In this chapter, we consider the Code’s provisions for deductions and credits for certain personal expenditures. We select only a few165 such provisions to examine, namely § 165’s allowance of a deduction for casualty losses, § 213’s allowance of a deduction for medical and dental expenses, § 170’s allowance of a deduction for charitable contributions, §§ 164/275’s allowance and disallowance for payment of certain taxes, and §§ 82/132/217’s, allowance of a deduction for moving expenses or exclusion from gross income.
The Tax Formula:
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)
Consider why there should be an allowable deduction of, exclusion of, or credit for any personal expenses. We might preliminarily observe that there are three basic purposes:
1. We want to encourage taxpayers to make a particular type of personal expenditure. We may choose to make a “tax expenditure.” In this group, we should place deductions, credits, or exclusions for charitable contributions, for home mortgage interest, and for adoption expenses.
2. We want to provide some relief to those taxpayers whose personal expenditures result from the exercise of choice among unappealing alternatives. When discretion among consumption choices is absent, a court is less likely to find that a taxpayer’s accession to wealth is in fact gross income. Cf. Gotcher; Benaglia, supra. Conversely, when taxpayers may spend an accession to wealth any way they choose – as when they receive cash – they have realized gross income. See Kowalski, supra. However, taxpayers must on occasion make some expenditures that we feel do not result from meaningful choices. The Code names some occasions when the absence of such discretion entitles a taxpayer to deduct (or exclude) an expenditure from his/her gross income. Examples include casualty losses and medical expenses.
3. We want to enlarge the tax base. Some taxpayer expenditures are not necessarily trade or business expenses, but they in fact enhance a taxpayer’s ability to generate taxable income. If they do that, they would also increase tax revenues. We should encourage taxpayers to make such expenditures. In this group, we place the Code’s provisions for moving expenses and child care.
I. “Tax Expenditures”
Congress may use the tax code to encourage166 (at least not to discourage) taxpayers to make certain types of expenditures. In § 170, Congress allows taxpayers a deduction for charitable contributions. This, coupled with the exemption from income tax that many charities enjoy,167 may provide sufficient incentive for some taxpayers to support the good work certain charities do.
In § 164, Congress has allowed a deduction for certain taxes that taxpayer has paid or accrued. Section 275 specifically disallows a deduction for certain taxes that taxpayer may have paid or accrued. This pattern may encourage some taxpayers to engage in activities subject to a deductible tax, most notably, owning property.
With respect to both charitable contributions and payment of taxes, a taxpayer may try to characterize payments that provide a benefit for the taxpayer as either a charitable contribution or as payment of a tax. For example, a taxpayer might contribute money to a university on the condition that the university grant a scholarship to taxpayer’s daughter. Or a taxpayer may pay his or her share of a condominium-owners’ association’s assessment to remodel the association’s common areas. In neither case should taxpayer be permitted to claim a deduction. Instead the taxpayer has simply “purchased something.” These are easy cases. How do we determine whether taxpayer has merely bought something – or has made a charitable contribution or paid a tax?
A. Charitable Contributions
Consider: Taxpayers entered into an agreement to purchase certain property contingent on the City Council rezoning it to permit use for a trailer court and shopping center. To assure access to the portion intended for a mobile home development, the rezoning proposal provided for dedication of a strip of the property for a public road. The road would also provide access or frontage for a public school, for a church, and for a home for the aged. Taxpayers completed their purchase and made the contemplated transfer to the city. The City Council formally adopted the rezoning ordinance.
• Should taxpayers be permitted a charitable deduction for the value of the land it donated to the city to be used for a road?
• Should the fact that the City of Tucson benefitted from taxpayer’s having provided the land, irrespective of taxpayer’s motive in making the donation, be sufficient in itself to permit taxpayer a deduction?
• Would it matter if the dedication of the land to the City did not in fact increase the value of Taxpayers’ property?
• See Stubbs v. United States, 428 F.2d 885 (9th Cir. 1970), cert. denied, 400 U.S. 1009 (1971).
If a charitable contribution deduction turns on a weighing of benefits against the taxpayer’s cost, whose benefit should be relevant – benefit to the public or benefit to the taxpayer?
Rolfs v. Commissioner, 668 F.3d 888 (7th Cir. 2012)
HAMILTON, Circuit Judge.
Taxpayers Theodore R. Rolfs and his wife Julia Gallagher (collectively, the Rolfs) purchased a three-acre lakefront property in the Village of Chenequa, Wisconsin. Not satisfied with the house that stood on the property, they decided to demolish it and build another. To accomplish the demolition, the Rolfs donated the house to the local fire department to be burned down in a firefighter training exercise. The Rolfs claimed a $76,000 charitable deduction on their 1998 tax return for the value of their donated and destroyed house. The IRS disallowed the deduction, and that decision was upheld by the United States Tax Court. The Rolfs appeal. To support the deduction, the Rolfs needed to show a value for their donation that exceeded the substantial benefit they received in return. The Tax Court found that they had not done so. We agree and therefore affirm.
Charitable deductions for burning down a house in a training exercise are unusual but not unprecedented. By valuing their gifts as if the houses were given away intact and without conditions, taxpayers like the Rolfs have claimed substantial deductions from their taxable income. But this is not a complete or correct way to value such a gift. When a gift is made with conditions, the conditions must be taken into account in determining the fair market value of the donated property. As we explain below, proper consideration of the economic effect of the condition that the house be destroyed reduces the fair market value of the gift so much that no net value is ever likely to be available for a deduction, and certainly not here.
What is the fair market value of a house, severed from the land, and donated on the condition that it soon be burned down? There is no evidence of a functional market of willing sellers and buyers of houses to burn. Any valuation must rely on analogy. The Rolfs relied primarily on an appraiser’s before-and-after approach, valuing their entire property both before and after destruction of the house. The difference showed the value of the house as a house available for unlimited use. The IRS, on the other hand, presented experts who attempted to value the house in light of the condition that it be burned. The closest analogies were the house’s value for salvage or removal from the site intact.
The Tax Court first found that the Rolfs received a substantial benefit from their donation: demolition services valued by experts and the court at approximately $10,000. The court then found that the Rolfs’ before-and-after valuation method failed to account for the condition placed on the gift requiring that the house be destroyed. The court also found that any valuation that did account for the destruction requirement would certainly be less than the value of the returned benefit. We find no error in the court’s factual or legal analysis. The IRS analogies provide reasonable methods for approximating the fair market value of the gift here. The before-and-after method does not.
I. Legal Background Concerning Charitable Donations Under Section 170(a)
The legal principles governing our decision are well established, and the parties focus their dispute on competing valuation methodologies. We briefly review the relevant law, addressing some factual prerequisites along the way.
