Personal Deductions and the Standard Deduction

To say that an expenditure is personal is to say that taxpayer may not shift the tax burden on the income necessary to make the expenditure to other taxpayers. The choice of where to live is a personal matter, so taxpayer must pay income tax on the income necessary to pay the commuting expenses associated with that choice. Flowers. The choice to be married is a personal matter, so taxpayer must pay income tax on the income necessary to pay the travel expenses that marriage necessitates. Hantzis. The choice to have children is a personal matter, so taxpayer must pay income tax on the income necessary to pay the expenses that having children necessitates. Smith. In theory the Code might allow deductions for no personal expenditures.

However, the Code has always permitted deductions from some personal expenditures. The Code allows a taxpayer to reduce her taxable income by a standard deduction, i.e., deduction of a fixed amount that differs among individuals only according to their filing status, and whether they have reached a certain age or are blind. § 63(b)(1), (c), (f). If a taxpayer spends more on selected personal items than the standard deduction, taxpayer may elect to itemize them rather than claim the standard deduction. § 63(e)(1).

A slightly different consideration is that taxpayers have no choice but to spend some of their income for themselves and their families to survive. The Code has allowed a deduction of a fixed amount for each dependent that the taxpayer supports (i.e., exemptions). §§ 151, 152. For tax years 2018 through 2025, the Code allows no deduction for personal exemptions. § 151(d)(5). For those years, Congress doubled the standard deduction and doubled the child tax credit.

The Code provides other tools to reduce the tax burden on income necessary to make certain expenditures. Some of these favored expenditures are personal in nature. The Code implements policies favoring certain expenditures through –

• Exclusions from gross income: We considered the subject of exclusions from gross income in chapter 3, supra. We observed that Congress has pursued certain policies concerning certain “accessions to wealth” by allowing taxpayers simply not to count them in determining the amount of income tax they must pay.

• To the taxpayer, an exclusion from gross income saves in income taxes – and so is worth – the taxpayer’s marginal tax rate multiplied by the amount excluded from gross income.

• Deductions that reduce adjusted gross income: In §§ 161 to 199A Congress has defined deductions available both to individual taxpayers and to corporate taxpayers. In §§ 211 to 224 Congress has defined deductions available only to individual taxpayers. In §§ 241 to 250, Congress has defined deductions available only to corporate taxpayers. In § 62, Congress named certain of these deductions that reduce an individual taxpayer’s “adjusted gross income.” For the individual taxpayer, inclusion of a deduction in § 62 has the practical effect of reducing taxpayer’s taxable income. Section 62’s deductions are in addition to the standard deduction or itemized deductions. Moreover, the amount of some itemized deductions is determined by taxpayer’s adjusted gross income.

• To the taxpayer, a deduction named in § 62 saves in income taxes – and so is worth – the taxpayer’s marginal tax rate multiplied by the amount of the deduction.

• Standard deduction OR itemized deductions that reduce taxable income: In computing her taxable income, a taxpayer may deduct a standard deduction. Alternatively, a taxpayer may elect to itemize her deductions that § 62 does not name and reduce her taxable income by the total of those deductions. § 63. Naturally a taxpayer will elect to deduct the amount that is greater.

• To the taxpayer, a below-the-line deduction saves in income taxes – and so is worth – the taxpayer’s marginal tax rate multiplied by the amount of the standard deduction or an itemized deduction.

• Credits against tax liability: After computing her income tax liability, taxpayer may be entitled to one or more credits against that tax liability. The amount of a credit reduces dollar-for-dollar taxpayer’s income tax liability. The amount of a credit is usually limited to a percentage of what taxpayer spent on the creditable item.

• To the taxpayer, a credit saves in income taxes – and so is worth – the amount of the credit. Notice: A tax credit is worth precisely the same amount as a § 62 deduction while placing the taxpayer in a tax bracket equal to the percentage of the expenditure allowed as a credit.

• Example, a 20% credit on dependent care expenses has the same worth to a taxpayer in an imaginary 20% tax bracket as a § 62 deduction of such an expense.

• Since the amount of the credit is usually limited to a percentage of the named expense, taxpayers whose tax rate is higher than that percentage would reduce their income tax liability more with an above-the-line deduction. Taxpayers whose tax rate is lower than that percentage reduce their income tax liability more with a credit than with an above-the-line deduction.

