internal Revenue determined that petitioners had realized income to the extent that the gift tax owed by petitioners, but paid by the donees, exceeded the donors’ basis in the property. Accordingly, petitioners’ taxable income for 1972 was increased by $5,959.50 Petitioners filed a petition in the United States Tax Court for redetermination of the deficiencies. The Tax Court held for the taxpayers, concluding that no income had been realized.




The United States Court of Appeals for the Eighth Circuit … reversed, concluding that, “to the extent the gift taxes paid by donees” exceeded the donors’ adjusted bases in the property transferred, “the donors realized taxable income.” The Court of Appeals rejected the Tax Court’s conclusion that the taxpayers merely had made a “net gift” of the difference between the fair market value of the transferred property and the gift taxes paid by the donees. The court reasoned that a donor receives a benefit when a donee discharges a donor’s legal obligation to pay gift taxes. The Court of Appeals agreed with the Commissioner in rejecting the holding in Turner v. Commissioner, 49 T.C. 356 (1968), aff’d per curiam, 410 F.2d 752 (CA6 1969), and its progeny, and adopted the approach of Johnson v. Commissioner, 59 T.C. 791 (1973), aff’d, 495 F.2d 1079 (CA6), cert. denied, 419 U.S. 1040 (1974), and Estate of Levine v. Commissioner, 72 T.C. 780 (1979), aff’d, 634 F.2d 12 (CA2 1980). We granted certiorari to resolve this conflict, and we affirm.


… This Court has recognized that “income” may be realized by a variety of indirect means. In Old Colony Trust Co. v. Commissioner, 279 U.S. 716 (1929), the Court held that payment of an employee’s income taxes by an employer constituted income to the employee. Speaking for the Court, Chief Justice Taft concluded that “[t]he payment of the tax by the employe[r] was in consideration of the services rendered by the employee, and was a gain derived by the employee from his labor.” Id., at 729. The Court made clear that the substance, not the form, of the agreed transaction controls. “The discharge by a third person of an obligation to him is equivalent to receipt by the person taxed.” Ibid. The employee, in other words, was placed in a better position as a result of the employer’s discharge of the employee’s legal obligation to pay the income taxes; the employee thus received a gain subject to income tax.

The holding in Old Colony was reaffirmed in Crane v. Commissioner, 331 U.S. 1 (1947). In Crane, the Court concluded that relief from the obligation of a nonrecourse mortgage in which the value of the property exceeded the value of the mortgage constituted income to the taxpayer. The taxpayer in Crane acquired depreciable property, an apartment building, subject to an unassumed mortgage. The taxpayer later sold the apartment building, which was still subject to the nonrecourse mortgage, for cash plus the buyer’s assumption of the mortgage. This Court held that the amount of the mortgage was properly included in the amount realized on the sale, noting that, if the taxpayer transfers subject to the mortgage,

“the benefit to him is as real and substantial as if the mortgage were discharged, or as if a personal debt in an equal amount had been assumed by another.” Id. at 331 U.S. 14.

Again, it was the “reality,” not the form, of the transaction that governed. Ibid. The Court found it immaterial whether the seller received money prior to the sale in order to discharge the mortgage, or whether the seller merely transferred the property subject to the mortgage. In either case the taxpayer realized an economic benefit.


The principles of Old Colony and Crane control.51 A common method of structuring gift transactions is for the donor to make the gift subject to the condition that the donee pay the resulting gift tax, as was done in … the case[] now before us. When a gift is made, the gift tax liability falls on the donor under 26 U.S.C. § 2502(d).52 When a donor makes a gift to a donee, a “debt” to the United States for the amount of the gift tax is incurred by the donor. Those taxes are as much the legal obligation of the donor as the donor’s income taxes; for these purposes, they are the same kind of debt obligation as the income taxes of the employee in Old Colony, supra. Similarly, when a donee agrees to discharge an indebtedness in consideration of the gift, the person relieved of the tax liability realizes an economic benefit. In short, the donor realizes an immediate economic benefit by the donee’s assumption of the donor’s legal obligation to pay the gift tax.

An examination of the donor’s intent does not change the character of this benefit. Although intent is relevant in determining whether a gift has been made, subjective intent has not characteristically been a factor in determining whether an individual has realized income. Even if intent were a factor, the donor’s intent with respect to the condition shifting the gift tax obligation from the donor to the donee was plainly to relieve the donor of a debt owed to the United States; the choice was made because the donor would receive a benefit in relief from the obligation to pay the gift tax.53

Finally, the benefit realized by the taxpayer is not diminished by the fact that the liability attaches during the course of a donative transfer. It cannot be doubted that the donors were aware that the gift tax obligation would arise immediately upon the transfer of the property; the economic benefit to the donors in the discharge of the gift tax liability is indistinguishable from the benefit arising from discharge of a preexisting obligation. Nor is there any doubt that, had the donors sold a portion of the stock immediately before the gift transfer in order to raise funds to pay the expected gift tax, a taxable gain would have been realized. 26 U.S.C. § 1001. The fact that the gift tax obligation was discharged by way of a conditional gift, rather than from funds derived from a pre-gift sale, does not alter the underlying benefit to the donors.


Consistent with the economic reality, the Commissioner has treated these conditional gifts as a discharge of indebtedness through a part gift and part sale of the gift property transferred. The transfer is treated as if the donor sells the property to the donee for less than the fair market value. The “sale” price is the amount necessary to discharge the gift tax indebtedness; the balance of the value of the transferred property is treated as a gift. The gain thus derived by the donor is the amount of the gift tax liability less the donor’s adjusted basis in the entire property. Accordingly, income is realized to the extent that the gift tax exceeds the donor’s adjusted basis in the property. This treatment is consistent with § 1001 of the Internal Revenue Code, which provides that the gain from the disposition of property is the excess of the amount realized over the transferor’s adjusted basis in the property.


We recognize that Congress has structured gift transactions to encourage transfer of property by limiting the tax consequences of a transfer. See, e.g., 26 U.S.C. § 102 (gifts excluded from donee’s gross income). Congress may obviously provide a similar exclusion for the conditional gift. Should Congress wish to encourage “net gifts,” changes in the income tax consequences of such gifts lie within the legislative responsibility. Until such time, we are bound by Congress’ mandate that gross income includes income “from whatever source derived.” We therefore hold that a donor who makes a gift of property on condition that the donee pay the resulting gift taxes realizes taxable income to the extent that the gift taxes paid by the donee exceed the donor’s adjusted basis in the property.

The judgment of the United States Court of Appeals for the Eighth Circuit is



… The Court in this case … begs the question of whether a taxable transaction has taken place at all when it concludes that “[t]he principles of Old Colony and Crane control” this case.

In Old Colony, the employer agreed to pay the employee’s federal tax liability as part of his compensation. The employee provided his services to the employer in exchange for compensation. The exchange of compensation for services was undeniably a taxable transaction. The only question was whether the employee’s taxable income included the employer’s assumption of the employee’s income tax liability.

In Crane, the taxpayer sold real property for cash plus the buyer’s assumption of a mortgage. Clearly a sale had occurred, and the only question was whether the amount of the mortgage assumed by the buyer should be included in the amount realized by the taxpayer. The Court rejected the taxpayer’s contention that what she sold was not the property itself, but her equity in that property.

Unlike Old Colony or Crane, the question in this case is not the amount of income the taxpayer has realized as a result of a concededly taxable transaction, but whether a taxable transaction has taken place at all. Only after one concludes that a partial sale occurs when the donee agrees to pay the gift tax do Old Colony and Crane become relevant in ascertaining the amount of income realized by the donor as a result of the transaction. Nowhere does the Court explain why a gift becomes a partial sale merely because the donor and donee structure the gift so that the gift tax imposed by Congress on the transaction is paid by the donee, rather than the donor.

In my view, the resolution of this case turns upon congressional intent: whether Congress intended to characterize a gift as a partial sale whenever the donee agrees to pay the gift tax. Congress has determined that a gift should not be considered income to the donee. 26 U.S.C. § 102. Instead, gift transactions are to be subject to a tax system wholly separate and distinct from the income tax. See 26 U.S.C. § 2501 et seq. Both the donor and the donee may be held liable for the gift tax. §§ 2502(d), 6324(b). Although the primary liability for the gift tax is on the donor, the donee is liable to the extent of the value of the gift should the donor fail to pay the tax. I see no evidence in the tax statutes that Congress forbade the parties to agree among themselves as to who would pay the gift tax upon pain of such an agreement being considered a taxable event for the purposes of the income tax. Although Congress could certainly determine that the payment of the gift tax by the donee constitutes income to the donor, the relevant statutes do not affirmatively indicate that Congress has made such a determination.

I dissent.

Notes and Questions:

1. Assuming that the outcome advocated by Justice Rehnquist is what the parties wanted, is there a way for the parties in Diedrich to structure the gift so as to achieve that result?

2. Return to the hypothetical in the note immediately preceding Diedrich. Read the second paragraph of the Court’s second footnote. In the hypothetical, how much gift tax should the son have to pay?

• Rev. Rul. 75-72 gives the following formula:

(tentative tax)/(1 + λ) = (true tax)

• “tentative tax” is the tax as computed on the fmv of the gifted property; λ is the tax rate; “true tax” is the actual gift tax that the donee must (actually) pay.

• Notice: In our example, application of the formula yields a “true tax” of $166.67. The net value of the gift would therefore be $833.33. 20% of $833.33 is $166.67.

• The use of a net gift enables the donor/donee, between them, to pay less gift tax. This enlarges the net gift.

• To what extent does the holding in Diedrich upset this planning?

3. There are times when we want to bifurcate the tax treatment of a transaction. In other words, we want to treat it as partly one thing and partly another. In part IIC of the opinion, the Court characterized the transaction as partly a gift and partly a sale. The logical way to treat a transaction that is partly one thing and partly another is to pro-rate it. A certain portion of the transaction is one thing and the remaining portion is another.

Remember that the taxpayer computes gains derived from dealings in property, § 61(a)(3), by subtracting “adjusted basis” from “amount realized,” § 1001(a).

If a transaction is partly a gift and partly a sale, how should we (logically) determine what portion of the transaction is gift and what portion is sale?

• Our taxpayer is disposing of the property.

• How should we logically determine the “amount realized” and the “adjusted basis” on the sale portion of the transaction?

• How should we logically determine the “amount realized” and the “adjusted basis” on the gift portion of the transaction?

Typically, we know some information and have to compute what we don’t know. In a part gift/part sale, we often know the total fmv of the property, the amount realized from the sale portion of the transaction, and the taxpayer’s basis in all of the property.

