Presentation:
Federal Income Taxation
Chapter 1 Overview
Professors Wells
August 28, 2012
Introduction to Federal Taxation
p.1
Federal Income Tax is a law school subject, but it is much more, it is
about the social compact. Other quotes on taxes:
“Taxes are what we pay for civilized society.” Justice Oliver Wendell Holmes, Compania General de
Tabacos de Filipinas v. Collector of Internal Revenue, 275 U.S. 87, 100 (1927) (dissenting).
“Basic tax, as everyone knows, is the only genuinely funny subject in law school.” --Martin D. Ginsburg
“[T]axation, in reality, is life. If you know the position a person takes on taxes, you can tell their whole
philosophy. The tax code, once you get to know it, embodies all the essence of life: greed, politics, power,
goodness, charity.” --Sheldon S. Cohen
“America's tax laws are similar to the writings of Karl Marx and the writings of Sigmund Freud in that
many of the people who loudly proclaim opinions about these documents have never read a word of
them.”--Jeffery L. Yablon
“One of the problems with trying to have a rational discussion about taxes is that so many people want
to believe what's convenient rather than what's accurate. Believing, after all, requires so much less
effort than thinking.” --Allan Sloan
“Tax issues are fun. Getting to love them may take a bit of effort, but the same is true for Beethoven's
string quartets, and think of how much pleasure they give if one does make the effort.”--Peter L. Faber
“People want just taxes more than they want lower taxes.” --Will Rogers
2 Congress “plans” much more tax revenue
p.3
Congress “plans” no discretionary spending growth
AN UPDATE TO THE BUDGET AND ECONOMIC OUTLOOK: FISCAL YEARS 2012 TO 2022
Table 1-1.
CBO’s Baseline Budget Projections
Actual,
2011
2012
2013
2014
117% Increase
2015
2016
2017
2018
2019
2020
2021
Total
2013- 20132022
2017
2022
In Billions of Dollars
Revenues
Individual income taxes
Social insurance taxes
Corporate income taxes
Other
Total
On-budget
Off-budgeta
1,091
1,123
1,425
1,543
1,719
1,886
2,069
2,234
2,387
2,542
2,704
2,870
8,642 21,379
819
851
958
1,020
1,074
1,143
1,217
1,289
1,351
1,412
1,474
1,539
5,411 12,476
181
235
298
363
440
482
491
488
475
473
478
489
2,074
4,477
212
225
232
283
308
307
305
317
338
363
382
398
1,434
3,232
_____ _____ _____ _____ _____ _____ _____ _____ _____ _____ _____ _____ ______ ______
2,303
2,435
2,913
3,208
3,541
3,817
4,083
4,328
4,551
4,790
5,039
1,738
566
1,863
572
2,240
673
2,479
729
2,772
768
2,998
819
3,209
874
3,401
927
3,577
974
3,771
1,019
3,975
1,064
5,295 17,562 41,565
4,187
1,108
13,699
3,863
32,608
8,957
Outlays
Mandatory
Discretionary
Net interest
Total
On-budget
Off-budgeta
Deficit (-) or Surplus
On-budget
Off-budgeta
Debt Held by the Public
2,027
2,053
2,105
2,174
2,311
2,499
2,617
2,738
2,926
3,104
3,296
3,555 11,705 27,324
1,346
1,289
1,231
1,194
1,199
1,220
1,236
1,253
1,286
1,316
1,346
1,384
6,079 12,664
230
220
218
227
244
284
354
416
470
512
541
570
1,327 ______
3,835
_____ _____ _____ _____ _____ _____ _____ _____ _____ _____ _____ _____ ______
3,603
3,563
3,554
3,595
3,754
4,003
4,206
4,407
4,681
4,932
5,183
3,104
499
3,055
507
2,919
635
2,885
710
2,993
761
3,191
812
3,341
865
3,489
919
3,707
974
3,897
1,035
4,083
1,099
4,341
1,168
-1,300 -1,128
-213 -1,549 -2,258
15,328
3,783
34,844
8,979
-641
-387
-213
-186
-123
-79
-130
-142
-144
-1,367
67
-1,192
64
-679
38
-405
19
-220
7
-193
7
-132
9
-88
9
-130
*
-126
-16
-109
-36
-154
-59
-1,629
80
-2,236
-22
10,128
11,318
12,064
12,545
12,861
13,144
13,371
13,536
13,746
13,964
14,181
14,464
n.a.
n.a.
