Federal Income Taxation --- Fall, 1995

Prof. Chirelstein
Summary of possible exam answers:

Question I:
The outcomes may depend on whether the deal is characterized as a two-party transaction
involving only Walgreen and Phar-Mor or a three-party transaction involving a payment of
$250,000 by Phar-Mor to Sara Creek and then a subsequent payment by Sara Creek to Walgreen.

If characterized as a two-party transaction:

Phar-Mor has made a capital expenditure of $250,000, which it should amortize over the 6 years
remaining on the Walgreen lease.

Sara Creek is apparently unaffected for tax purposes.

Walgreen might get capital gain treatment on the theory that it has sold a "property encumbrance
(protected by the injunction) to a third party. The Ferrer case would be helpful authority from the
taxpayer's standpoint. On the other hand, Walgreen could be viewed as having received a lump-
sum payment representing the value of 6 years' future business income and, as a result, get
ordinary treatment. Sort of a carved-out interest issue, and debatable.

If characterized as a three-party transaction:

Phar-Mor has again made a capital expenditure, but that outlay would be regarded as prepaid rent
(to Sara Creek) and would be amortizable over the term of Phar-Mor's own Mall lease, a period
which could be either shorter or longer (more likely longer) than the 6 years remaining on the
Walgreen lease.
Sara Creek is in an especially chancy legal position: it has $250,000 of prepaid rental income, all
taxable in the year "received" (from Phar-Mor), but then would be seen as having made a capital
expenditure, amortizable over the 6-year term, when it "paid" the same amount to Walgreen to
eliminate the lease restriction.

Walgreen would be regarded as having agreed to a lease modification rather than as having sold a
property right to a third party. In that event, section 1241 governs the outcome. while section
1241 specifically allows capital gain for the "cancellation" of a lease (despite the absence of a "sale
or exchange"), it might be inferred that Congress did not view "modification" of a lease in an
equally favorable light. Do Regs. sec.1.1241 give any guidance?

Two-party or three-party? Three-party, it would seem, despite the rather stern results. The
injunction, after all, runs against Sara Creek; both technically and in fact, it is Sara Creek's rights
that are enlarged when Walgreen agrees to the release. True, the deal in Ferrer was treated as a
two-party rather than a three-party transaction, but the question (two or three?) was never raised by
the IRS and the Court didn't have to face it.
[Strictly irrelevant: Sec's 102, 104, 108, 2703.. .1

Question II:

The personal expense/business expense distinction is a burden to the system, a heavy one. But that
doesn't mean that case-by-case analysis can be avoided - -indeed, that's exactly whv it's a burden.
It's not enough to say simply that a given outlay is normally personal or normally business.
Rather, the question, often difficult and time-consuming, is how to classify the outlay from the
standpoint of the particular taxpayer and his (inevitably) special circumstances. "Life in all its
fulness. . etc."

Jones spends $1,500 on a nutritionist and a physical training program. Deduct? Maybe, maybe not.
Diet and fitness programs are so widely used and so fashionable at present that the IRS would fear
a flood-gates response on the part of all kinds of professions and occupations, as well as sellers of
the services in question. This year, to be sure, Jones did what he did to keep his job. But what
about next year, when Jones continues his costly training program in order to hold his weight
down? And the year after? And why just Jones? why not every fireman (policeman, doctor,
lawyer) who joins a gym (or buys home equipment) for the same purpose? Not wanting to invite
such a widescale reaction, the Tax Court might find that the personal and professional elements
were an "inseparable aggregate" and deny deduction.
But isn't the foregoing a bit too general, given the ultimatum and deadline that Jones faces? The
FD expects and requires Jones to lose weight if he wants to keep his job, because the job itself
calls for physical stamina and agility (and little else). Surely a professional athlete can deduct his
training and fitness expenses; no doubt all do. Jones doesn't have to hit a baseball or block a
linebacker, but he does have to run up a ladder, duck falling timbers and carry unconscious bodies
through the smoke. Takes muscle, you know? At least let him deduct this year's outlay, which
represents a direct and reasonable response to the new FD regulation; as to future years and other
taxpayers, we'll worry about those cases as and when they arise.