• Logically, the sale portion of the transaction should be (amount realized)/(fmv of the property). That same fraction should be multiplied by taxpayer’s total basis in the property.

• The balance of the “adjusted basis” and the balance of the “amount realized” determine the gain on the non-sale portion of the transaction.

Taxpayers may transfer property to a charity through a part-gift/part-sale.

How would this analysis apply to the following facts:

• Taxpayer’s adjusted basis in Blackacre is $10. The fmv of Blackacre is now $100. Taxpayer sells Blackacre to State University for $20. Taxpayer may deduct the value of gifts to State University.

• On how much gain should taxpayer pay income tax?

4. Read Reg. § 1.1001-1(e)(1). This is the rule that the IRS applied in Diedrich. Does the logic of part IIC of the opinion support this rule? If not, why didn’t the taxpayer(s) point this out?

5. Read Reg. § 1.1015-4(a and b). Describe the calculation of the Diedrich children’s (i.e., the donees’) basis in the stock that they received. Consider: did the Diedrich children pay their parents anything for the property, or did they give a gift to their parents, and if so, what was it?

6. Read Reg. § 1.1015-4(a and b) Examples 1, 2, 3, and 4.

• Now throw in some gift tax. What should be the basis of A’s son in the property if gift tax of the following amounts is paid?

• $12,000 in Example 1.

• $18,000 in Example 2.

• $18,000 in Example 3.

• $6000 in Example 4.

7. What should be the basis rules when property is acquired from a decedent? Read § 1014.

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8. Do the CALI Lesson, Basic Federal Income Taxation: Property Transactions: Computation of Gain and Loss Realized. Some of the questions present new issues, but you can reason through them.

B. Exclusion of Gain from Sale of Principal Residence: § 121

President George Bush II announced early in his presidency that he wanted America to be an “ownership society.” How would (does) widespread taxpayer ownership of private homes make America a better place? We have already examined imputed income derived from ownership of property – and that is most significant with regard to ownership of principal residences.

• Read § 121.

• What is the rule of § 121(a)?

• Does § 121 promote an “ownership society” – or something else? Don’t forget that –

• § 163(h) permits deduction of mortgage interest on up to $1,000,000 of indebtedness incurred to purchase a home or of interest on up to $100,000 of home equity indebtedness.

• § 164(a)(1) permits a deduction for state and local, and foreign real property taxes.

• Notice that § 121(b)(4)[(5)] and § 121(c) employ bifurcation ratios. Are the ratios what you expect them to be?

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Do the CALI Lesson, Basic Federal Income Taxation: Property Transactions: Exclusion of Gain on the Sale of a Principal Residence.

C. Interest on State and Local Bonds: § 103

Read §§ 103 and 141.54

Interest derived from a state or local bond is excluded from a taxpayer’s gross income. § 103(a). This exclusion does not extend to interest derived from a “private activity bond,” § 103(b)(1), or an “arbitrage bond,” § 103(b)(2).55 This provision has always been a part of the Code. There may have been some doubt about whether Congress had the constitutional power to tax such income.


If one state has been profligate in its spending and now finds that it must borrow enormous amounts on which it will be paying interest far into the future, should taxpayers in other states care?

• Yes.

• Profligate states make it far more likely that the interest that state and local governments must pay will be attractive to taxpayers whose marginal tax bracket is less than the highest marginal tax bracket. This means that there will be a revenue transfer from the U.S. Treasury to those in the highest tax bracket instead of to the state and local governments.

• As more money is transferred from the U.S. Treasury to state and local governments and to the nation’s highest income earners, a tax increase becomes more likely – or a spending cut.

• Residents of the profligate state may have enjoyed consumption that the residents of more frugal (responsible?) states did not, but now must indirectly pay for.


It might appear that this would encourage investors to choose to purchase the bonds of state and local governments. After all, the interest income that such bonds generate is not subject to tax, whereas other investment income is subject to federal income tax. The investor should be able to keep more of his/her income. However, both borrowers (state and local governments) and investors know that the interest on such bonds is not subject to federal income tax. Hence, state and local governments are able to borrow money at less than prevailing interest rates, i.e., the rate that any other borrower would have to pay. If the market “bids down” the interest rate to the point that taxpayers in the highest tax bracket (now 39.6%) are no better off than they would be if they had simply purchased a corporate bond carrying equivalent risk and paid the income tax on the interest that they receive, the exclusion would function “only” as a means by which the U.S. Treasury transfers the tax revenue that it must forego to state and local governments. There are some (potential) economic distortions that this exclusion causes:

• If there are enough taxpayers in the highest tax bracket to “clear the market” for state and local bonds, the interest rate on such bonds should gravitate to (1 - λ)*(prevailing interest on corporate bonds), where λ denotes the highest marginal tax rate. If this is the case, all of the tax that the U.S. Treasury foregoes is transferred to state and local governments.

But if there are not enough taxpayers in the highest tax bracket to “clear the market” for state and local bonds, state and local governments must offer an interest rate higher than (1 - λ)*(prevailing interest on corporate bonds). Perhaps it will be necessary to entice some taxpayers in the second-to-highest or even third-to-highest bracket. The effect of this is to give taxpayers in the highest tax bracket a windfall, i.e., an after-tax return on state and local bonds that is higher than the after-tax return on corporate bonds. In this case, not all of the foregone tax revenue is transferred from the U.S. Treasury to state and local governments; some of it is transferred to taxpayers in the highest tax bracket.

• How will this affect the market for corporate bonds?

• In effect, those who invest in state and local bonds have the power to “vote” to have some of their tax dollars go to state and local governments rather than to the federal government. Most of the (rational) voters will have high incomes.

• There is no limit to the amount of interest that a taxpayer may exclude under this provision.56 Hence state and local governments may be encouraged to borrow more than they otherwise would. The laws of some states limit the amount that they can borrow.

• State and local governments may elect to finance “too many” capital projects – e.g., highways, schools, government buildings – by issuing bonds, as opposed either to foregoing such expenditures or by procuring necessary funds in another manner, e.g., raising taxes.

D. Scholarships: § 117

Read § 117.

What justification do you see for the exclusion(s) provided by § 117? Some of you receive scholarship assistance on which you pay no federal income tax. Others do not receive such assistance and must work to be here. The wages that such students earn are subject to federal income tax.


Moldaur is the son of a professor at the Mega State University. Moldaur has enrolled at Mega State University. Tuition is $20,000 at Mega State University. Moldaur is entitled to a 50% reduction in his tuition because he is the son of a professor. In addition, Moldaur qualified for a Hilfen Scholarship under the state’s lottery-to-education scholarship program. The state collects lottery revenues and divides them equally among those who qualify for scholarships. This year, each scholarship recipient was credited with $14,000 towards tuition. The result for Moldaur is that he had a $4000 account surplus, which the university refunded to him.

• Tax consequences to Moldaur? Read § 117(b)(1) and Reg. § 1.117-1(a) carefully.

• Tax consequences to Moldaur’s father? Read § 117(d) carefully.

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Do the CALI Lesson, Basic Federal Income Taxation: Gross Income: Scholarships.

E. Rental Value of Parsonages: § 107

Read §§ 107 and 265.

A “minister of the gospel” may exclude the housing allowance that a congregation pays to him/her. Such a taxpayer may spend some of this allowance on home mortgage interest (deductible under § 163(h)) or real estate taxes (deductible under § 164(a)(1)). Explain how this is a double dip. How might a congregation, as payor of this allowance, capture some or all of the benefit of the exclusion?

II. Social Benefits

The Code excludes from gross income payments for various benefits or the fmv of benefits taxpayer receives in kind. Who should administer government benefit programs, e.g., benefits for workplace injury? Who administers benefit “programs” when they are the product of exclusions from gross income?


A bit about insurance. The basic idea of insurance, of course, is that individual persons purchase a policy that promises payment upon materialization of a specified risk. The policy is effective for a certain period, e.g., one year. The insurance company pools the premiums, and pays those for whom the risk materializes. Notice that policy-holders pay their premiums from after-tax money. We could treat the “winner” as if s/he has simply received a gift from those who contributed to the pool of money. Under such a rationale, the proceeds would be excluded from gross income by § 102.


A. Life Insurance Death Benefits: § 101

Section 101(a)(1) excludes from gross income “amounts received (whether in a single sum or otherwise) under a life insurance contract, if such amounts are paid by reason of death.” This provision has always been a part of the Code, and the desire to avoid taxing heirs has made repeal difficult. Many people purchase life insurance so that family members will receive money at a time when they no longer have the income of the deceased insured. It could be unseemly to tax a grieving family under such circumstances.

• “If any amount excluded from gross income … is held under an agreement to pay interest thereon, the interest payments shall be included in gross income.” § 101(c).

• In the event that life insurance proceeds are paid otherwise than as a lump sum, a portion of each payment is allocated pro rata to the amount excluded and the remaining return on investment is subject to income tax. § 101(d)(1).

Consider: H purchased a life insurance policy on his life with a face amount of $200,000 and named W as the beneficiary. H died. W and the insurance company entered an agreement whereby the insurance company would hold $200,000 and pay her $250,000 in five years; W would have no claim of right to the funds during that time. At that time, instead of paying W $250,000, the insurance company will pay W $28,000 per year at a time when her life expectancy will be ten years.

• How would the payments to W be taxed during the first five years after H’s death?

• How would the payments to W during the succeeding ten years be taxed?

See §§ 101(c and d); Reg. § 1.101-3(a); Reg. § 1.101-4(a)(1)(i); Reg. § 1.101-4(g) (Examples 1 and 5 (first two sentences only)).

• The last provision might not be in your edition of the Regulations. Go to Westlaw or Lexis to find it.

Section 101(a)(2) provides that in the case of a transfer of a life insurance contract for valuable consideration, the exclusion is lost. The beneficiary in such a case may exclude only the amount paid for the policy (i.e., premiums) plus any subsequent payments, i.e., premiums.

• An exception to this exception is made when the transferee takes for his/her basis the basis of the transferor. § 101(a)(2)(A).

• When might a transferee take for his/her basis the basis of the transferee?

• Another exception to the exception is made when the transfer is to the insured, a partner of the insured, a partnership in which the insured is a partner, or a corporation in which the insured is a shareholder or officer. § 101(a)(2)(B).

• When (why) would transfers such as those described in § 101(a)(2)(B) occur?


A note about life insurance. Life insurance comes in various forms, and tax benefits can extend well beyond excluding death benefits from gross income. “Life insurance contract” is defined in § 7702 so as to preclude an investment from being a “life insurance contract.” To be insurance, there must be a shifting of risk from the insured to the insurer.