14,953
15,538
15,855
16,386
17,435
55%
Increase
18,571 19,695 20,774
21,760
22,737
23,719
24,730
11.4
11.6
Memorandum:
Gross Domestic Product
5,509 19,111 43,823
87,942 201,663
As a Percentage of Gross Domestic Product
Revenues
Individual income taxes
7.3
7.2
9.0
9.4
9.9
10.2
10.5
10.8
11.0
11.2
9.8
*CBO:
An Update
Budget
Economic
Fiscal6.2
Years6.2
2012 6.2
to 2022
2012)6.2
Social insurance
taxes to the5.5
5.5 and 6.0
6.2 Outlook:
6.2
6.2
6.2(August
6.2 22,6.2
3 10.6
6.2
CBO’s Comparison
(Baseline to Alternative Fiscal Scenario)
AN UPDATE TO THE BUDGET AND ECONOMIC OUTLOOK: FISCAL YEARS 2012 TO 2022
Table 1-6.
Deficits Projected in CBO’s Baseline and Under an Alternative Fiscal Scenario
2012
2013
2014
2015
2016
2017
2018
2019
2020
2021
2022
Total
2013- 20132017
2022
In Billions of Dollars
CBO's August 2012 Baseline
Revenues
Outlays
Deficit
Debt Held by the Public at the
End of the Year
2,435
3,563
______
2,913
3,554
____
3,208
3,595
____
3,541
3,754
____
3,817
4,003
____
4,083
4,206
____
4,328
4,407
____
4,551
4,681
____
4,790
4,932
____
5,039
5,183
____
5,295 17,562 41,565
5,509 ______
19,111 ______
43,823
____
-1,128
-641
-387
-213
-186
-123
-79
-130
-142
-144
-213
-1,549
-2,258
11,318 12,064 12,545 12,861 13,144 13,371 13,536 13,746 13,964 14,181 14,464
n.a.
n.a.
Alternative Fiscal Scenario
Revenues
Outlays
Deficit
Debt Held by the Public at the
End of the Year
2,435 2,583 2,825 3,111 3,361 3,596 3,808 3,996 4,196 4,399 4,608 15,476 36,483
3,563 ______
3,621 _____
3,748 _____
3,921 _____
4,193 _____
4,430 _____
4,678 ______
4,999 ______
5,298 ______
5,599 ______
5,970 ______
19,913 ______
46,457
______
-1,128 -1,037
-924
-810
-832
-833
-870 -1,003 -1,102 -1,200 -1,362
-4,437
-9,975
11,318 12,460 13,478 14,391 15,321 16,258 17,215 18,298 19,477 20,749 22,181
n.a.
n.a.