The requirements for a charitable deduction are governed by statute. Taxpayers may deduct from their return the verifiable amount of charitable contributions made to qualified organizations. 26 U.S.C. § 170(a)(1). Everyone agrees that the Village of Chenequa and its volunteer fire department are valid recipients of charitable contributions as defined under section 170(c). To qualify for deduction, contributions must also be unrequited—that is, made with “no expectation of a financial return commensurate with the amount of the gift.” Hernandez v. Comm’r of Internal Revenue, 490 U.S. 680, 690 (1989). The IRS and the courts look to the objective features of the transaction, not the subjective motives of the donor, to determine whether a gift was intended or whether a commensurate return could be expected as part of a quid pro quo exchange. Id. at 690–91.
The Treasury regulations implement the details of section 170, instructing taxpayers how to prove a deduction to the IRS and how to value donated property using its fair market value. Under section 1.170A–1(c) of the regulations, fair market value is to be determined as of the time of the contribution and under the hypothetical willing buyer/willing seller rule, wherein both parties to the imagined transaction are assumed to be aware of relevant facts and free from external compulsion to buy or sell. 26 C.F.R. § 1.170A–1(c). As with the question of the purpose of the claimed gift, fair market value requires an objective, economic inquiry and is a question of fact.
We can assume, as the record suggests, that the Rolfs were subjectively motivated at least in part by the hope of deducting the value of the demolished house on their tax return. Applying the objective test, however, we treat their donation the same as we would if it were motivated entirely by the desire to further the training of local firefighters. Objectively, the purpose of the transaction was to make a charitable contribution to the fire department for a specific use. … The Tax Court found … that when the transaction was properly evaluated, the Rolfs (a) received a substantial benefit in exchange for the donated property and (b) did not show that the value of the donated property exceeded the value of the benefit they received. We also agree with these findings. There was no net deductible value in this donation in light of the return benefit to the Rolfs.
A charitable contribution is a “transfer of money or property without adequate consideration.” United States v. American Bar Endowment, 477 U.S. 105, 118 (1986). A charitable deduction is not automatically disallowed if the donor received any consideration in return. Instead, as the Supreme Court observed in American Bar Endowment, some donations may have a dual purpose, as when a donor overpays for admission to a fund-raising dinner, but does in fact expect to enjoy the proverbial rubber-chicken dinner and accompanying entertainment. Where “the size of the payment is clearly out of proportion to the benefit received,” taxpayers can deduct the excess, provided that they objectively intended it as a gift. Id. at 116–18 (…). In practice then, the fair market value of any substantial returned benefit must be subtracted from the fair market value of the donation.
This approach differs from that of the Tax Court in Scharf v. Comm’r of Internal Revenue, T.C.M. 1973-265, an earlier case that allowed a charitable deduction for property donated to a fire department to be burned. In Scharf, a building had been partially burned and was about to be condemned. The owner donated the building to the fire department so it could burn it down the rest of the way. The Tax Court compared the value of the benefit obtained by the donor (land cleared of a ruined building) to the value of the public benefit in the form of training for the firefighters, and found that the public benefit substantially exceeded the private return benefit. Thus, the donation was deemed allowable as a legitimate charitable deduction, and the court proceeded to value the donation using the established insurance loss figure for the building. The Scharf court did not actually calculate a dollar value for the public benefit, and if it had tried, it probably would have found the task exceedingly difficult. Although Scharf supports the taxpayers’ claimed deduction here, its focus on public benefit measured against the benefit realized by the donor is not consistent with the Supreme Court’s later reasoning in American Bar Endowment. The Supreme Court did not rely on amorphous concepts of public benefit at all, but focused instead on the fair market value of the donated property relative to the fair market value of the benefit returned to the donor. 477 U.S. at 116–18. The Tax Court ruled correctly in this case that the Scharf test “has no vitality” after American Bar Endowment. 135 T.C. at 487.
With this background, the decisive legal principle for the Tax Court and for us is the common-sense requirement that the fair market valuation of donated property must take into account conditions on the donation that affect the market value of the donated property. This has long been the law. See Cooley v. Comm’r of Internal Revenue, 33 T.C. 223, 225 (1959) (“property otherwise intrinsically more valuable which is encumbered by some restriction or condition limiting its marketability must be valued in light of such limitation”). …
II. Valuation Methods
As this case demonstrates, however, knowing that one must account for a condition in a valuation opens up a second tier of questions about exactly how to do so. The Tax Court weighed conflicting evidence on valuation and rejected the taxpayers’ evidence claiming that the donated house had a value of $76,000. The Tax Court found instead that the condition requiring destruction of the house meant that the donated property had essentially no value. 135 T.C. at 494. The Tax Court did not err.
In this case there is no evidence of an actual market for, and thus no real or hypothetical willing buyers of, doomed houses as firefighter training sites. … Sometimes fire departments … conduct exercises using donated or abandoned property, but there is also no record evidence of any fire departments paying for such property. Without comparators from any established markets, the parties presented competing experts who advocated different valuation methods. The taxpayers relied on the conventional real estate market, as if they had given the fire department fee ownership of the house. The IRS relied on the salvage market and the market for relocated houses, attempting to account for the conditions proposed in the gift.
The taxpayers’ expert witness is a residential appraiser. … The taxpayers argued that the “before-and-after” method should be applied. Their appraiser started with an estimated value of $675,000 for the land and house together, based on comparisons to recent sales of similar properties in the area. Using the same method, he estimated a value of $599,000 for the land alone, without any house on it. He subtracted the latter from the former to estimate $76,000 as the value of the house alone.
The before-and-after approach is used most often to value conservation easements, where it is hard to put a value on the donated conservation use. Experts can estimate both the value of land without the encumbrance and the value of the land if sold with the specified use limitations, using the difference to estimate the value of the limitations imposed by the donor. As we explain below, there are significant differences between the Rolfs’ donation and a conservation easement. While this approach might superficially seem like a reasonable way to back into an answer for the house’s value apart from the underlying land, the before-and-after method cannot properly account for the conditions placed on the recipient with a gift of this type. The Tax Court properly rejected use of the before-and-after method for valuing a donation of property on the condition that the property be destroyed.
… The IRS asserted that a comparable market could be sales of houses, perhaps historically or architecturally important structures, where the buyer intends to have the house moved to her own land. Witness Robert George is a professional house mover who has experience throughout Wisconsin lifting houses from their foundations and transporting them to new locations. He concluded that it would cost at least $100,000 to move the Rolfs’ house off of their property. Even more important, he opined that no one would have paid the owners more than nominal consideration to have moved this house. In his expert opinion, the land in the surrounding area was too valuable to warrant moving such a modest house to a lot in the neighborhood. George also opined that the salvage value of the component materials of the house was minimal and would be offset by the labor cost of hauling them away. … Based on this testimony, the IRS argued that since the house would have had negligible value if sold under the condition that it be separated from the land and moved away, the house must also have had negligible value if sold under the condition that it be burned down.