• Term insurance is insurance that promises only for the term for which it is purchased to pay upon the occurrence of death. Upon expiration of the term, the policyholder has nothing.

• Permanent life insurance is life insurance that the insured maintains by paying a premium annually. Premiums for permanent life insurance are higher than they are for term insurance; the insurance company invests the excess on behalf of the insured. The policy builds up cash value (“inside buildup”) – tax-free. Inside buildup can reduce premiums in future years, notably as premiums would otherwise increase because the insured is older and the risk of his/her death higher.

• Non-taxation of inside buildup permits permanent life insurance to function as a tax shelter.


H purchased a permanent life insurance policy on his life with a face amount of $300,000. He named W as the beneficiary. When H was 63 years old and the children were grown, W died. H saw no need to continue making premium payments so he sold the policy to his employer for $100,000.

• How would you compute H’s gross income from this sale?

• How would you compute H’s gross income if instead H surrendered the policy to the insurance company for its cash value of $100,000?

• Are there additional facts that you would need to know?

• Read on.

Rev. Rul. 2009-13, 2009-21 I.R.B. 1029



What is the amount and character of A’s income recognized upon the surrender or sale of the life insurance contracts described in the situations below?


On January 1 of Year 1, A, an individual, entered into a “life insurance contract” (as defined in § 7702 …) with cash value. Under the contract, A was the insured, and the named beneficiary was a member of A’s family. A had the right to change the beneficiary, take out a policy loan, or surrender the contract for its cash surrender value. The contract in A’s hands was … [a capital asset].

On June 15 of Year 8, A surrendered the contract for its $78,000 cash surrender value, which reflected the subtraction of $10,000 of “cost-of-insurance” charges collected by the issuer for periods ending on or before the surrender of the contract. Through that date, A had paid premiums totaling $64,000 with regard to the life insurance contract. A had neither received any distributions under the contract nor borrowed against the contract’s cash surrender value.



The facts are the same as in Situation 1, except that on June 15 of Year 8, A sold the life insurance contract for $80,000 to B, a person unrelated to A and who would suffer no economic loss upon A’s death.




Amount of income recognized upon surrender of the life insurance contract


If a non-annuity amount is received … on the complete surrender, redemption, or maturity of the contract, § 72(e)(5)(A) requires that the amount be included in gross income but only to the extent it exceeds investment in the contract. For this purpose, § 72(e)(6) defines “investment in the contract” as of any date as the aggregate amount of premiums or other consideration paid for the contract before that date, less the aggregate amount received under the contract before that date to the extent that amount was excludable from gross income.

In Situation 1, A received $78,000 on the complete surrender of a life insurance contract. A’s income upon surrender of the contract is determined under § 72(e)(5). Under § 72(e)(5)(A), the amount received is included in gross income to the extent it exceeds the investment in the contract. As A paid aggregate premiums of $64,000 with regard to the contract, and neither received any distributions under the contract nor borrowed against the contract’s cash surrender value prior to surrender, A’s “investment in the contract” as required by § 72(e)(6) was $64,000. Consequently, pursuant to § 72(e)(5)(A), A recognized $14,000 of income on surrender of the contract, which is the excess of $78,000 received over $64,000.

[A’s gain is ordinary income.] …



Section 61(a)(3) provides that gross income includes gains derived from dealings in property.

Section 1001(a) provides that the gain realized from the sale or other disposition of property is the excess of the amount realized over the adjusted basis provided in § 1011 for determining gain. Thus, to determine the amount of A’s income from the sale of the life insurance contract in Situation 2, it is necessary to determine A’s amount realized from the sale, and A’s adjusted basis in the contract.

Pursuant to § 1001(b), A’s amount realized from the sale of the life insurance contract is the sum of money received from the sale, or $80,000.

Under §§ 1011 and 1012, the adjusted basis for determining gain or loss is generally the cost of the property adjusted as provided in § 1016 … Under § 1016(a)(1), proper adjustment must be made for expenditures, receipts, losses, or other items properly chargeable to capital account. See also Reg. § 1.1016-2(a). Section 72 has no bearing on the determination of the basis of a life insurance contract that is sold, because § 72 applies only to amounts received under the contract.

Both the Code and the courts acknowledge that a life insurance contract, although a single asset, may have both investment characteristics and insurance characteristics. See, e.g., § 7702 (defining life insurance contract for federal income tax purposes by reference, in part, to both the cash surrender value and death benefits under the contract); [citations omitted]. To measure a taxpayer’s gain upon the sale of a life insurance contract, it is necessary to reduce basis by that portion of the premium paid for the contract that was expended for the provision of insurance before the sale.


In Situation 2, A paid total premiums of $64,000 under the life insurance contract through the date of sale, and $10,000 was subtracted from the contract’s cash surrender value as cost-of-insurance charges. Accordingly, A’s adjusted basis in the contract as of the date of sale under §§ 1011 and 1012 and the authorities cited above was $54,000 ($64,000 premiums paid less $10,000 expended as cost of insurance).

Accordingly, A must recognize $26,000 on the sale of the life insurance contract to B, which is the excess of the amount realized on the sale ($80,000) over A’s adjusted basis of the contract ($54,000).

Unlike Situation 1, which involves the surrender of the life insurance contract to the issuer of the contract, Situation 2 involves an actual sale of the contract. Nevertheless some or all of the gain on the sale of the contract may be ordinary if the substitute for ordinary income doctrine applies.


Application of the “substitute for ordinary income” doctrine is limited to the amount that would be recognized as ordinary income if the contract were surrendered (i.e., to the inside build-up under the contract). Hence, if the income recognized on the sale or exchange of a life insurance contract exceeds the “inside build-up” under the contract, the excess may qualify as gain from the sale or exchange of a capital asset. See, e.g., Commissioner v. Phillips, 275 F.2d 33, 36 n.3 (4th Cir. 1960).

In Situation 2, the inside build-up under A’s life insurance contract immediately prior to the sale to B was $14,000 ($78,000 cash surrender value less $64,000 aggregate premiums paid). Hence, $14,000 of the $26,000 of income that A must recognize on the sale of the contract is ordinary income under the “substitute for ordinary income” doctrine. Because the life insurance contract in A’s hands was … [a capital asset] and was held by A for more than one year, the remaining $12,000 of income is long-term capital gain within the meaning of § 1222(3).




1. In Situation 1, A must recognize $14,000 of ordinary income upon surrender of the life insurance contract.

2. In Situation 2, A must recognize $26,000 of income upon sale of the life insurance contract. Of this $26,000 of income, $14,000 is ordinary income, and $12,000 is long-term capital gain.

3. …

Notes and Questions:

1. In the case of surrender of a life insurance policy, inside buildup that (helps to) pay future premiums is not subject to tax. In the case of a sale of an insurance policy, inside buildup that (helps to) pay future premiums is subject to tax.

2. In Situation 2, assume that the face amount of the policy was $400,000. B paid $80,000 for the policy plus another $500 per month in premiums for another six years. A died. B received $400,000 from the life insurance company. How much must B include in his/her gross income?

3. Section 72 governs the tax treatment of payouts from an annuity contract. Section 72(a)(1) provides that gross income includes “any amount received as an annuity … under an annuity, endowment, or life insurance contract.”

• Thus, annuity treatment can only apply to payments made under the named type of contracts.

• A taxpayer may invest after-tax dollars in an annuity contract. As with life insurance contracts, the inside buildup of an annuity contract is not subject to income tax. At a certain point in time, the taxpayer begins to receive a stream of payments from the investment and the income that the annuity has accumulated. [You should see immediately that taxpayer will be receiving some of his/her own after-tax money and some not-yet-taxed investment income.] There may be a fixed number of payments or the stream of payments may terminate only on the death of the taxpayer. Section 72 allocates a portion of each payment to taxpayer’s recovery of basis and a portion to not-yet-taxed inside buildup.

• Section 72(c)(1) defines taxpayer’s “investment in the contract.”

• Section 72(c)(4) defines “annuity starting date” as “the first day of the first period for which an amount is received as an annuity under the contract[.]”

• Section 72(a)(1) provides that taxpayer must include in gross income “any amount received as an annuity[.]”

• Section 72(b)(1) excepts from “amounts received as an annuity” a pro-rated amount of taxpayer’s basis in the contract. This requires a determination of taxpayer’s “expected return under the contract.”

• If the “expected return” depends on the life expectancy of one or more individuals, taxpayer determines the “expected return” in accordance with actuarial tables that the Secretary of the Treasury has prescribed. These tables are in the regulations, see Reg. § 1.72-9.

• Simply multiply the number of payments taxpayer can expect based on these actuarial tables by the amount of each payment. This product is the “expected return.”

• Divide the taxpayer’s investment in the contract by the “expected return.” Taxpayer multiplies this product by “any amount received as an annuity” to determine the amount that s/he excludes from gross income.

If taxpayer outlives what the actuaries predicted …: Once taxpayer has excluded his/her investment in the annuity contract from his/her gross income, taxpayer may no longer exclude any “amount received as an annuity” from his/her gross income. § 72(b)(2).

If taxpayer dies before the actuaries predicted s/he would …: On the other hand, should payments cease because taxpayer died prior to recovery of taxpayer’s investment in the contract, taxpayer may deduct the amount of the unrecovered investment for his/her last taxable year. § 72(b)(3)(A).

4. Section 72(e) states rules applicable to amounts received under an annuity, endowment, or life insurance contract that are not received as an annuity – if no other provision of this subtitle is applicable. § 72(e)(1).

• Section 1001 is a provision of “this subtitle.”

• In Situation 2, no payments were made under the contract. Instead, a third party bought the contract. For that reason, § 72(e)(1) did not apply. Instead, the ruling requires treatment of the sale as any other sale of property with adjustments to basis for prior expenditures on life insurance.

• Section 72(e)(5)(C) provides that § 72(e)(1) applies to amounts not received as an annuity under a life insurance or endowment contract.

• This describes the payment from the insurance company to the taxpayer in Situation 1.

• Section 72(e)(1) provides that the amount taxpayer must include in his/her gross income is the amount of the payment “to the extent it exceeds the investment in the contract.” Section 72(e)(6) defines “investment in the contract” to include the aggregate of premiums or other consideration paid for the contract minus any amounts previously received that taxpayer excluded from his/her gross income.

• It is because of § 72(e)(5) that Situations 1 and 2 are resolved differently.

5. Section 101(g): Amounts that a “terminally ill” or “chronically ill” person receives under a life insurance contract may qualify for exclusion under § 101(a)(1). The same is true of the “amount realized” on the sale of a life insurance policy to a “viatical settlement provider.” § 101(g)(2).