• Moreover, some credits are “refundable” and some are “nonrefundable.” A nonrefundable credit can reduce a taxpayer’s income tax liability only to $0. A refundable credit can reduce a taxpayer’s income tax liability to less than $0. Thus, a refundable credit functions as a government benefit program. An example of refundable credit is the earned income credit, § 32.

Taxpayers who structure their affairs with an eye on the Tax Code will be driven to seek accessions to wealth that are excludable – perhaps an employee benefit, that are listed in § 62 and so deductible without the need to itemize, or that are creditable against income tax. Congress will also learn that when it wants to lessen a burden of taxpayers who make a named expenditure, it matters more than previously that the tool it uses is not an itemized deduction.

With this as background, consider why there should be an allowable deduction of, exclusion of, or credit for any personal expenses. We might preliminarily observe that there are four basic purposes:

1. We want to encourage taxpayers to incur a certain personal expense. We choose to make a “tax expenditure.” In this group, we should place charitable contributions, home mortgage interest, and adoption expenses.

2. We want to provide some relief to those taxpayers whose personal expenditures result – at best – from the exercise of choice among unappealing alternatives. When discretion among consumption choices is absent, we have seen that 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 her gross income. Examples include casualty losses and medical expenses.

3. We want to enlarge the tax base. Some taxpayer expenses are not necessarily trade or business expenses, but they enhance a taxpayer’s ability to generate taxable income. If they do that, they would also enlarge the tax base. We should encourage taxpayers to make such expenditures. In this group, we place the Code’s provisions for child care and education.

4. We want taxpayers to save to meet a future expense that they know they will have to pay. The Code encourages such saving by various means, e.g., deferring the income tax on the income taxpayer sets aside to spend later on selected items of consumption, not taxing the growth of a fund established to meet future consumption of selected items, shifting (and presumably lightening) the tax burden from the growth of a fund that taxpayer established to another taxpayer. In this group, we should place the Code’s provisions for setting money aside for retirement, medical expenses, or educational expenses.

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. These rules may encourage some taxpayers to engage in activities subject to a deductible tax, most notably, owning property.

• As noted, in the Tax Cuts and Jobs Act Congress doubled the standard deduction. At the same time, it suspended the deduction for foreign real property taxes and capped a taxpayer’s total deductions for state and local taxes paid (i.e., “SALT”) until 2026 at $10,000. § 164(b)(6).

• Congress also increased the allowable deduction for cash contributions to charity from 50% of a taxpayer’s contribution base to 60%. § 170(b)(G).

• Can you identify policies that Congress has opted to pursue in these changes?

The definitions (read: conditions) of the items for which an expenditure is deductible structure the policy that Congress pursues. Of course, it is the IRS that enforces that policy, at least in the first instance.

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 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

Section 170(a)(1) permits taxpayers to deduct charitable contributions that they make within a taxable year. Section 170(c) defines a “charitable contribution” to be a gift “to or for the use of” certain types of organizations.

Such organizations include any political subdivision of a state, so long as the “contribution is made for exclusively public purposes.” § 170(c)(1). 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, a church, and 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 donation of the land be sufficient to permit taxpayer a deduction, irrespective of her motive in making the donation?

• 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 (9^th 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?

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 § 170, instructing taxpayers how to prove a deduction to the IRS and how to value donated property using its fair market value. Under § 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. …

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 compared the value of the land with the house on it with the value of the land without the house.] He subtracted the latter from the former to estimate $76,000 as the value of the house alone.

… 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 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 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?

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. 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 … 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.

4. A gift “to” an organization and a gift “for the use of” an organization are not the same thing. 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.

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)(H).

• A taxpayer may deduct in a taxable year only a certain percentage of her “contribution base,” the percentage limit dependent on the type of property that taxpayer contributes, the type of charity to which the contribution is made, and whether the contribution is “to” or “for the use of” the organization.

6. Type of property: A charitable contribution may take one of several forms. It may of course take the form of cash. It may also take the form of “ordinary income” property. And:

• 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).

• 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 without a certification that it made a substantial use related to its charitable purpose, 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 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.

7. Type of charity: Section 170(c) describes five numbered types of charities, and taxpayer may deduct contributions to them. However, § 170(b) classifies these charities further.

• The Code creates so-called “A” charities, § 170(b)(1)(A), and “B” charities, § 170(b)(1)(B).