The Tax Court found that the parties to the donation understood that the house must be promptly burned down, and the court credited testimony by the fire chief that he knew the house could be put to no other use by the department. The court rejected the taxpayers’ before-and-after method as an inaccurate measure of the value of the house “as donated” to the department. The taxpayers’ method measured the value of a house that remained a house, on the land, and available for residential use. The conditions of the donation, however, required that the house be severed from the land and destroyed. The Tax Court, accepting the testimony of the IRS experts, concluded that a house severed from the land had no substantial value, either for moving off-site or for salvage. Moving and salvage were analogous situations that the court found to be reasonable approximations of the actual scenario. We agree with these conclusions, which follow the Cooley principle by taking into account the economic effect of the main condition that the taxpayers put on their donation. The Tax Court correctly required, as a matter of law, that the valuation must incorporate any reduction in market value resulting from a restriction on the gift. We review the Tax Court’s findings of fact for clear error and its conclusions of law de novo. Freda v. Comm’r of Internal Revenue, 656 F.3d 570, 573 (7th Cir. 2011). We find no clear error in the factual findings and conclude further that it would have been an error of law to ascribe any weight to the taxpayers’ before-and-after valuation evidence.
… The taxpayers here gave away only the right to come onto their property and demolish their house, a service for which they otherwise would have paid a substantial sum. … The demolition condition placed on the donation of the house reduced the fair market value of the house to a negligible amount, well enough approximated by its negligible salvage value.
The authorities the taxpayers cite to support the before-and-after valuation method relate to conservation easements and other restrictive covenants, but the features of this donation are quite different from such an easement. When an easement is granted, part of the landowners’ rights are carved out and transferred to the recipient. For example, the Forest Service might be given the right to manage undeveloped land, or a conservation trust might be given the right to control disposition of property. Because it can be difficult to measure the value of this sort of right in isolation, experts instead estimate the difference in sale price for property with and without similar encumbrances. Here, in contrast, the initial value of the home can be estimated with the before-and-after method, but the donation destroyed that residential value rather than transferred it.
That’s why conservation easements provide a poor model for the situation here, and other possible valuation models suffer from a lack of supporting evidence. The value of the training exercises to the fire department is not in evidence. The fire chief testified in the Tax Court that he could not assign a specific value to the significant public benefit of the training—but in any event, we know from American Bar Endowment that trying to measure the benefit to the charity is not the appropriate approach. …
The Tax Court also undertook a fair market valuation of the benefit received by the taxpayers. The expert witnesses for the IRS both agreed with Mr. Rolfs’ own testimony (based on his investigation) that the house would cost upwards of $10,000 to demolish. … We see no error in the Tax Court’s factual determination, based on the available evidence and testimony, that the Rolfs received a benefit worth at least $10,000.
When property is donated to a charity on the condition that it be destroyed, that condition must be taken into account when valuing the gift. In light of that condition, the value of the gift did not exceed the fair market value of the benefit that the donating taxpayers received in return. Accordingly, the judgment of the Tax Court is Affirmed.
Notes and Questions:
1. How does the test of American Bar Endowment as the court articulates it differ from the test that the Tax Court (evidently) applied in Scharf?
• Basis is how a taxpayer keeps score with the government. No one’s argument in Rolfs concerning an allowable charitable contribution deduction involved consideration of the house’s pro-rated share of the overall basis of the property. Why not?
2. Why should taxpayer be able to claim the fmv of the property as the amount to be deducted when that amount is greater than the adjusted basis of the property?
• Shouldn’t taxpayer be limited to a deduction equal to the property’s adjusted basis? See § 170(e)(1)(A).
3. The Supreme Court construed the meaning of the phrase “to or for the use of” in § 170(c) in Davis v. United States, 495 U.S. 472 (1990). Taxpayers’ sons were missionaries for the Church of Jesus Christ of Latter-Day Saints. Taxpayers deposited amounts into the individual accounts of their sons. The Church had requested the payments and set their amounts. The Church issued written guidelines, instructing that the funds be used exclusively for missionary work. In accordance with the guidelines, petitioners’ sons used the money primarily to pay for rent, food, transportation, and personal needs while on their missions. Taxpayers claimed that these amounts were deductible under § 170. The Supreme Court denied the deductibility of such payments and adopted the IRS’s interpretation of the phrase. “[W]e conclude that a gift or contribution is ‘for the use of’ a qualified organization when it is held in a legally enforceable trust for the qualified organization or in a similar legal arrangement.” Id. at 485. “[B]ecause petitioners did not donate the funds in trust for the Church, or in a similarly enforceable legal arrangement for the benefit of the Church, the funds were not donated ‘for the use of’ the Church for purposes of § 170.” Id. at 486. And while “the Service’s interpretation does not require that the qualified organization take actual possession of the contribution, it nevertheless reflects that the beneficiary [(organization)] must have significant legal rights with respect to the disposition of donated funds.” Id. at 483.
4. In 1971, the IRS issued Rev. Rul. 71-447 in which it stated the position that a private school that does not have a racially non-discriminatory policy as to students is not “charitable” within the common-law concepts reflected in §§ 170 and 501(c)(3). The IRS relied on this position to revoke the tax-exempt status of two private schools. The United States Supreme Court upheld this determination:
There can thus be no question that the interpretation of § 170 and § 501(c)(3) announced by the IRS in 1970 was correct. That it may be seen as belated does not undermine its soundness. It would be wholly incompatible with the concepts underlying tax exemption to grant the benefit of tax-exempt status to racially discriminatory educational entities, which “exer[t] a pervasive influence on the entire educational process.” [citation omitted] Whatever may be the rationale for such private schools’ policies, and however sincere the rationale may be, racial discrimination in education is contrary to public policy. Racially discriminatory educational institutions cannot be viewed as conferring a public benefit within the “charitable” concept discussed earlier, or within the Congressional intent underlying § 170 and § 501(c)(3).
Bob Jones University v. United States, 461 U.S. 574, 595-96 (1983). The schools’ tax-exempt status was lost. Donors could not claim a charitable contribution deduction for contributing money to it.
• This is one area where public policy is a part of income tax law.
5. There are limits to the amount of a charitable contribution that a taxpayer may deduct. Section 170’s rules are complex.
• An individual has a “contribution base,” i.e., adjusted gross income without regard to an NOL carryback. § 170(b)(1)(G).
• A taxpayer may deduct in a taxable year only a certain percentage of his/her “contribution base,” the percentage limit dependent on the type of charity to which the contribution is made and the form of the contribution.
6. Section 170(c) describes five numbered types of charities.
• The Code creates so-called “A” charities, § 170(b)(1)(A), and “B” charities, § 170(b)(1)(B).
• Generally,168 “A” charities include churches, educational organizations, an organization whose principal purpose is medical research or education, university endowment funds, governmental units if the gift is for public purposes, publicly supported organizations with certain specified purposes, certain private foundations, and organizations that support certain other tax-exempt organizations. § 170(b)(1)(A).
• “B” charities are all other charities. § 170(b)(1)(B). This generally169 includes veterans’ organizations, fraternal societies, nonprofit cemeteries, and certain nonoperating foundations.
7. A charitable contribution may take one of several forms:
• A charitable contribution may be of “capital gain property,” i.e., a “capital asset the sale of which at its fair market value at the time of the contribution would have resulted in gain which would have been long-term capital gain” (LTCG) or § 1231 property. § 170(b)(1)(C)(iv).
