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University of Illinois School of Law
Kaplan, Richard L.

I.    What Type of Income? Unlike the 3 previous questions, this is a superfluous question, causing unnecessary complications.
A. Capital Gains is the single most unnecessary complication in the tax code – there is no inherent reason to have special treatment of capital gains.
1.   Look at the state income tax, 5 out of 6 have no special tax preference for CG; it is taxed the same as ordinary income, making it simpler and easier.
2.   There was no special tax treatment for CG during Reagan presidency. He felt the government shouldn’t pick the winners/losers, approx 1987-1997.
3.   Fallacy –ordinary people think they will have a benefit even though their money is in retirement plans (401K, IRA). There is no special treatment for retirement plans – when it comes out it is treated as ordinary income. 
B.   3 Structural Preferences given to CG:
1.   DEFERRAL – not taxed until T realizes the gain by authorizing some sort of transaction. T can choose when or if to sell at all or to exchange it. 
2.   STEP UP BASIS – (Gigantic benefit) – ability of humanoid T (not corporation) to hold the asset until (s)he dies and the basis is stepped up, 1014(a) and no capital gains tax is imposed on anyone. No matter how low the rate is legislated to be, it will never be as tempting to T to hold on till the very end and taxed at zero.
      a.   Vast majority of CG is held until death – ¾. As a consequence, there’s a justification for     the estate tax since the vast majority of assets aren’t subject to income tax.
      b.   The real source of the lock-in is the step-up basis in death. If you’re really afraid that          people      locked in their assets, repeal 1014. Of course, lock-in isn’t a concern that you          should pay much attention to – generally doesn’t affect the flow of capital and no real       societal detriment.
3.   COMPLETE EXCLUSION FROM THE PAYROLL TAX. Social security tax and Medicare tax does not apply to CG. This is the equivalent to a 15% differential between wages on one hand and CG on another.
      a.   So when people can change their compensation to stock, they’re trying to shift their wages to stock for the favorable treatment of CG.
      b.   This is why Warren Buffet pays the lowest tax in his company even including the     secretaries.
C.   Inflation: CGs held for over 12 months are said to be given a preferential rate b/c of inflation. Most are taxed at a maximum rate of 15%, though there are a bunch of sub-rates. If inflation is the justification, inflation affects all income and there should be a sliding scale as time increases.
II.   What is a Capital Asset?
A.     § 1221(a) – A capital asset is “property held by the taxpayer (whether or not in connection with his trade or business)” except for property falling into one of 8 categories. See page 583 of the supplement.
B.     Hold period – there is no benefit for short term CG, all of the benefits are long-term assets. § 1222 – long term means more than 1 year. In most cases this is pretty straight forward, look at date asset was bought and sold. But there are always complications:
1.       see §1223(2) – donor’s holding period will be tacked onto donee.
2.      § 1223(9) – if people have inherited property than it’s long term, period. We don’t worry about how long decedent held it for, as long as § 1014 applies, it’s treated as long-term, wink*wink*.
·         Meaning if decedent bought it weeks before she died and then left it to you, it will be treated as long-term. Don’t have to do any computation of holding period.
C.     Extremely critical issue, the single most litigated issue is whether an item is a capital asset. 
D.     Flagrant violation of horizontal equity. Anyone who receives income from CG pays less tax than those who receive comparable amount in wages and salary. § 1(a) –any wage earner pays a higher federal tax than the richest Rockefeller or basketball player.
E.      Why do we tolerate this? 3 factors have been identified which seem to give CG a different quality than income.
1.   Disposition of a capital asset may involve only a continuation of an investment in a different form.
2.   Gain said to be realized may merely or largely reflect only changes in the overall price structure.
·         CG are paid in current dollars, the same inflated currency that is being used to calibrate CG – so there’s no rationale for CG.
·         Most CG are not inflationary but represent largely short-term dispositions. 44% of all CG assets are only held 1-2 years. ¾ of all CG’s are held for less than 4 years. Thus, we don’t need an inflation adjustment.
3.   Gain may have been some time in the making, raising the question of whether it is fair to bunch it into a single taxable year with possible attending tax attrition through progressive rate tables.
·         If bunching was really the concern, than lets tax it as it accrues, which we do in certain markets, thus we already have a mechanism in the code.   There’s a liquidity issue but we can always borrow against it.
F.      Considerations.
1.      Accuracy – If CG’s are supposed to compensate for the asset being held for a long time, why does § 1222 make the demarcation at 12 months? If you believe in the erosion of inflation , inflation has an impact over 12 years, rather than 12 months. If this was really an inflation issue, we’d have a stratified tax preference through an exclusion or lower rate. Also, adjust the basis of the asset by an inflation index.
·         Wall Street investment firms lobbied hard against inflation adjustment for assets claiming they don’t want people to have a tax incentive to hold assets for a long time.
2.   Fairness – Let’s say you’re working at a law firm and you’re given a 5% raise, than you see a newspaper showing that the cost of living is up 5%. You haven’t progressed. Nevertheless the 5% raise is subject to income tax and may or may not put you in a higher tax bracket. Inflation affects everything, why does CG get an extra benefit?
3.   Preferential Treatment of CG – it is in the top 10 of all revenue losers. Thus, we pay in other tax ways because of this preference.
4.   Huge Cost in Terms of Complexity.   The retained dichotomy of ordinary income and CG with preferential treatment for CG has one major disadvantage à Thwarts congressional objective of tax simplification.
a.   By treating CG as the same as income, this would be fairer and more neutral with business decisions being based on economic merit.
b.   What lawmakers are advocating is greater complexity, more involvement of lawyers, and far greater problems with compliance.