8. Deductible contributions to or for the use of: A taxpayer’s allowable contributions are subject to the following limitations:

• Taxpayer may carry excess cash contributions to “A” charities to each of the succeeding five tax years in sequence, § 170(b)(1)(G)(ii); otherwise –

• Taxpayer may carry excess contributions to “A” charities to each of the five succeeding years in sequence, § 170(d)(1)(A);

• Taxpayer may deduct up to 30% of her contribution base to “B” charities, or for the use of “A” or “B” charities, § 170(b)(1)(B);

• Taxpayer may carry excess contributions to “B” charities or for the use of “A” or “B” charities to each of the succeeding five tax years in sequence, §§ 170(d)(1)(B), 170(d)(1)(A).

• Taxpayer may also deduct up to 30% of 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 her contribution base to “B” charities or for the use of “A” or “B” charities of “capital gain property, § 170(b)(1)(D)(i);

• Taxpayer may carry excess contributions of “capital gain property” to “B” charities or for the use of “A” or “B” charities to each of the succeeding five tax years in sequence, §§ 170(b)(1)(D)(ii), 170(d)(1)(A).

• Example: Taxpayer donates property worth 40% of her contribution base to an “A” charity. Taxpayer also contributed “capital gain property” with a fmv equal to 30% of her contribution base to “A” charities. This latter contribution is subject to the 50% limit on contributions to “A” charities. Hence, taxpayer must carry ⅔ 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). Taxpayers must work within these rules to manage their charitable contributions efficiently.

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, § 199A deduction for qualified pass-through business income, 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 an 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 she 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 she 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. 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. 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?

Do the CALI Lesson, Basic Federal Income Taxation: Deductions: Charitable Contribution Deductions: Basic Concepts and Computations.

B. Taxes Paid

Section 164 names some taxes that are deductible, irrespective of the circumstances of the taxpayer. These taxes do not have to be connected with a trade or business, or with 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. Hence the taxpayer’s costs of taxes associated with the choices that taxpayer makes are borne at least in part by the federal government.

For tax years 2018 to 2025, there is a $10,000 cap on the deduction of real property taxes, personal property taxes, state and local income taxes, and state and local sales taxes. § 164(b)(6)(B). Moreover, Congress suspended the deduction for foreign real property taxes. § 164(b)(6)(A). These limitations do not apply to taxes otherwise fully deductible when they are “paid or accrued in carrying on a trade or business or an” expense incurred for the production of income. § 164(b)(6) (carryout ¶).

• Such caps and limitations on itemized deductions increase the number of taxpayers who do not itemize their deductions.

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). Hence, 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 her neighborhood, should the property owner be permitted to add the amount of the assessment to her basis in 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 she received reimbursement from the buyer? See § 1001(b)(1); Reg. § 1.1001-1(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); Reg. § 1.1001-1(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.

Do the CALI Lesson, Basic Federal Income Taxation: Interest Deductions.

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 by insurance or otherwise” to the extent such expenses exceed 10% of the taxpayer’s adjusted gross income. For tax year 2018, the floor is 7.5% of adjusted gross income. § 213(f)(2). This includes the expenses of prescription drugs or of insulin. § 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 include 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. § 213(d)(1).

• 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?

The question raised by this appeal is whether the taxpayer Samuel Ochs was entitled under § [213] 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 § [213] …

‘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 § [213] …

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 expenses at issue 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 their continued control 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 (6^th Cir. 1969).

Do the CALI Lesson, Basic Federal Income Taxation: Medical Expense Deductions.

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 her burden with other taxpayers. Consider:

• We drop a plate, and it breaks. It’s called “life,” not a casualty.

• We willingly assume a risk and complain when something untoward happens. We own a cat and an expensive vase and leave them together in room. The cat knocks the vase over, and it breaks. See Dyer v. Commissioner, T.C. Memo. 1961-141, 1961 WL 424 (1961) (not a casualty).

• We deliberately cause a casualty. An arsonist claims a casualty loss deduction when she burns down her own house. After all, her loss was quite literally caused by “fire.” See Blackmun v. Commissioner, 88 T.C. 677, 681 (1987), aff’d, 867 F.2d 605 (1^st 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.