As a Percentage of Gross Domestic Product
CBO's August 2012 Baseline
Revenues
Outlays
Deficit
15.7
22.9
____
18.4
22.4
____
19.6
21.9
____
20.3
21.5
____
20.6
21.6
____
20.7
21.4
____
20.8
21.2
____
20.9
21.5
____
21.1
21.7
____
21.2
21.8
____
21.4
22.3
____
20.0
21.7
____
20.6
21.7
____
-7.3
-4.0
-2.4
-1.2
-1.0
-0.6
-0.4
-0.6
-0.6
-0.6
-0.9
-1.8
-1.1
4 *CBO: An Update to the Budget and Economic Outlook: Fiscal Years 2012 to 2022 (August 22, 2012)
Sources of Federal Revenue GDP
CBO (June 2010)
Average Tax Rate
All Federal Taxes
Individual Taxes
Payroll Taxes
Corporate Income Taxes
Excise Taxes
Shares of Tax Liabilities
All Federal Taxes
Individual Taxes
Payroll Taxes
Corporate Income Taxes
Excise Taxes
Lowest
Quintile
4.0
- 6.8
8.8
0.4
1.6
0.8
- 3.0
4.8
0.6
1.6
Second
Quintile
10.6
-0.4
9.5
0.5
1.0
4.4
-0.3
10.8
1.4
1.0
Third
Quintile
14.3
3.3
9.4
0.8
0.8
9.2
4.6
16.6
3.3
0.8
p.6
Fourth
Quintile
17.4
6.2
9.5
1.1
0.7
Fifth
Quintile
25.1
14.4
5.7
4.6
0.4
Top
10%
26.7
16.2
4.5
5.7
0.3
Top
1%
29.5
19.0
1.6
8.8
0.1
16.5
12.7
24.7
6.8
0.7
68.9
86.0
42.9
86.8
0.4
55.0
72.7
25.4
80.0
0.3
28.1
39.5
4.1
57.0
0.1
Is the tax burden “fair?”
Is society happier with higher or lower taxes?
See Johnston, “Taxes,
Happiness & Heliocentrism”
“People want just taxes more than they want lower taxes.” -Will
Rogers. Is Will Rogers right?
5 Economic Consequences of Taxes
p.7
6 History of U.S. Taxation
p.8
U.S. Constitution Art.1, Sec. 8, Cl. 1: The Congress shall have Power To lay and collect Taxes, Du>es, Imposts and Excises, to pay the Debts and provide for the common Defence and general Welfare of the United States; but all Du>es, Imposts and Excises shall be uniform throughout the United States; Art. 1, Sec. 9, Cl. 4: No Capita>on, or other direct, Tax shall be laid, unless in Propor>on to the Census or enumera>on herein before directed to be taken. 7 Federal Taxes – History Before the 16th Amendment
p.8
Carriage tax not a “direct tax”
Civil War Period: Income Tax of 1862 with 1864 Amendments
1894 - personal income tax
Unconstitutionally imposed tax Pollock v. Farmers Loan & Trust - p. 9
Held: a tax on unapportioned real property rental income was
unconstitutional
8 Federal Taxes –16th Amendment
p.8
U.S. Constitution -
16th Amendment:
Congress shall have power to lay and collect taxes on
incomes, from whatever source derived, without
apportionment among the several states, and without
regard to any census or enumeration.
9 Top Marginal Tax Rates, 1909-2012
p. 10
10 Distributional Effects: Ability to Pay
p.11
Should the rich pay more proportionately?
Utility
Lost Utility
Taxes
Lost Utility
Taxes
Income
11 WHAT IS INCOME?
p.14
How is the concept of “income” defined?
Consider the Haig-Simons definition: Y = C + ΔW
“Accession to wealth” consisting of
1) Consumption (during the measurement period), plus
2)  Change in net worth (during the measurement period).
12 Tax Expenditure Budget
p.16
What is a “tax expenditure”?
- deviations from the norm for the measurement of economic
income (both positive and negative amounts)
What is the “tax expenditure budget”?
What is the starting point for measuring the deviation from true
income?
Appropriations without the budget process?
Use “dynamic scoring”?
13 Tax Expenditures, cont.
Tax Subsidies vs. “Tax-Induced Structural Distortions”
Tax subsidies:
-  Tax transfers (e.g., refundable credits, energy credits, first
time homebuyer credits)
-  Social spending, e.g., charitable deduction
What are “upside-down” subsidies?
14 Tax Expenditures, cont.
•  Prof. Shaviro (NYU) has
commented that some
“special tax breaks […]
don’t merely create
perverse incentives but
seriously aggravate major
economic
problems” (writing in the
context of the $500,000
exemption for home
appreciation).