• A “terminally ill” taxpayer is one who is certified by a physician as having “an illness or physical condition which can reasonably be expected to result in death in 24 months or less after the date of the certification.” § 101(g)(4)(A).

• A “chronically ill” taxpayer is one who is not “terminally ill” and is unable to perform at least two activities of daily living (i.e., eating, toileting, transferring, bathing, dressing, and continence) or requires substantial supervision to protect himself/herself “from threats to health and safety due to severe cognitive impairment.” § 101(g)(4)(B), referencing § 7702B(c)(2).

• A “chronically ill” taxpayer must use the payment for unreimbursed costs of long-term care. § 101(g)(3)(A).

Section 101(g) enables an insured taxpayer to get money out of a life insurance policy at a time when s/he has a substantial need for cash and the risk of death has nearly materialized.

6. In the movie, Capitalism: A Love Story (2009), Michael Moore recounts how Wal-Mart purchased life insurance policies on the lives of low-paid persons. Wal-Mart of course liked the fact that inside buildup was free of income tax. If one of the employees died, Wal-Mart would collect the proceeds of the policy without tax. A number of businesses engaged in this practice of purchasing “corporate-owned life insurance” (COLI) and did not inform the affected employees that it had done this. [Michael Moore lamented that Wal-Mart did not hand the money over to the family of a deceased employee.]

• In 2006 – before release of the movie – Congress enacted § 101(j) which limited the exclusion in the case of employer-owned contracts to the amounts paid for the policy. § 101(j)(1).

• There is an exception to the exception if the employee is a key employee and is notified that the employer intends to procure such insurance and the employee gives his/her consent. § 101(g)(2 and 4).

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B. Compensation for Injuries or Sickness: §§ 104, 105, 106

Read § 104. Injured persons need compensation. Consider the precise extent to which the subsections of § 104 exclude compensation for injury.

• Section 104(a)(2) seems to compel taxpayers to search for a physical injury, much as a tort claim involving only emotional distress involves a search for a physical manifestation. Review part IIB of CADC’s opinion in Murphy v. Internal Revenue Service, 493 F.3d 170 (CADC 2007), supra, chapter 2. The Government was correct in its reading of the “on account of” language in the statute. There must be a strong causal connection between the physical injury and the emotional distress – not the other way around – in order for it to be excluded from gross income by § 104(a)(2).

• What does § 104(a)(3) mean? What health or accident insurance payments does § 104(a)(3) reference?

• “Health and accident” insurance includes wage continuation policies. This would be important for employees whose employers provide health insurance but not disability insurance.

• The exclusion applies to multiple payments from more than one self-purchased policy, even though the amount received exceeds the expense against which taxpayer procured the insurance.

• Read § 105. What rule emerges from §§ 105(a and b)?

• The following two problems are derived from and answered by Rev. Rul. 69-154. What is your intuition about how they should be solved? Feel free to examine the revenue ruling.

• C is covered by his employer’s health insurance policy. C’s employer pays the annual premium of $10,000. This amount is excluded from C’s gross income. In addition, C paid the entire premium of $5000 for a personal health insurance policy.

• During the year, C had only one illness and incurred and paid total medical expenses, as defined in § 213 of the Code, of $2700. In the same year as a result of this illness, C was indemnified $2100 under his employer’s insurance policy and $1500 under his personal insurance policy.

• What is C’s gross income from the insurance companies’ reimbursements?

• D is covered by his employer’s health insurance policy. The annual premium is $10,000, of which the employer pays $4000 and $6000 is deducted from D’s wages. In addition, D paid the entire premium of $5000 for a personal health insurance policy.

• During the year, D had only one illness and paid total medical expenses, as defined in § 213 of the Code, of $2700. In the same year as a result of this illness, D was indemnified $2100 under his employer’s insurance policy and $1500 under his personal insurance policy.

• What is D’s gross income from these reimbursements?

• Read § 106(a).

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C. Social Security: § 86

Read § 86. It is not an easy read. It is an example of the drafting contortions necessary to accomplish legislative compromise. Section 86 of course is among the Code provisions that require inclusion of certain items in gross income. Section 86 limits the amount of social security benefits that a taxpayer must include in gross income. Taxpayer excludes the remainder.

• Section 86 establishes three levels of so-called “(b)(1)(A) amounts” of income – which we define momentarily.

• This amount will fall into one of three ranges that the Code defines in terms of the taxpayer’s filing status. Each income range is subject to a different set of rules governing inclusion of social security benefits in taxpayer’s gross income. The three income ranges are the following:

• “(b)(1)(A) amount” of income that is below the statutory “base amount.”

• “(b)(1)(A) amount” of income that is above the statutory “base amount” but below the statutory “modified base amount.”

• “(b)(1)(A) amount” of income that is above the statutory “modified base amount.”

Rather than try to state the computation rules, we will apply the rules through three problems involving the taxpayer “Joe the Pensioner.” He is single and receives social security benefits. Consider:

• Joe the Pensioner received $20,000 of social security benefits payments last year. In addition, he received $1000 in municipal bond interest that § 103 exempts from his gross income. Joe also did some work for his old employer for which he received $6000. What is Joe’s gross income?

Section 86(a) with deceptive simplicity sets forth rules governing taxpayer inclusion in gross income of social security benefits. Section 86(a) requires computations of various amounts and then comparing them. Hopefully, we can reduce this to a few straight-forward “if … then” rules. It is best57 to begin with § 86(b) – the provision that actually defines the “Taxpayers to Whom Subsection (a) applies.”

• Section 86(b)(1)(A)(i) requires that we determine what Joe’s “modified agi” is. That phrase is defined in § 86(b)(2). Joe’s agi at the moment, not counting his social security benefits or tax exempt interest, is $6000. To obtain Joe’s “modified agi,” we do not add his benefits (§ 86(b)(2)(A) (“determined without regard to this section”)) but we do add his tax exempt interest, § 86(b)(2)(B), i.e., $1000. Joe’s modified adjusted gross income is $7000.

• Section 86(b)(1)(A) requires us to add Joe’s modified adjusted gross income plus one-half of his social security benefits. $7000 + $10,000 = $17,000. We will refer to this as the “(b)(1)(A) amount.”

• Subtract the “base amount” from $17,000. “Base amount” is defined for Joe in § 86(c)(1)(A) as $25,000. Joe’s “modified agi” does not exceed this “base amount.”

• Section 86(a)(1)(B) requires us to compute one-half of the excess described in § 86(b)(1)(A). In our case, that will of course be $0.

• § 86(a)(1) requires a comparison: $0 < $10,000.

• Joe must include $0 of his Social Security benefits in his gross income.

Notice that if the base amount exceeds taxpayer’s “modified agi” plus one-half of his/her social security benefits, then there will be no “excess” – a term that appears in § 86(a)(1)(B). We can state the following straight-forward rule.

1. If taxpayer’s “modified agi” plus one-half of his/her social security benefits is less than the statutory “base amount,” none of taxpayer’s social security benefits will be subject to federal income tax.

Now suppose that Joe the Pensioner received $20,000 of social security benefit payments, $1000 in tax exempt interest, and $18,000 of payments for work he did for his old employer.

• Joe’s “modified agi” plus one-half of his social security benefits plus tax exempt interest (i.e., “(b)(1)(A)” amount) equals $29,000. This is more than the statutory “base amount,” i.e., $25,000, § 86(c)(1)(A).

• Section 86(b)(1) describes a taxpayer whose “(b)(1)(A) amount” is more than a “modified base amount.” For Joe, that amount is $34,000. § 86(c)(2)(A). Joe’s “(b)(1)(A) amount” does not exceed his “modified base amount,” so § 86(a)(1) applies to him.

• According to § 86(a)(1), Joe must include in his gross income the lesser of one-half of the social security benefits that he received or one-half of the amount by which his “(b)(1)(A)” amount exceeds his “base amount.”

• The first amount is $10,000. The second amount is $2000.

• Joe must include $2000 of social security benefits in his gross income.

We can now state the second of our straight-forward rules.

2. If taxpayer’s “modified agi” plus one-half of his/her social security benefits is more than the statutory “base amount” but less than the “modified base amount,” taxpayer must include in his/her gross income the lesser of one-half of his/her social security benefits or one-half of the amount by which his/her “modified agi” exceeds the statutory base amount.

Now suppose that Joe the Pensioner received $20,000 of social security benefit payments, $1000 in tax exempt interest, and $30,000 of payments for work he did for his old employer.

• Joe’s “(b)(1)(A) amount” is now $41,000. This is $7000 more than his “modified base amount,” i.e., $34,000, § 86(c)(2)(A). This means that § 86(a)(2) applies rather than § 86(a)(1).

• Section 86(a)(2) requires us to determine two different amounts and to include the lesser in Joe’s gross income.

• The first amount (§ 86(a)(2)(A)) is –

• 85% of the “excess,” i.e., 85% of $7000 – or $5950, PLUS

• the lesser of

• the amount that would be included in Joe’s gross income if our second rule (i.e., § 86(a)(1)) did apply. The lesser of one-half of Joe’s social security benefits (i.e., $10,000) or one-half of the excess of Joe’s “(b)(1)(A) amount” over his “base amount” (i.e., ½ of ($41,000 − $25,000) = $8000) is $8000.


• one-half of the difference between Joe’s “base amount” and “modified base amount.” The difference between Joe’s “base amount” and his “modified base amount” is $34,000 − $25,000. One-half of that amount is $4500.

• $4500 < $8000.

• $5940 + $4500 EQUALS $10,440.

• The second amount (§ 86(a)(2)(B)) is –

• 85% of Joe’s social security benefit, i.e., 85% of $20,000 = $17,000.

• $10,440 < $17,000. Joe must include $10,440 in his gross income.

We state the third of our straight-forward rules.

3. If taxpayer’s “modified agi” plus one-half of his/her social security benefits is more than the statutory “adjusted base amount,” taxpayer must include in his/her gross income the lesser of two amounts computed according to two more rules.

D. Unemployment Benefits: § 85

A taxpayer must include in his/her gross income unemployment compensation. § 85.

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III. Employment-Based Exclusions from Gross Income

The employment relationship is the seat of a very substantial number of exclusions from gross income. You will find that the benefits excluded from gross income by §§ 79, 106, 119, 127, 129, 132, and 137 are only available to “an employee.” Employment-based exclusions from gross income can have a powerful influence in shaping employment relationships. Be alert to the possibility that the employer may capture the benefit of the exclusion through the simple expedient of paying employees less than it otherwise would have. We should expect employees to deem employers who pay substandard wages in exchange for benefits that employees don’t really want to be not particularly desirable. The converse is true also: employees should seek out employers who provide benefits that they particularly value.