The line between “life” and casualty has not proved to be easy to draw – and one does not have to search the digests very hard to find contradictory results. Moreover, the availability of insurance to protect against financial loss that a casualty causes may lead us to conclude that taxpayers should avail themselves of such protection. The cost of the folly of going uninsured should not be one that other taxpayers should bear when the foreseeable and insurable loss materializes. The involuntary conversion rules of § 1033, see chapter 2, supra, become more important. This is the position that Congress has taken for tax years 2018 to 2025. § 165(b)(5)(A). For those years, the deduction for personal casualty losses is limited to personal casualty losses attributable to a Federally declared disaster. § 165(h)(5)(A).

• 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 personal loss for each casualty to the amount by which the loss exceeds $100.

• Section 165(h)(3)(A) defines “personal casualty gain” to be “recognized gain from any involuntary conversion of property” resulting from a casualty. Section 165(h)(3)(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 her adjusted gross income by the net personal casualty loss in making this 10% determination. § 165(h)(4)(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).

• For tax years 2018 to 2025, the casualty loss deduction is limited to losses attributable to a Federally declared disaster. Casualty losses other than those attributable to a Federally declared disaster do not offset casualty gains attributable to a Federally declared disaster. § 165(h)(5)(B)(i).

• In the case of casualties other than those attributable to a Federally declared disaster, no deduction for loss is allowed. Taxpayer should still net personal casualty losses against personal casualty gains to reduce the capital gain she must recognize from the event. The personal casualty gain attributable to a Federally declared disaster is not used in the computation of personal casualty gain attributable to other casualties. § 165(h)(5)(B)(ii).

• These rules manifest the importance of insurance – both in defining what is a casualty and in compensating for loss from a casualty – and of the deferral rule of § 1033 for involuntary conversions.

• 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. This provision should help get funds into the hands of the victims of Federally declared disasters quickly. § 165(i)(1). The casualty loss is then treated as having occurred in the year for which the deduction is claimed. § 165(i)(2).

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.

• Also under this heading are the expenses of moving to a better – and presumably more valuable – job. Sections §§ 82, 217, 62(a)(15), 132(a)(6), and 132(g) create a set of rules assuring that a taxpayer pays no income tax on the income necessary to move to a new or different job. But: the Tax Cuts and Jobs Act suspended the operation of these provisions for tax years 2018 to 2025. See §§ 132(g)(2) and 217(k).

Sections 221 and 62(a)(17) provide a deduction for interest paid on student loans. Because the § 221 deduction is named in § 62(a)(17), taxpayer benefits from this deduction even when she claims the standard deduction. The maximum interest deduction is $2500, and the availability of the deduction phases out as taxpayers’ AGI rises. The phaseout range is indexed for inflation and is $140,000 to $170,000 for tax year 2019 for taxpayers married filing jointly (half those amounts for unmarried taxpayers). § 221(b)(2)(B) (Rev. Proc. 2018-57, § 3.30).

• What do you think the profile of the student is for whom this deduction would have the greatest impact?

The Code also provides credits that reduce the tax liability of a taxpayer, for pursuing education – which should enhance the tax base. This implies that taxpayers with higher incomes do not need strong incentives (or perhaps any incentives) to incur such expenses.

• Section 25A provides two credits for investment in a taxpayer’s, her spouse’s, or her dependent’s education.

• The American Opportunity Credit provides a credit of up to $2500 for an education expenditure of $4000. For taxpayers married filing jointly, the credit is phased out at AGI levels between $160,000 and $180,000 (between $80,000 and $90,000 for other taxpayers). Taxpayer may claim the credit for each of the first four years of post-secondary education. § 25A(i). Forty percent of the credit is refundable. § 25A(i)(5).

• The Lifetime Learning Credit alternatively, § 25A(c)(2)(A) (only American Opportunity Credit or Lifetime Learning Credit available on one individual), provides a credit of up to 20% of $10,000 of educational expenses. There is no limit to the number of times a Lifetime Learning Credit can be claimed for an individual. The Lifetime Learning Credit is subject to an income phaseout. For tax year 2019 for taxpayers married filing jointly, the credit is phased out at AGI levels between $116,000 and $136,000 ($58,000 and $68,000 for other taxpayers). § 25A(d)(2) (Rev. Proc. 2018-57, § 3.06 (indexed figures)).

• What do you think the profile of the student is for whom these credits would have the greatest impact?