• The fmv of the property is the amount of the allowable deduction. Reg. § 1.170A-1(c)(1). This means that the LTCG on such property is never taxed – thus creating a true loophole.170
• If the donee’s use of the property is unrelated to the charity’s purpose, the charity disposes of the property before the last day of the taxable year, the charity is a certain type of private foundation, the property was intellectual property, or the property is self-created taxidermy property – then the deduction is limited to the taxpayer’s basis in the property or its fmv, whichever is lower. § 170(e)(1)(B).
• A charitable contribution may be of property, the gain on whose sale would not be long-term capital gain.
• The taxpayer’s deduction is limited to his/her adjusted basis in the property or its fmv, whichever is less. § 170(e)(1)(A).
• If a charitable contribution of property is partly a sale, then the taxpayer’s basis in the property is allocated pro rata according to the amount realized on the sale portion of the transaction and the fmv of the property. § 170(e)(2); Reg. § 1.1011-2(b). Taxpayer recognizes gain on the sale portion of such a transaction.
• Of course a charitable contribution may take the form of cash.
8. A taxpayer’s allowable contributions are subject to the following limitations:
• Taxpayer may deduct up to 50% of his/her contribution base to “A” charities, § 170(b)(1)(A);
• Taxpayer may carry excess contributions to “A” charities to each of the succeeding five tax years in sequence, § 170(d)(1)(A);
• Taxpayer may deduct up to 30% of his/her contribution base to “B” charities, § 170(b)(1)(B);
• Taxpayer may carry excess contributions to “B” charities to each of the succeeding five tax years in sequence, §§ 170(d)(1)(B), 170(d)(1)(A).
• Taxpayer may deduct up to 30% of his/her contribution base to “A” charities of “capital gain property,” § 170(b)(1)(C)(i);
• Taxpayer may carry excess contributions of “capital gain property” to “A” charities to each of the succeeding five tax years in sequence, §§ 170(b)(1)(C)(ii), 170(d)(1)(A);
• Taxpayer may deduct up to 20% of his/her contribution base to “B” charities of “capital gain property, § 170(b)(1)(D)(i);
• Taxpayer may carry excess contributions of “capital gain property” to “B” charities to each of the succeeding five tax years in sequence, §§ 170(b)(1)(D)(ii), 170(d)(1)(A).
• These limitations are presented in a certain order. Every type of contribution is subject to the limitations imposed on gifts above it.
• Example: Taxpayer contributed 40% of her contribution base in cash to an “A” charity. Taxpayer also contributed “capital gain property” with a fmv equal to 20% of her contribution base to “A” charities. Taxpayer must carry half of her “capital gain property” contributions to the next succeeding tax year as a contribution of “capital gain property” to an “A” charity.
• Moreover, as the sequence of the list implies, carryovers may be used only subject to the contribution limits of the succeeding year. § 170(d)(1)(A)(i). The carryforward period is five years. § 170(d)(1)(A). This may discourage particularly generous taxpayers from making contributions in excess of the limits any more frequently than once every five years.
9. Corporations: A corporation may deduct only 10% of its taxable income as charitable contributions. § 170(b)(2)(A). A corporation may not circumvent this limitation by recharacterizing a contribution or gift that qualifies as a charitable contribution as a business expenditure. § 162(b). A corporation computes its taxable income for purposes of calculating this limit without regard to any dividends-received deduction, NOL carryback, § 199 deduction for domestic production activities, and capital loss carryback. § 170(b)(2)(C). A corporation may carry over an excess contribution to each of the next succeeding five tax years. § 170(d)(2)(A). The carryover cannot operate to increase an NOL in a succeeding year. § 170(d)(2)(B).
10. Taxpayer made a $1000 contribution to WKNO-FM, the local public radio station. WKNO-FM is an “A” organization. Because Taxpayer gave “at the $1000 level,” WKNO-FM presented Taxpayer with a HD radio. WKNO-FM had purchased several such radios for its fund-raising drive at a cost of $163 each. The fmv of the radio was $200. Taxpayer already owned an HD radio so s/he put the new one – still in the box it came in – in the attic. How much may Taxpayer deduct as a charitable contribution?
• See Shoshone-First National Bank v. United States, 29 A.F.T.R.2d 72-323, 72-1 USTC (CCH) ¶ 9119, 1971 WL 454 (D. Wyo. 1971).
10a. Playhouse on the Circle will “sell the house” to any organization willing to pay $2500 to see a private showing on a Sunday afternoon of the play it is currently showing. A ticket to see the same play on Saturday night – the immediately preceding night – normally costs $35. Many charities engage Playhouse on the Circle to raise funds for their organization. St. Marlboro, an “A” organization engaged in medical research to determine the consequences of smoking only a few cigarettes a day, has “bought the house” and is selling tickets for $35/each. If Taxpayer purchased four tickets at a total cost of $140, how much should Taxpayer be permitted to deduct as a charitable contribution if Taxpayer throws the tickets away because s/he is not the least bit interested in seeing the play that Playhouse is currently showing?
• See Rev. Rul. 67-246 (Example 3).
10b. Taxpayer has $200,000 of adjusted gross income and no NOL carryback. Taxpayer made the following charitable contributions:
• $20,000 cash to her church, an “A” charity;
• “long-term capital gain property” to her favorite university, an “A” charity, ab = $10,000, fmv = $80,000;
• “long-term capital gain property” to the sorority of which she was a member during her years in college, a “B” organization, ab = $15,000, fmv = $40,000.
What is Taxpayer’s allowable charitable contribution deduction? What charitable contribution carryovers will Taxpayer have?
10c. Taxpayer has $200,000 of adjusted gross income and no NOL carryback. Taxpayer made no charitable contributions except for the following transaction:
• Taxpayer sold to a “B” charity some stock that he purchased many years ago for $10,000. Its current fmv = $50,000. Taxpayer sold the stock to the charity for $10,000.
What are the tax consequences to Taxpayer?
B. Taxes Paid
Section 164 names some taxes that are deductible, irrespective of the circumstances of the taxpayer. The payments do not have to be connected with a trade or business, or for the production of income. They are deductible simply because taxpayer paid them. Section 275 names certain taxes that are not deductible.
There is of course an involuntary element of paying any of the taxes that § 164 names. However, there is also an element of choice involved in the sense that some taxes are simply the cost of owning property – wherever situated – or making income in one place rather than another. Moreover, the taxes named support governments other than the federal government. Thus the taxpayer’s costs of taxes associated with the choices that taxpayer makes are borne at least in part by the federal government.
Some important points about §§ 164/275 are the following:
• To be deductible, a “personal property tax” must be an ad valorem tax, § 164(b)(1), i.e., “substantially in proportion to the value of the personal property.” Reg. § 1.164-3(c)(1). Thus payment of a uniform “wheel tax” imposed on automobiles is not deductible.
• A taxpayer may deduct either state and local income taxes or state and local sales taxes. § 164(b)(5)(A). For a time, state and local sales taxes were not deductible.
• What are the fairness implications of these current and former rules for taxpayers who reside in states that raise most of their revenue through income taxes, through sales taxes, or through a combination of income and sales taxes?