There is overlap between benefits provided in the employment setting that the Code excludes from gross income and social benefits that the Code excludes from gross income. An implicit message is that the employment setting is where employees should seek and employers should provide certain social benefits. See whether you agree.

A. Group Term Life Insurance: § 79

Read § 79. What is the effect of restricting the exclusion to the purchase of group-term life insurance and not allowing discrimination in favor of a key employee? Why should there be a $50,000 ceiling on the amount of group-term life insurance whose purchase is excluded from an employee’s gross income?

B. Educational Assistance Programs: § 127

Read § 127. Why might a relatively low-cost private school charge more tuition per credit hour in its night or weekend MBA programs than it does for its full-time day program?

C. Dependent Care Assistance Programs: § 129

Read § 129. Why might a highly-paid employee prefer a dependent care assistance program to a 20% credit against income tax liability? What is the maximum available exclusion if taxpayer has one child? Compare these figure with that of § 21.

• Consider: Taxpayers (married filing jointly) have three children, none of whom has reached the age of 13. They both work and earn substantial incomes. They are in the 35% income tax bracket, and their credit under § 21 is 20% of their dependent care expenses. They incur $6000 of dependent care expenses during the year. Should they prefer an exclusion under § 129 or a tax credit under § 21?

• Same facts, except that the ages of the children are 10, 15, and 16. Should they prefer an exclusion under § 129 or a tax credit under § 21?

D. Employer Contributions to Accident and Health Plans: § 106

Read §§ 106 and 223.

During World War II, the nation lived under wage and price controls. Employers could circumvent wage controls by providing employees with certain benefits, notably pensions and health insurance. In 1954, Congress codified the employee exclusion of employer payments for accident or health plans in § 106(a). Recall that § 105(b) excludes the payments that such plans provide for care from gross income. Employers of course deduct whatever payments they make as employee compensation, § 162(a)(1). Thus most of the money that employees spend or employers spend on their behalf for health care is never subject to income tax at either the employer or employee level. Not surprisingly, in the United States health care is now a significant aspect of any employment relationship. Costs have spiraled upward, and payments for health plans have become the most costly expenditure that employers make for employee benefits. Highly distorted markets for health care services now exist in the United States. See William P. Kratzke, Tax Subsidies, Third-Party Payments, and Cross-Subsidization: America’s Distorted Health Care Markets, 40 U. Mem. L. Rev. 279 (2009).

Health Savings Accounts (HSA) are savings accounts established for the benefit of an individual who has a high-deductible health plan. See § 223. An employee taxpayer may deduct the contributions s/he makes to such an account. § 223(a). An employee taxpayer may exclude employer contributions to such an account. § 106(d). Unspent funds in an HSA grow tax-free. § 223(e)(1). There is a monthly limit to the amount that taxpayer may save in such accounts. The savings in the account can be withdrawn without income tax to pay for medical expenses, presumably for the deductible portion that the health plan will not pay for. § 213(f)(1). Employer contributions to an HSA are not subject to employment taxes, § 106(d)(1), but employee contributions are subject to employment taxes.

Beginning in tax year 2018, a 40% excise tax will be due from the health insurance issuer, the employer, or the plan administrator – as the case may be – on amounts paid for coverage that exceed a threshold cost of so-called “Cadillac health plans.” § 4980I. This tax is not deductible. § 275(a)(6). Such a tax will likely greatly increase the cost of such coverage and make employers less willing to provide it, even for substantial trade-offs in wages.

E. Meals or Lodging Furnished for the Convenience of the Employer: § 119

Read § 119.

Commissioner v. Kowalski, 434 U.S. 77 (1977)

MR. JUSTICE BRENNAN delivered the opinion of the Court.

This case presents the question whether cash payments to state police troopers, designated as meal allowances, are included in gross income under § 61(a) of the Internal Revenue Code …, 26 U.S.C. § 61(a), and, if so, are otherwise excludable under § 119 of the Code, 26 U.S.C. § 119.


… Respondent is a state police trooper employed by the Division of State Police of the Department of Law and Public Safety of the State of New Jersey. During 1970, the tax year in question, he received a base salary of $8,739.38, and an additional $1,697.54 designated as an allowance for meals.

… Under [the State’s cash allowance] system, troopers remain on call in their assigned patrol areas during their midshift break. Otherwise, troopers are not restricted in any way with respect to where they may eat in the patrol area and, indeed, may eat at home if it is located within that area. Troopers may also bring their midshift meal to the job and eat it in or near their patrol cars.

The meal allowance is paid biweekly in advance and is included, although separately stated, with the trooper’s salary. The meal allowance money is also separately accounted for in the State’s accounting system. Funds are never commingled between the salary and meal allowance accounts. Because of these characteristics of the meal allowance system, the Tax Court concluded that the “meal allowance was not intended to represent additional compensation.”

Notwithstanding this conclusion, it is not disputed that the meal allowance has many features inconsistent with its characterization as a simple reimbursement for meals that would otherwise have been taken at a meal station. For example, troopers are not required to spend their meal allowances on their midshift meals, nor are they required to account for the manner in which the money is spent. … [N]o reduction in the meal allowance is made for periods when a trooper is not on patrol because, for example, he is assigned to a headquarters building or is away from active duty on vacation, leave, or sick leave. In addition, the cash allowance for meals is described on a state police recruitment brochure as an item of salary to be received in addition to an officer’s base salary and the amount of the meal allowance is a subject of negotiations between the State and the police troopers’ union. Finally, the amount of an officer’s cash meal allowance varies with his rank, and is included in his gross pay for purposes of calculating pension benefits.

On his 1970 income tax return, respondent reported $9,066 in wages. That amount included his salary plus $326.45 which represented cash meal allowances reported by the State on respondent’s Wage and Tax Statement (Form W-2). The remaining amount of meal allowance, $1,371.09, was not reported. On audit, the Commissioner determined that this amount should have been included in respondent’s 1970 income, and assessed a deficiency.

Respondent sought review in the United States Tax Court, arguing that the cash meal allowance was not compensatory, but was furnished for the convenience of the employer, and hence was not “income” within the meaning of § 61(a), and that, in any case, the allowance could be excluded under § 119. … [T]he Tax Court, with six dissents, held that the cash meal payments were income within the meaning of § 61 and, further, that such payments were not excludable under § 119. . The Court of Appeals for the Third Circuit, in a per curiam opinion, held that its earlier decision in Saunders v. Commissioner, 215 F.2d 768 (1954), which determined that cash payments under the New Jersey meal allowance program were not taxable, required reversal. We granted certiorari to resolve a conflict among the Courts of Appeals on the question. . … In the absence of a specific exemption, therefore, respondent’s meal allowance payments are income within the meaning of § 61 since, like the payments involved in Glenshaw Glass Co., the payments are “undeniabl[y] accessions to wealth, clearly realized, and over which the [respondent has] complete dominion.” Commissioner v. Glenshaw Glass Co., [348 U.S. 426, 431 (1955)]. [citations omitted].

Respondent contends, however, that § 119 can be construed to be a specific exemption covering the meal allowance payments to New Jersey troopers. Alternatively, respondent argues that notwithstanding § 119, a specific exemption may be found in a line of lower court cases and administrative rulings which recognize that benefits conferred by an employer on an employee “for the convenience of the employer” – at least when such benefits are not “compensatory” – are not income within the meaning of the Internal Revenue Code. In responding to these contentions, we turn first to § 119. Since we hold that § 119 does not cover cash payments of any kind, we then trace the development over several decades of the “convenience of the employer” doctrine as a determinant of the tax status of meals and lodging, turning finally to the question whether the doctrine as applied to meals and lodging survives the enactment of the Internal Revenue Code of 1954.


Section 119 provides that an employee may exclude from income “the value of any meals … furnished to him by his employer for the convenience of the employer, but only if … the meals are furnished on the business premises of the employer …” By its terms, § 119 covers meals furnished by the employer, and not cash reimbursements for meals. This is not a mere oversight. As we shall explain at greater length below, the form of § 119 which Congress enacted originated in the Senate and the Report accompanying the Senate bill is very clear: “Section 119 applies only to meals or lodging furnished in kind.” S. Rep. No. 1622, 83d Cong., 2d Sess., 190 (1954). See also Treas. Reg. § 1.119-1(c)(2) … Accordingly, respondent’s meal allowance payments are not subject to exclusion under § 119.


The “convenience of the employer” doctrine is not a tidy one. The phrase “convenience of the employer” first appeared in O.D. 265, 1 Cum. Bull. 71 (1919), in a ruling exempting from the income tax board and lodging furnished seamen aboard ship. The following year, T.D. 2992, 2 Cum. Bull. 76 (1920), was issued, and added a “convenience of the employer” section to Treas. Regs. 45, Art. 33 … While T.D. 2992 extended the “convenience of the employer” test as a general rule solely to items received in kind, O.D. 514, 2 Cum. Bull. 90 (1920), extended the “convenience of the employer” doctrine to cash payments for “supper money.”

The rationale of both T.D. 2992 and O.D. 514 appears to have been that benefits conferred by an employer on an employee in the designated circumstances were not compensation for services, and hence not income. Subsequent rulings equivocate on whether the noncompensatory character of a benefit could be inferred merely from its characterization by the employer, or whether there must be additional evidence that employees are granted a benefit solely because the employer’s business could not function properly unless an employee was furnished that benefit on the employer’s premises. O.D. 514, for example, focuses only on the employer’s characterization. Two rulings issued in 1921, however, dealing respectively with cannery workers and hospital employees, emphasize the necessity of the benefits to the functioning of the employer’s business, and this emphasis was made the authoritative interpretation of the “convenience of the employer” provisions of the regulations in Mim. 5023, 1940-1 Cum. Bull. 14.58

Adding complexity, however, is Mim. 6472, 1950-1 Cum. Bull. 15, issued in 1950. This mimeograph states in relevant part:

“The ‘convenience of the employer’ rule is simply an administrative test to be applied only in cases in which the compensatory character of … benefits is not otherwise determinable. It follows that the rule should not be applied in any case in which it is evident from the other circumstances involved that the receipt of quarters or meals by the employee represents compensation for services rendered.” Ibid.

Mimeograph 6472 expressly modified all previous rulings which had suggested that meals and lodging could be excluded from income upon a simple finding that the furnishing of such benefits was necessary to allow an employee to perform his duties properly. However, the ruling apparently did not affect O.D. 514, which, as noted above, creates an exclusion from income based solely on an employer’s characterization of a payment as noncompensatory.