An “income tax” is a tax on income. A “consumption tax” is a tax on consumption. We have largely regarded the Code as creating an income tax. The Code actually creates a hybrid whereby income that a taxpayer holds in order to spend later on certain items of consumption is not subject to tax – if at all – until taxpayer actually spends it on those forms of consumption. Taxpayers know that they may one day retire and no longer have the income that their employment provided. They know that they may one day need money to pay for health care services. They know that they may one day need money to pay for the education of their children. The Code implicitly encourages taxpayers to set money aside to meet a personal expense they know they will incur later. The Code accomplishes this through various funding and income tax rules

Financial institutions are usually very interested in you being interested in at least some of these accounts. Question: Is it better to deduct a current deposit to one of these accounts and pay income tax later or to deposit after-tax income in the account and never pay income tax on the investment income? This is one point of distinction between these patterns, and it is the question you must answer when deciding between a traditional IRA or a Roth IRA, assuming you may contribute to either without being subject to an income phaseout. Now for some smoke and mirrors.

Imagine: Taxpayer has $5000 to deposit in an IRA or to deposit in a Roth IRA after paying income tax on it. Taxpayer is a 20% bracket taxpayer. Over the course of 30 years, savings will grow by a multiple of six (implying an interest rate between 6% and 7%, see Table 1 in the notes following Bruun).

• Traditional IRA: Taxpayer deposits $5000 in an IRA without paying income tax on it. In 30 years, taxpayer will have $30,000 in her account. Upon withdrawal, taxpayer must pay a 20% income tax, i.e., $6000. This will leave taxpayer $24,000.

• Roth IRA: Taxpayer must pay income tax of $1000 (i.e., 20% of $5000) on $5000 and deposit the balance of $4000 in her account. In thirty years, taxpayer will have $24,000 in her account – the same amount she would have in her account if she had deposited the money in a traditional IRA.

Does this mean there is no difference between a traditional IRA and a Roth IRA? Hardly.

• While § 408A(c)(2) seemingly establishes the same cumulative limit for contributions to a Roth IRA as to a traditional IRA, one difference lies in the fact that deposits in a Roth IRA have already been taxed whereas contributions to a traditional IRA have not. AND: $5000 of pre-tax money is not equal in value to $5000 of after-tax money. In fact, the contribution limit for a Roth IRA is higher.

Does this mean that we should always prefer a Roth IRA to a traditional IRA? Hardly.

• The income that is spent on consumption in retirement is subject to tax at some point. We assumed that the rate of tax was the same, whether paid prior to deposit of money or upon withdrawal.

• How likely is that to be true?

• Congress periodically changes tax brackets and it most certainly will change tax brackets sometime in the next thirty years.

• Furthermore, even without such bracket tinkering, it is unlikely that the income tax bracket of a taxpayer would be the same on dates that are thirty years apart. In retirement, most taxpayers have less income than they did in their working years and so are in a lower bracket. The Roth IRA (likely) requires payment of income tax when the taxpayer “is at the top of her game,” i.e., when her tax bracket is the highest it will ever be. The pattern is reversed for a traditional IRA, i.e., deductible when the deduction is worth more than it will ever be.

• Determining the relative merits of a traditional IRA and a Roth IRA requires that we examine the assumptions that we made in this exercise very carefully.

Final Note: Limitations on Deductions: Floors, Phaseouts, and Phasedowns

We know that deduction floors and income phaseouts or phasedowns can reduce the availability of various income-tax-reducing measures to some taxpayers. The effect of these limitations on deductions is to raise the tax bracket of affected taxpayers by an undetermined amount and makes comparison of effective tax rates between two or more taxpayers extremely difficult.

Section § 68 provides an overall phasedown on itemized deductions. This phasedown has been suspended for tax years 2018 to 2025. § 68(f).

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? Why should there be a $10,000 limit to the deductibility of the sum of these deductions?

3. Congress recently increased the floor for medical deductions from 7.5% of AGI to 10% of agi. The floor was once 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. What is the effect of deferring income tax on the income necessary to purchase a benefit, e.g., a comfortable retirement?

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?

Can you explain or define –

• Whose benefit, donor’s or donee’s, is relevant in weighing the costs of a charitable contribution against its benefits?

• What is an individual’s contribution base? Why is it relevant?

• Whether a taxpayer may deduct both state and local income taxes, and state and local sales taxes?

• Who, in this time of the Affordable Care Act, is most likely to benefit from the medical expense deduction?

• How the Code measures a personal casualty loss and the extent to which taxpayer may have to recognize casualty gain until tax year 2026?

• How credits for education expenses promote a more productive economy?

• How tax credits ameliorate the upside-down effect of deductions and exclusions?