III, Whether a Gain or Loss is subject to special treatment as “Capital” as opposed to ordinary income usually is dependent upon whether
(1)   It arises in a transaction involving a “capital asset,”
(2)   Whether the capital asset has been the subject of a sale or exchange, and
(3)   How long the T has held the asset
A.     Note T preference in characterization: thus taxpayers generally prefer to characterize income as capital and loss as ordinary.
B.     IRA’s and 401K’s: earning from these are always taxed as ordinary income.
C.     Corporations rule 1212(a):Corporations may deduct capital losses realized during a taxable year only to the extent of their capital gain during the year. Losses that cannot be deducted because of this limitation are called “net capital losses” and carry back to the previous three taxable years and forward to the following 5 taxable years.
D.     Capital Gains
                              1.            Requires at a bare minimum an additional computation. The more classifications, that means additional computations.
a.   Creates the potential for category shifting meaning the IRS monitors it & more complexity
b.   CG preference has virtually no informational content so can’t operate to change behavior since most people don’t know what CG rate applies.
c.   Structural preference for deferral means that there needs to be limitations on capital losses.
d.   Short term and Long term must be segregated.
e.   $3,000 loss limitation is not affected by marital status, thus married Jack & Jill can only deduct $3K à embedded marriage penalty.
                              2.            Short-term capital gain: There is no tax benefit for short-term capital gain, except it can absorb capital loss w/o limitation.
                              3.            Long-term capital gain: Capital investments for greater than 12 months shall be given special treatment.   People in the lowest 2 tax brackets are taxed at a rate of 0%. People in the remaining 4 tax brackets are taxed at a rate of 15%.
a.   Rule, inheritance: income inherited from a decedent will always be considered long term, regardless of the amount of time it has actually been held.
b.   Rule, gift: If the capital asset is given as an intercedent gift the period carries over from donor to donee.
                              4.            Special rule for Collectibles and §1202 stock: collectibles and 1202 stock is taxed at the same rate as ordinary income, but is capped at 28%. 
·         Note: Thus, a T receives no benefit from gain from these types of investments unless she is in the top 2 tax brackets.
·         If T is in the 25% tax bracket, T will be taxed at 25% for the collectible, not 28%, T gets the benefit of the lower rate.
                              5.            Depreciable Realty: there is no benefit for lower 3 brackets, but there is for the upper 3 brackets.
                              6.            Lo

l exercised by T over representatives selling the property 7) Time and effort T habitually devotes to sales.
d.   The weight of each of these factors is unclear though #3 is always important.
e.   Strategies for avoiding dealer status is difficult to formulate – reconciliation of the cases is fruitless. “I don’t know and no one else in town can tell you.”
II.   Interpretation of “Primarily.” Rule: To determine if property is held as inventory, ask whether it is principally held for sale to customers in the ordinary course of business.
A.     Malat v. Riddell. P acquired a 45 acre parcel of land as part of a joint venture. P contends it was to operate an apartment complex while respondent claims that it was for “dual purpose” of developing for rental or selling, whichever was more profitable. When P couldn’t obtain the financing, he and his partners subdivided and sold portions of the parcel ,and it was reported as ordinary income. P then decided to terminate the joint venture and sell his interest, claiming a CG on the sale. Commsnr claimed that since P had a dual purpose and falls within the 1221(1) exception, precluding treatment as CG.
Issue: Is “primarily” as used in § 1221 (1) meant to mean a “substantial” purpose as the Commissioner contends?
            Held: No.
1.   The words of the statutes should be interpreted in their ordinary, everyday senses. Departure from a literal reading may be indicated by relevant internal evidence of the statute itself and necessary to effect the legislative purpose.
2.   The purpose of the statutory provision is to differentiate between the “profits and losses arising from the everyday operation of a business” and “the realization of appreciation in value accrued over a substantial period of time.”
3.   “Primarily” means “of first importance” or “principally.”
B.    Biefeldt v. Commsn’r.    T claims that he was not a trader but a dealer in US Treasury notes and therefore wants the losses that he incurred in the sale of the securities to be connected with his dealer’s “stock in trade” so that his losses would be treated as ordinary rather than capital losses and can therefore be fully offset against ordinary income Thus, entitling him to an $85 million refund. 
        Issue: Is T a dealer in securities which would qualify his sales as ordinary income and not as sales of a capital asset? T was not a dealer.
1.      The rationale of the statute is relied on by the courts – legislative purpose.
2.      Distinction – dealer’s income is based on the service he provides in the chain of distribution of the goods he buys and sells (he’s in the market everyday b/c that’s his job). Trader’s income is based not on any service he provides bur rather on fluctuations in the market value.
3.      Treasury securities are not sold on an organized exchanged and so there are no floor specialist. It’s an over the counter market. Dealers who specialize in Treasury securities are registered, with some exceptions, with the SEC. Unlike a floor specialist, T undertook no obligation to maintain an orderly market in Treasury securities; did not maintain an inventory of securities; and he skipped auctions that didn’t seem likely to produce the glut that was the basis of his speculative profits.
4.      Note, Investors, traders, dealers: When dealing with securities whether they are considered capital asset or ordinary income depends on whether they were held primarily for sale to customers in the ordinary course of business.
5.      NOTE: real estate is not a capital asset if you are a real estate dealer, stock is not a capital asset if you are a stockbroker.   The key is the relationship of the asset to the taxpayer. § 1221(a)(1). There is nothing that is a capital asset in nature, it’s an artificial construct, dependent on who is owning it at the specific time.