Coexisting with the regulations and administrative determinations of the Treasury, but independent of them, is a body of case law also applying the “convenience of the employer” test to exclude from an employee’s statutory income benefits conferred by his employer.

An early case is Jones v. United States, 60 Ct. Cl. 552 (1925). There, the Court of Claims ruled that neither the value of quarters provided an Army officer for nine months of a tax year nor payments in commutation of quarters paid the officer for the remainder of the year were includable in income. The decision appears to rest both on a conclusion that public quarters, by tradition and law, were not “compensation received as such” within the meaning of § 213 of the Revenue Act of 1921, 42 Stat. 237, and also on the proposition that “public quarters for the housing of … officers is as much a military necessity as the procurement of implements of warfare or the training of troops.” 60 Ct. Cl. at 569; 565-568. …

Subsequent judicial development of the “convenience of the employer” doctrine centered primarily in the Tax Court. In two reviewed cases decided more than a decade apart, Benaglia v. Commissioner, 36 B.T.A. 838 (1937), and Van Rosen v. Commissioner, 17 T.C. 834 (1951), that court settled on the business necessity rationale for excluding food and lodging from an employee’s income.59 Van Rosen’s unanimous decision is of particular interest in interpreting the legislative history of the 1954 recodification of the Internal Revenue Code, since it predates that recodification by only three years. There, the Tax Court expressly rejected any reading of Jones, supra, that would make tax consequences turn on the intent of the employer, even though the employer in Van Rosen, as in Jones, was the United States, and, also as in Jones, the subsistence payments involved in the litigation were provided by military regulation. . In addition, Van Rosen refused to follow the Jones holding with respect to cash allowances, apparently on the theory that a civilian who receives cash allowances for expenses otherwise nondeductible has funds he can “take, appropriate, use and expend,” 17 T.C. at 838, in substantially the same manner as “any other civilian employee whose employment is such as to permit him to live at home while performing the duties of his employment.” Id. at 836, 839-840. It is not clear from the opinion whether the last conclusion is based on notions of equity among taxpayers or is simply an evidentiary conclusion that, since Van Rosen was allowed to live at home while performing his duties, there was no business purpose for the furnishing of food and lodging.

Two years later, the Tax Court, in an unreviewed decision in Doran v. Commissioner, 21 T.C. 374 (1953), returned in part to the “employer’s characterization” rationale rejected by Van Rosen. In Doran, the taxpayer was furnished lodging in kind by a state school. State law required the value of the lodging to be included in the employee’s compensation. Although the court concluded that the lodging was furnished to allow the taxpayer to be on 24-hour call, a reason normally sufficient to justify a “convenience of the employer” exclusion, it required the value of the lodging to be included in income on the basis of the characterization of the lodging as compensation under state law. The approach taken in Doran is the same as that in Mim. 6472, supra. However, the Court of Appeals for the Second Circuit, in Diamond v. Sturr, 221 F.2d 264 (1955), on facts indistinguishable from Doran, reviewed the law prior to 1954 and held that the business necessity view of the “convenience of the employer”’ test, “having persisted through the interpretations of the Treasury and the Tax Court throughout years of reenactment of the Internal Revenue Code,” was the sole test to be applied. 221 F.2d at 268.


Even if we assume that respondent’s meal allowance payments could have been excluded from income under the 1939 Code pursuant to the doctrine we have just sketched, we must nonetheless inquire whether such an implied exclusion survives the 1954 recodification of the Internal Revenue Code. [citation omitted]. Two provisions of the 1954 Code are relevant to this inquiry: § 119 and § 120 , now repealed , which allowed police officers to exclude from income subsistence allowances of up to $5 per day.

In enacting § 119, the Congress was determined to “end the confusion as to the tax status of meals and lodging furnished an employee by his employer.” H.R. Rep. No. 1337, 83d Cong., 2d Sess., 18 (1954); S. Rep. No. 1622, 83d Cong., 2d Sess., 19 (1954). However, the House and Senate initially differed on the significance that should be given the “convenience of the employer” doctrine for the purposes of § 119. As explained in its Report, the House proposed to exclude meals from gross income “if they [were] furnished at the place of employment and the employee [was] required to accept them at the place of employment as a condition of his employment.” H.R. Rep. No. 1337, supra, at 18; see H.R. 8300, 83d Cong., 2d Sess., § 119 (1954). Since no reference whatsoever was made to the concept, the House view apparently was that a statute “designed to end the confusion as to the tax status of meals and lodging furnished an employee by his employer” required complete disregard of the “convenience of the employer” doctrine.

The Senate, however, was of the view that the doctrine had at least a limited role to play. After noting the existence of the doctrine and the Tax Court’s reliance on state law to refuse to apply it in Doran v. Commissioner, supra, the Senate Report states:

“Your committee believes that the House provision is ambiguous in providing that meals or lodging furnished on the employer’s premises, which the employee is required to accept as a condition of his employment, are excludable from income whether or not furnished as compensation. Your committee has provided that the basic test of exclusion is to be whether the meals or lodging are furnished primarily for the convenience of the employer (and thus excludable), or whether they were primarily for the convenience of the employee (and therefore taxable). However, in deciding whether they were furnished for the convenience of the employer, the fact that a State statute or an employment contract fixing the terms of the employment indicate the meals or lodging are intended as compensation is not to be determinative. This means that employees of State institutions who are required to live and eat on the premises will not be taxed on the value of the meals and lodging even though the State statute indicates the meals and lodging are part of the employee’s compensation.” S. Rep. No. 1622, supra, at 19.

In a technical appendix, the Senate Report further elaborated:

“Section 119 applies only to meals or lodging furnished in kind. Therefore, any cash allowances for meals or lodging received by an employee will continue to be includible in gross income to the extent that such allowances constitute compensation.” Id. at 190-91.

After conference, the House acquiesced in the Senate’s version of § 119. Because of this, respondent urges that § 119, as passed, did not discard the “convenience of the employer” doctrine, but indeed endorsed the doctrine shorn of the confusion created by Mim. 6472 and cases like Doran. Respondent further argues that, by negative implication, the technical appendix to the Senate Report creates a class of noncompensatory cash meal payments that are to be excluded from income. We disagree.

The Senate unquestionably intended to overrule Doran and rulings like Mim. 6472. Equally clearly, the Senate refused completely to abandon the “convenience of the employer” doctrine as the House wished to do. On the other hand, the Senate did not propose to leave undisturbed the convenience of the employer doctrine as it had evolved prior to the promulgation of Mim. 6472. The language of § 11960 quite plainly rejects the reasoning behind rulings like O.D. 514, see n. 15, supra, which rest on the employer’s characterization of the nature of a payment. . This conclusion is buttressed by the Senate’s choice of a term of art, “convenience of the employer,” in describing one of the conditions for exclusion under § 119. In so choosing, the Senate obviously intended to adopt the meaning of that term as it had developed over time, except, of course, to the extent § 119 overrules decisions like Doran. As we have noted above, Van Rosen v. Commissioner, 17 T.C. 834 (1951), provided the controlling court definition at the time of the 1954 recodification, and it expressly rejected the Jones theory of “convenience of the employer” – and, by implication, the theory of O.D. 514 – and adopted as the exclusive rationale the business necessity theory. See 17 T.C. at 838-840. The business necessity theory was also the controlling administrative interpretation of “convenience of the employer” prior to Mim. 6472. See supra at 434 U.S. 85-86, and n 19. Finally, although the Senate Report did not expressly define “convenience of the employer,” it did describe those situations in which it wished to reverse the courts and create an exclusion as those where “an employee must accept … meals or lodging in order properly to perform his duties.” S. Rep. No. 1622, supra, at 190.

As the last step in its restructuring of prior law, the Senate adopted an additional restriction, created by the House and not theretofore a part of the law, which required that meals subject to exclusion had to be taken on the business premises of the employer. Thus, § 119 comprehensively modified the prior law, both expanding and contracting the exclusion for meals and lodging previously provided, and it must therefore be construed as its draftsmen obviously intended it to be – as a replacement for the prior law, designed to “end [its] confusion.”

Because § 119 replaces prior law, respondent’s further argument – that the technical appendix in the Senate Report recognized the existence under § 61 of an exclusion for a class of noncompensatory cash payments – is without merit. If cash meal allowances could be excluded on the mere showing that such payments served the convenience of the employer, as respondent suggests, then cash would be more widely excluded from income than meals in kind, an extraordinary result given the presumptively compensatory nature of cash payments and the obvious intent of § 119 to narrow the circumstances in which meals could be excluded. Moreover, there is no reason to suppose that Congress would have wanted to recognize a class of excludable cash meal payments. The two precedents for the exclusion of cash – O.D. 514 and Jones v. United States – both rest on the proposition that the convenience of the employer can be inferred from the characterization given the cash payments by the employer, and the heart of this proposition is undercut by both the language of § 119 and the Senate Report. Finally, as petitioner suggests, it is much more reasonable to assume that the cryptic statement in the technical appendix – “cash allowances … will continue to be includable in gross income to the extent that such allowances constitute compensation” – was meant to indicate only that meal payments otherwise deductible under § 162(a)(2) of the 1954 Code were not affected by § 119.

Moreover, even if we were to assume with respondent that cash meal payments made for the convenience of the employer could qualify for an exclusion notwithstanding the express limitations upon the doctrine embodied in § 119, there would still be no reason to allow the meal allowance here to be excluded. Under the pre-1954 “convenience of the employer” doctrine, respondent’s allowance is indistinguishable from that in Van Rosen v. Commissioner, supra, and hence it is income. … In any case, to avoid the completely unwarranted result of creating a larger exclusion for cash than kind, the meal allowances here would have to be demonstrated to be necessary to allow respondent “properly to perform his duties.” There is not even a suggestion on this record of any such necessity.

Finally, respondent argues that it is unfair that members of the military may exclude their subsistence allowances from income, while respondent cannot. While this may be so, arguments of equity have little force in construing the boundaries of exclusions and deductions from income many of which, to be administrable, must be arbitrary. …


MR. JUSTICE BLACKMUN, with whom THE CHIEF JUSTICE joins, dissenting.


I fear that state troopers the country over, not handsomely paid to begin with, will never understand today’s decision. And I doubt that their reading of the Court’s opinion – if, indeed, a layman can be expected to understand its technical wording – will convince them that the situation is as clear as the Court purports to find it.

Notes and Questions:

1. In the first sentence of its opinion, the Court set forth the issue it undertook resolve. How did it resolve that issue?