• Section 164(c)(1) provides in part: “Taxes assessed against local benefits of a kind tending to increase the value of the property assessed” are not deductible. Reg. § 1.164-4(a) provides in part: “A tax is considered assessed against local benefits when the property subject to the tax is limited to property benefited. Special assessments are not deductible, even though an incidental benefit may inure to the public welfare. The real property taxes deductible are those levied for the general public welfare by the proper taxing authorities at a like rate against all property in the territory over which such authorities have jurisdiction.”
• If a property owner may not deduct an assessment for the construction of, say, sidewalks in his/her neighborhood, should the property owner be permitted to add the amount of the assessment to his/her basis in his/her property?
• If real property is sold during a tax year, § 164(d) pro rates the real property tax allocable to seller and buyer by the number of days each owned the property. The seller is treated as owning the property up to the day before the sale. § 164(d)(1)(A).
• How should a seller treat real estate taxes that the seller has already paid and for which s/he received reimbursement from the buyer? See § 1001(b)(1).
• How should a seller treat real estate taxes that are the obligation of the seller but which the purchaser pays, perhaps because they are only due after the date of sale? See § 1001(b)(2).
• The last sentence of § 164(a) provides that taxes paid in connection with the sale or acquisition of property are to be treated as amount realized or cost.
• If this treatment of such taxes does not (ultimately) alter taxpayer’s taxable income, what difference does it make to deduct a payment as opposed to reducing the amount realized or increasing the cost?
Do the CALI Lesson, Basic Federal Income Taxation: Deductions: Deductions for Taxes.
II. Denial of Discretion in Choosing How or What to Consume
A. Medical and Dental Expenses
Section 213(a) allows a taxpayer to deduct expenses of medical care “paid during the taxable year, not compensated for insurance or otherwise” to the extent such expenses exceed 10% of the taxpayer’s adjusted gross income. This includes the expenses of prescription drugs. § 213(b). Section 213(d)(1)(A) defines “medical care” expenses to include expenditures “for the diagnosis, cure, mitigation, treatment, or prevention of disease, or for the purpose of affecting any structure or function of the body.” Medical care expenses also includes the expenses of transportation “primarily for and essential to medical care,” certain long-term care services, and insurance that covers “medical care” as so defined.
• Why should there be a floor on the deductibility of medical expenses? Why should the determinant of that floor be a taxpayer’s adjusted gross income? See William P. Kratzke, The (Im)Balance of Externalities in Employment-Based Exclusions from Gross Income, 60 The Tax Lawyer 1, 24-25 (2006).
• Think: What is the profile of taxpayers most likely to claim a medical expense deduction? See id. What type of medical expenditures are such taxpayers likely to make?
We are met once again by the chicken-and-egg question of when taxpayer’s personal circumstances can support a deduction for certain expenditures. Why did taxpayer have little choice in making the expenditure?
Ochs v. Commissioner, 195 F.2d 692 (2d Cir.), cert. denied, 344 U.S. 827 (1952)
The question raised by this appeal is whether the taxpayer Samuel Ochs was entitled under §  of the Internal Revenue Code to deduct the sum of $1,456.50 paid by him for maintaining his two minor children in day school and boarding school as medical expenses incurred for the benefit of his wife. …
The Tax Court made the following findings:
‘During the taxable year petitioner was the husband of Helen H. Ochs. They had two children, Josephine age six and Jeanne age four.
‘On December 10, 1943, a thyroidectomy was performed on petitioner’s wife. A histological examination disclosed a papillary carcinoma of the thyroid with multiple lymph node metastases, according to the surgeon’s report. During the taxable year the petitioner maintained his two children in day school during the first half of the year and in boarding school during the latter half of the year at a cost of $1,456.50. Petitioner deducted this sum from his income for the year 1946 as a medical expense under §  …
‘During the taxable year, as a result of the operation on December 10, 1943, petitioner’s wife was unable to speak above a whisper. Efforts of petitioner’s wife to speak were painful, required much of her strength, and left her in a highly nervous state. Petitioner was advised by the operating surgeon that his wife suffered from cancer of the throat, a condition which was fatal in many cases. … Petitioner became alarmed when, by 1946, his wife’s voice had failed to improve … Petitioner and his wife consulted a reputable physician and were advised by him that if the children were not separated from petitioner’s wife she would not improve and her nervousness and irritation might cause a recurrence of the cancer. Petitioner continued to maintain his children in boarding school after the taxable year here involved until up to the end of five years following the operation of December 10, 1943, petitioner having been advised that if there was no recurrence of the cancer during that time his wife could be considered as having recovered from the cancer.
‘During the taxable year petitioner’s income was between $5,000 and $6,000. Petitioner’s two children have not attended private school but have lived at home and attended public school since a period beginning five years after the operation of December 10, 1943. Petitioner’s purpose in sending the children to boarding school during the year 1946 was to alleviate his wife’s pain and suffering in caring for the children by reason of her inability to speak above a whisper and to prevent a recurrence of the cancer which was responsible for the condition of her voice. He also thought it would be good for the children to be away from their mother as much as possible while she was unable to speak to them above a whisper.
‘Petitioner’s wife was employed part of her time in 1946 as a typist and stenographer. On account of the impairment which existed in her voice she found it difficult to hold a position and was only able to do part-time work. At the time of the hearing of this proceeding in 1951, she had recovered the use of her voice and seems to have entirely recovered from her throat cancer.’
The Tax Court said in its opinion that it had no reason to doubt the good faith and truthfulness of the taxpayer …, but it nevertheless held that the expense of sending the children to school was not deductible as a medical expense under the provisions of §  …
In our opinion the expenses incurred by the taxpayer were non-deductible family expenses within the meaning of § [262(a)] of the Code rather than medical expenses. Concededly the line between the two is a difficult one to draw, but this only reflects the fact that expenditures made on behalf of some members of a family unit frequently benefit others in the family as well. The wife in this case had in the past contributed the services – caring for the children – for which the husband was required to pay because, owing to her illness, she could no longer care for them. If, for example, the husband had employed a governess for the children, or a cook, the wages he would have paid would not be deductible. Or, if the wife had died, and the children were sent to a boarding school, there would certainly be no basis for contending that such expenses were deductible. The examples given serve to illustrate that the expenses here were made necessary by the loss of the wife’s services, and that the only reason for allowing them as a deduction is that the wife also received a benefit. We think it unlikely that Congress intended to transform family expenses into medical expenses for this reason. The decision of the Tax Court is further supported by its conclusion that the expenditures were to some extent at least incurred while the wife was acting as a typist in order to earn money for the family. …
The decision is affirmed.
FRANK, Circuit Judge (dissenting).