Smith spends $1,500 on a lawsuit challenging the Dept regulations as arbitrary. Deduct? Probably.
Details aren't given, but the chances are that firemen have civil service rights and can't be
discharged without "cause". whether overweight is "cause" is litigable, no doubt. Expenses
incurred by an employee to enforce or defend his employment status (contractual or statutory) are
surely deductible as business expenses. There's no "personal" benefit in a lawsuit, no flood-gates
danger, and the "ordinary and necessary" requirement is easily met since the taxpayer's continued
employment is at stake.

Maybe the IRS could argue that the status of the $1,500 outlay cannot be determined until Smith's
appeal is decided. If he loses, all his legal expenses are then deductible; but if he wins, such
expenditures should be capitalized and amortized over the term of his employment (or something).
Not too compelling, though debatable.
Brown spends $1,500 taking a course that qualifies him to be an office-clerk instead of a fireman.
Deduct? Possibly. Regs. sec.1.162-5, indispensable on this question, roughly distinguish between
qualifying for a "new employment" (non-deductible) and retaining an "established employment"
(deductible), so Brown's status as a continuing employee of the FD at least gives him a start.

Regs. Sec.1.162-5(b) (3) may be critical. That section says: "In the case of an employee, a change
of duties does not constitute a new trade or business if the new duties involve the same general
type of work as is involved in the individual's present employment". So, where are we? "...same
general ..... .?" Climb a ladder and swing an axe v. pound a typewriter and keep the books?
Clerical work certainly involves a separate set of skills, and perhaps for that reason such work
should be regarded as a "new employment" and the deduction be denied.

But isn't that analysis rather narrow and unrealistic? All this effort (on Brown's part) is taking
place within the Fire Department, as noted. Couldn't Brown argue that firefighter-to-clerk is a
kind of natural career progression as you get older (fatter and weaker)? Surely Brown's
experience as a firefighter contributes to his efficiency as an FD administrator - - he knows
whereof he's administering -- so that one can easily perceive an element of benefit to Brown's
present employer.

Anyway, the above-cited Treasury Regs are chiefly concerned with education costs leading to the
improvement of one's professional status. The aim is to identify expenditures that can be treated
as "personal" - - hence nonrecoverable - - though actually capital in nature. But the cost of
retraining for a downgraded post, especially when designed to avoid sudden loss of employment
or forced retirement, looks quite different: more like a "repair" expense, to put it cornily.

Had the FD reimbursed Brown, would the reimbursement be taxable? Probably not. Of course it
didn't.

Question III:

"why is a sales tax equivalent to 'a tax on wages'?" asks your friend. Easy question.
A taxpayer can derive income from only two sources: wages and investment. If we eliminate the
tax on investment income, only wages remain. So the question becomes: does a sales tax
somehow eliminate investment income from the tax base? Answer: Yes.

Under a sales tax regime, consumption outlays are subject to tax but amounts allocated to
savings and investment are not. Thus, if somebody earns $1000 this year, spends $600 and saves
and invests $400, the $600 spent is taxable but the $400 saved and invested is deductible. On
analysis, it turns out that treating the $400 invested as deductible is the same as treating the
income (the yield) derived from such investment as exempt. Ergo, a sales tax is equivalent to a
tax on wages only. Familiar illustration:

Assume a 40% taxpayer and a 10% interest rate.

Under a yield-exemption system, the $400 saved is taxed in Yr 1 and the taxpayer has $240 left
to invest. He receives $24 of interest in Yr 2. Such interest is exempt, and hence the taxpayer
has $24 after tax. Under a current deduction system, the $400 saved is not taxed in Yr 1. The
taxpayer receives $40 of taxable interest in Yr 2, and similarly is left with $24 after tax.

The result under a yield-exemption system is thus equivalent to the result under a current
deduction system.

In effect, investment income can be removed from the tax base either by exempting such income
or by allowing the original investment to be deducted. Yield exemption = current deduction.
Since a sales tax allows current deduction, sales tax = yield exemption.
Once again, personal services and capital investment are the only income sources. If income
from investment is exempt, "wages" remains the only taxable receipt. It follows that a sales tax
is equivalent to a wage tax just as the learned commentator asserted.