2. Whether meal money falls within an exclusion and whether it is gross income are separate questions. With regard to the second question, let’s review: What facts were particularly bad for Officer Kowalski and why? What strings were attached to the meal money that were different than the strings attached to any worker’s wages?

3. How important should the employer’s treatment of meal money – separate accounting, no commingling of funds – be in resolution of the question of whether cash-for-meals should be included in an employee’s gross income? Isn’t that a red herring in determining whether taxpayer Kowalski has enjoyed an accession to wealth? The Tax Court concluded that the meal money was not intended to be additional compensation, but was nevertheless includable in taxpayer’s gross income.

4. In the second footnote of the case, the Court quoted a case that quoted Benaglia. Taxpayer Benaglia was given accommodations at the Royal Hawaiian Hotel and ate his meals in the hotel dining room because otherwise he could not perform the services required of him as manager of that hotel and others. Moreover, Benaglia was denied the discretion to spend this accession to wealth in any manner that he saw fit.

• Have we seen the “deprivation of discretion” theme before?

• What conclusion did it suggest?

5. Surely even a taxpayer denied a choice in his/her purchase of meals or lodging and whose employment requires that any meal that s/he does eat be taken where and when the employer orders derives some consumption benefit that s/he would have paid something for if the employer had not provided it. Does it have to be all-or-nothing?

• Section 274(n)(1)(A) limits deductions for food or beverages to 50% of the amount spent. The other 50% in essence is treated as a personal expenditure and so is subject to federal income tax – but it is the one who pays for the meal who must pay the income tax, not the one who consumes it.

• However, § 274(n)(2)(B) excepts from the 50% limitation meals that § 132(e) excludes from an employee’s gross income. Section 132(e) treats employees as having paid the direct operating costs of their meal if it is excluded from their gross income under § 119.

• How important is administrative ease in this? How important is accuracy? If 50% isn’t the right figure (and neither is another figure), should we revert to all-or-nothing? Perhaps 50% is simply a “least-bad” figure.

6. Should “underpayment” of a class of workers provide any support whatsoever for a conclusion that § 119 encompasses the cash payments in this case – as Justice Blackmun suggests? How many people do not feel that they are “underpaid?”

• Were the view of Justice Blackmun to have prevailed, the consequences would have been highly unfortunate. How so and why? What economic distortions would have resulted?

7. What interest should the State of New Jersey, Officer Kowalski’s employer, have in the outcome of this case? If Officer Kowalski must pay income tax on his meal money, the State of New Jersey may find that it must increase the wages of its state troopers. It is entirely possible that the State of New Jersey captured all of the tax savings that Justice Blackmun feels all state troopers deserve.

8. Using the figures that the Court provided, Officer Kowalski received 13% ($1371 out of $10,437) tax-free. Naturally, this affects the amount of income tax that others must pay if the Government is to raise a certain amount of revenue. Moreover, other workers who might pay income tax on $9066 – the amount on which Officer Kowalski did pay income tax – who do not receive meal money that they may spend any way they wish probably would understand very well the system’s discriminatory treatment of two different taxpayers’ unequal accessions to wealth – contrary to Justice Blackmun’s inferential suggestion that this decision is difficult for lay people to understand.

9. In a sense, the Kowalski case presents the tip of an iceberg. Peruse the topics that §§ 105, 106, 107, 125, 127, 129, 132, 137 cover. All of these code provisions provide for some benefit that an employer can provide employees that are not subject to income tax to either the employer or the employee. These provisions assure that like taxpayers who work for different employers are not taxed alike.


Deadweight Loss: Deadweight loss is someone’s loss and no one’s gain. The value of a good or service to a person is what the person is willing to pay for it. Everyone seeks to maximize value to himself/herself through purchasing choices within the limits of his/her after-tax income. Do exclusions from gross income cause deadweight loss? Yes.

Consider: Taxpayer pays income taxes at a marginal rate of 25%. Taxpayer is willing to pay $90 for a particular benefit and no more. Taxpayer would have to earn $120 in order to pay tax on the income necessary to purchase the benefit for $90. Naturally, taxpayer would be willing to pay less. The market price of the benefit is $100. Taxpayer is rational and makes no purchases for more money than the value s/he places on an item. Producers in turn strive to provide taxpayer goods and services at a cost to them that is less than the price taxpayer (and others) are willing to pay. All producers make a profit, so the markets are “sustainable.” Taxpayer does not purchase this benefit, but spends his/her after-tax income in ways that maximize his/her own consumer surplus. The economy works with allocative efficiency.

Now suppose that the Code excludes the benefit from taxpayer’s gross income if his/her employer provides it. Taxpayer’s employer offers to provide the benefit to taxpayer if taxpayer will accept a $100 reduction in pay. Should taxpayer accept the offer?

From taxpayer’s perspective, s/he can choose to keep the $100 in wages; this nets taxpayer $75 after taxes. Taxpayer can now rationally choose to accept the benefit because taxpayer essentially “pays” $75 for something s/he values at $90. That’s $15 of consumer surplus.

Unfortunately, the producers of the things taxpayer would have bought with his/her $75 of after-tax income lose the sales. The surplus value that they and taxpayer would have created by entering value-increasing bargains is lost – and replaced by a transaction that most assuredly does not increase after-tax value. No one captures the net loss in surplus value. It is deadweight loss.

All exclusions from gross income imply some deadweight loss. Assume that you had access to any information you wanted. How would you determine whether the nation should incur such deadweight losses?


10. Presumably, the accessions to wealth that employers offer employees that employees may in turn exclude from their gross income empower employers to customize the type of workforce they want. Maybe that is good. Airlines can pay less-than-market wages to persons who like to travel. Retailers can give employee discounts to persons who would (enthusiastically) shop at their establishments anyway. And so on.

• Consider this proposition: instead of aspiring to horizontal equality, aspire to horizontal equity by permitting a fixed ceiling on the value of excludable benefits that employers may provide employees. See William P. Kratzke, The (Im)Balance of Externalities in Employment-Based Exclusions from Gross Income, 60 Tax Law. 1, 3-8 (2006) (effective rate of federal income and employment taxes would be more progressive).

11. Read Reg. § 1.119-1(a)(2)(ii)(d).

• Do you think that someone lobbied to have this provision included in the regulations? Who?

12. Consider:

12a. Fishing Expeditions, Inc. provides flight services, accommodations, and guides to remote places for fishing aficionados to fish in very remote places. Its employees are small airplane pilots, guides, and cooks. The company flies fishing parties to remote cabins that it owns in Alaska. Obviously while servicing a fishing party, the employees must reside at a remote cabin and take meals there also. The employees must pay Fishing Expeditions, Inc. $200 per week, which Fishing Expeditions deducts from their paychecks. The employees must include the $200 in their gross income.

• True or false.

12b. Cicely is an employee of the Hanford Nuclear Works. The HNR is located 60 miles from the nearest structure and 70 miles from the nearest town. HNR maintains some barracks-style housing for free onsite that it provides various workers, who are typically in their 20s and single. The value of this housing is $500 per month. To be fair to the other workers, HNR pays a housing stipend of $500 per month to employees who elect to live in the nearest town and commute to the jobsite.

• Tax consequences to the workers who live onsite?

• Tax consequences to the workers who live in town?

F. Employee Fringe Benefits: § 132

Prior to 1984 – and as taxpayer Kowalski argued – there evolved an uneven patchwork of “fringe benefits” that employers and employees alike assumed were not subject to income tax. This cost the Treasury revenue and resulted in horizontal inequities. Congress addressed the problem, and in 1984, “drew a line in the sand.” The following is an explanation of what Congress did and why.

H. Rep. No. 98-432 (II), 98th Cong., 2d Sess. 1984, at 412, 1984 U.S.C.C.A.N. 697, 1215, 1984 WL 37400, to accompany H.R. 4170.


In providing statutory rules for exclusion of certain fringe benefits for income and payroll tax purposes, the committee has attempted to strike a balance between two competing objectives.

First, the committee is aware that in many industries, employees may receive, either free or at a discount, goods and services which the employer sells to the general public. In many cases, these practices are long established, and have been treated by employers, employees, and the IRS as not giving rise to taxable income. Although employees may receive an economic benefit from the availability of these free or discounted goods or services, employers often have valid business reasons, other than simply providing compensation, for encouraging employees to avail themselves of the products which they sell to the public. For example, a retail clothing business will want its salespersons to wear, when they deal with customers, the clothing which it seeks to sell to the public. In addition, the fact that the selection of goods and services usually available from a particular employer usually is restricted makes it appropriate to provide a limited exclusion, when such discounts are generally made available to employees, for the income employees realize from obtaining free or reduced-cost goods or services. The committee believes, therefore, that many present practices under which employers may provide to a broad group of employees, either free or at a discount, the products and services which the employer sells or provides to the public do not serve merely to replace cash compensation. These reasons support the committee’s decision to codify the ability of employers to continue these practices without imposition of income or payroll taxes.

The second objective of the committee’s bill is to set forth clear boundaries for the provision of tax-free benefits. … [A]dministrators of the tax law have not had clear guidelines in this area, and hence taxpayers in identical situations have been treated differently. The inequities, confusion, and administrative difficulties for businesses, employees, and the IRS … have increased substantially in recent years. The committee believes that it is unacceptable to allow these conditions … to continue any longer.

In addition, the committee is concerned that without any well-defined limits on the ability of employers to compensate their employees tax-free by using a medium other than cash, new practices will emerge that could shrink the income tax base significantly, and further shift a disproportionate tax burden to those individuals whose compensation is in the form of cash. A shrinkage of the base of the social security payroll tax could also pose a threat to the viability of the social security system above and beyond the adverse projections which the congress recently addressed in the social security amendments of 1983. Finally, an unrestrained expansion of noncash compensation would increase inequities among employees in different types of businesses, and among employers as well.

The nondiscrimination rule is an important common thread among the types of fringe benefits which are excluded under the bill from income and employment taxes. Under the bill, most fringe benefits may be made available tax-free to officers, owners, or highly compensated employees only if the benefits are also provided on substantially equal terms to other employees. The committee believes that it would be fundamentally unfair to provide tax-free treatment for economic benefits that are furnished only to highly paid executives. Further, where benefits are limited to the highly paid, it is more likely that the benefit is being provided so that those who control the business can receive compensation in a nontaxable form; in that situation, the reasons stated above for allowing tax-free treatment would not be applicable. Also, if highly paid executives could receive free from taxation economic benefits that are denied to lower-paid employees, while the latter are compensated only in fully taxable cash, the committee is concerned that this situation would exacerbate problems of noncompliance among taxpayers. In this regard, some commentators argue that the current situation – in which the lack of clear rules for the tax treatment of nonstatutory fringe benefits encourages the nonreporting of many types of compensatory benefits – has led to nonreporting of types of cash income which are clearly taxable under present-law rules, such as interest and dividends.