… The Commissioner argued, successfully in the Tax Court, that, because the money spent was only indirectly for the sake of the wife’s health and directly for the children’s maintenance, it could not qualify as a ‘medical expense.’ Much is made of the fact that the children themselves were healthy and normal – and little of the fact that it was their very health and normality which were draining away the mother’s strength. The Commissioner seemingly admits that the deduction might be a medical expense if the wife were sent away from her children to a sanitarium for rest and quiet, but asserts that it never can be if, for the very same purpose, the children are sent away from the mother – even if a boarding school for the children is cheaper than a sanitarium for the wife. I cannot believe that Congress intended such a meaningless distinction, that it meant to rule out all kinds of therapeutic treatment applied indirectly rather than directly – even though the indirect treatment be ‘primarily for the *** alleviation of a physical or mental defect or illness.’ . The cure ought to be the doctor’s business, not the Commissioner’s.
The only sensible criterion of a ‘medical expense’ – and I think this criterion satisfies Congressional caution without destroying what little humanity remains in the Internal Revenue Code – should be that the taxpayer, in incurring the expense, was guided by a physician’s bona fide advice that such a treatment was necessary to the patient’s recovery from, or prevention of, a specific ailment.
In the final analysis, the Commissioner, the Tax Court and my colleagues all seem to reject Mr. Ochs’ plea because of the nightmarish spectacle of opening the floodgates to cases involving expense for cooks, governesses, baby-sitters, nourishing food, clothing, frigidaires, electric dish-washers – in short, allowances as medical expenses for everything ‘helpful to a convalescent housewife or to one who is nervous or weak from past illness.’ I, for one, trust the Commissioner to make short shrift of most such claims. The tests should be: Would the taxpayer, considering his income and his living standard, normally spend money in this way regardless of illness? Has he enjoyed such luxuries or services in the past? Did a competent physician prescribe this specific expense as an indispensable part of the treatment? Has the taxpayer followed the physician’s advice in most economical way possible? Are the so-called medical expenses over and above what the patient would have to pay anyway for his living expenses, i.e., room, board, etc? Is the treatment closely geared to a particular condition and not just to the patient’s general good health or well-being?
My colleagues are particularly worried about family expenses, traditionally nondeductible, passing as medical expenses. They would classify the children’s schooling here as a family expense, because, they say, it resulted from the loss of the wife’s services. I think they are mistaken. The Tax Court specifically found that the children were sent away so they would not bother the wife, and not because there was no one to take care of them. Och’s expenditures fit into the Congressional test for medical deductions because he was compelled to go to the expense of putting the children away primarily for the benefit of his sick wife. Expenses incurred solely because of the loss of the patient’s services and not as a part of his cure are a different thing altogether. Wendell v. Commissioner, 12 T.C. 161, for instance, disallowed a deduction for the salary of a nurse engaged in caring for a healthy infant whose mother had died in childbirth. The case turned on the simple fact that, where there is no patient, there can be no deduction.
Thus, even here, expense attributed solely to the education, at least of the older child, should not be included as a medical expense. See Stringham v. Commissioner, supra. Nor should care of the children during that part of the day when the mother would be away, during the period while she was working part-time. Smith v. Commissioner, 40 B.T.A. 1038, aff’d 2d Cir., 113 F.2d 114. The same goes for any period when the older child would be away at public school during the day. In so far as the costs of this private schooling are thus allocable, I would limit the deductible expense to the care of the children at the times when they would otherwise be around the mother. …
Notes and Questions:
1. Is the rationale offered by the court consistent with the tax rules concerning imputed income?
• Does the rationale seem a bit reminiscent of the rationale in Smith?
2. What caused taxpayer to have to incur the expenses on his relatively modest income of sending the children to boarding school?
• Would taxpayers have had to bear these expenses if they did not have children?
• Would taxpayers have had to bear these expenses if Mrs. Ochs did not have throat cancer?
3. How much discretion did taxpayer have in incurring the particular expense in Ochs? If taxpayer had paid for Mrs. Ochs to reside in a sanitarium, that expense would qualify as a medical expense.
4. Consider: Prior to 1962 Mrs. Gerstacker had a history of emotional-mental problems which had grown gradually worse. In 1962 she ran away from mental hospitals twice after voluntarily entering them. Her doctors advised Mr. Gerstacker that successful treatment required continuing control of the doctors so that Mrs. Gerstacker could not leave and disrupt her therapy. They recommended guardianship proceedings and hospitalization in Milwaukee Sanitarium, Wauwatosa, Wisconsin. Mr. Gerstacker instituted guardianship proceedings. Both Mr. and Mrs. Gerstacker employed attorneys. The court appointed guardians. Mrs. Gerstacker was hospitalized from 1962 until the latter part of 1963 when she was released by her doctors for further treatment on an out-patient basis. The guardianship was then terminated on the recommendation of her doctors because it was no longer necessary due to improved condition of the patient.
• Should the legal expenses for establishing, conducting, and terminating the guardianship be deductible as medical expenses? For whose benefit were the expenses incurred?
• See Gerstacker v. Commissioner, 414 F.2d 448 (6th Cir. 1969).
5. Do the CALI Lesson, Basic Federal Income Taxation: Medical Expense Deductions. Do not worry about question 17. The floor is now 10%.
B. Casualty Losses
Read § 165(c)(3), § 165(e), § 165(h), § 165(i).
Losses caused by “fire, storm, shipwreck, or other casualty, or from theft” do not usually result from personal consumption choices. Hence, a deduction seems appropriate. From the beginning, a problem has been to distinguish between a “bad hair day” and the type of damage that represents such a deprivation of consumption choice that a taxpayer should be permitted to share his/her burden with other taxpayers. This has not proved to be an easy line to draw – and one does not have to search the digests very hard to find contradictory results.
Courts have had great difficulty defining “casualty,” and there is no definition in the regulations. Certain considerations seem relevant:
• Not every loss should be treated as resulting from a casualty. We drop a plate, and it breaks. It’s called “life,” not a casualty.
• There are certain risks that we may willingly assume. When something untoward materializes, we are in no position to complain. We own a cat and an expensive vase and put both of them in the same room at the same time. The cat knocks the vase over, and it breaks. See Dyer v. Commissioner, T.C. Memo. 1961-141, 1961 WL 424 (1961).
• We certainly should not complain when the casualty is the result of our deliberate conduct. The arsonist should not be permitted to claim a casualty loss deduction when he burns down his own house, even though his loss was quite literally caused by “fire.” See Blackmun v. Commissioner, 88 T.C. 677, 681 (1987), aff’d, 867 F.2d 605 (1st Cir. 1988) (violation of public policy).
• We engage in a business where a certain amount of breakage is predictable. Taxpayer operates a fleet of taxicabs, and a few of them are damaged in traffic accidents.
• There are risks that we should be expected to address. When damage occurs over a period of time, perhaps taxpayer should be expected to take measures to address the problem. There are many cases involving damage that termites caused, and the results are not entirely consistent.
What clues does the IRS provide in the following revenue ruling to help determine just what is a deductible casualty loss?
Rev. Rul. 76-134
CASUALTY LOSS DUE TO FLOOD DAMAGE
The questions presented are (1) whether losses from damage to property resulting from abnormally high water levels on bodies of water and (2) amounts expended for the construction of protective works or for moving homes back from their original locations to prevent probable losses from future storms are deductible as casualty losses under § 165 of the Internal Revenue Code of 1954.