(M. Sullivan, Tax Notes,
29 September 2008)
15 Tax Incidence Theory
p.18
Tax Incidence: Describes the person that bears the ultimate burden
of a tax.
Hypothetical: Are retail sales taxes borne economically by the
customer or by the retailer? Depends on whether prices can be
increased.
Hypothetical: Exemption for state and local interest. Municipal
bond rates are lower to reflect in part the tax preference given to
the investor. So, the investor tax savings is “shared” with states
and municipalities via lower interest rates.
Assumption: Income taxes (particularly on wages, salaries, and
service income is typically not shifted but stays with the individual.
16 Inflation
p.19
Example: Purchase property of $100. Inflation is 5% and property
is sold for $105.
Issue: Economically, the taxpayer is no wealthier with $105 since the
price of all goods and services is now $5 more expensive, but the
taxpayer has a gain of $5.
How does the tax code handle this issue? Imperfectly. Lower tax
rates on investment income as “rough justice?” Index certain
deductions for cost-of-living adjustments?
17 Average versus Marginal Rates
p.20
1.  Types of Income Taxes.
A.  Progressive Income Tax: Tax rates increase as income
increases.
B.  Regressive Income Tax: Tax rates decrease as income
increases.
C.  Proportional Income Tax: Tax rates remain constant.
2.  Marginal tax rates. The incremental rate on incremental
income. Marginal rates are what influence tax planning and
investment decisions.
18 Considering the Marriage Bonus/Penalty
p.22
Effect of joint return income tax status – twice the tax on
1/2 of combined income.
Objective: To enable equality with community property
jurisdictions – where an automatic split of the income occurs
under state law.
19 Marriage Penalty/Bonus: Code §1 (2012 Rates)
Bonus (only one earner): Single taxpayer & married
taxpayer have taxable income of $388,350 – 112,683 tax
(single) vs. 105,062 (married); $7,621 benefit for marrieds.
Penalty (two equal earners): Two single taxpayers & each
married taxpayer has income of $194,175 – single taxpayers
have 48,606 tax each (total – $97,212); married taxpayers
have $105,062 of tax; $7,850 penalty for marrieds.
20 Reasons to Treat Married Couples Differently
Costs of children (limited to marriage?).
But, imputed income of the “non-working” spouse; provide
deduction for the second wage-earner?
Costs of working for both spouses (rather than collecting
investment income).
Should the “ability to pay” tax liabilities be based on the
wealth accession for the “family unit”?
Should parents be required to include income of minor
children? §73 provides for separate taxpayer treatment of
the child.
21 Self-Assessment System
p.24
1.  The income tax is a “voluntary” self-assessment regime. It is the
taxpayer’s obligation to submit the information, prove the
amount that is due, and to properly pay their tax.
2.  The IRS is there to help the taxpayer understand their obligation
and to verify that the taxpayer did comply with their obligations.
22 Penalties for Noncompliance
p.26
Penalties Apply for Failure to File or Pay the Right Amount of Tax
1.  Negligence (reckless & intentional): 20% penalty regardless of
amount of underpayment.
2.  Substantial Understatement: 20% penalty for underpayment that
is greater than $5,000 or 10% of the proper tax amount.
A.  Exception #1: Reasonable Cause. Taxpayer is not subject to a
penalty if they have “substantial authority” for a position.
B.  Exception #2: Adequate disclosure of the position on return
plus a “reasonable basis.”
3.  Failure to file penalty. 5% per month up to 25% of deficiency.
4.  Interest for late payment.
5.  Civil Fraud: 75% penalty.
6.  Criminal Tax Evasion: Not more than $100,000 and 5 years in
prison
23 Opinion Practice
p.27
Opinion Levels
1.  “Reasonable Basis” (15% to 30% chance of success)
2.  “Substantial Authority” (30% to 50% chance of success)
3.  “More Likely Than Not” (more than 50%)
4.  “Should” Prevail (more than 70%)
Tax opinions are regulated by the IRS in Circular 230 that sets forth
criteria for professional quality and care in the opinion.