In summary, the committee believes that by providing rules which essentially codify many present practices under which employers provide their own products and services tax-free to a broad group of employees … the bill substantially improves the equity and administration of the tax system.

C. Explanation of Provisions
1. Overview

Under the bill, certain fringe benefits provided by an employer are excluded from the recipient employee’s gross income for federal income tax purposes and from the wage base (and, if applicable, the benefit base) for purposes of income tax withholding, FICA, FUTA, and RRTA.


Any fringe benefit that does not qualify for exclusion under the bill (for example, free or discounted goods or services which are limited to corporate officers) and that is not excluded under another statutory fringe benefit provision of the code is taxable to the recipient under … §§ 61 and 83, and is includible in wages for employment tax purposes, at the excess of its fair market value over any amount paid by the employee for the benefit.

Notes and Questions:

1. As the Report implies, the notion that fringe benefits were nontaxable had gotten out of hand. The approach of Congress was to define fringe benefits that are excludible from gross income and to draw a line in the sand: “this far and no farther.”

2. Read § 132. Consider these problems:

1. Phillip works for Sports World, a mega-sporting goods store. Phillip enjoys being outdoors and so would probably spend a lot of time shopping at Sports World, even if he didn’t work there. Last year, Sports World sold $10M worth of sporting goods. The cost of its merchandise was $7M, but its overhead was $2M. Sports World offers its employees a 25% employee discount on items that employees purchase. Phillip purchased a fishing boat that retails for $1000. Phillip paid $750.

• Tax consequences to Phillip?

1a. One week later, Phillip sold the fishing boat to his brother for $1050.

• Tax consequences to Phillip?

See § 132(a)(2) and § 132(c).

1b. Sports World is located in a large building whose tenants once included a professional basketball team and a perennial NCAA basketball power. The oddly-shaped building stood empty for several years. Service merchants in the area (restaurants, dry cleaners, dentists, optometrists, etc.) were anxious that Sports World would occupy the building and readily entered into reciprocal arrangements whereby employees of Sports World were entitled to a 20% discount off the retail prices of these merchants’ services. Sports World agreed to give only a 10% discount for the employees of these service merchants. Last week, Phillip paid $80 for dental services that normally cost $100. A nearby optometrist purchased a tent from Sports World that normally retails for $100 for only $90.

• Tax consequences to Phillip?

• Tax consequences to the optometrist?

See § 132(i).

2. Mesquite Airlines is a commercial airline. It offers its employees free standby air travel. Moreover, Mesquite Airlines has entered into a reciprocal agreement with several other airlines whereby employees of Mesquite may fly standby for free on other airlines, and employees of the other airlines may fly free on Mesquite Airlines. Megan is a retired airline pilot who flew airplanes for Mesquite Airlines for 35 years. Megan flew standby on a Mesquite Airlines flight; the normal fare was $400.

• Tax consequences to Megan? See § 132(h).

2a. Megan flew standby on another airline. The normal fare was $400.

• Tax consequences to Megan?

2b. Without charging her, Mesquite Airlines permitted Megan to reserve her seat for two weeks from now. The normal fare was $400.

• Tax consequences to Megan?

3. The University of Memphis recently moved into a new building in downtown Memphis. The faculty members chose their offices pursuant to a system that incorporated consideration of rank and seniority. Staff offices have a rental value of $3600 per year. Professor K now has a corner office with a nice view of the Mississippi River. The rental value of the “worst” faculty office is $4800 per year. The rental value of Professor K’s office is $14,400 per year.

• Tax consequences to Professor K? See § 132(a)(3) and § 132(d).


Codes and Regulations: By now you should have gained some facility flipping between the provisions of the Code and the Regulations. Within that context, this reminder might be appropriate. The Code is the text that Congress enacted. It is law so long as it is consistent with the Constitution. The Regulations are text that the Treasury Department adopted to construe the Code. It also is law, so long as it is consistent with the Code and the Constitution. You have already seen implementation of this hierarchy in cases that you have read.


3a. Same facts. The Law School purchased for Professor K and one other professor (but no one else) online access to the CCH Federal Tax Reporter. The retail cost of this access is $2500 per year.

• Tax consequences to Professor K?

• Is there any other information you need to answer this question?

4. Joe the Plumber, Inc. sells plumbing services to customers. It has a policy of offering employees a 25% discount on plumbing services that they purchase from Joe the Plumber, Inc. However, Joe the Plumber, Inc. offers a 40% discount to its “highly-compensated” employees. An employee purchased plumbing services that normally cost $200 for $150. One of Joe the Plumber’s highly-compensated employees purchased the same services for $120.

• Tax consequences to the employee?

• Tax consequences to the highly-compensated employee?

See § 132(j)(1).

5. Lotsa Refunds, Inc. is a tax return preparer that does a volume business among unbanked, low-income persons. The corporation has ten employees. At the end of a very hectic tax season, Lotsa Refunds presented each of its employees with a $50 prepaid Mastercard cash card, in addition to their normal wages. This was because of the gratitude Lotsa Refunds felt for its employees having worked long hours against tight deadlines. Lotsa Refunds’ highly-compensated employees did not receive such a card.

• Tax consequences to the employees?

5a. The employees of Lotsa Refunds, Inc. worked from 7 a.m. until 12 midnight every night between April 1 and April 15. Because of the fact that criminal activity increases after midnight, Lotsa Refunds paid cab-fare to all of its employees on those days – both from and to work in the morning. Assume that a typical cab fare is $15.

• Tax consequences to the employees? See Reg. § 1.132-6(d)(2)(iii)(A, B, and C).

• Are there any more facts you might wish to know?

6. Springfield Memorial Hospital operates a cafeteria for its workers. Its prices for each food item cover the direct operating costs of selling that item. This price is less than the fmv of the item if it were sold in a for-profit cafeteria. Some of its workers are on call for emergencies at all times, even during their mealtimes. The mealtimes of these workers is 30 minutes. These employees have special passes in the cafeteria which permit them to take food equal to $7 “worth” of food. Other personnel may eat in the cafeteria, but must pay the charge listed for each food item; these persons are not on call, and many of them do not eat in the cafeteria. Overall, the cafeteria loses money because most employees in the first group do eat in the cafeteria.

• Tax consequences to the first group of employees?

• Tax consequences to the second group of employees?

See § 132(e)(2), including carryout paragraph.

7. Taxpayer Wheeler lives five miles from his place of employment. Every day, he rides his Pistoldale Black Shadow bicycle that he bought several years ago and has used ever since for exercise and enjoyment. He also uses his bicycle every summer for a bicycle tour, and these tours are usually between 1000 and 1500 miles in length. He usually rides about sixty miles per weekend with a bicycle club. During the calendar year, Wheeler purchased new pedals for his bicycle to replace the ones he had that were ten years old (price: $120), a new chain which must be replaced every year (price: $10), tire tubes (4 @ $6/tube, total $24), and a new headlight because he did not have one (price: $30). Wheeler did not receive from his employer transportation in a commuter highway vehicle, a transit pass, or a parking place near his employer’s office. At the end of the year, Wheeler presented his receipts for the above items to his employer who reimbursed him $174 in cash. How much of this reimbursement must Wheeler include in his gross income?

8. Read §§ 82, 132(a)(6), 132(g), 217. Moving expenses are excluded from gross income only in certain circumstances. What are they? How does the Code provide for horizontal equity among taxpayers, some of whose employers pay their moving expenses and some of whose employers do not pay such expenses. We take up the Code provisions governing moving expenses in more detail in chapter 7-III-A.

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Do (again) CALI Lesson, Basic Federal Income Taxation: Gross Income: The Taxability of Employment Connected Payments: Fringe Benefits, Meals and Lodging, Unemployment Compensation, and Social Security Benefits.

G. Cafeteria Plans, § 125

Normally, a taxpayer may not avoid realizing gross income by turning his/her back on cash. Hence, if an employer were to give all employees a choice between, say, $5000 cash or $5000 of dependent care assistance, taxpayer would have to realize gross income no matter which choice s/he made. Either the employee accepted the cash (taxable) or could have accepted the cash (also taxable).

Some of an employer’s workforce might be parents whose children are in need of, say, after-school care. In order to avoid application of this “constructive receipt” doctrine, the employer would have to offer a dependent care assistance program to all employees.

• The non-parents would give up wages for this benefit, even though they derive no value from it.

• If the employer did not offer such a program, the parents could not avail themselves of the § 129 exclusion.

Section 125 mitigates these effects substantially, and gives employers and employees the power to customize a benefits package to a point – or to accept cash. A participant in a “cafeteria plan” does not realize gross income simply because s/he may choose to receive cash or among qualified benefits of the plan that the employer offers.

• Section 125(f) defines a “qualified benefit” to be any benefit which is not includible in the gross income of an employee except for § 106(b) (Archer MSAs), § 117 (scholarships, qualified tuition reduction), § 127 (employer educational assistance programs), and § 132 (fringe benefits).

• However, qualified transportation fringes are treated in the same manner as other qualified benefits of a cafeteria plan, § 132(f)(4).

• Moreover, group-term life insurance (see ¶ 79) in excess of $50,000 is a qualified benefit.

• Reg. § 1.125-1(a)(3) lists qualified benefits that an employer may offer in a cafeteria plan.

Section 125(j) establishes “simple cafeteria plans for small businesses.”

Proposed Reg. § 1.125-5(a)(1) authorizes flexible spending arrangements whereby employees agree to a reduction in their salary to be spent on a use-it-or-lose it basis on qualified benefits.

Why should an employer offer a cafeteria plan?

Wrap-up Questions for Chapter 3

1. In what ways – good or bad – do you think exclusions from gross income affect markets? It may help to consider one example, e.g., the market for health care.

2. What does it mean that an exclusion may be “captured” by someone other than the taxpayer Congress intended to benefit? Consider the exclusion from gross income of scholarships or the rental value of parsonages.

3. Why is the receipt of cash so rarely excluded from a taxpayer’s gross income? If an employer gave an employee a gift card to a particular store, should the employee be treated as having received cash for purposes of the income tax? Are there additional facts you might want to know?

4. Are there any statutory exclusions from gross income that you would like to see repealed? Which ones and why?

5. What is deadweight loss? Which exclusions do you think cause the most deadweight loss?

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