Your friend gives you an odd look and hurries off to keep her appointment.

question IV:

Howard owes the Bank $1,000,000 and is personally liable for the debt. With the Bank's
consent, Howard converts the personal loan into a secured nonrecourse loan, the securing
property being worth $800,000. The personal loan had a 10-year maturity; the nonrecourse loan
matures in 30 years. Any tax consequences to Howard?
Maybe you could make out 3 possible results (of which, I admit, #1 is most likely, though the
others, #2 especially, need to be considered).
#1. No consequences at all. Crane, Parker v. Delaney and especially Tufts stand for the general
proposition that personal and nonrecourse loans are to be treated alike (i.e., as if both were
personal). Since Howard continues to "owe" the Bank $1,000, you could say (citing the cases
just mentioned) that switching from personal debt to nonrecourse debt should be disregarded for
income tax purposes, although the switch obviously has economic significance to the parties. On
this view, as long as the face amount of the debt is unreduced, neither Howard nor the Bank
would be held to have done anything that has a tax effect.

#2. But how about that good old "economic significance"? The Bank previously had a claim on
$1,000 of Howard's personal wealth. Now it has a claim on only $800 (assuming the proposed
deal is done). The face amount of the debt remains $1,000, it's true, but the excess of $200 over
the market value of the securing property has no current financial value whatever. Wouldn't the
Bank have a pretty good argument if it now took a $200 bad debt loss? For the same reason,
shouldn't Howard have to recognize $200 of debt cancellation income at this point? The "new"
30-year mortgage bears little resemblance to the "old" 10-year mortgage. Practically speaking, it
is "as if" Howard borrowed $800 cash by mortgaging the Westchester property nonrecourse, and
then used that borrowing to pay off his outstanding personal debt of $1,000. If he actually did
that, of course, there would be no doubt about taxability.
So: is there any real difference between what Howard proposes to do and what Kirby Lumber did
when it repurchased its outstanding debentures for less than face amount? There's some,
admittedly, since the Bank can claim any further appreciation in the Westchester property up to
$200 if Howard defaults. But will that be a saving factor? The Knetsch case, and even more
clearly the decision in Estate of Franklin, support the proposition that nonrecourse debt lacks
bona fide status if (or to the extent that) its economic significance depends on substantial
subsequent appreciation in the value of the securing property. Here, the property would have to
appreciate a further 25% ($800 to $1,000) before the original debt became fully collectible. For
tax purposes, therefore, maybe the original debt of $1,000 should be deemed to have been scaled
down to equal the value of the substituted collateral -- $800.

#3. The Westchester property cost $300 and is now worth $800. Might there be a "realization"
problem? If we viewed the proposed arrangement as involving an exchange of the Westchester
residence for the release of Howard's personal debt, it would follow that the $500 ($800-$300) of
appreciation would be deemed realized and hence taxable as capital gain. If I owe my tailor $10
and he accepts in satisfaction stock that cost me $3 and has a value of $8, I suppose it could be
argued that I have both $2 of ordinary debt-cancellation income and $5 of realized capital gain.
Or perhaps the "exchange" would not be fragmented in that fashion (see the majority's rejection
of Justice O'Connor's concurring opinion in Tufts); if not, the result would be a $700 capital gain
and no ordinary debt-cancellation income at all.

To be sure, Howard hasn't given up equitable ownership of the Westchester property, and
Woodsam holds that nonrecourse mortgaging is not a realization. So perhaps the idea that the
property has been "exchanged" is rebuttable. Even so, the West. property is the essential element
in a deal that enables Howard to eliminate his personal indebtedness, and in that sense it might
be said to have been converted, or "drawn down", rather than merely used as collateral.

A lot depends on whether Howard's original mortgage debt would be deemed to have survived
the proposed restructuring - - or whether, on the other hand, the new arrangement would be
considered to have taken the place of the old. If the former, then the well-established Crane rule
-- viz., that personal and nonrecourse debt are indistinguishable for tax purposes - - would pretty
clearly point to the no-tax result in #1. Otherwise, if the latter.