24 Tax Terminology
1) 
p.31
Taxable Income: This is the “base” on which we calculate the
tax due. How we get there:
Step One:
Start with Gross
Income defined in §61
Step Two:
Deductions (set forth in §62) from Gross Income to
arrive at Adjusted
Step Three:
Gross Income.
Deductions (personal exemptions plus either standard
deduction or itemized deductions) to arrive at Taxable
Income.
Taxes are computed on Taxable Income to
derive tentative tax due.
Step Four:
Credits and minimum tax computations to derive final
Tax Payable.
25 Capital Gain and Dividend
p.33
1) 
A tax rate preference for much of our history has existed for
certain “capital gains.”
2) 
Thus, we need to categorize whether income is from a sale or
exchange of a capital asset or if it is “ordinary income.” We will
cover this character question in Chapter 8.
26 Timing Issues
1) 
2) 
3) 
p.34
Tax Accounting Methods
A.  Cash Method.
Exception: Capital Expenditures
B.  Accrual Method
C.  Regardless of method, the tax period is typically an
annual accounting period. Issue: transactional
consistency versus annual reporting.
Timing of Income Recognition: governed by when income is
realized and when it must be recognized. A realized gain is
generally recognized for tax purposes. When is a gain realized?
When is a realized gain not recognized? These are Chapter 3
concepts.
Timing of Deductions (Cost recovery, depreciation, basis).
These are Chapter 6 questions.
27 Whose Income Is It?
p.36
1) 
Assignment of Income Issues. To preserve a progressive tax
system, we must have the right taxpayer report their income
and not have it deflected to others at lower rates.
2) 
Deflecting income to business entities (corporations/
partnerships), trusts, or to family members to be reported as the
income of others is a Chapter 7 issue.
28 New BigLaw Associates to Spend First Month in B-School
WSJ Law Blog, Trendy New Perk (or Punishment?) for Law Firm Junior Lawyers
Debevoise & Plimpton’s presiding partner Michael Blair announced internally that the 675lawyer firm has arranged for a group of 23 incoming associates to participate in a program
developed by Fullbridge, a year-old company co-founded by two Harvard MBA graduates.
The associates from its New York and London offices arriving at the firm September 12 will
participate in the program full-time over their first four weeks at the firm, Mr. Blair said in an
email to the firm. The program will be a pilot this year, he noted.
The Fullbridge program, which combines an online format with individualized coaching and
group projects, aims to teach the junior lawyers financial and accounting concepts, including
how to read balance sheets and analyze financial statements, as well as how to spot and
resolve business problems in case studies.
They’ll also learn practical skills which many law schools don’t teach, such as creating powerpoint presentations and computer spreadsheets. Those skills can come in handy when junior
lawyers are calculating damages or compiling facts for investigations or litigation, Debevoise
says.
Skadden, Arps, Slate, Meagher & Flom in January rolled out a training program for its
associates though Fullbridge, according to Carol Sprague, the law firm’s director of associate
and alumni relations and attorney recruiting. Fullbridge will run a second program for all 100
or so of Skadden’s fall associates in its U.S. offices, she said. The fall Fullbridge program will
take place over the course of four weeks.
29 TIME VALUE OF MONEY
Pay Tax Today or Tomorrow?
p.37-40
What is the importance of the “time value of money” concept?
Dollars that are invested will give a return over time. It follows
then that a dollar received early is worth more than a dollar
received later. The earlier dollar will grow to be worth more than
a dollar received later.
It follows also that dollars received at different times do not have
the same real meaning (even if there were no inflation). They are
like apples and oranges. Dollars received or paid at different times
cannot be compared or netted as if they were the same.
How is this done?
30 TIME VALUE OF MONEY
Pay Tax Today or Tomorrow?
p.37-40
Dollars received or paid at different times can not be compared
or netted as if they were the same.