Section 165(a) of the Code provides the general rule that there shall be allowed as a deduction any loss sustained during the taxable year and not compensated for by insurance or otherwise. Section 165(c) provides, in part, that in the case of an individual, the deduction is limited to (1) losses incurred in a trade or business, (2) losses incurred in any transaction entered into for profit, though not connected with a trade or business, and (3) losses of property not connected with a trade or business, if such losses arise from fire, storm, shipwreck, or other casualty, or from theft. In respect of property not connected with a trade or business, a loss shall be allowed only to the extent that the amount of loss to such individual arising from each casualty, or from each theft, exceeds $100.
Section 263 of the Code provides that no deduction shall be allowed for any amount paid out for new buildings or for permanent improvements or betterments made to increase the value of any property or estate.
Court decisions and revenue rulings have established standards for the application of the above provisions, and have developed the overall concept that the term ‘casualty’ as used in such provisions refers to an identifiable event of a sudden, unexpected, or unusual nature and that damage or loss resulting from progressive deterioration of property through a steadily operating cause would not be a casualty loss. [citations omitted].
Accordingly, losses due to physical damage to property, such as buildings, docks, seawalls, etc., as a result of wave action and wind during a storm are deductible as casualty losses under § 165 of the Code. Similarly, losses due to flooding of buildings and basements as a result of a storm and the complete destruction of buildings, occurring as a result of storm damage, are deductible casualty losses.
However, there are situations in which damage or expenditures may be incurred due to high water on bodies of water that may not be casualty losses under § 165 of the Code such as damage or loss of value due to gradual erosion or inundation occurring at still water levels. The term ‘still water levels’ as used herein means normal seasonal variations in the water level of a body of water.
These variations are not such sudden and identifiable events that the gradual erosion resulting therefrom may be attributed to a specific period of time. The rise and fall of the water levels of a body of water is a normal process, and damage resulting from normal high water levels alone lacks the characteristics of a casualty loss under § 165. Thus, where the taxpayer’s loss was due to progressive deterioration rather than some sudden, unexpected, or unusual cause, such loss is not a deductible casualty loss for Federal income tax purposes.
Another situation involves expenditures by taxpayers for the construction of protective works or for moving their homes back from their original locations to prevent probable losses from future storms. In such cases, no casualty loss deduction is allowable under § 165 of the Code because § 165(c) expressly limits a casualty loss deduction to losses of property. Such expenditures are within the purview of § 263, which provides that no deduction shall be allowed for any amount paid out for new buildings or for permanent improvements or betterments made to increase the value of the property.
Where a casualty loss is allowed for the loss of property, the amount of loss deductible is measured by the excess of the value of the property just before the casualty over its value immediately after the casualty (but not more than the cost or other adjusted basis of the property), reduced by any insurance or compensation received. In the case of property not used in a trade or business, such amount is further reduced by $100 for each casualty.
Notes and Questions:
1. For which of the following do you think there should be an allowable deduction for a casualty loss?
• moth damage to a fur coat?
• damage caused by a quarry blast?
• freezing and bursting of water pipes?
• damage from disease and insect attack to a tree?
• damage to automobile engine caused by freezing conditions?
• damage to automobile caused by taxpayer’s negligent driving?
• damage to automobile caused by rusting and corrosion?
See generally Standard Federal Income Tax Reporter (2011), ¶ 10,005.023.
2. Upon what narrow ground does Revenue Ruling 76-134 deny a casualty loss deduction? What tax treatment does the Revenue Ruling specify for such expenditures?
3. Calculation of the personal casualty loss deduction.
• Section 165(h) limits the losses that an individual may deduct as casualty losses.
• Reg. § 1.165-7(b)(1) limits all casualty losses – whether trade or business, transactions entered into for profit, or personal – to the lesser of the property’s fmv before the casualty reduced by the fmv of the property after the casualty OR the property’s adjusted basis.
• If the property is used in a trade or business or held for the production of income AND it is totally destroyed by the casualty, the allowable loss is limited to the adjusted basis of the property.
• What is the theoretical underpinning of these limitations?
• Section 165(h)(1) limits the deductibility of the personal loss for each casualty to the amount by which the loss exceeds $100.
• Section 165(h)(4)(A) defines “personal casualty gain” to be “recognized gain from any involuntary conversion of property” resulting from a casualty. Section 165(h)(4)(B) defines “personal casualty loss” to be a casualty loss after reduction by $100.
• Section 165(h)(2) limits the deductibility of all personal casualty losses to the amount by which they exceed personal casualty gains and by which this net amount exceeds 10% of a taxpayer’s adjusted gross income. Taxpayer may reduce his/her adjusted gross income by the net personal casualty loss in making this 10% determination. § 165(h)(5)(A).
• In the event personal casualty gains exceed personal casualty losses, taxpayer must treat all such gains and all such losses as if they resulted from the sales or exchanges of capital assets. § 165(h)(2)(B).
4. A taxpayer suffering a casualty loss in a federally declared disaster area may elect to claim the casualty loss deduction for the taxable year immediately preceding the taxable year in which the disaster occurred. § 165(i)(1). The casualty loss is then treated as having occurred in the year in which the deduction is claimed. § 165(i)(2). This provision may help get funds into the hands of the victims of federally declared disasters quickly.
III. Creating a More Efficient and Productive Economy
There are some deductions that the Code permits that promote a more efficient or productive economy. Under this heading, we might include dependent care expenses incurred so that taxpayer can work. We have already examined such expenditures. We should also include provisions that give taxpayers credits against tax liability for investing in making themselves more productive, i.e., in education, and for working. Also under this heading are the expenses of moving to a better – and presumably more valuable – job.
A. Moving Expenses
Read §§ 82, 217, 62(a)(15), 132(a)(6), and 132(g). These provisions interlock to assure that a taxpayer does not pay income tax on certain moving expenses, as § 217 defines and limits them.
• Section 82 provides that a taxpayer who receives, directly or indirectly, payment for or reimbursement of moving expenses must include such payment in his/her gross income.
• Section 217 permits taxpayer to deduct certain expenses of moving. § 217(b). This deduction is above-the-line, i.e., it reduces taxpayer’s agi. § 62(a)(15).
• Thus taxpayer must include in his/her gross income an employer’s payment of taxpayer’s moving expenses, but paying or incurring moving expenses named in § 217(b) entitles taxpayer to a deduction. These amounts could offset.
• Of course, if an employer pays for expenses that are not included in the statutory definition of “moving expenses,” the net result is that those amounts will be included in taxpayer’s gross income as compensation income.
• If an employer does not pay for all of the expenses that are included in the statutory definition of “moving expenses,” the net result is that taxpayer may deduct these unreimbursed amounts, and these deductions will reduce his/her adjusted gross income.
• Sections 132(a)(6) and 132(g) exclude an employer’s direct or indirect payment of an individual’s moving expenses, to the extent those expenses are within § 217(b), from the individual’s gross income.
Section 217(c) establishes the rules for deductibility/excludability of moving expenses.