•  One must first “translate” the earlier dollar into what it
would be worth later.
•  Alternatively, one must translate the later dollar into its
equivalent at the earlier time. Dollars payable at different
times are translated into either a “future value” or a
“present value” before they are compared. Financial
analysis only insists on translation to a single time. Dollars
received earlier than the point of comparison must be
translated forward by taking into account the compound
growth that is available; dollars received later than the point
of comparison must be translated back by “discounting.”
31 TIME VALUE OF MONEY
Future Value Concepts
p.37-40
Example: $100 dollars at Year Zero with a 10% interest market
rate has the following equivalent values depending on the date
(assuming no taxes for the moment)
$110
Year 1
$121
$133
Year 2
Year 3
$100
Year 0
Conclusion: If I can defer paying a $100 tax until Year 3, I will pay
the $100 and have an extra $32 to keep. In real terms, I have used
the government’s money to earn $32 to apply against my tax bill.
32 TIME VALUE OF MONEY
Future Value Concepts
$110
Year 1
$121
$133
Year 2
Year 3
p.37-40
$100
Year 0
Although the above picture shows the principle graphically, we can
also express this concept mathmatically as follows:
P * (1+r)
n
where r is the interest rate and n is the periods
100 * (1+10%)
100 * (1.1)
3
3
100 * (1.331) = 133.1
33 TIME VALUE OF MONEY
Present Value Concepts
p.37-40
“Discounting” or present value calculations are just the inverse of
compound growth calculations.
•  The present value of a future value is the amount that will
grow to equal this future value amount at given compound
growth rates. The present value answers the question of how
much must I put into an account if I need to have the future
value by the end of n periods.
•  If, for instance, I need $133 in 3 years and get 10% tax
exempt in my best investment, I can calculate that I must put
$100 aside now: $100 will grow to equal $133 by the end of three
years. So $133 in three years is like $100 now.
34 TIME VALUE OF MONEY
Present Value Concepts
p.37-40
I can demonstrate that $100 is the present value equivalent of $133
from Year 3 pictorially as follows:
$110
Year 1
$121
$133
Year 2
Year 3
$100
Year 0
Or, I can express the same idea mathmatically for a future value of A
as follows:
PV=
A
since 133
= 133 =
n
3
3
(1+r)
(1+10%)
(1.1)
133
=
1.331
100
35 TIME VALUE OF MONEY
p.37-40
How Financial Concepts Turn the World Around
Why does any of this matter?
Prove to me that it makes any real difference?
Okay, stay with me on this and let’s look at a simple example.
36 TIME VALUE OF MONEY
p.37-40
How Financial Concepts Turn the World Around
An investor is given a choice of the following three investments
expressed in red numbers that provide cash flow in black
numbers.
Year 0
Year 1
Year 2
Year 3
A
($100)
$0
$20
$0
B
($100)
$40
$40
$40
C
($30)
$55
$20
$20
Year 4
Year 5
$110
($70)
Which investment has the highest accounting profit?
37 TIME VALUE OF MONEY
p.37-40
How Financial Concepts Turn the World Around
An investor is given a choice of the following three investments.
Year 0
Year 1
Year 2
Year 3
A
($100)
$0
$20
$0
B
($100)
$40
$40
$40
C
($30)
$55
$20
$20
Year 4
Year 5
$110
($70)
Which investment has the highest accounting profit?
Answer:
A= $30 profits
B= $20 profits
C=($5) loss
38 TIME VALUE OF MONEY
p.37-40
How Financial Concepts Turn the World Around
An investor is given a choice of the following three investments.
Year 0
Year 1
Year 2
Year 3
A
($100)
$0
$20
$0
B
($100)
$40
$40
$40
C
($30)
$55
$20
$20
Year 4
Year 5
$110
($70)
What choice has the highest net present value assuming a 5%
discount rate?
39 TIME VALUE OF MONEY
p.37-40
How Financial Concepts Turn the World Around
An investor is given a choice of the following three investments.
Year 0
Year 1
Year 2
Year 3
Year 4
Year 5
A ($100)
$0
$20
$0
$110
B ($100)
$40
$40
$40
C
($30)
$55
$20
$20
($70)
What is the net present value of each investment assuming a 5%
hurdle rate? Answer:
NPV @ 5% Year 0 Year 1 Year 2 Year 3 Year 4 Year 5
A
$4.33 ($100)
$0
$20
$0
B
$8.93 ($100)
$40
$40
$40
C
$0.21
$55
$20
$20
($30)
$110
($70)
40 TIME VALUE OF MONEY
p.37-40
How Financial Concepts Turn the World Around
An investor is given a choice of the following three investments.
Year 0
Year 1
Year 2
Year 3
A
($100)
$0
$20
$0
B
($100)
$40
$40
$40
C
($30)
$55
$20
$20
Year 4
Year 5
$110
($70)
Which investment has the highest internal rate of return?
41 TIME VALUE OF MONEY
p.37-40
How Financial Concepts Turn the World Around
An investor is given a choice of the following three investments.
Year 0
Year 1
Year 2
Year 3
A
($100)
$0
$20
$0
B
($100)
$40
$40
$40
Year 4
Year 5
$110
C
($30)
$55
$20
$20
($70)
What is the internal rate of return of each investment? Answer:
IRR Year 0 Year 1 Year 2 Year 3 Year 4 Year 5
A
7% ($100)
$0
$20
$0
B
10% ($100)
$40
$40
$40
$55
$20
$20
C
5%
($30)
$110
($70)
42 TIME VALUE OF MONEY
p.37-40
How Financial Concepts Turn the World Around
An investor is given a choice of the following three investments.
Year 0
Year 1
Year 2
Year 3
A
($100)
$0
$20
$0
B
($100)
$40
$40
$40
C
($30)
$55
$20
$20
Year 4
Year 5
$110
($70)
What is the result assuming a 10% hurdle rate
43 TIME VALUE OF MONEY
p.37-40
How Financial Concepts Turn the World Around
An investor is given a choice of the following three investments.
Year 0 Year 1 Year 2 Year 3 Year 4 Year 5
A
($100)
$0
$20
$0
$110
B ($100)
$40
$40
$40
C
($30)
$55
$20
$20
($70)
What is the result assuming a 10% hurdle rate?
Answer:
NPV @
10% Year 0 Year 1 Year 2 Year 3 Year 4 Year 5
A
($15.17) ($100)
$0
$20
$0
$110
B
($0.53) ($100)
$40
$40
$40
C
$3.75 ($30)
$55
$20
$20 ($70)
44 Relevancy of Time Value of Money Tax Law p.37-40
Implication: Timing matters greatly. We are not striving to make
you financial planners in this class. We will leave that to the
business school, but lawyers need to understand what makes
deferral a financial benefit.
Tax lawyers must be sensitive to time value of money issues to
understand whether a case is being decided correctly or wrongly.
Without knowing these concepts and without a grasp of the HaigSimon ideal, you are at sea without a compass.
Tax laws that can achieve tax deferral for clients provide an
enormous value to their clients.
45 Relevancy of Time Value of Money Tax Law p.37-40
Let’s think about it another way:
Suppose I told you that I could provide you the equivalent of a
tax-free profit regardless of your investment. Does that sound
too good to be true?
46 Cary Brown Thesis
An immediate deduction for the cost of a capital asset, which is often
called expensing, can produce the same results as exempting the
income produced by the asset under certain conditions, including the
assumption that tax rates remain the same. Under that assumption,
the equivalence between exemption and expensing holds because the
tax savings from the deduction, if reinvested in comparable assets,
will fully fund future tax liabilities on income produced by the
investment
See E. Cary Brown, Business Income Taxation and Investment
Incentives, in INCOME, EMPLOYMENT AND PUBLIC POLICY:
ESSAYS IN HONOR OF ALVIN H. HANSEN 300, 309-10 (1948),
reprinted in THE AMERICAN ECONOMICS ASSOCIATION,
READINGS IN THE ECONOMICS OF TAXATION 525 (Richard
A. Musgrave & Carl S. Shoup eds., 1959).
47 Cary Brown Thesis
Cary Brown Thesis Proven
-------------------------------------------------------------------------------------------------------(B)
(A)
Soft Money
Capitalized
Expensed or
Investment
Excluded
-------------------------------------------------------------------------------------------------------1. Income at $100
2. Tax on row 1 at 33 percent
3. Investable amount (row 1 - row 2)
4. Investment (row 3) triples
5. Basis
6. Taxable amount
7. Tax at one-third of row 6
8. End result (row 4 - row 7)
$100
-$35
$65
$195
$65
$130
Tax exempt
$195
$100
$0
$100
$300
$0
$300
-$105
$195
48 Cary Brown Thesis
Soft Money Investing
What is the value of deferring tax on $1,000 for 5 years?
Assume the tax rate is 35% and that the investment will grow 10% per
year for 5 years when the tax deferral is ended.
49 Cary Brown Thesis
Soft Money Investing
What is the value of deferring tax on $1,000 for 5 years?
Answer: The ability to earn a return on the government’s tax money
will pay for the tax on profits for the taxpayer’s original investment.
Year 0 Growth
Year 1 Growth
Year 2 Growth
Year 3 Growth
Year 4 Growth
Year 5
(a) Post-Tax
650
1.10
715
1.10
786
1.10
865
1.10
952
1.10
1047
(b) Soft Money
350
1.10
385
1.10
424
1.10
466
1.10
512
1.10
564
1000
1.10
1100
1.10
1210
1.10
1331
1.10
1464
1.10
1611
(a+b) Total
Proof: 1611 x 35% = 564
50 Cary Brown Thesis
Soft Money Investing
The ability to deduct an investment immediately or to do the
equivalent by the taxation on income in order to make an
investment with this pre-tax amount is called "soft money
investing.“ This concept is routine to tax economics but is not
commonly evident in statutory or judicial decision-making. The
effect of “soft money investing” is that taxpayers are given tax-free
treatment on the return related to their after-tax equivalent
amount.
Many people would object to giving tax-free income to certain
types of investment activities, but failing to recognize that tax
deferral creates the equivalent of that result is a fundamental
conceptual mistake that will get you into trouble.
51 Federal Taxation
Is A Statutory Based Set of Laws
1) 
p.40
Primary source of law - The Internal Revenue Code (Title
26 of the United States Code) (assuming authority under
U.S. Constitution).
Legislative History: Committee Reports (Senate
Finance, House Ways & Means Committee,
Conference Report, and the staff of the Joint
Committee on Taxation
52 IRS Responsibilities
p.41
2)  Administrative law is pronounced by the Internal Revenue
Service (part of the U.S. Treasury Dept.) through regulations
and other pronouncements.
Acquiescence by IRS to Tax Court decisions
IRS Revenue Rulings (Rev. Rul.)
IRS Revenue Procedures (Rev. Proc.)
IRS Notices
IRS Private Letter Rulings (PLRs)
Technical Advice Memoranda (TAM)
Closing Agreements
IRS Determination Letters
IRS is responsible for the enforcement of tax laws, including tax
reporting, collection and litigation
53 Tax Litigation –
Judicial Review -
p.42
2)  Resolution of disputes through the IRS administrative appeals
process and then ultimately by the U.S. Courts, including the
United States Tax Court (an Article 1, not Article 3, court).
A.  U.S. Tax Court petition after a “90 day letter” received
from IRS.
B.  Refund litigation:
U.S. District Court
U.S. Court of Federal Claims
Forum shopping opportunities?
C.  Appeals to a U.S. Courts of Appeals. What if a “split” in
the Circuits? What impact of the Golsen case?
D.  U.S. Supreme Court as the final arbiter.
54