• Taxpayer’s new “principal place of work” must be “at least 50 miles farther from his former residence than was his former principal place of work,” § 217(c)(1)(A), OR if taxpayer had no former principal place of work, then his/her new “principal place of work” must be at least 50 miles from his/her former residence, § 217(c)(1)(B).
• Taxpayer need not have a job in the place that s/he leaves. Moving expenses are deductible if incurred to travel to a new job or to become self-employed full-time.
• The regulations also create a “reasonable proximity” requirement concerning the new residence with respect to both time and distance. Reg. § 1.217-2(a)(3)(i).
• Moving expenses incurred within one year of the date of commencing work at the new location are presumed to be reasonably proximate. Reg. § 1.217-2(a)(3)(i).
• Generally, a taxpayer’s commute at the new location may not be longer than his/her commute at the old location. Reg. § 1.217-2(a)(3)(i).
• Taxpayer must be a full-time employee for at least 39 weeks during the 12-month period immediately following his/her arrival in the general location of his/her principal place or work, § 217(c)(2)(A), OR during the 24 month period immediately following his/her arrival, must be a full-time employee or self-employed on a full-time basis during at least 78 weeks, not less than 39 of which are during the 12-month period immediately following arrival in the general location of his/her principal place of work, § 217(c)(2)(B).
• If a taxpayer has not fulfilled the employment requirements at the time of filing the return for the taxable year during which s/he paid or incurred moving expenses but may yet satisfy them, then taxpayer may elect to deduct them. § 217(d)(2).
• However, if taxpayer makes such an election and later fails to fulfill the employment requirements, taxpayer must recapture the amount previously deducted as gross income. § 217(d)(3).
Section 217(b) names the moving expenses that taxpayer may deduct/exclude. These include the expenses “of moving household goods and personal effects from the former residence to the new residence[.]” § 217(b)(1)(A). “Moving expenses” also include travel expenses, including lodging, but not meal expenses. § 217(b)(1)(B). Taxpayer may deduct as “moving expenses” the moving expenses of any member of the taxpayer’s household who has both the “former residence and the new residence as his principal place of abode[.]” § 217(b)(2).
Do the CALI Lesson, Basic Federal Income Taxation: Deductions: Moving Expenses
B. Credits Against Tax
The Code provides that certain expenditures count as credits against the taxpayer’s tax liability. Some of these credits promote a more efficient or productive economy, i.e., the credit for dependent care services necessary for gainful employment (§ 21) and the Hope and Lifetime Learning Credits for some educational expenses (§ 25A). They are subject to income phasedowns (§ 21) or phaseouts (§ 25A). This implies that taxpayers with higher incomes do not need strong incentives or do not need incentives at all in order to incur such expenses. These credits are not refundable, meaning that they can reduce taxpayer’s tax liability to $0, but no more.
Section 24 provides a “child tax credit” of $1000 for each qualifying child of the taxpayer who is 16 or younger and a resident or citizen of the United States. The credit is subject to a phaseout as taxpayer’s income increases. A portion of this credit is refundable through tax year 2017.
The earned income credit (§ 32) is available to lower-income taxpayers who work. The tax credit first increases with earned income and then phases out completely. The idea here is to encourage lower-income taxpayers to work and to earn more. This credit is refundable, meaning that taxpayer is entitled to a refund if the credit is for more than taxpayer’s tax liability. Section 36B provides a refundable credit to low income taxpayers who purchase health insurance.
Note about Tax Credits
We should note that Congress can use credits to target tax benefits to certain taxpayers. Congress can target tax benefits by phasing out or phasing down entitlement to them as taxpayer’s adjusted gross income increases. Congress can also target greater benefits to those in certain tax brackets, even if a tax credit is not subject to a phasedown or phaseout. We earlier noted the “upside down” effect of progressive tax rates on deductions. Higher income taxpayers benefit more from a deduction than lower income taxpayers. A credit can reverse this. The amount of a tax credit can be dependent on the amount that taxpayer spends on a certain item, e.g., 20%. That percentage will provide a greater benefit to those taxpayers whose marginal tax bracket is lower than 20% than a deduction would. The converse is true for those taxpayers whose marginal tax bracket is above 20%; those whose tax brackets are more than 20% would have benefit more from a deduction.
Consider this example: Taxpayer has $100,000 of taxable income on which s/he pays $20,000 of income tax. Congress wishes to “reward” Taxpayer for having spent the last $1000 that Taxpayer earned on a particular item. The net after-tax cost to the Taxpayer for having spent the money in this way would be the following for taxpayers in each of the current tax brackets with either a deduction or a credit.
|Taxpayer’s Tax Bracket||Net Cost of Benefit with a Deduction||Net Cost of Benefit with a 20% Tax Credit|
You can see from the table that taxpayers in the 10% and 15% brackets should prefer a credit. Taxpayers in the brackets above 20% should prefer a deduction or exclusion. By setting the credit amount between the marginal tax rates, Congress can favor those taxpayers whose tax brackets are lower than the credit amount, and disfavor those taxpayers whose tax brackets are higher than the credit amount.
Do you think that Congress should make more use of tax credits? Less use? Why?
Limitations on Deductions: Floors, Phaseouts, and Phaseouts
Section 67 limits so-called “miscellaneous deductions” to the amount by which they exceed 2% of taxpayer’s AGI. In addition, Congress recently reinstated a phasedown of high income taxpayers’ itemized deductions and a phaseout of high income taxpayers’ deduction for personal exemptions. Section 68 reduces the itemized deductions171 of taxpayers whose AGI is above a threshold amount by 3% of the excess, but no more than 80% of taxpayer’s itemized deductions. The threshold amount is $300,000 for a joint return or surviving spouse, ½ that amount for a married individual filing separately, $275,000 for a head of household, and $250,000 for all others. § 68(b))(1). These amounts are subject to adjustments for inflation after 2013. § 68(b)(2). Section 151(d)(3) phases down a taxpayer’s deduction for personal exemptions by a certain percentage, that percentage increasing in 2% increments for every $2500 by which taxpayer’s AGI exceeds the threshold of § 68, but no more than 100% of taxpayer’s deductions for personal exemptions.
Wrap-Up Questions for Chapter 7
1. Describe how § 170(e)(1)(A), which permits a deduction of the fmv of gifts of property to charity rather than the adjusted basis of the property creates a “true” loophole.
2. Why should state and local property taxes and/or state and local income or sales taxes be deductible? What policies do such deductions pursue?
3. Congress recently increased the floor for medical deductions from 7.5% of agi to 10% of agi. The floor used to be 3%. The general trend of this floor has been upward. How are these movements in the floor likely to affect who may take the medical expense deduction and how big a deduction they may take?
4. When a taxpayer is entitled to deduct moving expenses, why should a taxpayer be permitted to deduct the expense associated with a move of kenneling a dog but not the cost of a meal while en route to taxpayer’s new home?
5. Should Congress implement its tax policy with greater use of credits against tax liability rather than deductions or exclusions from gross income? Why? What about phasedowns or phaseouts?